“It is remarkable how much long-term advantage people like us have gotten by trying to be consistently not stupid, instead of trying to be very intelligent.” - Charlie Fucking Munger
I always get a kick out of reading “analysts” and bloggers’ take on the latest financial scandals and business collapses. Especially if they come from a non-financial background and have nothing to show for the topics that they write about other than “research” and no successful experiences in the topic.
A tech company dies and everyone is an armchair business genius when dissecting the corpse. A tech company has a massive IPO and everyone is talking about how they predicted its meteoric rise. Nevermind the fact that they predicted 9 out of the last 5 recessions. Or don’t practice what they preach in their own lives.
Truly, the real life person doesn’t fall far from the Reddit tree.
Take for example the engineer who tries to predict the next 10x startup IPO. He hems and haws at all the qualities of what makes a great unicorn company and how to avoid losers. Yet he has never once managed to join a 10x IPO himself. And his gains in the past 10 years on stocks are little better than the S&P 500. He also cannot read or understand a 10k, an annual report that every publicly traded company has to file with the SEC.
Would you ever trust him to teach you how to avoid bad businesses and judge good ones?
Yet these people write as if they understand a business’s finances and how to predict these incidents ahead of time. The fact is that not even the hedge funds and venture capitalists who study and manage these businesses can predict these successes that well. The average return on equity for venture capital doesn’t even beat the S&P until you hit the 20 year horizon and that’s if you get in on the early stage! Do you plan to hold illiquid Series A equity for 20 years? I don’t imagine most engineers would.
Imagine holding extremely risky stock with odds as good as Vegas and doing only as good as the S&P. Or maybe you think you’re special or something.
While I could throw my copy of The Black Swan (and my entire Taleb book collection) at these people, it would be simpler for me to make fun of them. On one hand, it gives me a great topic to actually talk about: how to evaluate both your career and equity investment in a company without a deep financial background.
And it's funny to laugh at.
Anyway, let’s talk about picking a company to work for without killing your engineering career. Or, more specifically, why these people who can’t read a balance sheet are just wrong in their advice on how to pick a business to work for.
Do I Know What I Am Talking About?
Let’s get the elephant out of the way. Here are my returns for the past 3 years. I’d show 5 but unfortunately E-trade can’t produce that for me. Don’t worry, I’ll tell you how to get to that number later.
If you look carefully, you’ll notice that over the long run, not only is it highly correlated with the S&P, it also blows it out of the water. Why? Because I’m singularly concentrated in a single stock that has been carrying the S&P for the past 5 years. This has single handedly been responsible for 90% of my returns. The last 10% were various small losses and 1 huge loss in a certain Chinese stock.
Yet I’ve still managed to come out clean at a roughly 36% compound annual growth rate (CAGR) without leverage, yoloing into meme stocks, or keeping a large amount of stock in unprofitable tech. Not bad. By this metric, I’m already twice as good as the average private venture capital firm.
If you read my material and content, you’ll instantly know what stock I am talking about. I’ve also given you another hint in the past few paragraphs: the fact that it carries the S&P as of this writing. You can backtest your guess by tracking the stock’s price over the same time period and figure out my gains for the past 5 years.
Why am I showing you this? Not only is it a direct challenge for people to post their profit and losses, CAGR, and portfolios before they decide to chat away about business, it should show you that I at least have some understanding of what makes a good business a good business. Stocks don’t appreciate or grow this fast for this long without good fundamentals and people don’t hold onto these positions for a long time without some kind of intuition and understanding of their worth. I’d like to think I have some understanding of this and that I’m not an influencer who’s doing “research” without testing it in the real world.
Simply being an engineer in this space does not qualify you to talk about how to find good businesses to work for. Show some results! At least I can say that the only 100% of the early stage startups I have equity in are still alive today.
Let me make this clear: I’m not qualified to give business advice. I just believe I’m marginally more qualified than most other people to give my opinion.
If you want to find someone remotely qualified to talk about what startups to work for, it's a very simple exercise. You would need to find someone who chronically joins successful startups right before IPO, makes amazing returns from those startups that significantly beat the S&P during the same time period, cashed out at the right time, and has done it at least twice. I can only think of 2 people in my life who have done this. I wouldn’t dare compare my opinion to someone who can do successful predictions repeatedly in this space.
