The Least Bad Option

A different mental model

Perhaps because I am currently living in Sweden and looking at my home country from a foreigner’s perspective, this quote often comes to mind:

Americans can always be trusted to do the right thing, once all other possibilities have been exhausted.

It is often attributed to Winston Churchill, but I cannot find any verified documentation of him saying it. It summarizes a mental model that I have used over the years: “The Least Bad Option.” For me, this came to light in my corporate career. In situations with many constituents and conflicting goals, there is often no “right” answer. There is only a least bad option. We all strive for win-win situations. And despite being skeptical, I believe that the world is a positive-sum game; that is, we can all come out of situations better than we went into them. But sometimes, the options downright suck, and all we can do is play for the least bad option.

Of course, like almost everything I think about, there are investing implications. I often have this framework in mind when I’m evaluating management decisions. How are they pursuing their strategy? Why did they make the decision they made? I think you can tell a lot about a company based on the types of decisions they make, even the ones that you may not like.

Let’s talk about an example. I invest in some very small companies. Capital raising is often an issue for these companies. Ideally, we would like to see management pursue a straightforward and predictable path:

• Raise money, maybe from an IPO or, if a going concern, a secondary share offering.

• Carefully use the capital to execute your plan, judiciously spending money on high-priority areas with a high return on capital.

• Build out your process and organization into a profitable, cash-flowing business.

Sometimes, this is what happens. Other times, something else happens. Along the way, companies may make mistakes, or products take longer to launch or a capital project longer to complete than expected. As an investor, you can often sniff out when these things will start to be a problem. The tone of conference calls changes. They stop issuing press releases. Or they start issuing press releases. You start to feel like there is a challenge that will have to be overcome. It is interesting to see how management deals with this.

Let’s stay with capital raising for a moment - although this thought process could apply to a variety of issues. If a company that we are invested in starts to experience setbacks that imply they need capital, then you might expect management to behave in a variety of ways (from best to worst):

1. Plan for the future purposefully. Management is closer to the business than anyone. They should see the signs before we do and have contingency plans ready. Perhaps raising capital well in advance of the need so as to be ready if necessary.

2. Realize they may need capital and find strategic partners to help. Aligned customers and suppliers may well be able to provide funds on reasonable terms.

3. Partner with key banking partners. If you are caught somewhat flat-footed, then having strong banking partners who know your business can help. Perhaps convertible debt with a strike price much higher than the current share price: capital now, plus capital on reasonable terms later.

4. Reduce costs and conserve cash. Try to conserve cash so that the business can perform before it is necessary to raise money.

5. Wait until it is apparent that cash will run out. As the stock price declines, issue shares at historically low prices, which will cause major dilution to existing shareholders.

Obviously, option 5 should be the last choice. Yet, some companies do exactly that. There are many less bad options. So why pick the worst? What is in it for management? Did they not know better? Do they not care about existing shareholders? None of these options are great. How management decides which is least bad is very important.

To me, these types of decisions are very telling. Problems happen. And capital raising can be a problem, just like your warehouse catching fire or an assembly line going down. It is the management’s job to be clear-eyed about issues and opportunities and address them in as straightforward a manner as possible. In this sense, raising capital is a decision, just like what type of product to build or how many people to hire.

I hope all of your investment decisions are win-win. In the event that they are not, I hope that your management teams are skilled at picking the least bad option.

I don’t think there is a bad option here: cheese in Paris