Can Prospect Theory Explain High Start-up Valuations?

Human beings are not particularly good at thinking about probabilities. The last several decades of research in psychology and behavioral economics have unearthed an array of cognitive biases in how we reason about uncertain events. For example, we are prone to misinterpret the results of diagnostic tests, by failing to account for the base rate of a disease in the population. This has enormous implications in the medical field, and may be leading us to over-diagnose and over-prescribe treatments for a variety of illnesses.

One of the foundational theories in behavioral economics is prospect theory, formulated by Daniel Kahneman and Amos Tversky. This theory is most well known for the observation that humans interpret losses as more consequential than gains of the same magnitude. Thus, simply changing the framing of a decision from a ‘gain frame’ to a ‘loss frame’ can make people much more averse to taking risks. In this blog post I want to focus on another prong of prospect theory: the over-weighting of rare events.

Prospect theory suggests—and experimental evidence supports—the idea that people ‘filter’ probabilities: we act as though very low probability events are more likely than they really are (and as though high probability events are less likely than they really are). This helps explain why people fret so much over low probability dangers such as shark attacks and ignore more mundane risks such as accidental falls. It also helps explain why people gamble money on lotteries even when the odds of winning are very slim, and the expected return is negative.

What has this got to do with valuing a start-up? The conventional way to value a company is to make a forecast of its future cash flows, then discount these back to find the ‘net present value’ of its future income. Alternatively, as a heuristic we can apply a multiplier to its earnings based on accepted valuations of other companies. Neither of these works for an emerging venture with a novel business proposition (i.e. your typical Silicon Valley start-up). The future prospects of such a company are shrouded in uncertainty.

Instead of trying to establish the likely path of a given venture’s future cash flows, investors—usually venture capitalists—take a portfolio approach. They pick companies they think will have a chance at becoming massively successful, but realize that many will fail to do so. Each investment is a bit like a lottery ticket. In the classical VC portfolio model, roughly one investment in ten would need to exit at a blockbuster valuation for the overall fund to make a decent return on investment.

In the present wave of technology venture activity, three key things are being done differently to the past. First, the definition of a ‘massively successful exit’ has inflated: ventures now aspire to be ‘unicorns’ with a billion-dollar valuation. Second, investors are spreading their money out, investing in a larger number of ventures. This is most visibly true in accelerator programs, which provide large numbers of nascent ventures with seed funding and mentoring in return for a small equity stake: they explicitly rely on a scattershot approach. Instead of a VC picking ten investments and hoping for two or three large exits, the accelerator approach is to invest in a hundred startup teams and hope for one unicorn. Third, more ventures are staying private for longer, rather than go public through an IPO. As described in this FT article, this allows them to effectively manage their headline valuation figure by giving new investors guaranteed financial returns (risking, in the process, the equity of preceding investors). This prevents negative opinions of the venture’s prospects from being incorporated in its valuation.

And so we have a perfect storm in which valuations are based on someone’s estimate that a given venture will become a unicorn, and—according to prospect theory—they are biased to overestimate how likely this is. For every thousand startups, maybe one of them will be hugely successful, but all of them might be valued as if they have a one-in-a-hundred chance of this success. This is a problem. More fundamentally, we are dealing with such small probabilities that we can easily get them very wrong.

Earlier in the year I considered a few possible mechanisms by which a hypothetical technology bubble might burst. Here, I’ve described one psychological factor that might be behind high startup valuations in the first place. It’s also worth noting that prospect theory can explain rapid changes in investor sentiment. If prices start falling—for example if a bubble shows signs of bursting—investors can switch from a gain mindset to a loss mindset, and immediately become much more risk averse. I hope this doesn’t happen, because the present wave of entrepreneurial activity is generating a lot of innovation. But a wise investor or entrepreneur should be aware that the tide might turn in the near future, and plan accordingly—or risk getting swept away when it does.

Will the Circular Economy be dominated by entrepreneurs or big business?

Two of the big environmental problems that exist today – the high amount of waste we produce, and the vast amount of raw materials we consume – would appear to have a fairly straightforward, complementary solution. We need to re-use more stuff.