But as the great philosopher Diogenes says: I am looking for an honest man.
It’s also a classic example of the extreme nature of the winner-take-all system we live in. Where all the gains we get in life and finance almost entirely are gained (and lost) in a few moments.
If you took away the top 5 of the hundreds or so of Warren Buffett’s investments of all time, you would end up with a portfolio that performed arguably on par with the S&P. Yet Buffett remains the all time greatest of investor to the point where people will name drop him to justify something as stupid as leveraging 10:1 on out of the money call options. How can that be if most of the benefits of life come from a few lucky shots? Should Buffett himself not be an anomaly?
Which brings me the idea of avoiding bad businesses and how to avoid mistakes. As the man says himself, “if you avoid the losers (bad businesses), the winners will take care of themselves.”
So how then can we avoid the bad businesses to have the best odds of working for a great company and have a better chance of working for a multibagger IPO? Or at least a good company that isn’t going to tank our equity?
Hindsight Fallacy
There are thousands of variables that can cause a business to fail ranging from poor business planning to simply bad execution. But just like in investment portfolios, there are only a handful that can boost them to superstar status. To pick 1 or 2 of the thousand of factors and call that the key to business is the hindsight fallacy.
Consider the “rules” that people are suggesting for avoiding companies like Fast.
“The CEO should have lots of experience.” Then you never would have joined Facebook. Or Alibaba. Zuckerberg started in his college dorm and Jack Ma started as an English teacher.
“There should be clear metrics and a vision for progress.” Then you never would have joined Microsoft after Bill Gates left in 2008. Or Apple after Steve Jobs died.
“The company needs to have a clear and exciting future.” Then you never would have joined Palo Alto Networks which has gained +1100% since its 2012 IPO.
“The business should be profitable.” Then you never would have joined Amazon before 2012. Or Tesla before 2021.
In all of these points, I have done a small sleight of hand: I have committed the same sin of cherry-picking survivors that defy these rules. Survivors that people would sacrifice their first born to work at. But is that not the same as cherry-picking factors that are the most important to a company’s success? Most blogs and entries you read reason their rules simply by looking at patterns or saying what sounds correct.
This is what I mean by the hindsight fallacy: in a post-mortem of any incident (engineering or otherwise), we assume that we know all the information about the situation and draw a line through any pattern we see. While this may work in engineering where the depth and domain of knowledge is relatively limited, it hardly works in real life. How many people would have been able to predict Putin invading Ukraine before this year? Could you look at past historical invasions and come up with a ruleset for predicting wars? Probably not.
This also brings me to the survivorship bias where a pattern is extrapolated from, well, the survivors only. Imagine all the businesses that did follow all the rules and still failed. Are they the exception or the norm? If they are the exceptions, then the rule is a very good rule. If it is the norm, then the rule is absolutely terrible.
In World War 2, researchers studied the damage on planes that came back from a mission. They decided to add armor to the areas that sustained the most damage. Except that was wrong because the planes that were shot down never returned to base and weren’t in the sample. The truth was that the planes that took damage in the supposedly non-critical areas were the ones that never made it back. The researchers only studied the survivors and only focused on the damaged areas.
Areas that instead of being critical were actually a symptom of being non-critical.
Along those lines, let’s take these 4 rules again that I’ve proposed. This time, let’s try to incorporate the graveyard of failed businesses that did follow all these rules and still died. Were they the norm or the exception? It should be reasoned that if a rule is followed and a majority of followers still die, then it is a shitty rule.
“The CEO should have lots of experience.”
Consider, founders of a previously successful business have a 30 percent chance of success with their next venture, founders who have failed at a prior business have a 20 percent chance of succeeding versus an 18 percent chance of success for first time entrepreneurs. (Small Business Trends)
So it looks like even with experience, companies still fail with experience having only a slight bearing on the success statistic. We may change this rule to “the CEO should have at least one successful past experience” and the rule may be acceptable as a minor heuristic. But that still means the startup has a 70% chance of failure versus a 80% chance.
