Last month's post was a somewhat lengthy introduction to a simple concept I learned in a Tax/Finance class I took from Myron Scholes. (Yes, the guy who co-invented the Black-Scholes model). Had I known that he would someday win the Nobel Prize, I probably would have paid more attention - but one thing I did learn was the concept of compounding.
Getting past the math (Scholes loved to write equation after equation on the blackboard), a key lesson from class was that if you invest in securities which grow in value for a long time, and pay taxes at the end, you end up much better off than if you invest for short term gains and pay taxes in interim periods. (This is one of the rationales behind Bob Kirby's "coffee can portfolio" - the exact opposite of the trader's approach to wealth creation).
Luckily, as venture capitalists, we are saved from ourselves - we're more apt to resist that strange human impulse to monitor stock quotes because our capital is locked up in illiquid investments. When we invest, we price securities based on our assessment of intrinsic value, potential for appreciation, and negotiations between private parties. Once we make an investment, our job is to assist entrepreneurs and help companies grow and grow.
To compound value in venture capital, two critical factors to remember are patience and capital efficiency. These factors, are often overlooked by VCs who seem to care more about other issues - they ask "how big is the opportunity?" (it must have homerun potential), "how quickly can they get there?" (the company should have $100mm revenue potential within 5 years), and "how much money can be put to work?" (bigger funds must deploy more capital per deal - or end up with too many deals).
Why is patience relevant to the discussion on compounding? Because time is required for compounding to take effect. In Silicon Valley, VCs as well as entrepreneurs want very fast growth rates - 100% per year or more. In contrast, we'd rather focus on building a growth engine which can last a very long time. The only way this can happen is if we build a great company - one with smart, responsible management, sustainable competitive advantages, and a commitment to creating long term value. There are no short cuts.
(To see the impact of time, refer back to the Buffet examples from the last article. There is a HUGE difference between 1.243^10 and 1.243^49 - the latter being Buffet's track record from his partnership days to today: 1957-2006. Compounding growth at 24.3% is quite satisfactory!).
Perhaps the above point is totally obvious. But why is capital-efficiency relevant?
After we make an investment, if substantial amounts of additional funding are required to grow, then over time, the compounding rate of shareholder value will be far lower. Myron Scholes' equations showed that death and taxes are certain enemies of compounding. So is dilution! (Too much funding is not only bad for investors - it's even worse for founders, managers and employees who suffer liquidation preference overhangs as well as dilution).
Capital efficiency and patience are inextricably linked. Over the years, we've learned that if we help our companies become profitable quickly, we can afford to be more patient. In contrast, companies which burn through lots of capital or play venture lotto produce far lower rates of return (or fail in spectacular fashion).
At Altos, we place less emphasis on 100% growth or conventional VC metrics like "$100 million revenues in 5 years." We've seen thousands of business plans with such projections. It's like they were cut and pasted from the same "VC 101" business plan!
We've learned that the key to great returns is to be impatient when it comes to burning cash and patient when it comes to growth. When companies figure out how to make money early on, they are more likely to figure out how to make money later, as they get bigger and bigger. If companies grow without learning how to make money, they may never figure it out! They lose their edge. They become more in tune with what investors want rather than what customers want.
We look to invest in companies which can grow consistently, at compounded rates (i.e. in a capital efficient manner), for long periods. It's not to say that we won't take fast growth when we can get it and we certainly would love to invest as much as possible if ROIs meet our targets. However, we've learned that hyper-growth is far more a function of market dynamics than of managerial brilliance and the best companies do not require much capital. Investors who invest more than what is required or pressure companies to grow at unsustainable rates can make things far, far worse. Start-ups are risky enough as it is - we don't need sloppiness, wishful thinking, or foolishness in the mix.
Great companies win based on ingenuity and relentless drive, not by hosing money behind projects. Sometimes they win because of superior technology, or marketing, or service - but more money is not the answer. Think about it. If access to capital was the key to winning, then big companies, the ones which have access to the most capital, would always win. Perhaps, in the old days, when physical assets were more important than informational assets, capital was more of a barrier to entry. But take a look around - it's just not true anymore. Information, knowledge, and creativity are the most compelling competitive weapons in more and more industries.
We believe there is an inverse correlation between huge winners and the amount of capital raised (for example, think about Microsoft, Google, Cisco, eBay, Oracle, SAP, SAS, Qualcomm, RIMM, Broadcom, Intuit, etc). To quote Marissa Mayer of Google, creativity loves constraints. Time and time again, the best companies are created with very little outside funding. It's guerrilla warfare vs. conventional warfare. The disruptors vs. the establishment. We've seen over and over again that companies which stay hungry and figure out how to do more with less end up developing much more staying power. It's a paradox which confounds investors with too much money to put to work - when it comes to creating companies built to last, less is more.
As a final point, we have to concede that, as venture investors (managing other people's money with limited fund lives), we can't buy and hold investments forever (like Warren Buffet). But the key to spectacular returns is investing in, and helping to nurture, create and build great companies - those which will stand the test of time. The traders and flippers, or investors looking to get rich off management fees, may get lucky once in a while, but they will never create wealth in the leagues of a Warren Buffet, Bill Gates or Sam Walton.
The power of compounding is pretty straightforward. But I've found over and over again that the human mind has a surprisingly hard time grasping its effects which is why I've devoted two consecutive articles to this topic. (Here's a quick mind puzzle - if you had to choose between taking $1 BILLION, or a stream of payouts which starts with just one dollar on the first day - that then doubles every day for 31 days, which would you choose? Click here for the answer: 1*2^31)
Too many VC backed companies seem built to flip rather than built to last. There is a better way to create real value.
If we are going to be competitive in a more global world, we have to change our way of thinking. Many foreign entrepreneurs grew up in cultures which have an appreciation for much longer time horizons. (For example, in Korea, my ancestors are buried in a cemetery dating back 600 years - and my father's family has owned that land throughout the centuries. In China, they probably think about millenniums).
As VCs and entrepreneurs, if we want to build the dominant companies of the next millennium, It's time to start thinking about the power (and the joys) of compounding.