Entrepreneurs sometimes wonder why VCs are so bent on owning a 20% stake in the companies they invest in. The answer is surprisingly simple: It’s a successful heuristic. Heuristics are “rules of thumb” and they turn out to be really useful whenever you deal with a lot of uncertainty. As an investor, one might be tempted to try to optimize the ownership percentage on a deal-by-deal basis. But so much can go wrong with any particular company that such optimizations are likely to backfire – if you don’t stick to a simple heuristic, you would likely wind up owning a lot less of your successful investments and a lot more of your unsuccessful ones. That makes it hard to generate a good overall return.
Entrepreneurs face as much uncertainty – in fact more, since they don’t have a portfolio. This means entrepreneurs too can benefit from using heuristics. Take budgeting for example. There is great value in creating a budget to make sure everyone in the company is on the same page and to be able to measure progress. But it would be dangerous to think you can optimize your startup budget the way you might be able to optimize the budget of a low volatility manufacturing operation. For instance, pulling expenses forward to accelerate revenue growth, can easily leave you with just more expenses when the revenues for some unexpected reason don’t kick in. So when you are trying to budget to breakeven on your (possibly) last round of financing, a great heuristic is to just “double it,” i.e., make your initial plan to determine the time you think it will take you to get to breakeven and then double it.
In areas of high uncertainty, models – without heuristics – tend to provide a false sense of accuracy and control. Many financial institutions have been learning this lesson the hard way (again). They built elaborate models about how various mortgage backed securities and derivatives would behave and how much leverage they could take on given these models. Those models led them to believe that they could operate safely at 30x or more leverage. Had they instead followd simple rules of thumb about acceptable levels of leverage they would not have been as profitable on the way up but they would have survived on the way down.