“There should be clear metrics and a vision for progress.”
The main challenge to the success of a startup is generating new business. (Statista)
So it looks like acquiring new customers is the problem. If customers are sticky and already in place, this isn’t as much of a hazard.
“The company needs to have a clear and exciting future.”
The number one reason why startups fail is due to misreading market demand — this is found in 42% of cases. (Statista)
The future can be exciting and wonderful as any salesman makes it. A clear and exciting future means nothing if the analysis is wrong. In other words, the future has to be reasonable and in line with market demands. Exciting can come after.
“The business should be profitable.”
In 2018, 82% of businesses that went under did so because of cash flow problems. (Fundera)
The second largest reason why startups fail (29% of cases) is due to running out of funding and personal money. (Statista)
In other words, if you consider all these rules, the ONLY one that really makes sense is the business profitability one because it avoids one of the biggest and most easily predictable pitfalls. If you can join a profitable business, you eliminate 82% of the losers.
I suggest you reapply this thinking to any ruleset. Incorporate the losers who did follow these rules. Were they the norm or the exception? Again, if a rule is followed and a majority of followers still die, then it is a shitty rule.
Business is Business
“But surely, you can’t just judge a business based on numbers alone! A business’s real value is run by its people! It's up to you to judge them and make the best decision!”
Says the heckler in the crowd. Ok let’s address that: why “just do your own research” is to business decisions as gym bro advice is to Olympic lifting.
“Talk with lead investors, future managers, the founder, and people who left.”
“Ask for numbers.”
“Make a plan if the equity is worthless.” (Actually this one is very good and I can wholeheartedly agree with)
Instead of tackling each of these one by one and repeating the previous section, I’ll just give you a simple story.
You’re 22 and walked into a car dealership to buy your first car to get to your first programming job at Facebook. The dealer welcomes you and asks what car you’re interested in buying and your price point. You say you want a daily driver Honda Civic 2020 at a $25k price point with no more than 40k miles. The car man says that they have one in stock but that you would be better off investing in a new car since the civics have been dropping in reliability and quality. He quotes you $35k for a brand new 2021 which you flatly reject. You know the game: he’s just trying to upsell you. You firmly restate that you cannot go above $25k. No problem. He instead finds a 2016 Honda Civic for $20,000 with 40k miles. He even admits he will cut the price by 10% to get it off his lot for a nice price of $18,200 and throws in a 30 day guarantee. You quickly check Craigslist and find few other comparables but believe the 30 day guarantee should give you enough time to truly judge the car. You agree and drive off happy that you saved almost $7,000.
As you drive off the lot, a stray car hits you. The airbags deploy and you pass out unconscious. You wake up in the hospital. It turns out the car you were sold happened to have an airbag that malfunctioned and sprayed shrapnel instead, turning your steering wheel into a grenade and blowing off both your hands.
So much for a keyboard.
Imagine the Honda Civic to be your stocks, the dealer to be the CEO, and the stray car that hit you to be the US economy or whatever business environment the company operates in.
Your gut reaction might be to point out how I threw a random disaster scenario into the situation. I’ll get to that.
The first thing I’d want to draw your attention to is the numerous mistakes you didn’t even know you made when negotiating. The most obvious one: you said your hard limit. Now the dealer knows what number anchor you’re sticking to and can play around it.
Since you’re negotiating roughly every 3-4 years for your salary, I don’t think that many of you are well versed or well practiced in this. You are at a severe disadvantage in this realm alone.
You also were weighted by his statement that Honda’s quality had been dropping, which primed you into buying an older model that you did not research. That was why you rejected a higher priced newer model that you did research. It may have been severely overpriced but you could have negotiated him down.
But let’s say you are competent in the art of negotiating.
The second is the asymmetry of the information and competency at the table when buying a car. The dealer clearly knew how to work you and knew his numbers whereas you had to Google the numbers when the situation changed and new information was presented. Information that only he could offer and he would know off the top of his head. And that’s before we even know if the information is accurate.
The entire exercise of acquiring stock in public or private companies is no different from buying a car. You are exchanging money (or time) for an asset and you want to make sure you are at least being compensated fairly for that.
