When you should stick to your knitting

How do you know when you should change your business or keep doing things the same way? Applying two principles, Security and Economy of Force, will help you determine what type of problem you’re facing before you decide how to analyze it.

Here, we’re going to talk about making decisions that increase your business’s risk. A recent WSJ article describes the resurgence of lawyers trading legal fees for equity in pre-funding startup clients.

Equity stakes as a kicker are not a bad economic idea, but the handful of firms that really went full-bore down that road were generally unaware that they had traded some of the risks inherent to running a law firm for those inherent to running a VC fund. And, just as taking on lots of real estate risk is a field best left to real estate investors rather than law firms (see, e.g., Brobeck Palo Alto, San Diego, & Austin), VC risks are best left to VCs. It’s hard enough for them to make money regularly and that’s all they do.

Realistically, for long-tenured firms such as WSGR, the opportunity to make equity investments in clients is more about creating assets that are not tied to the pure fee-for-services model: in the firm investment fund model, the partners have funds and they’d like to diversify into a field where they can expect to be smarter than the average bear. Co-investment is a much better way to approach this strategy, and most investment funds see little threat from bringing related parties in. The amount of funds invested seldom approach the dollars of the primary equity investors, so there are seldom any of the typical issues when a deal is split among several funds (such as splitting control).

Trading fees for equity is a great specific example of risk expansion: assuming risks without necessarily subjecting the intent to do so to the same analysis you would if you were starting out with a new business. In other words, five prospective partners might sit down and create a new law firm that would take equity in lieu of fees, and they would likely spend more time analyzing the effects of that decision than a traditional five-partner firm who slides into that model bit by bit — another example of boiling the frog.

Assumed risk expands to absorb available economic surplus.

This false assumption that continuation of decisions is somehow different from a new decision is the result of a bundle of fallacies. Sunk cost fallacies and path dependency combine to cause many investors, for example, to hold investments that they would refuse to purchase at that day’s FMV. That’s nonsense of the highest order, particularly where transaction costs are low such as with widely held public securities in a liquid market. If you wouldn’t start your business today, that means you should be doing some serious thinking.

From a strategy perspective, this notion of sticking to your knitting is about acknowledging core competencies, playing to your strengths, and eliminating ancillary risks. Ancillary risks are those that your business model fundamentally rejects in favor of others you’d like to take on. The main reason for rejecting risks is that you’re not particularly well-equipped to handle them better than someone else. Managing business risk is very conveniently described in insurance terms, even when the other party is another company just like yours. Security is the principle of business that most reflects this notion of protecting yourself against risks you don’t want to assume. The difference between Security and Economy of Force is that Security is protection against additional risks — increased number of assumed risks — whereas Economy of Force is protection against additional revenue streams — increased number of businesses.