Kinds of businesses and kinds of business(wo)men

Paul Kedrosky discusses some of the consequences coming down the pipe for the VC industry.  Paul draws much of his inspiration from his friend, Bill Stensrud, who's a VC investor himself.  Thinking about the current state of the VC industry, Bill observes that an overweening interest in getting to an exit (read: finding a buyer) has come to replace an interest in cash flow (read: making money).

What [all VC] firms have in common is that they exist to buy and sell equities.  They both buy from entrepreneurs and they both sell to acquirers or (very infrequently these days) to public shareholders.  They are, at their very core, traders.  Their job is to buy low and sell high.  This fundamental truth about the venture business informs every action they take whether mainstream of super-angel.  It also informs the culture of the businesses they create.  Everyone is looking for a pot of gold at the end of the rainbow - the life changing - all consuming - EXIT!!  The nature of their business model demands it.  These are close-end funds.  They have to return money - cash - to their investors.

In this blog over the next several months I am going to explore another - even more ancient - model for company creation.  This is art and practice of building and running a business for POSITIVE CASH FLOW.  Before there was venture capital and before there were EXITS, people built businesses to make money so they could pay their bills.  I will argue that re-discovering this model drives a corporate culture which is much healthier, more robust and more survivable than the EXIT-focused culture created by the venture capital model.  I will also argue that the cash flow model can engage the employees, the critical human capital asset of every business, to significantly greater efficacy than equity models.  Lastly, I will argue that we can modestly scale this model to the point that it can become a significant factor in new business creation.

One of the consequences of thinking about business environments as ecologies is that it makes it relatively easy to think the relationship between the people who run businesses and the generic conditions in which those businesses operate.  It becomes easy to see how VCs, in actively selecting with an eye toward the exit, might over time change the population of entrepreneurs they partner with.  It might be obvious that business ideas that make money, but have no clear exit strategies, do not fare well securing VC in today's market.  But business ideas are developed by and instantiated by businesspeople.

Today's VC climate actively selects against entrepreneurs who want to "build and hold" profitable businesses.  "Build and hold" doesn't just describe a business model--it describes a temperament:

• Thoughtful - concerned with long-term secular trends rather than high-velocity volatile fads
• Prudent - husbands scarce resources for the long haul--including and especially managerial stamina (contemporary VC expects managerial burnout, though it hopes to exit before it happens)
• Patient - satisfied to build a strong foundation for big success by stringing together a long series of small, cumulative successes

If we want businesses that are conceived and constructed as long-term money-making ventures, we need entrepreneurs with the right temperament.  If modern VC's intensive focus on the exit has changed the character of our pool of important and interesting business ideas, well, so what?  New ideas are easy to come by.  But I fear there may have been a more subtle and more fundamental change in the character of our entrepreneurs (as a group, not as individuals).  We now have one, maybe two generations of top-tier entrepreneurs (with the right experience and connections) who think of starting a business as aiming for an exit.

In order to make best use of our limited resources, we have created a streamlined system whereby everyone must exit at Easy Street.

Our current business culture of get-what-you-can-while-you-can follows directly from the preferences of the VC investors who hire people with that kind of temperament to build and run their businesses.  As go new businesses, so goes all business.  It's hard to see how we get sensible businesspeople to run our businesses until investors stop thinking like traders.

Social attitudes usually reflect social conditions (not moral preferences)

It turns out that personal finance isn't so "personal."  Much of it has to do with prevailing attitudes toward financial conditions.  Bank of America CEO Kenneth Lewis recently worried in public [WSJ; behind firewall] about people who might walk away from their mortgages now their homes are worth less than their loan balance.

Calculated Risk puts up some scary numbers, which indicate the potentially seismic consequences of large-scale shifts in social attitudes. How scary?  How does TWO TRILLION strike you?

If every upside down homeowner resorted to "jingle mail" (mailing the keys to the lender), the losses for the lenders could be staggering. Assuming a 15% total price decline, and a 50% average loss per mortgage, the losses for lenders and investors would be about $1 trillion. Assuming a 30% price decline, the losses would be over $2 trillion.

Not every upside down homeowner will use jingle mail, but if prices drop 30%, the losses for the lenders and investors might well be over $1 trillion (far in excess of the $70 to $80 billion in losses reported so far).

There's a huge social component to personal ethics--much larger than we usually suppose.  Is walking away from your mortgage bad behavior?  Well, what if not only makes financial sense, but many people are doing it?  What if it were recommended?  Shame depends on the visibility of certain personal behavior in the eyes of a public, and there seems to be much less shame associated with cutting one's mortgage losses.  The big lesson (apart from the shame I hope the banks are feeling) is that personal character is developed in symbiosis with social conditions, not in spite of them.

The economists have no clothes

Over at The Atlantic, Gregory Clark admits, rather refreshingly, that academic economists have no clothes.

The current recession has revealed the weaknesses in the structures of modern capitalism. But it also revealed as useless the mathematical contortions of academic economics. There is no totemic power.

As a discipline, economics proposes models, which are by definition incomplete. That is, they exclude some details and highlight others. To think that economic theories actually describe reality--as opposed to offer an image of reality that is useful for some purposes--is to mistake the map for the world.

Ceci n'est pas le monde.

Further, the dismal science has all too often provided models whose validity is impossible to ascertain, since it has often built its theories on the basis of premises that are false prima facie. The point here is that, logically speaking, false premises do not yield false conclusions; rather, false premises render the truth values of an argument's conclusions indeterminate. It isn't that economic models are false, but rather that the falseness of their premises means that can know nothing with certainty about their conclusions. We can't say whether economic models are true, false, or some determinate mix of the two. Logically speaking, they're mere speculation, with the same logical status as wishful thinking.

You mean we came all this way and we don't even know if we're wrong?

For example, the theories of classical economics generally accept as axioms (i.e., they accept as true without argument) the following:

1. All economic actors are rational.
2. All economic actors have perfect information about the markets in which they act.
3. All resources are scarce.

These are bad axioms, since they're obviously not true. As in, there's no doubt at all that these are false. Of course, not all branches of modern economics still accept these premises without qualification, but historically speaking these assumptions lie at the foundation of all economic thought. This is precisely the main reason I never studied economics in college. Who can take seriously a discipline that, wherever it ends up, begins with nonsense? While there's no doubt that the phenomena we think of as economic are intrinsically interesting, I remain skeptical that the formal discipline of economics has a great deal to offer beyond the obvious. As Clark notes:

The debate about the bank bailout, and the stimulus package, has all revolved around issues that are entirely at the level of Econ 1. What is the multiplier from government spending? Does government spending crowd out private spending? How quickly can you increase government spending? If you got a A in college in Econ 1 you are an expert in this debate: fully an equal of Summers and Geithner.

Common sense cloaked in jargon and equations. Even the economists' invisible clothes look rather shabby these days.