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.

Disorganize the schools!

The NYT covers the--gasp!--new trend of tutoring students (mostly boys) who seem to be having trouble in school. OK, OK, it's not the tutoring itself which is interesting. We've known for some time that tutoring is among the most successful of teaching methods. It's the fact that the tutors aren't teaching subjects, they're teaching habits. In other words, ethical tutoring.

If you want to get 'em educated, you first gotta' get 'em organized.
(Photo by Jim Wilson for the New York Times)

As per their standard operating procedure, the NYT adds zero content to and only a confused, watery viewpoint on the conversation. (When will they stop "reporting" and start giving us the story?) We've known for some time that girls outperform boys in almost every subject until puberty hits, at which point boys edge ahead in math and science. But why? And what to do about it?

The NYT frames the problem as one of organizational habits--which is curious because it focuses not on the problem, but on the (stopgap) solution. Providing boys with better organizational skills will undoubtedly help them do better in school. But doesn't this beg the question of why schools demand that children be "well-organized" in order to receive an education? Why should high-school boys need to develop bureaucratic skills and habits in order to learn? After all, the world itself wasn't color-coded the last time I checked.

A classic case of mistaking your map of the world for the world itself.

Too, the culture's perception of schooling has changed. I believe that parents used to be more focused on the education itself--what the child was learning, how s/he was doing in class, etc. There was a sense that the learning itself was the primary propellant provided by schools to children aimed at moving up in the world. Nowadays there's a great deal more focus on getting the certification at the end. It's the paper that matters--not the process. Especially with No Child Left Behind [free registration required], our focus become fixed on making the grade, and the means seem to matter little.

On top of our intense focus on the finish line, we still teach using methods which we know (and have known for years) don't work all that well. Is it any surprise that energetic, independent students should rapidly come to the conclusion that school isn't worth their time? Why not simply cheat, or cram for the test? And why worry at all, since that silly certificate isn't worth much any more unless you've got the right parents in any case?

Ultimately, it isn't boys who are less organized, it's our pedagogy (and indeed every institutional activity in our culture) which has become more rigidly organized. Turning in your not-very-interesting and not-at-all-important homework on time isn't equivalent to responsibility. It's just punching in. People who focus intensely on thing they themselves find trivial and meaningless are usually pretty unhappy. And no surprise there either.

The myth of "passive income"

A friend of mine, JD, who used to work as a developer in New England, tells me that there's a new board game which is "sweeping the country." The game: Cashflow 101. The object of the game: become wealthy by mastering the art of investing. The game's designer (or perhaps just endorser): Robert Kiyosaki of Rich Dad, Poor Dad fame.

After reading his Yahoo! Finance column a few times, I've come to conclusion that Kiyosaki is a financial charlatan (which means that I refuse to drive traffic his way by linking to his stuff directly). In a nutshell, Kiyosaki's financial advice boils down to "Choose to be wealthy." I'm not kidding. His is the worst kind of quasi-libertarian snowjob, since if you pay for any of his motivational products or services, but don't get rich, why, it must be that you just haven't "really committed yourself" to being wealthy. If you're poor, it's your fault. You just haven't really, in your heart of hearts, chosen to be rich.

"As you can see, my heart of hearts loves poverty more than I do."

While it's true that the acquisition of wealth can be a very subtle art, it's an open secret that (in the US, at least) the most simple, most direct, and by far most common strategy for getting rich is to have wealthy parents. But this is all really an aside. What I really want to discuss is the folly underlying Kiyosaki's game and the worldview it reflects.

In Cashflow 101, each player begins with a randomly selected income-expense profile--a job and a bunch of expenses. After that,

There are two stages to the game. In the first, "the rat race", the player aims to raise his or her character's passive income level to where it exceeds the character's expenses. The winner is determined in the second stage, "the fast track". To win, a player must get his or her character to buy their "dream" or accumulate an additional $50,000 in monthly cash flow.

The whole thing revolves around this mysterious concept of passive income.

He just followed me home. Seriously. So... can I keep him?

Aaron Maxwell has written a pretty good beginner's guide to Cashflow 101, which explains that

[p]assive income is income that comes in with little or no additional effort on your part. If you have royalties from a book, income from a rental property you own, or stock that pays dividends each quarter, you have passive income.

