There’s a quote from Charlie Munger, Warren Buffett’s partner at Berkshire Hathaway, that states “When you get a seamless web of deserved trust, you get enormous efficiencies”. The corollary is also true. When you don’t have a relationship based on trust, you get tremendous inefficiencies because you spend as much time monitoring the accuracy of the statements and the performance of the person you don’t trust. Sometimes you can spend more time on this than on the actual work that you should be doing.
This quote is also very accurate in describing the relationship between investors and entrepreneurs. There’s a lot of information asymmetry after an investment is made, with the entrepreneur knowing much more about their company than the investor. If the investor doesn’t trust the entrepreneur, they can spend more time trying to stay updated on what’s happening at the company and cross-checking the accuracy of the metrics and financial information they receive than actually thinking about how to add value to the company.
Similarly, entrepreneurs may not trust their investor. If they believe that the investor won’t keep information confidential, they may not share it. If they believe that the investor is going to take advantage of their declining cash balance in their upcoming round, they can start fundraising too early and derail the company’s operational performance. In countries like Turkey which don’t have formal share vesting laws, if they don’t believe that the investor will release their shares as they vest, they may not accept an equity vesting arrangement which helps them just as much as investors.
In terms of solutions, legal terms which try to enforce trustworthy behavior do very little. For example, an investor may establish information rights in the shareholders’ agreement, but if an entrepreneur decides not to share information, there isn’t much that an investor can do in practice.
The only solution for investors is to back entrepreneurs whose character they trust. Similarly, entrepreneurs need to take money from investors who they believe they can trust. And deciding whether or not to trust someone is an art, not a science. Reference checks from people they’ve worked with in the past help evaluate whether you should trust someone to a certain extent, but for a reference to be valuable you also need to trust the person providing the reference. Sometimes they, not the person you’re getting a reference on, are the one who shouldn’t be trusted.
At the end of the day, I rely on my gut feeling about someone’s character as the key determinant of how much trust I have in them. It’s been a pretty good indicator so far.
Also published on Medium.