May 26, 2021
The Tyranny of 0.8 to the 5th
There are many things in life that are easy to criticize but difficult to change. The US Tax Code comes to mind. Our healthcare system has to be up there. And of course it’s incredibly easy to slam pretty much everything about every cable TV station on the planet
But as an operator turned investor, it took me all of one minute on the job to figure out that a big piece of where I could create value was to help the companies I funded change the distribution of their projected outcomes. Criticizing is easier than affecting change and most Investors are practitioners of the first and observers of the second.
As a result, my perspective and work cadence is different than that of most Investors I know. And unless I’m delusional, my style and actions (as well as those of my fellow team members) seem to be well received by the companies QED Investors has funded. To be clear, a big piece of what I do is the same as that of all other Investors: I study market trends, evaluate management teams, help recruit talent and provide high level strategic guidance to Founders and their teams. But I can say with near certainty that if I don’t believe I can influence the outcome of a company then I don’t invest.
Much of this philosophy comes from a very nerdy concept that the QED crew used frequently back in our Capital One days. We’ve affectionately dubbed the concept “0.8 to the 5th” (bear with me….it will make sense in a second).
Basically, contingent probabilities suck. If a business plan has many “ands” joining process steps to create outcomes then its stuck in the world of contingent probabilities. This AND that need to happen for the business to succeed. And most businesses are very complex with strings of three, four and sometimes five or more dependencies linked together.
This might not seem like a problem on the surface but if you’ve ever been in a complex operating role you’re probably recalling bad memories right now. Why? Because the best operator in the world only has in the ballpark of an 80 percent chance of hitting an aggressive goal if it’s one of many complex priorities on their plate. And while 80 percent sounds pretty good (it’s definitely worth betting on) when all of the goals are contingent on each other the chances of achieving the desired outcome are very low. The implications of 0.8 to the 5th are stunning and intimidating. Having less than a one-in-three chance of hitting plan is not a fun statistic to stare at, and this is what one should expect from a world class operator. Average operators don’t have a chance in this type of environment.
So, at QED Investors, we’ve made it our jobs to improve the odds. Through personal sweat equity, mining relationships, applying experience based pattern recognition and helping Entrepreneurs reduce the scope of what they’re building, our goal is to tilt the odds in our favor as much as is possible. That’s our value add. That’s what we do every day.
For instance, many of the businesses we fund are two sided lending marketplaces. A simplistic version of how they work can be described the following way: The business generates demand for loans (i.e. – finds borrowers) and then fills the demand by selling the loans to an interested party (i.e. – finds lenders). Balancing the supply and demand across every credit tier and product configuration while attempting to at least double every year is a great example of a contingent probability problem, especially if the lenders care about the quality of the loans being produced!
So how do I influence the outcome? In the above example I would connect the company to and help them negotiate with a “friendly” source of capital that’s willing to buy all the loan volume as it’s originated. While these deals can appear to be expensive on the surface (i.e. – warrants in the company, high cost of capital, etc) they usually end up being fantastic “investments” because they effectively reduce the chain of contingencies by one. 0.8 to the 4th is a heck of a lot better than 0.8 to the 5th, and what’s nice is that by reducing the number of battlefronts the management team is fighting on they should be able to increase the probability of accomplishing their other goals. So 0.8 to the 5th becomes 0.85 to the 4th becomes 0.9 to the 3rd, etc. Eventually the business has a fighting chance of success, especially if everyone in the system has a maniacal focus on reducing contingencies and delivering on the tasks at hand.
What’s interesting is that this theory applies to problems that crop up every day in the business building process but most Entrepreneurs and Investors don’t typically use this logic in their decision making process. Think about it as the 0.8 to the 5th lens. Much of my job is getting them to see through this lens and step in when I can directly influence the outcome.
Here are two other examples:
1. Should a company hire a seasoned employee by offering them a robust package and executive role or bring on a less expensive individual with potential? If the skills the seasoned executive possesses can influence the contingent probabilities, you’ll likely want to pay-up to get them on board. The incremental dilution will end up as rounding error if they’re able to increase the probability of the entity succeeding.
2. Should a company sign a deal with a partner that can deliver significant volume but at the cost of all profit being stripped out of the arrangement? If the partner is able to hand the company volume with little effort, the company’s employees can focus their energies on refining all the important operational processes rather than sourcing volume. And it shouldn’t be underestimated how valuable it can be to get a well known logo to endorse a business. Many times it will make sales easier in the future and open doors that otherwise would be shut.
With this said, my suggestion to entrepreneurs and investors alike is to do everything in your power every day to fight the tyranny of 0.8 to the 5th. 'Simplify to succeed' is a good mantra to live by and one that I strongly endorse.