How Billionaires Can Have Bad Financial Plans

If you’ve followed any financial news lately, you have probably heard about the (now former) billionaire Elizabeth Holmes and the company she founded, Theranos. After a series of tough discoveries around her company’s flagship product, Theranos has gone from a company valued at more than $9 billion to somewhere closer to $800 million. And given the fact that Holmes owns 50% of the company, you might still not feel much sympathy for her right now. But there’s a catch here…

Theranos has raised more than $720 million in private equity funding and is still privately held. As part of that fund raising, a large number of investors have structured their investments as “participating preferred shares”. In short, these investors are entitled to any proceeds from the sale or liquidation of Theranos before common shareholders get paid. So a 50% common equity position, given that math, may not be worth much at the moment, especially given how long it would take to liquidate.

How could someone so smart and wealthy get into such a bind? Well, it’s more common than you might think.

The key lies in understanding the difference between wealth that is concentrated and illiquid versus wealth that is diversified and liquid. Believe it or not, many billionaires (especially newer or younger ones) may not fully understand this difference, either. Elizabeth Holmes is the perfect example of this considering her wealth is, presumably, almost entirely in the value of her stake in Theranos. That seems great when Theranos is valued at $9 billion, but her eggs are all in one basket. When Theranos’ value (which is still not entirely clear) was cut by something like 90%, Holmes net worth may have fallen closer to 100% because of the way her investment partners structured their deals. Even for a billionaire, a 100% reduction to your net worth is hard to rebound from.

To put that in perspective, if someone had all of their money in the S&P 500 before the Great Recession and sold on the worst possible day, they would have lost just under 60% of their capital. That example would have left Holmes with a net worth closer to $1.8 billion – enough that her lifestyle would never change. However, our average “Millionaire Next Door” would have had a significant lifestyle change after moving from $1 million to just $400,000.

Many start-up founders and venture capitalists are fine with taking the risk that they could be financially wiped out in one fell swoop. And extremely concentrated and illiquid positions can compensate you much more for taking that risk – but there is clearly a lesson here. Whether it’s your primary residence (which can be pretty illiquid) or a large stake in a private business, there’s something to be said for taking some time to review how diversified and liquid you are in your own financial life. Otherwise, you may find yourself unexpectedly changing your lifestyle quickly one day in the future.

 

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