Hi, it’s Nicolas from The Family. Today, I’m preparing the ground for making sounder investment decisions in the Entrepreneurial Age. Let’s start with a reminder about capitalism.
⚠️ My colleague Younès Rharbaoui, who works with me on managing The Family’s finances, has just launched his newsletter, Chasing Paper. It’s specifically targeted at CFOs to help them upgrade their practices and best navigate today’s widespread uncertainty. Needless to say, it’s rooted in our own way of doing things at The Family as well as the work we do with our many portfolio companies as they tackle financial challenges.
Have a look at the first issue of Chasing Paper, Uncertainty & a post-fixed costs economy:
What’s different this time around? Isn’t it the same in all crises? Fixed costs get unplugged and replugged all the time. Here’s the thing: I believe we’re in a post-fixed costs economy, rather than just another instance of crisis cash management, because technology now makes it possible for companies to keep growing while lowering their fixed costs structure. It is viable to kill some fixed costs that had always been inherent to growing a business.
An important idea brought forward by Younès is that “the economics supported by venture capital over the past 10 years (high growth, high cash burn, blitzscale) will start meeting typical private equity issues (EBITDA, cash conversion, self-financing capacity) earlier in the company life cycle”.
He and I will be working quite a lot in the coming months on designing frameworks to help investors deploy capital in tech companies, but with a private equity perspective. Today, I’d like to lay out the fundamentals by describing what capitalism is all about. Then on Friday, I’ll send to my paying subscribers a draft framework for making sound investment decisions in the Entrepreneurial Age 👇
1/ Everyone likes to talk about capitalism these days, usually to denounce it or to explain that it needs to change. But few people can clearly articulate what capitalism is really about. It’s two things:
The goal of capitalism—what motivates capitalists—is to generate increasing returns to scale, defined (by W. Brian Arthur) as “the tendency for that which is ahead to get further ahead, for that which loses advantage to lose further advantage. They are mechanisms of positive feedback that operate to reinforce that which gains success or aggravate that which suffers loss”.
In most cases, pursuing those increasing returns is more easily done when a third party (known as a “capitalist”) is invited to the corporate table so as to assist on two fronts: helping the two other parties (workers and customers) find the right balance so as to maximize returns, and providing the resources (“capital”) to actually deliver those returns (and being rewarded for it).
2/ It’s not that the entire economy follows the rules of capitalism. Quite the opposite, actually: true capitalism is fairly marginal in the grand scheme of activity. As I wrote in Capitalism and the Future of Nation States, echoing French historian Fernand Braudel,
The economy can be subdivided into three categories. The first, which he calls “material life”, is made up of the infinite, informal transactions that form our daily lives. The second, the “market economy”, is where individuals conduct business, establishing a link between production and consumption. The third, finally, is “capitalism”...an ensemble of processes that allow one to extricate oneself from the trivialities of commerce and pursue increasing returns to scale. The market economy is the world of merchants, those who buy and sell while taking a small margin as items pass through their hands. Capitalism, on the other hand, is the world of the traders, financiers, and entrepreneurs who...attenuate the rigorous competition in the market economy by “inserting” capital into the production process.
Tl;dr: The market economy and capitalism are not the same things. They don’t attract the same players and they don’t generate the same outcomes. They coexist, but in two different and only occasionally overlapping dimensions, with one (“capitalism”) being all about escaping the other (the “market economy”).
3/ Even though it’s marginal as compared to Braudel’s “material life” and “market economy”, capitalism is an essential contributor to economic development:
Thanks to increasing returns to scale, capitalist enterprises contribute to generating a huge economic surplus, which is a fancy name for all the economic value that corporations create and capture as part of their ongoing business. That surplus is the pie that workers, customers, and capitalists grow together, with its value being realized as it’s transformed into wealth.
Once formed, that surplus is redistributed through many channels: a fraction is allocated to paying workers their wages; another is allocated to lowering prices or increasing quality for customers; yet another is allocated to rewarding capitalists with proceeds. There are also taxes paid to the state, and money allocated to buying goods and services from suppliers.
