Eyes fixed firmly on the prize, some entrepreneurs deliberately choose to finance their ventures in a way that most people would consider worryingly risky. This is the surprising finding of my latest research – carried out in collaboration with Dmitry Makarov, Associate Professor of Finance, Higher School of Economics; Alex Shapiro, Assistant Professor of Finance, New York University; and Marti Subrahmanyam, Charles E Merrill Professor of Finance, New York University.
Wealth isn’t enough, apparently. Achieving ultra-high financial status is the goal. That’s why some entrepreneurs opt to fund their projects through riskier securities, even though they stand to lose more if the project fails. We investigated how status-driven entrepreneurs decide what securities to issue to finance their projects and how to manage them over time. Using detailed analysis we’ve shown that issuing a convertible security is the way to max out your chance of a massive return.
Further, we’ve discovered that relatively riskier companies – start-ups and small firms – issue convertible securities more often not because they have to, but because they want to. It has often been assumed that convertible equity is something forced on the entrepreneur by risk-reducing investors, as a defence against opportunistic behaviour by the entrepreneur (such as when they hide important information or acts for their own interest ahead of those of pure investors). But in fact it can be the entrepreneur who pushes for convertible equity instruments in order to increase the likelihood that they’ll end up super-rich.
These entrepreneurs are willing to gamble to increase the chances of a high exit even if it means there’s a higher likelihood that they’ll get nothing at all – because the high status they aspire to requires a substantial sum to achieve. Small sums of money from sale of equity aren’t enough to propel entrepreneurs to the point where they can afford the higher-priced goods and services they “need” to be seen to have achieved stellar financial status. A sailboat is nice but nothing says success like a luxury yacht.
Status symbols are nothing new, although they may be subtly changing now that bling is available to the masses. Conspicuous consumption may be losing ground to less visible trappings of wealth, such as the best education money can buy. But it remains a fact that people care about their financial status in society. And how much a person cares about status is likely to be related to how strenuously they pursue activities that might help them achieve higher status.
Previous research has shown that entrepreneurs can be distinguished in three ways. One, they have a strong desire to achieve, i.e. attain high status. According to the 2011 High Impact Entrepreneurship Global Report, a cross-country study of entrepreneurship, successful entrepreneurs are widely perceived to have high status. Two, they are unusually willing to take risks. Three, they are happy to tolerate ambiguity.
Someone whose wealth is very nearly at the level to put them in the high-status bracket may be willing to pursue high-risk strategies. This is because the ensuing higher volatility of wealth implies a higher chance to end up above the threshold in that gilded elite to which they so want to belong. On the other hand, when status change is unlikely – when a person’s wealth is either much lower or much higher than the threshold – that person is more likely to be risk-averse.
We modelled different securities using a continuous-time framework in which an entrepreneur dynamically manages a project – looking at both internal financing (where the entrepreneur uses their own money) and external financing (where they finance the project by selling a security – a claim on the project’s future value – to one or more financiers).
Among our discoveries, we found that when high status is within sight, the entrepreneur substantially increases the product novelty – and, as a result, the project risk. In addition, when status is a motivating factor, the entrepreneur introduces a debt-like segment to insulate the risk for the financier. This means lower risk but lower return on any upside; however, it gives them the option to convert to equity at any point should the investable business look likely to be successful – usually just before the sale of the venture.
If the risk pays off then the payoff is likely to yield the sums they need to achieve that higher status. If the project doesn’t pay off then they lose everything built up so far in the business – but this loss is only slightly less than if they had undertaken a non-risky, low-return project whose success wouldn’t have yielded the sums needed to achieve high status.
By offering to reduce investor risk by issuing convertible equity instruments, the entrepreneur can seek to retain a greater share of the post-option equity. She can offer, say, 30% of pure equity or convertible equity that converts to (say) 20% of the post-conversion equity. Of course, if the business sells for very little then the convertible equity holders don’t convert and the entire proceeds may go to paying off the unconverted debt, but if the entrepreneur is in a “double or quits” frame of mind, they might not care.
Interestingly, our analysis seems to apply to established companies issuing securities as well. We suggest this is because companies’ important decisions, such as security issuance, are ultimately made by CEOs – and CEOs also care about status. In addition, when companies are deciding how much risk to take, they consider their current performance relative to a certain aspiration level and/or achievement target. There is evidence that executives consider risk-taking to be more warranted when they are closer to hitting their target. The drive for higher status is not just the preserve of the entrepreneur.