Capitalists Beat Merchants Everytime

European Straits #35

Dear all,

I’m spending a few days in Tallinn (Estonia), where I’ve been participating in a bootcamp organized by the INET’s Innovation Working Group. I also dedicated some time to meeting local entrepreneurs, investors, and government representatives to get a better grasp of the local entrepreneurial ecosystem.

Among the highlights of the bootcamp—which included talks by Erik S. Reinert, Carlota Perez, Dan Breznitz, and Bill Janeway—was a presentation by Mary O’Sullivan of the University of Geneva (Switzerland). Mary gave a fascinating talk on capital as discussed by economists throughout history. To make a long (and stimulating) story short, two lessons can be drawn from her reasoning:

  • If you want to learn more about capital, talk to capitalists (those who invest in and run businesses—people like us) rather than to economists.

  • Capitalists mostly care about return on assets (RoA) and return on equity (RoE), which enables them to take the larger view. As they’re focused on capital asset velocity, they tend to beat those whom Mary calls the “merchants”, who obsess primarily about net operating margin.

Mary’s talk triggered a chain of thoughts. I have long been reflecting on the relationship between microeconomics and business, notably corporate finance. On the one hand, network theory, increasing returns to scale and complexity economics in general are very helpful when it comes to understanding the digital economy. On the other hand, the disciplines you must master to handle investors and effectively manage a corporation are business strategy and corporate finance. Yet to my knowledge, the gap between the two worlds—network economics and business—has not been bridged yet.

To remedy that, I recently enrolled friends to work together on how to translate increasing returns (the core microeconomic property at the heart of tech companies’ strategy) into practical financial modeling. Here are my latest ideas on that subject, in large part inspired by Mary’s talk in Tallinn on Monday:

  • A key feature of tech companies: they accomplish a lot without immobilizing as many assets or employing that many people. This explains the high rate of return on equity for those who make it to a successful exit (Instagram) or to perennial domination (Facebook).

  • However far-fetched that sounds, this very much reminds me of leveraged buyouts (LBO), in which target companies are purchased with more debt than equity. An LBO enables private equity investors to own 100% of a company’s shares while bringing only a small amount of equity to the table. Once the debt is paid back (usually with the target’s profits), return on equity reaches record levels: equity investors pocket 100% of the exit price while having committed only a small slice of the acquisition price. Debt financing bridges the gap and allows one to grab additional capital. Financial leverage is what makes it possible to boost return on equity. (To be fair, it’s with a little help from the tax shield on interest payments.)

  • What would be the equivalent of LBO debt financing in the tech world? Mostly it’s the additional capital provided by us, the users—whom I call the multitude. That includes user-owned tangible assets (apartments on Airbnb, cars on Uber and Lyft), user-generated content (Amazon reviews, Instagram pictures), Trebor Scholz’s “digital labor” (‘likes’, ‘shares’ and other clicks are congruent to labor), money (as with peer-to-peer lending), and many other intangible resources such as peer trust, sensitivity, creativity, and the wisdom of the crowd. All in all, there’s corporate value in bonding with the multitude because it gives corporations easy access to all of the additional capital above and thus contributes to maximizing return on equity. The only thing is, it’s not (tax-free) financial leverage—it’s leverage based on the multitude (which in a way is also tax-free, but that’s another story).

  • If bonding with the multitude equals additional capital in the future, it can be accounted for with a net present value—like any other asset (even though, unlike buyout debt, it cannot be accounted for on the balance sheet). One challenge is to calculate the value of a company’s alliance with the multitude in the future: this requires projecting what users bring to the table as well as the various technology-driven positive feedback loops (among them network effects—here’s the microeconomics). Another challenge is to infer the net present value of that alliance by applying a discount rate (here comes corporate finance).

  • There’s a thing with the multitude: it cannot be taken for granted. Individual users become an active part of digital supply chains and contribute to creating value if (and only if) they get something in return—the equivalent of interest on LBO debt. I think that in the case of tech companies, that ‘something’ is a well-designed, rewarding, exceptional experience. Indeed as discussed in Rana Foroohar’s latest column, we’re still not sure if it’s a fair price for the value we all create. Still, why do you think Jeff Bezos declared Amazon “the Earth’s most customer-centric company”? Not because he’s altruistic, but because he’s known all along that serving customers well maximizes the value of that singular asset: the alliance forged between Amazon and the multitude. At stake, after all, is what matters for the capitalist: higher return on equity!

  • My thought is that the discount rate can be used to account for the customer experience. An exceptional experience is predictive of a strong, lasting alliance with the multitude, which equals high retention rates in the future, which implies a low discount rate (as is the case, I think, with Amazon and Facebook). Conversely, a less-than-average experience, even with a strategy based on the multitude as leverage, calls for a higher discount rate due to the increased probability that users will at some point walk away and break the alliance (consider Yahoo in the past, and maybe LinkedIn in the future). (As for companies that don’t rely on the multitude AND inflict a bad experience on their customers, they simply don’t qualify for being called tech companies—and they’re downright bad at capitalism.)

I’m amazed every time I realize it: all of us who try and understand the digital economy are merely walking in the steps of Jeff Bezos. As a capitalist rather than a merchant, Bezos envisioned the whole thing from day one: in the digital economy, return on equity depends on forging an alliance with the multitude so as to acquire additional capital over the years; and maximizing the net present value of this alliance depends on being customer-centric and gratifying customers with an exceptional experience.

I’m grateful to Mary O’Sullivan for having contributed to that epiphany. Obviously there’s more to come, but in the meantime I’m very interested in your remarks. What do you think?

Warm regards (from Tallinn, Estonia),