Risk, Leverage, and Talent

"Arguing in My Spare Time" No. 27

by Arnold Kling

Nov. 10, 1998

May not be redistributed commercially without the author's permission.


In finance, leverage refers to the ratio of debt to equity. A firm that has issued a lot of debt relative to equity is said to be highly levered. Someone who makes a low down payment to purchase a home thereby obtains a highly levered investment in real estate. High leverage means that if things go well, you do very well, but if things go poorly you lose just about everything.

Someone whose financial well-being is tied closely to that of a particular firm is taking a highly levered position in that firm. For example, if I take my entire net worth and use it to buy call options on Microsoft stock, then I will have a highly levered position in Microsoft.

The most important asset that many people have to allocate is their human capital, or talent. In general, someone who chooses to become a principal in a small business takes a highly levered position in her talent. Someone who takes a regular salaried position with a big company takes a relatively unlevered position in her talent.

In the previous essay, I argued that stock options for non-principal employees are inefficient. Such stock options give employees leverage in the firm, but they do not give them leverage with respect to their own talent. If my actions and decisions do not have much effect on the value of the firm, then stock options do not create leverage with respect to my talent. In the hypothetical case where I put my entire net worth into call options on Microsoft stock, the outcome of that bet has nothing at all to do with my own talent. I do not even have to work for Microsoft to make that bet.

In yet another essay ("Should middle managers be encouraged to take more risk"), I pointed out that because middle managers at large firms are not personally levered with respect to their own talent, it is necessary to have bureaucracy to control risk-taking. The advantage of the entrepeneurial setting is that the leverage of the principals gives them the incentive to evaluate risk in a balanced way.

Most individuals want the best of both worlds. They want the financial security of an unlevered position in their talent. Yet they want the upside potential of a levered position in their own talent.

Consulting, or what FastCompany Magazine calls "free agency," is an intermediate position. A consultant is more levered in her own talent than a salaried employee. However, there is limited upside in consulting. The revenue per employee in consulting is never going to reach the stratospheric levels that create fortunes.

In equilibrium, the income of a salaried employee is going to be close to the expected income of an entrepeneru with the same talent. This is a standard prediction of economic theory.

If the expected income of people working as entrepeneurs were higher than their income as employees, venture capitalists would bid people away from salaried positions to join small start-ups. This process will continue until a point is reached where the risk aversion of the marginal employee is greater than the difference between the expected value of an entrepeneurial lottery ticket and the income one can earn as a salaried employee.

How large is the risk premium earned by entrepeneurs? I suspect that many people over-estimate the risk premium, because they look only ex post at the most successful entrepeneurs. These multimillionaires indeed have earned more than they could on salary. However, if one thinks of each entrepreneur as having purchased a lottery ticket, one should look at the average value of all the lottery tickets purchased, not just the value of the winning ticket. That is, one should average in the failed enterprises with the successful ones.

From that perspective, I suspect that the average value of entrepeneurial lottery tickets is not much higher than the value that those same individuals could get working for a salary. Thus, the risk premium is not very high.

The Adrenaline Group, a small local computer consulting firm, will give small start-up businesses a lower fee in exchange for an equity stake in the business. This is an interesting model. Because the consulting firm's work is a significant contribution to the start-up, giving the consulting firm an equity stake is a reasonable way to align incentives. At the same time, the consulting firm is able to diversify its risks across several start-ups. The consulting firm buys several lottery tickets rather than one. Of course, owning several lottery tickets dilutes the leverage of one lottery ticket. Thus, the consulting firm is levering its talent, but it is diversifying its risk across various entrepeneurial businsses.

Whether this is more efficient than simply taking a fee and investing some of the income in the market portfolio is an interesting question. The answer depends on how much value is created by aligning the incentives of the client businesses with the consulting firm.

The reduced importance of physical capital in today's economy has made it possible for more people to obtain entrepeneurial lottery tickets. The economy is groping for an equilibrium where the right number of people choose such lottery tickets, the right number of people work for a salary, and the right number choose something in between.

The stock market is acting as if Internet lottery tickets have tremendous upside. It places values of billions of dollars on companies that are barely breaking even, at best. I have argued in "Deconstructing McKinsey" that the network and lock-in effects needed to justify such valuations probably are not as pervasive as people think. Thus, I suspect that the stock market is not the solution for allocating talent.

Large firms also cannot solve the talent allocation problem internally. The lottery tickets that large firms have to offer--stock options--do no align with the risks that middle managers take. Thus, large firms, although they may attempt to deny it, must necessarily be bureaucratic.

If the structure of the economy is changing to favor entrepeneurial lottery tickets over salaries, then my expectation is that the institutions that evolve to make the process more efficient will be focused on small businesses. Innovations like The Adrenaline Group's attempt to take a levered but diversified position in its talent will be worth following. Part-time entrepeneurs, who work as professors or consultants some of the time and spend the rest of the week trying to launch businesses, may be another solution. The attempt by people and the market to find the right balance of risk and leverage with respect to human talent will be a major issue going forward.