This is easy when buying a car because you can figure out what the car is worth via Kelly Blue Book or Craigslist for market comparables. You can even take the car to a mechanic to get the guts inspected and have him help you adjust. This is harder when you are trying to value stocks in a relatively less studied company with few comparables and in an entirely novel business area.
The only way to handle this is with information and to try and process it to the best of your ability. Information that only the company has in the hands of people who know the business better than you do. It would be incredibly stupid to believe someone at the other side of the business negotiation has your best interests first and foremost. Even Fast withheld revenue numbers from their employees before revealing they only made $600k in revenue and lost $10M and closing shop.
Business heads are incentivized to throw half truths at you and paint pretty pictures, especially when you don’t have the information or knowledge to verify what they are saying. Combine that with the practiced salesman charisma of the CEO or VP and you’ll walk out that door thinking any terrible company is a wonderful one.
This happens all the time with publicly traded and well understood companies as well. There is no business so lousy that a banker or investor cannot just give it a wonderful projection and try to sell the deal. After all, the banker wants his fee and the investor wants to cash out by selling his shares to someone else who believes in the company/IPO. This happens in mergers and acquisitions all the time where the average premium is 20-30% of the acquisition price.
That’s a whole lot of incentive to lie, especially when you are dealing with billion dollar companies.
In short, a company and its investors have a lot of incentives to defraud you. And if they want to defraud you, they WILL defraud you and convince themselves they are just expressing their opinion and were just being clever. If things turn sour, they will blame you and tell you that you should have done your own research and come up with your own opinion (a practice I especially loathe. If anyone ever tries to pull this crap on me, I will pray that they end up in the lowest circle of hell).
The funniest example I can think of where professional industry analysts were unknowingly complicit is this one.
Enron would go bust 2 months later.
A short history lesson: Enron, the biggest company in the world at the time, eventually went bankrupt and were found guilty of financial fraud. If industry analysts can be fooled, why can’t you?
If you invert this sentiment, you should understand why talking to ex-employees is also a somewhat meaningless task. If the opportunity was good, employees would stay so the only stories you will hear are biased and could easily be the exception rather than the norm.
The only way to prove this is otherwise is to keep talking to ex-employees. And how many ex-employees can a startup have? Is the amount not only statistically meaningful but also worth your time?
This situation is a great example of where more information actually makes your decision making worse: your only sources of information are 2 extremely biased sources in opposite directions and the truth is somewhere in the entire middle ground. It’s a task about as easy as trying to find a middle ground between the political left and right on the internet.
Also don’t bother trying to ask a company for their numbers. Companies aren't going to give you numbers that aren’t favorable to them or are going to say anything that isn’t a rehearsed talking point . Just ask for their 409A as this is independently audited.
But let’s also assume that these people aren’t going to flat out lie to you. Let’s also assume you magically got the skill to figure out what a business is worth and the information you got was completely impartial and fair.
Finally, going back to the car-buying story, you did your research on the car/business. You knew what the car was worth and you held to your price point. You knew Honda had a great reputation for reliability and figured you could drive it an extra 100,000 miles easily. What killed you was something neither the dealer nor you could have predicted. This happens in business all the time: a business pursues the most reasonable line of business and gets destroyed by a highly improbable or unexpected event. Facebook was the black swan of Myspace.
Why do you think they call billion dollar companies “unicorns”?
Again, if we are about avoiding mistakes, then we should also guard against the probability of catastrophes and disaster situations while still having reasonable upside for the endeavor. All it takes is just 1 event to destroy a business. With the competitive nature of startup land, why else do half of all startups fail in the first 5 years? They’re fighting off disasters and competitors every day and all it takes is 1 punch to knock them out.
In short, any checklist that requires you to take significant steps outside your circle of competency is a terrible one. The game should not be to figure out the expected value of the equity. It is not to just do these utterly pointless exercises of research, chatting with your future business partner and asking him to convince you, or even talking to ex-engineers. Exercises you are not well versed in engaging in or evaluating.
It's to avoid these extremely obvious and highly correlated blowups and failures and to survive the black swans. It's to invent your own luck and to progress in your career. You are an engineer trading your time for money or equity and your competency should be in valuing your own skill.
