12 Cornerstones of Investing
Ayn Rand said, “You can avoid reality, but you cannot avoid the consequences of avoiding reality.”
Not dealing with reality is the reason why most entrepreneurs and deals do not get funded or quickly go south. The deviation from realty starts early, with proforma numbers that are overly optimistic and speculative: the expenses are too low, the revenue is too high, and/or the time frame for execution is too short. This is what we call “chasing unicorns.” Dealing with what is real in a deal positions it and you for the greatest chance of success.
It’s Reality – Deal With It
With a poorly executed proforma, the project will take longer, be more expensive, and won’t reach revenue projections. This is where you have to be very honest about your business or the deal that you are getting into. If you trick yourself into thinking that the numbers are something they are not, you could get into a bad deal and create unnecessary headaches for yourself. Not dealing in reality may make you negotiate poorly and over-leverage the investment. Remember, you would rather have NO deal than a bad one.
The Unicorn – Stay Away From Animals That Don’t Exist
You are the golden child. You have the Midas touch. This deal is too good to pass up. If any of these thoughts cross your mind when you hear the tiny voice in your gut whispering that it’s a bad deal, you have lost touch with reality. Even people with vast experience and resources can lose touch and get involved in a bad deal. We have seen very smart people with very deep pockets (not to mention fabulous careers) get annihilated in a downturn. Not staying grounded in what is real, can lead to disaster.
Don’t fall into the trap of convincing yourself that the income will be better than it is, the expenses will be lower than they are, and the market is stronger than it is, or the market will come back faster than it will. The reality is the market and the economics of a deal can stay irrational longer than one may be able to stay solvent. Chasing unicorns lead to poor negotiation, higher purchase prices, over-leverage, and fiscal problems associated with the deal for years to come.
The Solution – Implement “The Rule of 25%”
Investment discipline is the solution to avoiding unicorns. We came up with the 25% rule to build in a margin of safety. It is very simple, but difficult to do in the excitement of executing transactions.
It works like this:
- Whatever you think the costs are, RAISE them by 25%
- Whatever you think the revenue is, REDUCE it by 25%
- Whatever you think the time frame to execution is, INCREASE it by 25%
This simple formula takes enormous discipline. But if implemented in your decision making, you will have a significant cushion or “margin of safety.” If you get hit hard by a recession or other unforeseen circumstances, it will give you a better chance to recover. It’s hard to do at first but you’ll be glad you did in the long run.
Reality Is Your Friend
Patience, discipline, and dealing with reality will serve investments well. Avoid speculation, rainbows, and unicorns. They all have the same thing in common: beautiful from a distance, but when you reach for them they fade away like mist.
Paul Martinez – Principal