The laws of gravity work the same way in finance as they do in physics – what goes up must come down. It’s only a question of timing. Look at Sears. It took about 130 years for the company to go from startup-broke to its peak to bankrupt-broke. But it happened. Trends change. All it takes is one leader to make a company irrelevant – or relevant again. Microsoft was on its way to irrelevancy until Satya Nadella altered its course. GE was on its way to irrelevancy. Now the jury is out.
Here are 7 laws of financial gravity that entrepreneurs should understand.
#1. Capital flows to attractive returns. This is usually considered the most important law of finance – all other things being equal, higher returns attract more capital. This is one reason why venture capitalists seek home runs – to get attractive returns. Since they fail on 80% of their investments and make moderate returns on 19%, they need a home run to offset the losses and earn a high return. Do not expect VC from the top 20 VCs (who earn 95% of VC profits) unless you can show that your venture is a potential home run.
#2. Capital flows in the direction of growth. To get attractive returns, growth helps. Ventures that offer attractive returns to shareholders are those that can grow the top line (sales) and bottom line (net income) to dominate. Without growth, it is usually difficult to show high returns. Can you prove that you can deliver growth?
#3. Capital flows to emerging industries (and away from declining industries). The most attractive growth rates and returns have been in emerging industries. This is one reason why more VC is flowing to Silicon Valley and away from fading industries and companies such as Sears. Silicon Valley has a proven track-record to dominate nearly every emerging industry.
#4. Capital flows to less fog. Emerging industries are foggy until a winner shows us the winning strategy. The only ones who think they can forecast accurately are Indian astrologers, American economists, stock market analysts, and media pundits who offer their (usually) self-serving forecasts as if they can see the future. Statistics suggest that everyone is right occasionally, and this is the forecast they promote in future ads to tout their services. But as the old saying goes, “even a stopped watch tells the right time twice a day.”
#5. Capital flows after proof of potential. Entrepreneurs need to reduce risk at each stage and prove their potential. It is not enough to reduce risk. Investors also want proof of high potential at each stage. Look at Uber. When their growth potential became murky, their valuation tanked. Proof can take many forms:
· Opportunity Aha: This is when the product or service is so great that the world wants to fund you. The co-founder of Genentech had to split the gene. Cure cancer today and you will have financiers lined up outside the door.
· Strategy Aha: This is when you launch your venture and prove your strategy. The proof is your take off in an emerging industry or trend. That’s what Jan Koum and Niraj Jain offered.
· Leadership Aha: This is when your opportunity, your strategy and your leadership are all proven – and you are on the way to dominating your emerging industry. When Zuckerberg started getting millions of users, he could pick VCs who allowed him to vote their shares.
#6. Capital flows in the direction of skills more than unproven ideas. To bridge the capital gap from idea to Aha, entrepreneurs need skills more than unproven ideas. Capital usually flows in the direction of entrepreneurs who have proven their skills in finding the right opportunity in the right emerging, high-potential industry, and taking off. Jeff Bezos has not had any problems attracting capital after he proved his skills to unleash his potential. But sometimes capital unintentionally flows towards pretenders – sooner or later the merry-go-round comes to a stop. Look at Elizabeth Holmes of Theranos and Adam Neumann of WeWork. So get the right skills.
#7. Capital flows to entrepreneurs who can build the right organization and dominate. At the end of the day, capital flows to entrepreneurs who can build the right organization to dominate their industries and deliver great returns. Everyone wants an Amazon or Facebook – not a Theranos or a WeWork.
MY TAKE: So what do these laws mean for entrepreneurs.
· Get skills to reach Aha because financiers hate risk. Before Aha, you are all risk and unknown potential, or as the Texans say, “all hat and no cattle.”
· Test alternatives to find the fulcrum of an emerging industry or trend. Your success is dependent on the right strategy. But no one knows the right strategy until someone finds it and takes off. The key is to stay flexible and pivot to find it.
· Focus to get more bang with limited capital. Warren Buffett said it well, “diversification is protection against ignorance” The question is where to focus.