In a post last week I mentioned that we were going to share with you our stand-out favourite emerging market this week. Our humble apologies but its still in the oven so instead we’ll be detailing it next week. 

In my last post I discussed how ego affects our personal decisions. I’d like to follow on from this theme as it applies to more than just our own perspective on life but if we understand the phenomenon correctly we are able to apply this to our dealing with others, which in my world typically means investing, managing capital, creating businesses, and everything in between.

In the early 2000’s I was on the hunt for some residential real estate in NZ. Simple 3 bedroom homes in mid range neighborhoods that I could rent out for a +14% yield. Yeah things were that good! I came across a particular property which fit my criteria. I negotiated the price down a few thousand dollars and was conducting my due diligence to ensure the property was sound when I found out that an almost identical property down the road had just sold for $132,000. I had negotiated a price of $143,000. Mmm… Now I was determined that I could get the same or a better deal on the property I was intending on purchasing. I wanted what the “other guy” managed to get, never mind the fact that real estate is highly illiquid and that the guy down the road was not even in competition with me. He almost certainly was unaware I was trolling through the details of his purchase.

Long story short I did not follow through with the purchase even though it met all my criteria. What the hell was I thinking? Seriously someone must have put something in the drugs. I will NEVER make such a stupid mistake again. How many times have you valued a company and decided to buy it when the share price suddenly jumps 10%? Now you would, under any rational basis still buy the company stock at the new price but something holds you back. You know it traded just 10% lower a few weeks prior so you decide not to get in. “I want it cheaper…it was there recently it’ll come back for me”…Says who?

I’ve watched my own children fight over the last piece of dry bread, which ironically neither of them actually wants. I still have visions of my own mother sharing out equally arbitrary things like a glass of juice amongst myself and siblings. We would line the glasses up next to each other comparing them with military precision and complain bitterly if there was a nano cm difference in liquid levels. Insane? You bet. Human nature? You bet.

What do the above stories have to do with investing and structuring deals?

I mentioned in the previous article how a friend had sought my ear on the structuring of a business deal. To refresh your memory, the financier in the deal, after learning what his % ownership relative to others in the company was, walked from the deal. Someone else got more juice than him. An intellectual tantrum.

We can easily criticize this behavior but probably the only thing worthy of criticism would be the lack of DD conducted by the financier. To be blindsided by realizing the structure of the company is unforgivable.  Rather than dealing with the lack of DD conducted lets focus on acknowledging the human flaw of ego related to hierarchical status and seeing how to better negotiate in a situation such as this.

OK Chris what do you propose then?

Indulge me for a minute and consider yourself in the position of being a financier of a company and I, the CEO.

First scenario

You and I have agreed in principal that you will provide a cash injection for a 15% equity stake in the business and a return of 15% of gross profits. The business cannot function at present without your capital and I have had difficulty in finding any financiers.

You were under the incorrect assumption that my stake in the business was 15% like you but then learn that my stake in the business amounts to 55% of equity and 55% of gross profits.

How do you feel?

Second scenario:

My stake in the business stays the same however I offer you the following:

A 15% equity stake in the business with 15% of gross profits, a seat on the board, and the title of executive VP of strategy complete with business cards and mobile phone.

How do you feel?

Note: Given that you now have a seat on the board it is entirely possible for me to structure the shareholders agreement to ensure that important decisions go to a shareholders vote and NOT a board vote rendering the board seat of little importance.

Human emotion drives people to the latter arrangement while it’s actually less beneficial for the investor and not more.

Why?

Because there are liabilities that go with the latter which do not come with the former. I personally don’t like Directorships due to the liabilities that exist and frankly if I’m investing in the early stages of a business I can ensure that the shareholders agreement is structured to provide me with the same, or greater control than I would obtain through a seat on the board or a directorship. As for the mobile phone, I’ll pass, for all I know they give you cancer anyway!

Whether you’re an investor providing capital to business, or an entrepreneur raising capital you’re likely to come across this psychology and understanding what we are driven by and why we make the decisions we make can be extremely useful.

Chris

“A lot of people become pessimists from financing optimists.” — C.T. Jones