While this is easy to say, it is not so easy to do. Our products were not designed with re-use in mind. With a few exceptions, it is normally more profitable to let people throw away the old so they can purchase something new. Dismantling an old product to re-use the materials is often more costly than getting fresh raw materials for your manufacturing process.

Having said this, recycling of raw materials has become ever more prevalent due to a mixture of legislation and rising commodity prices. But environmentalists have long argued that we need to take matters to another level: instead of decomposing waste into raw materials that resemble our current commodity feedstock, why not design products in such a way that at the end of their lives they can be dismantled and the components re-used without extensive materials processing.

For example, you might want to dispose of a bicycle once the seat and gear mechanisms are worn out. On the one hand, you might take it to the tip, where the steel frame would be used as scrap to help manufacture fresh steel, and the rest would end up in landfill. On the other hand you might give it to a small business which would overhaul the bike, fitting a new seat, a new gear mechanism, giving it a new lick of paint, and then selling it on. In a world where raw materials and landfill space are increasingly scarce, it makes send to do the latter – and this is what the hypothetical ‘Circular Economy’ is all about.

Last week’s New Scientist contained a small but notable article highlighting the publishing of two high profile reports into the potential of the Circular Economy. The reports are well worth a read in their own right, but the most important message is that the idea of the Circular Economy is gaining traction.

Over the next few decades, the Circular Economy has clear potential to be a disruptive force in almost every manufacturing industry. Big companies need to ask themselves where they will fit in the circular value chains of the future. If they don’t take a lead in the move towards ‘remanufacturing’, they risk allowing a new generation of industrial entrepreneurs get a head start. Economies of scale should give established businesses a clear advantage in moving towards a new economic paradigm. But organisational inertia – the natural preference for maintaining the status quo – could hold back companies even when some of their managers understand the need for change. It has happened many times before and it could happen again. For entrepreneurs there are valuable opportunities for building businesses with the circular economy in mind.

It will be fascinating to watch the transition to a more circular economy. I expect it to occur gradually, and it may not even be complete in my lifetime, but the next 10 to 20 years should begin to reveal who will be the winners and who will be the losers.

Next generation entrepreneurs: coupling the growth of emerging markets with business ideas from the West

How do you become a successful entrepreneur? Amongst the many answers to this question, one thing that undoubtedly helps is starting your business in a growing market. Nearly all of the biggest entrepreneurial success stories involve rapidly growing markets: think of Microsoft (founded 1975) and Apple (1976) growing in the 1980s Computing boom; Amazon (1994) and EBay (1995) in the 1990s eCommerce boom, and Skype (2003) and Facebook (2004) in the 2000s Social Networking boom. Success in tackling mature industries is much rarer, though not impossible as proved by Sir Richard Branson, whose Virgin group has had major successes in both the Retail and Airline industries.

Many growth markets (those growing over 20% p.a.) in the Western world are the result of technological innovation. Except when a new technology triggers a wave of entrepreneurial activity, most business in the West is done by old and well-established firms (which typically grow less than 10% p.a.). The business hierarchy and supply chain structure is well understood; most corporate strategies are honed and fairly constant, and winners and losers emerge over decades. As a result, success as an entrepreneur is, for the most part, limited to the tech-savvy.

In comparison, in emerging markets the economic order is in a state of flux. A whole host of industries which are mature in the West are still in the process of being formed. In many cases, there are no ‘old and well-established firms,’ with new entrants appearing regularly. The winners and losers in these markets are far from clear.

One particular opportunity is to introduce business ideas that have proved successful in the West but do not exist in the emerging market you are targeting. For example, the most popular search engine in China is Baidu, a company often seen as an imitating Google’s successful search functionality. Last year the FT published an article about a group of entrepreneurs in Shanghai setting up a bar with the ‘Cheers’ theme, taken from Western popular culture. To me these are both effective examples of ‘Cross Cultural Arbitrage,’ where the value-add is in transferring a business model from one locality to another. It doesn’t involve doing anything ground-breaking, but it can lead to strong success. It requires a familiarity with several cultures, which a growing proportion of young people are developing through an education that spans two or three continents. I expect to see a great deal more of these kinds of business success stories, a positive impact of ever-increasing globalization.

