Cornerstone 3 – Smart Decisions Using Backward Thinking
When making a decision about allocating capital to any venture, backward thinking is a powerful guiding tool to making smart decisions. To simplify, it is working through a deal, project, problem, or goal backwards.
It is easy to get caught up in how sexy the deal looks on the outside or on past performance, but that doesn’t guarantee what will happen moving forward. How people kicked themselves for buying Blockbuster at the same time Netflix came into the mix? As we all know, there are no guarantees to anything, which is why developing guidelines for better thinking is another layer of protection against market risk.
There are a few different ways to use backward thinking effectively. The first is turning the problem or desired result inside out. The second is determining if the demand, end user, or competitive advantage for the company /deal is real. They both represent backward thinking. One is taking the desired result, goal, or problem and inverting the questions so that come up with a more effective way of thinking. The other is to be able to clearly identify a true “end user” or “competitive advantage.” Getting good at both will help us make smarter decisions.
Avoid Errors By Turning Things Inside Out
Some of the most successful mathematicians use this strategy to solve complex problems. Carl Jacobi, a 19th century mathematician, said, “invert, always invert.” It is usually easier to think of the worst possible scenario and then come up with a plan to avoid it. Instead of asking, “What do I need to do to buy this company at $4M and take it to $5M?” ask:
• What activities will guarantee that I will not grow the company by $1M?
• What actions can I take that will make sure the company goes bankrupt?
• What are the root causes of these actions and activities?
• How can I avoid these causes?
And then, based on the answers to the previous questions, ask: “What key activities will allow me to reach that growth of $1M? How can I implement these activities?”
Serve Demand, Don’t Create It
According to Albert Einstein, “A man should look for what is, and not for what he thinks it should be.” We want to put ourselves in the path of demand, not spend time and energy trying to create it or fooling ourselves by pretending it’s there. It is much more difficult to create an end user than to serve one that already exists. So, the key is identifying the end user or, to put it simply, make sure demand is greater than supply.
This step is the hardest to implement because many times we tend to over-exaggerate the attractiveness of a deal and sugarcoat the negative aspects. Using backward thinking helps us stay focused on what actually is, not what we wish it to be.
Let’s say that we were looking at a site that was entitled for 60 units of apartments. We were excited about the site because we were getting it fully entitled, which essentially means we are removing “entitlement risk” and saving ourselves 1-2 years in the development process. This is attractive to our company. Let’s also say the zoning was in place, the price was right, the terms of the deal were solid, and everything pointed in the direction of “we need to close on this property.” Then we find out that the market for apartments is oversupplied by 10,000 units. This is a big problem for two main reasons. First, it is going to take us longer to lease the units. Second ,because supply is outstripping demand, rents will drop, cutting into profits.
To make sure this is a viable deal, we need to find out the average vacancy for apartments in the specific area and how many units are scheduled to hit the market over a specific period of time. This will tell us if we have a stable end user. As you can see we are working backwards from the end, very likely saving us from a potentially bad deal.