Brooke’s Note: The three-day weekend allowed me the luxury of reading a couple of articles in The New Yorker, and I found an interesting one: “The Sure Thing: How entrepreneurs really succeed” by Malcolm Gladwell, whose recent book Outliers examined the phenomenon of success. The New Yorker article takes on the myth of the entrepreneur. Gladwell concludes that entrepreneurs are not brave people who are willing to take extraordinary risks to achieve business success. Rather, he finds that the most successful entrepreneurs are profoundly risk averse. My interest was piqued immediately. I believe that almost all RIA firms are headed by entrepreneurs, and that the findings of the article would be helpful for anyone looking to hone their approach to running a business. As a bonus, the article uses the success of John Paulson, the uber-successful hedge fund manager, as one of its case studies – a subject close to home for most financial advisors.

Malcolm Gladwell’s The Sure Thing offers insight into a more metaphysical aspect of managing practices that gets labeled as entrepreneurialism. Here are some of the findings based on a study by French scholars Michel Villette and Catherine Vuillermot entitled: “From Predators to Icons”:

1.) An entrepreneur’s success almost always includes a “moment of great capital accumulation,” which is to say a particular transaction that catapults him or her into success. In the case of RIAs, it’s hard not to think of the moment when many these advisors took their relatively hum-drum jobs as stock brokers and parlayed them into living, breathing businesses. Advisors take steps to own the stream of revenue generated by their clients rather than borrowing it.

2.) A businessman or woman looks for transaction partners who do not have the same definition as he or she of the value of the goods exchanged. The partners may undervalue what they sell or overvalue what they buy in comparison to the entrepreneur’s own evaluation. When an RIA pulls away from a wirehouse, it is because the RIA has placed a much higher value than the wirehouse on those clients. The advisor proves it by upending his or her own life to institute a new business model.

3.) The entrepreneur moves decisively, the scholars add. He or she repeats the good deal over and over again until the opportunity closes, and – most crucially – the focus throughout the sequence is on hedging bets and minimizing chances of failure. Elliot Weissbluth of HighTower, Rudy Adolf of Focus Financial and Joe Duran of United Capital leap to mind when I think of repeating the good deal over and over as they buy independent financial advisors from a world that undervalues them. RIAs themselves do this on a micro basis as they bring aboard clients from wirehouses in this climate of low resistance.

A second set of findings were attributed to Scott Shane, author of “The Illusions of Entrepreneurship.” Here are some of his findings:

4.) Business success is highly correlated with how well capitalized the entrepreneur is. Failed entrepreneurs tend to be “wildly undercapitalized.” Perhaps the reason that breakaways by stockbrokers with solid businesses rarely fail is that they have cash flow [almost] from day one.

5.) Failed entrepreneurs tend to organize as sole proprietorships. Successful businesses organize with a corporate structure. Most advisors tend to have a corporation or LLC. The few RIAs I’ve encountered with sole proprietorships tend to have $15 million or less of assets under management. RIAs of this size are also the ones that occasionally fail.

6.) Failed entrepreneurs rarely write a business plan. I think honestly that there are plenty of good RIAs with no written business plan. But the ones that continue to grow and thrive tend to be beneficiaries of good planning.

7.) Ninety percent of the fastest growing companies in the country sell to other businesses “Failed entrepreneurs usually try selling to consumers,” the article states. Obviously this does not apply directly to most RIAs. Still, I think it’s food for thought. I hear of more and more RIAs who succeed by offering business owners help through 401(k) plans or even supplying merger-related advice. Family offices succeed by serving individuals as if they are a business and even compare themselves to the chief financial officers of corporations.

8.) Other qualities of failed entrepreneurs include: underemphasizing marketing and financial controls. Competing on price is another no-no. No doubt most RIAs can relate to falling in to these traps. Practice management programs at the custodians may help address these issues – at least for the custodians’ larger RIA clients.

9.) A final point made by Shane is that sociologists Hongwei Xu and Martin Ruef polled a large number of entrepreneurs and non-entrepreneurs and asked them to choose among three scenarios: a.) A business that had a 20% chance of making $5 million or b.) A business with $2 million of profit and a 20% chance of succeeding or c.) One with a $1.25 million profit and an 80% chance to succeed. Of the group, entrepreneurs were the most likely to choose the conservative third scenario. Most RIAs are ambitious, but they will not take any steps that can endanger the book of business that they have already established. This was highly evident during the past two years of turmoil. It may also explain a frustrating [from the standpoint of their custodians] aspect of RIAs — that they reach a comfortable level with their practices and throttle back their growth efforts.

Gladwell went into detail to describe how Paulson & Co. generated a profit of $15 billion in 2007 and $5 billion in 2008. He did it by finding a way to bet big on the popping of the housing bubble. It sounds risky but Paulson didn’t see it that way.

10.) Gladwell quotes an excerpt from Gregory Zuckerman’s account of Paulson’s success in “The Greatest Trade Ever.” It explains the reason that Paulson believed his bet was conservative. “Their findings seemed surprising: Even if prices just flat-lined, homeowners would feel so much financial pressure that it would result in losses of 7% of the value of a typical pool of subprime mortgages. And if home prices fell 5%, it would lead to losses as high as 17%.” These are the kinds of down-to-earth assessments I heard RIAs making last spring when the world was going to financial hell and they faced the dilemma of whether or not to bail out of the market. Even a modest improvement in corporate earnings justified holding the shares of companies on behalf of clients. This wasn’t a wild bet of people’s savings. It was a sober bet that saved many clients and kept RIAs in business.