This is where I introduce the second part to the equation: your career. I have wholly admitted and have always maintained the position that gambling your career on a lottery ticket is absolutely insane as the odds are not in your favor and that its simply more profitable to bet on your career. I talk about this in my other post, The State Of The Engineering Union and Owner Of Nothing. All else being equal, value your ability to become a better engineer and getting promoted over lottery tickets outside of your control.
As the old saying goes, it is better to have one in hand than two in the bush.
The CheckList
Alright enough of me bashing. I’ll give you the checklist I use to value if a business worthy of my time and investment. Note that this checklist is not absolute as some factors will vastly outweigh others. But for some people, they may take it as gospel.
Engineering
Will you become a better engineer here?
Reverse look up your manager and CEO on LinkedIn. Patterns repeat. Run away from grifters.
Business/Investment
A business gets the people they deserve. What is the biggest sticking point of the recruiter?
A business must have been profitable for a long time and ethical.
What does the world look like if this business is successful? Would you find it more valuable and meaningful?
It's an incredibly simple checklist as business should be. Do not get confused: you are not in the business of valuing companies and investing in them. You’re in the business of creating value as an engineer in exchange for money and that value should last as long as possible. That is what you are marketing and trying to produce for the right price. Well, at least an honest business person would.
To steal a parabole from one of my heros, Charlie Munger:
“A man has this wonderful horse. It's a marvelous horse. But occasionally the horse gets dangerous and vicious. He takes the horse to the vet and asks him 'what should I do about this horse?' The Vet says 'That's a very easy problem and I'm glad to help you. Next time your horse is behaving well, sell it.' Think of how immoral that is.”
Let’s examine why I have this checklist.
Will you become a better engineer here?
Reverse look up your manager on LinkedIn. Patterns repeat. Run away from grifters and unethical people.
As far as your career as an engineer goes, it should revolve around learning from people better than you. Joining a team where they have hired grifters to manage the engineers should tell you what priorities management has. Or you can at least envision what will happen to your career should you work with someone like that.
As for whether we suffer from a survivorship bias, most people do not simply become more competent through luck. Nor do grifters last very long. It is simply better to avoid people who cannot encourage or help you to do better to avoid their influence.
I am very lucky to continually have met and worked with extremely competent and highly performing individuals. Then again, I also wish to become more competent at my craft and work every day to do so. Perhaps that also plays a role.
A business gets the people they deserve. What is the biggest sticking point of the recruiter?
Recruiters often give the same pitches to candidates. If they try to heavily sell you on pay and equity appreciation, don’t you think they gave the same pitch to other people? What kind of people do you think they’re going to attract? What do you think happens to these people when the stock price goes down? And what will happen to the company in this case?
Much along the previous sentiment, we wish to avoid a crowd with the wrong incentives and desires. They will kill your career and the company for a nickel.
Also, if you’re the kind of person who believes in the efficient market hypothesis (that stock price also reflects the underlying value of the business and not the other way around), I would gladly refer you to every financial crisis we have ever suffered. But alas, a blog for another day.
The business must take measures to be ethical.
I personally find it distasteful to work for people and companies that engage in horribly unethical behavior. It pays well, yes, but it's a miserable existence that I cannot respect. If the business tends to tolerate the unethical, then chances are they will be more inclined to commit fraud and encourage unethical behavior in their organization. Eventually, the day of reckoning will come and the shareholders will pay for it. Maybe it's in the form of an SEC investigation and penalties. Maybe it's in the form of making up fraudulent metrics for success. Or even just straight up lies.
Once nobody believes in your business, you can never sell anything to anyone again. In which case, the business is dead anyway. We want to avoid businesses that engage in self-sabotage.
The business must have been profitable for a long time.
Nobody would invest in a money losing business unless they believed in the vision. However, as an employee, if you have no way of significantly influencing the direction of the business, this is not a situation you should engage with at all. You would be acting on blind faith and nobody should ever do business on blind faith. Profitability is a way for businesses to show that the value that businesses provide is sustainable and that there is a market demand. It's easy to cook the books for a year or two. But over a long period of time, that is far more difficult.