Debt free aged 73: How £9,000 tuition fees could be with you for life

I have plenty more to write about China, but I couldn’t let this week pass without commenting on the government’s proposal to cap University tuition fees at £9,000 instead of the current £3,290.

I have previously expressed concern that student loans create a damaging cycle of graduate debt, forcing graduates into steady, low-risk jobs. Many graduates are full of entrepreneurial ideas, but the weight of thousands of pounds of debt stifles their ability to take risks by starting their own businesses. It is precisely these kinds of small high-growth companies that the economy requires for long-term growth, as the majority of net new jobs are created by such companies. The existing student loans system has already discouraged one generation from founding innovative start-ups, and the proposed increase tuition fees will make this many times worse.

There is no easy solution to the funding crisis facing Universities. But what struck me this week is just how far the government has got it wrong. I wonder if they have done the sums:

1.) If we take the average graduate starting salary as £25,000 (the figure in c.2009)
2.) Assume a moderate salary upon reaching retirement of £50,000 (in today’s money)
3.) Assume for simplicity that progress between starting and finishing salary is in a straight line

‘Back of the envelope’ method
The average salary over this person’s career is £37,500. They would pay 9% of their earnings above £21,000, which is an average of £1,485 per year. At this rate they would need 18 years to pay off their debt, not including interest, and not accounting for the change in repayments over time.

More detailed calculation
In order to better understand the proposed fee system I have created a simple financial model of the repayments individuals will need to make over time. With the three assumptions above the more accurate ‘time to pay off’ is 27 years, so a 21 year-old graduate would be paying off student debt until they are 48.

If you add a real interest element to the loan, this has a substantial effect on time to pay off, as for several years the repayments do not even cover the interest. Under a 2% real interest scenario, a graduate on a four year course would not be debt free until they are (about) 73...

Note: A correction to the method, though not the message, of this post can be found here

An Immigration Cap? Bad for the UK; Good for everywhere else

There is a lot of debate at the moment over whether the UK should put a cap on the number of migrant workers allowed into the country. Even the two coalition party leaders are at odds over this issue. With visa restrictions already tightening, it looks as though the conservatives are bowing to populist demand for an immigration cap, to the detriment of British business.

There are convincing theoretical arguments for why limiting immigration of skilled workers is a bad thing for the country. Workers coming to the UK from overseas are benefitting the economy by expanding the supply of goods and services while also increasing consumption. Working adults generally pay more in tax than they receive in public services, thus helping the public finances. And by working in the UK they are increasing the country’s capacity to export goods, which improves the long term sustainability of the economy.

To back up the theory, there is empirical and anecdotal evidence that demonstrates the benefits immigrants bring to an economy. In his book “Outliers”, Malcolm Gladwell describes the entrepreneurial success of Jewish immigrants in New York in the early 20th century. He argues that migrants are at an advantage when it comes to starting new businesses, as they can apply knowledge from their home country to a new environment (more of my own views on this at a later time!) Looking at the 21st century, Thomas Friedman writes in “The World is Flat” about the large number of Indian entrepreneurs who studied for degrees in the USA, but started their businesses in India as the visa restrictions made it so difficult to settle in The States.

These should serve as a lesson to UK politicians as they consider the UK’s immigration policy. It seems the main argument in favour of capping immigration is so that more jobs are available for British workers. While this may be true on a timescale of 3 to 12 months, in the longer term businesses will simply choose to expand in other countries.

This would be bad for the UK. However I did not start this blog just to write about the UK. Taking a “World View” instead of a country-centric one, I actually believe that transferring the economic benefit that skilled workers produce from developed countries to developing ones is a good thing for the world as a whole. All those Indian entrepreneurs who left the US to start outsourcing companies in Bombay, Bangalore and Hyderabad have helped rebalance the wealth and power in the world; if more of the same happens because of the UK government’s short-sightedness, I won’t hold it against David Cameron.