Maxwell immediately goes on the qualify that definition:

Sometimes you'll have to do SOME work - if that rental house develops a leaky roof, you'd better have it fixed if you want to continue collecting rent! The difference is that for a "normal" job, you have to invest your time continually to keep receiving income, and if you work half as much, your income immediately goes down by half or more. With passive income, after you do some initial work up front, you have an income stream that continues with little or no time on your part to maintain it.

And there's the rub. Passive income isn't genuinely passive in the sense that it requires no effort. It's simply that compensation isn't immediately correlated to effort. Passive income doesn't require endless, futile labor to sustain it. Rather passive income represents one flow within a relationship of ownership--and in the opposite direction flows responsibility. We receive passive income from assets for whose condition and behavior we are liable.

Calling the income passive is misleading, because it implies that such income arrives not simply without--or with minimal--effort, but with minimal worry as well. But ask any landlord--you're essentially paid to worry about stuff. Whatever the gods of pop music claim to the contrary, tenants do not call Ghostbusters first. Especially when the heat goes out. First, they call the landlord. Then, they call their lawyers.

I ain't afraid o' no tenant.

Responsibility implies liability. Although rental property income provides the most stark example, other kinds of passive income also admit of analogous forms of responsibility. In exchange for book royalties, the author remains responsible for what he's written. In exchange for stock dividends, the owner becomes responsible for the behavior of the company whose shares she owns. (Warren Buffett famously advocates treating the purchase of stock as equivalent to the purchase of the entire company.)

The point here is that wealth, because it depends upon ownership, entails responsibility and liability in direct proportion. There's no such thing as truly passive income, and anyone who thinks she wants to be rich should be warned that Easy Street is the main thoroughfare in Neverland. Wealth is a sacred social trust, not a ticket to heedless self-indulgence. It is most certainly possible to enjoys the fruits of responsibility, but only for so long as and to the degree that one proves willing and able to bear its weight.

We have a word for those who take the lazy way to easy street, and it ain't flattering.

Sector four

A riddle: If you're not for-profit, and you're not non-profit, what are you?

"Ah..." says the clever reader. "You're the government."

"But my lawyers tell me that I really am the government."

But let's just say that you're not the government either. (You listening, George?) You're still a private organization, you don't live off charitable donations, and you're not just in it for the money. Is there a fourth option?

There is. Although not fully formed, the emergent fourth sector comprises organizations not interested in playing by the old rules. Goodbye Marx, Spencer, Jacobs, and even Keynes. Hello KaosPilots. Increasingly referred to as "for-benefit," 4th Sector organizations have the following features:

• Privately owned and controlled (not government)
• Sustains its operations based on income generated by their activities (not a charity)
• Returns some of their surplus to their equity owners in the form of profits (not a non-profit)
• Leaves some of the value it generates in the community where it can continue to accrue (not merely a profit machine)

While for-benefit organizations often represent the fruit of social entrepreneurship, they're not one and the same. Social entrepreneurship (which has very official support here in Canada and elsewhere) means using the tools, techniques, and attitude of for-profit entrepreneurship to tackle social issues. For-benefits are one possible outcome of social entrepreneurship, but so are innovative charities, non-profits, political organizations, one-off events... even for-profits can be conscripted sometimes.

While no one knows exactly what the 4th Sector is going to look like, it's increasingly obvious that it's coming. (Even the last-to-every-party NYT has caught the shift in the wind.) And it won't be just companies--it's a whole new ecosystem. They're even growing their own venture capital firms. Watch out, old order.

"4th Sector rabble resists Ancien Régime forces?" No way.
"4th Sector overruns final barricade manned by scruffy Ancien Régime holdouts." Oh, yeah.

Caging the innovation bird

So, 800-pound Microsoft has begun developing a network of Innovation Centers around the globe as part of strategy to "to foster innovation and growth in local software economies." Hmmm....

I think most people would be at least a little suspicious of Microsoft's intentions in spearheading such an effort. Innovation is inherently a collaborative and not a competitive process. Microsoft claims to be cooperating with governments, universities, and other software companies; while I see no reason to think that they're not doing so, I do believe there are grounds for thinking that Microsoft may understand "cooperation" differently than some of its Innovation Center partners. Microsoft Founder Mr. Gates may or may not have reconnected with his inner philanthropist; it remains the case that Microsoft's behavior and corporate culture during his tenure was profoundly combative and territorial.

