Back in 2007, I invested in a private company called Bulldog Gin (11/2009 interview). A friend from William & Mary co-founded the company after several dark years in banking and asked me to invest. At the time, I was making good money as a 29 year old VP in banking, so I figured why not. I believed in his drive and I liked the idea of making gin cool like SKYY did for vodka.
Sometime over the past five years, I started believing I had invested $75,000 in Bulldog Gin at a $10M valuation. When Campari Group announced recently they were to acquire Bulldog Gin for $55M plus an attractive earn-out paid in 2021, I was pumped! I mentally wrote off the $75,000 investment from my net worth because it was made so long ago. After about five years of zero dividends, you start losing hope your money is ever coming back.
When I dug out the capitalization table from 10 years ago, I realized I had not invested $75,000 in Bulldog Gin. Instead, I had only invested $60,000. Drat. $60,000 is still a decent amount of money to invest in a private company, but overestimating my investment by 25% is a egregious financial miscalculation.
I’ve always wondered how so many startup companies could “miscalculate” their finances so badly. For example, in a Startup Podcast episode about the now defunct food delivery company, Bento Now, the founders said one month they spent $70,000 more than they realized. I mean, how does $70,000 just go unaccounted for? But here I was doing the same thing, given $70,000 was roughly 30% more than their budget.
If you’ve ever seen the movie Memento, you realize that one small lie or factual error starts compounding on itself until it becomes one monumental error. What I think happened was I had bought $2,500 in shares in an earlier round from a colleague when Bulldog Gin was valued at only $5M (I think). For some reason, I just rounded up my investment to $75,000. Then I checked with my ex-colleague whom I bought the shares from and he said I had only bought $1,700 worth of shares! See how the errors start stacking up? Thankfully, we had a notarized document of the transaction he PDFed over.
Given Bulldog Gin is selling for 5.5X more than my purchase price, the $13,700 differential in what I thought I invested could end up being a $75,350 miscalculation to my net worth. I like to call my situation an example of financial distortion. This phenomenon is more common than we think.
Financial Distortion Can Really Hurt You
The Bulldog Gin investment is considered one financial account on my Personal Capital dashboard because it is one tax filing (K-1). Given I’ve got about 40 financial accounts now, the amount of financial distortion in my net worth can really add up over time if I’m not correctly tracking everything. Let’s say each miscalculation is roughly $5,000, we’re talking $200,000 in distortion that can equate to potentially millions of dollars of non-existent money in the future.
Three Examples Of Financial Distortion
Can you imagine in 20 years thinking you only have two years left to go until the mortgage is paid off, but you actually have another 10 years left due to some HELOC or cash-out refinance you forgot about? Seems impossible, but this is exactly what a relative of mine thought once she retired from her 25-year career as a $38,000 a year university healthcare administrator. She just never bothered to check the remaining principal balance in her mortgage all these years. Now her cash flow isn’t going to give her the retirement she had imagined.
Can you imagine thinking you only spent $500,000 for your house because you somehow forgot to add the $100,000 in home improvement costs you’ve made over the years? When it comes time to sell, you’ll miscalculate your profits and may very well pay more taxes than you should have.
What about your grandfather’s collectibles? When a distant relative died, there was an expectation by his children that his stamp collection was worth far more than reality. There was even some internal bickering on who got to keep the coveted collection. When they finally went to an appraiser, they realized the stamp collection was worth 80% less than they thought.
It’s just too hard to keep track of all your financial accounts without using an Excel spreadsheet or a free financial tool. In some cases, you may have underestimated a positive investment or overestimated a cost. But for some reason, we tend to overestimate good outcomes and underestimate bad outcomes.
Why Does Financial Distortion Occur?
1) Basic forgetfulness. We tend to remember the good and forget the bad. The older we get, the easier it is to forget. There are more things that have happened in a 50-year-old’s life than in a 25-year-old’s life. In most cases, financial distortion isn’t intentional, it’s just what happens when you start rounding up or down a particular financial event to cope with all the data. It should be harder to forget the cost of larger ticket items like a TV, car, or house. But it still happens all the time.
2) Ego. We like to attribute greater amounts towards positive investments and lesser amounts towards negative investments. It’s just like attributing a successful outcome to our own abilities and downplaying another person’s successful outcome to luck.
When Campari Group agreed to partner with Bulldog Gin a couple years ago, I started feeling good about my investment again. As a result, I started rounding up my investment amount to $75,000 when people asked me about my private equity experience. Perhaps if there was bad news two years ago, I may have rounded down my investment to $50,000 or said nothing at all.
3) Miscalculation. It’s easy to say you made a $500,000 profit on a house purchased for $1,000,000 and sold for $1,500,000, 10 years later. The reality is there’s a bunch of maintenance, interest, insurance, amortization recapture, taxation, and other selling expenses that need to be accounted for. By the time you actually get the proceeds, you’re going to have much less than $500,000 in envisioned profits.
The same goes for buying a stock for $50 and selling for $100 over a 10 year period. If the stock was also paying a 3% annual dividend yield every year, your total return is closer to 135% instead of 100%.
Finally, when starting a business, we may miscalculate the cost of our time in getting everything off the ground by paying ourselves next to nothing. If you don’t pay any of your employees, you can certainly improve your margins. But how long will that last until your employees flee?
Be Careful About Private Equity
I don’t want everybody to start investing in private deals due to the success of the Snapchat IPO and this average Bulldog Gin investment. Unless you’re OK with having zero liquidity for 10 years and being fine with losing 100% of your money 90% of the time, I would stick to public equity investing. I was actually considering investing $25,000 in Bento Now two years ago. And, I was going to invest $50,000 in Triggit, my poker buddies Facebook retargeting ad agency that also would have lost me 100%.
I’m disappointed in not making as much in Bulldog Gin as I thought, despite expecting to lose all my money. But the reality is, I’m probably going to make far less than a simple 5.5X multiple on my purchase valuation due to dilution, accounts payable, and company selling expenses. I’ll be lucky to earn a 2.5X return after 10 years, which isn’t that great due to higher risk and zero liquidity compared to the S&P 500. Then of course there is tax to pay.
Once I get the final numbers next month, I’ll detail exactly how much a $61,700 investment in a gin company valued at $10M nets an investor once it closes for $55M. In the meantime, conduct a proper net worth audit to make sure all your numbers make sense today. You don’t want to wake up in the future confused and disappointed.
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