Thursday, July 10, 2014

Should I invest in my excess cash into my start-up or use it build up my stock portfolio ?

A friend who attended my talk was having a discussion with me yesterday, he mentioned in passing that one of the Zopim founders actually attended my session and actually interacted with me on my talk. And I was going WOW ! It was such a great honour that someone who is part of an exit of such historical scale would be able to attend my session.

Anyway, my friend also expressed disappointment that in the Temple of Startup Capitalism, no one asked me a challenging question which we sort of "prepared" in case someone were to raise it during my talk.

And the question is : If I had money, should I invest in my start-up to make it grow or should I invest it into a portfolio different asset classes ?

I'm going to present, in my view, an answer to this question. 

To answer this question, we will need to look at the notion of human capital as proposed by Economics Nobel Prize winner Gary Becker. Human capital can be seen as a sum total of your unearned income. This is contrasted with your financial capital, capital which has already been earned, which is an asset in your bank, real estate or CDP account.  

Human capital is a vital part of your wealth. It explains why venture capitalists have faith in you - they see you as a potential future profit. Your total wealth is, therefore, a sum total of your human capital and financial capital.

In light of this insight, we also realise that your human capital also has characteristics similar to stocks, bonds and commodities. A salesman or marketing professional with a salary tied to company performance can be said to have human capital which behaves like stock equity. It goes up and down based on company profits. A civil servant has a salary very much like a bond. It is predictable with not much upside or downside.

So let's examine what happens when you found a start-up company. Assuming it has only had seed funding, your start-up has yet to produce any profit. Your profits are in the far future, it has to receive more funding and complete product development before profits will only start rolling. i.e. The closest asset class your human capital will look like is an equity option ! Your human capital provides you a minimal profit but can potentially give you a huge upside. 

Now let's move on to another insight this time from Moshe Milevsky. Moshe proposes that diversification of assets should also account for human capital. Another words, a salesman with human capital which behaves like an equity should look to a higher proportion of bonds in his financial portfolio. A civil servant can buy more equities to improve his upside.

So let's get back to our founder who wants to determine where he should invest his money. 

If your human capital acts as a derivative instrument like a stock option, the answer is clear, the prudent option would be to invest your money in a more conservative asset like bonds or various income yielding instruments. 

Of course, a host of non-finance related concerns if you accept my suggestions without question. If a founder refuses to invest their cash in their own businesses, would it signal the lack of commitment to their ideas ? Would their motivation be reduced if that occurs ? What if the funding is crucial for the company to complete their first product just to start turning into a profit ?

I don't have an answer to these concerns. 

The existence of VCs in an ecosystem is to rally high net worth investors to take on such risks. Private equity has historically performed well for investors even though many business fail on an individual basis. 

A savvy founder should trust the VC to fund his business to make it work. If it means loss of some equity, so be it. Therefore, I still think it prudent to look after own welfare by prudent diversification of human and financial capital assets. 








3 comments:

  1. Hi there. I've been an ardent follower of your blog since the start of the year and would like to pay my compliments to your beliefs, the contrarian approach and more importantly, actions that you have undertaken and the effort put in to maintain this communication channel in order to share your thoughts.

    By way of introduction, I'm in my late twenties who was fortunate enough to start the rat race in investment banking (corporate finance) in Singapore, and have been running that same wheel for close to 5 years or so. We share common ground on quite a number of topics, such as a career or the lack thereof, money, etc.

    My simple and most humble opinion of the question posed for a 20 something year old dude would be to invest the excess cash in the avenue that would produce the highest yield in order to attain financial freedom.

    The quantum required in order to achieve that would vary with circumstances. Some would require S$500k, some would require S$3m. But once you have amassed that amount of cash, and if you have a basic enough understanding of investing, having a yield of 2-5% would possibly be attainable and possibly safe, subject to your lifestyle needs.

    And once you have managed to do that, one could been deemed to have won the capitalist game. He can then undertake various endeavours, such as starting a new business, doing jackshit, or even undertake continuing education such as yourself.

    Just some thoughts.

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  2. Wow ! Thanks for the kind words !

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