What does the world look like if this business is successful? Would you find it more valuable and meaningful?
This is probably the easiest one. Yet I put this one last because it has nothing to do with negotiating or research but simply your own belief in the world. If you yourself find value or think the world will gain an immense amount of value from the business, then the answer to this question is a resounding yes. After all, I think it's simply better to be true to one’s own beliefs and understandings of the world rather than follow the word of someone else blindly.
A business that cannot add value to the world does not survive for very long. But a business that does continually add value to people’s lives in a significant way will certainly have a less likelihood of failing. Being able to serve that market means being able to read the market properly.
Also, why would you spend your life producing no value in the world and want to be overpaid for it? I find that horribly unethical.
If you’d like more on this section, I would recommend Peter Lynch’s series One Up on Wall Street. I am merely summarizing the big point.
Notice that I have not said anything about the price or what equity you should demand. I find this exercise very hard and entire classes and papers are dedicated to the various ways to value a startup or business. I’ll kick the can down the road and write about it in the future.
I’ll simply state that taking options is extremely risky and pricing them is basically no better than throwing darts. It's better to demand just equity and be safe to prevent them from going under water. A good business will last a long time and eventually the equity will appreciate if you think in the long term (provided the business is not terribly overpriced).
In the worst case scenario, are you really going to complain if your compensation ends up being $5M instead of $7M? I feel sorry for the man who lets envy and what could have rob him of what he has.
Yours Truly
To wrap things up, let’s apply this to me. It should be incredibly obvious why Apple meets this checklist. But let’s put myself under the microscope and see how my decision to join Uber in 2020 stacked up, before the COVID shutdowns happened.
Except I’d rather not do that to avoid saying anything that may get me in trouble with my current employer. If the day comes that I should switch companies, I may update this blog to reflect this. But you should run the above checklist on Uber and see what you yourself come up with.
However, I would like to point out a few things:
I may have been lucky to join Apple when I did. But I am also lucky enough to recognize a great company, a great opportunity, and to hold onto for the long run, instead of getting greedy, selling it off, and buying into Ark Invest. I am also unlucky enough to not have bought into Tesla where I could have had a 15,000% price appreciation. I guess I’m lucky and unlucky?
I purchased a certain Chinese stock that is now trading at 50% of my purchase price. And I still beat the S&P average in 2021. I guess I’m lucky and unlucky?
I joined Uber when the stock price was near its all time low during COVID. You may call me lucky considering the price is nearly 50% higher. But since then, the company has rebalanced their salary and equity across the board so my advantage is gone. It was great downside protection while it lasted though. Easy come, easy go. Although I like to think that this fact alone shows I have the cojones the size of avocados to make a jump like that. I guess I’m lucky and unlucky?
Also I’m not bothered by that either. Envy is the great thief of satisfaction.
Do I know what I am talking about and should you take my word for granted? Maybe. Maybe not. Give it some time though because people do get the results they deserve in the long run. I’m on year 8.
Conclusion
At the end of the day, I am lucky. But I’ve stacked the odds in such a way that my luck has paid off tremendously. Like I said in the beginning, the asymmetry of life comes down to just a few decisions and opportunities that were entirely outside of my control. The massive luck that I’ve had in the past few years has been attributed to just trying new opportunities, taking my small and painful losses, and recovering by making great bets.
This has applied to both my career and finances starting in 2014.
I believe startups are just a more extreme version of this game. With a high failure rate, extremely disappointing averages, but extremely high payoffs, it truly is a lottery ticket. If you are able to stack the odds in your favor by picking and choosing your lottery ticket, you may be able to reap better rewards.
The best strategy isn’t one that tries to draw a line through the survivors because there are plenty of failures who do follow that line and still fail. Nor is it to constantly change and shift strategy when new information comes in. The best strategy is to avoid the bad businesses and most obvious mistakes while increasing the capacity and power of that which is easily controllable, namely your career. Anyone who says otherwise is either a god amongst men or ignorant to their own ignorance. Most are in the latter and their finances and careers have probably suffered for it.
Who knows? Maybe give this blog another 5 years and I could look like an idiot. I’d be happy to take that L and learn from it. It’s gotten me this far, hasn’t it?