Soon every innovation in this neighborhood... will be mine!
(Photo by oddthingies)

A key question private businesses are asking themselves these days is how to capture value generated by an innovation process--how keep the innovation bird happy in its cage, as it were. Innovation, however, doesn't just thrive in an open environment--it arguably cannot even survive unless it can roam freely, build doors in impenetrable walls, outgrow its origins. While people can own innovation processes and products in the looser sense of taking responsibility for them, it's hard to see how anyone can own them in the stricter legal sense. (And I seriously, seriously doubt that Microsoft will be the one to crack this nut; their outlook is too closed.)

And if you've been wondering whether or not the new fixation on innovation is just a passing fad, it isn't. My ex-boss David Smith of the Affordable Housing Institute recently blogged about an April 2007 PNAS paper by Luís M. A. Bettencourt, et al., entitled "Growth, innovation, scaling, and the pace of life in cities." According to Smith, Bettencourt et al. divide all the factors of urban life into three categories:

1. Factors that scale linearly with the city's size, such as number of jobs, water consumption, etc. (Smith calls these "personal matters");
2. Factors that scale sublinearly with the city's size--i.e., those factors that enjoy economies of scale--such as consumption of energy and transportation resources (Smith calls these "hardware");
3. those factors that scale superlinearly with the city's scale--i.e., those factors which enjoy network effects--such as disease rates, innovation rates, and wealth generation (Smith calls these "software," or "social interactions").
   

Wealth is, as Jane Jacobs has noted, an urban phenomenon. But wealth moves hand in hand with innovation--both are superlinear urban effects. Which means that big cities both demand and generate higher rates of innovation and wealth generation. Note that superlinear effects are not merely epiphenomena--that is, it's not just that bigger cities "happen to" generate exponentially more innovation, crime, wealth, and disease. The economies of bigger cities, when they grow (again, as Jacobs has noted), grow on the basis of wealth and innovation. An ever-growing economy producing ever more wealth--the holy grail of Protestant democratic capitalism--both requires and produces ever more innovation. As long as our cities keep getting bigger we will keep getting wealthier and smarter, and innovation will weave itself ever more inextricably into our economies and cultures.

As anyone who's tried to innovate knows, innovation relies upon creativity, and creativity thrives in open systems, open networks, and open minds. It's no wonder that the interests in innovation and social entrepreneurship have developed in parallel, since social entrepreneurs seem willing to perform all kinds of commercial functions without basing their organizations on the pathological greed and egomania which lie at the heart of corporate misbehavior. Greed and egomania are diametrically opposed to the values of generosity and humility which form the basis of every successful culture of innovation.

Corporations today--and Microsoft is no exception--want the wealth that follows on the heels of good innovation, but they can't bring themselves to believe that "proprietary innovation" makes about as much sense as "a happily caged falcon." At bottom, I think it's our whole notion of ownership which needs rethinking. In a sense, after all, wealth belongs to communities (or societies, if you prefer). We just entrust it to corporations and families and individuals in the belief that they will use it responsibly if their personal well-being depends upon its sound management. A pretty smart system, overall. But can we imagine (and design) a better one? Can we imagine (and design) a form of ownership which engenders and protects responsibility, but also resists the excesses of the miser and the tyrant?

Maybe building a better cage means not building a cage at all; maybe it means becoming falconers.
(Photo by wallyg)

The only way to stress less is to let it go

The NYT covers an emerging trend in affluent US high schools, where a culture of "super-achievement" has taken over.

Relaxation, like stress, is a habitual behavior based on learned techniques.
(Photo by Jodi Hilton for NYT)

I have a feeling that many people will view requiring stressed out high school seniors to take yoga (and the like) as a kind of fad aimed at making kids even more well rounded. But I would suggest that such efforts may really reflect the first wave of a shift in consciousness which sees clearly that the habits kids acquire in school become the backbones of their respective characters. And being stressed by work is one of those habits. (And remember, this is all high school level coursework--i.e., almost completely insignificant.)