Risk
Let’s say that you are given two options.
Option 1: You will receive $350,000 in three years with probability 1.
Option 2: You will receive $2,000,000 in three years with probability p and $0 in three years with probability (1 – p).
How large would p need to be in order for you to be indifferent between the two alternatives?
For the sake of argument, assume that the intangibles are rolled into the monetary amounts. Also, if you rush out and calculate the risk-neutral answer (0.175), then you’re missing the point.
This is analogous to the choice between working for an established company or starting your own, respectively. Doing both simultaneously is untenable — or at least it dooms the solo venture to failure. Numerous conversations with successful entrepreneurs has convinced me of that reality. No, the choice must be all or nothing. Put the decision to yourself for all of your chips.
Of course, the answer to that first question gets you only so far. It informs you about your tolerance of risk, but more data is needed for an informed decision. You must estimate the probability that the venture will be successful; in other words, estimate the actual value of p, not just your own indifference threshold.
The conventional rule of thumb is that 1 out of 10 startups succeeds. I believe that understates the likelihood of success in the high-tech software field. Part of the problem is the definition of success: an exit (acquisition or IPO) where the founder nets $2 million wouldn’t be considered exceptional; in fact, depending on circumstances, it might not be considered a success. Based on my own conversations with entrepreneurs and investors, I believe that the success rate — defined here as the company being at least sustainable — is closer to 30-50%. That’s not bad.
So, what’s your value of p?
So, I realized that I never posted my value of p. In case you’re curious, it’s about 0.10 in this case. A risk-seeking stance (as opposed to risk-neutral or risk-averse).
All of this is related contestant behavior on shows like “Deal or No Deal,” in which the banker’s offer is often (though not always) below the expected value of the remaining briefcases. Most of the contestants are not wealthy, so the difference in utility between, say $100k and $200k is very small for them; they will be rich either way. Since the utility is similar, the player might be inclined to take $100k and quit even though she could be expected, on average, to win $200k by staying in the game. The difference, of course, is that the $100k in the example is certain, while there is a risk of winning nothing if she stays for the expected $200k.
My value of P is currently in the range of .65 to .75. A nice hearty number for a risk-averse Minnesotan…
My answer was going to have something to do with utility and marginal returns, you beat me to it and your smarter at these things…
This reminds me of a overly hypothetical question I posed years ago to my coworkers of which I should write myself one day: Your company has given you a briefcase of money to deliver. Ignoring the moral implications of stealing it, how much needs to be in the briefcase for you to take it and bolt? This assuming they were guaranteed to be unable to find you as long as you never had any contact in any form with that company again. And other assumptions but I’m trying to keep this brief.
For many its a question of how committed you are to the company, but it also allows you to consider your career, and how fulfilling it is. For instance, one might take it if there’s enough money to pay the equivalent of your yearly salary plus college tuition for four years, take it and go back to school and do something you love. Many of the older people picked numbers high enough to cover their retirement accounts. My number was something like $1400.
As far as p in your question: 350K to me is a ridiculously large sum of money. So it was hard for me to consider. I think my p would probably be high and my actual value would be low. However, I’d like to be someone one who would have a very low individual p, and ultimately someone who is indifferent to the actual value.