“Rule No.1: Never lose money. Rule No.2: Never forget rule No.1.” - Warren Buffett
My father always encouraged us to live well below our means. As my professional confidence grew and I learned the basics of accounting, I explained to him that I would “focus on the revenue side of the equation rather than the cost side.” That was my smug way of telling him (a science guy without formal business training) that I would earn enough to live large. He then explained the mathematics of compounding interest to me and added that I should take into consideration that capital gains are lower than income tax rates for those in my desired tax bracket — further fueling the mathemagic of compounding interest.
This is a hard lesson to learn. Harder still when you have easy access to capital, as do many wealthy individuals and companies. When you spend $1,000, you aren’t spending $1,000 — you are giving up the opportunity cost of what the $1,000 could have been worth (see the table below, or download the Excel document entitled value_of_money.xls here).
Now apply this idea to your business. If you work at a large company, chances are that your managers are not thinking about every dollar spent this way. If they do, your company is likely very valuable. Startups have the advantage, if you will, of not having enough capital to be [as] wasteful. But even many startups spend their cash without thinking about the opportunity cost of their capital.
I have noticed an interesting correlation amongst many of the successful people I know — they’re cheap. The table above explains why.
8 responses so far ↓
Ben // December 4, 2008 at 11:15 pm |
Paul over at USVP often jokes about the $500 free coke in a board meeting. Given the returns expected on a venture investment, that .50 coke bought for your board member with thier investment money can cost you $500 in returns.
Now, I will buy a $500 free beer for a board member, but I am not so sure about $500 cokes or $50000 expense for them to attend a board meeting.
Michael F. Martin // December 4, 2008 at 11:35 pm |
Great post. Might I humbly add that the same concept of compounding interest in tangible capital applies to intangible human capital also? Many of my friends thought I was crazy to get married young, but it only took a few years before I started to look smart for getting hitched to a beautiful, smart, and honest lady before she had the chance to shop around. And social capital in business relationships is systematically underestimated in service-based industries. The customer isn’t always right. But on average, having that policy means compounding on customer loyalty.
Ibod Catooga // December 5, 2008 at 2:02 am |
Ha this stupid because there is no capital cost to Coke even the knid you snort.
LUNIX RULES!!!!!!!!1111
Q dub // December 5, 2008 at 4:00 am |
I find this philosophy incredibly hard to use in personal life. What is the ROI on getting the lakeview condo instead of a modest loft? Personal pleasure is impossible to quantify, you’re simply not spending for the sake of more returns further down the road. I think the only time personal consumption can be viewed as a capex investment is when the person so deeply impoverished that sustenance is in question, and basic nutrition has high returns in the form of productivity.
$500 coke…aww the fallacy of constant incremental ROI =)
Mike Speiser // December 5, 2008 at 7:38 pm |
Agree that it’s hard. And I am not suggesting that anyone should live in squalor. However, it’s clear that delaying gratification is a key success factor in both personal and professional life. There have been numerous studies on the topic, starting with the famous “marshmallow” experiment. See snippet below, from this site.
“Stanford University psychology researcher Michael Mischel demonstrated how important self-discipline (the ability to delay immediate gratification in exchange for long term goal achievement) is to lifelong success? In a longitudinal study which began in the 1960s, he offered hungry 4-year-olds a marshmallow, but told them that if they could wait for the experimenter to return after running an errand, they could have two marshmallows.
Those who could wait the fifteen or twenty minutes for the experimenter to return would be demonstrating the ability to delay gratification and control impulse. About one-third of of the children grabbed the single marshmallow right away while some waited a little longer, and about one-third were able to wait 15 or 20 minutes for the researcher to return.
Years later when the children graduated from high school, the differences between the two groups were dramatic: the resisters were more positive, self-motivating, persistent in the face of difficulties, and able to delay gratification in pursuit of their goals. They had the habits of successful people which resulted in more successful marriages, higher incomes, greater career satisfaction, better health, and more fulfilling lives than most of the population.
Those having grabbed the marshmallow were more troubled, stubborn and indecisive, mistrustful, less self-confident, and still could not put off gratification. They had trouble subordinating immediate impulses to achieve long-range goals. When it was time to study for the big test, they tended to get distracted into doing activities that brought instant gratification This impulse followed them throughout their lives and resulted in unsuccessful marriages, low job satisfaction and income, bad health, and frustrating lives.”
George // December 9, 2008 at 12:40 am |
Excellent timing. Helps me justify meager Christmas gifts for everyone!
Jake // December 12, 2008 at 1:59 am |
For start-ups in SV, they have an imperative to spend b/c the VCs all want growth now. The model doesn’t really work using “rational” company development timeframes. Maybe the story flips in this economy, but part of a venture co’s mandate is to create a market opportunity and that means spending cash, even in difficult economies. The risk of underinvesting in an opportunity and having it taken away or not developing is the cardinal sin for a start-up, isn’t it?
Leland Creswell // February 23, 2009 at 9:03 am |
I have to agree with Jake.
This is similar to the problem that many managers face meeting their budget. If the manager overspends, then they may get a slightly increased budget the next cycle. However, if they underspend and do not use their full budget, they will usually receive a smaller budget the next cycle.
Similarly, startups are given a budget, the initial seed money, with which to provide results. Underspending and missing possible opportunities could result in a lower second round, or no second round at all.
Think of it like this:
Which VC is happier?
1. The VC who sees their invested company slowly spending small amounts of money on only sure things.
2. The VC who sees their invested company aggressively spending money at every possible opportunity in an effort to “go big”.
We must remember that frequently, time is NOT on the side of a startup company. Competitive pressures and market changes can crush even good ideas if they are not pushed as hard as possible during the early adapter stage.