What’s important here is the following: capitalism is about growing the pie. Dividing the pie and distributing the slices is an entirely different set of matters. There are ways to spread the wealth that retroactively favor the capitalist system: after all, a fair distribution of wealth is good for business. But again, those are two separate discussions: one is about how to create the surplus, the other about what to make of it.
4/ Note that capitalism is not about creating jobs. We’ve all heard the gospel about capitalists as “job creators”, but really, since capitalism is all about increasing returns to scale, its focus is on how to produce as much as possible with as few expenses (and therefore workers) as possible. The better you get at doing capitalism, the fewer jobs you create as your business grows. Capitalism tends to create wealth while destroying jobs at the same time.
That doesn’t mean that capitalism doesn’t contribute to creating jobs, just that it’s an indirect contribution. In fact, the reason government officials like to attract capitalist enterprises to their territory is because they know that part of the wealth will spill over and create jobs in the immediate surroundings, notably in proximity services (retail, food, healthcare, education) and public services.
5/ A franchise is the most educational example of a capitalist organization. At its core, the franchise model is about outsourcing every part of the business that comes with diminishing returns to scale, while retaining only those links in the value chain that lend themselves to increasing returns to scale. Have a look at the following scene of the movie The Founder 👇 It’s the best lesson on what capitalism is about, delivered in 4 minutes by a fictional Harry J. Sonneborn. (My wife Laetitia and I watched the movie again a few days ago with our two kids, aged 11 and 8. They loved it ❤️)
Ray Kroc’s original approach to building the McDonald’s franchise was to outsource everything but the brand and the ‘system’. Yet that was suboptimal for two reasons: it created difficulties for financing the expansion of the business, and it deprived the franchise of being able to assert its control over the franchisees so as to ensure quality standards.
The lesson I draw from this is that of the ‘grip’: every successful enterprise in the history of capitalism has focused on relentlessly pursuing increasing returns to scale, which requires focusing on certain parts of the business, while still maintaining a grip over the rest of their value chain. And how do you get that ‘grip’? By operating at least two separate links in the value chain.
For McDonald’s, it’s the ‘system’... and real estate. For General Motors, it’s the brands and assembling the cars. For a publishing house, it’s editing manuscripts and distributing print copies at a large scale. Wherever you find capitalist success, you’ll find these two things: increasing returns to scale, and the ‘grip’.
6/ Fast forward to today: most successful tech companies also fit into this model of a successful capitalist enterprise. They obviously have increasing returns to scale (we’re talking about computing and networks), and they usually have that ‘grip’, like Amazon with its own retail operation AND the marketplace (and AWS), or Netflix, with its streaming business AND producing original content. Those without a ‘grip’ (like Uber) have obvious difficulties making a living.
It’s really not that different from a franchise. In fact, as once written by Paul Graham,
It's obvious that biotech or software startups exist to solve hard technical problems, but I think it will also be found to be true in businesses that don't seem to be about technology. McDonald's, for example, grew big by designing a system, the McDonald's franchise, that could then be reproduced at will all over the face of the earth. A McDonald's franchise is controlled by rules so precise that it is practically a piece of software. Write once, run everywhere. Ditto for Wal-Mart. Sam Walton got rich not by being a retailer, but by designing a new kind of store.
People in the tech world have even promoted that concept of “scalability” as the main goal of tech entrepreneurship. Per Steve Blank, a startup is a temporary organization in search of a business model that’s scalable. And scalability is the software people’s word for increasing returns to scale, that holy grail in the capitalist system. It’s where the obsession with “growth” comes from. Here’s Paul Graham again:
Let's start with a distinction that should be obvious but is often overlooked: not every newly founded company is a startup. Millions of companies are started every year in the US. Only a tiny fraction are startups. Most are service businesses — restaurants, barbershops, plumbers, and so on. These are not startups, except in a few unusual cases. A barbershop isn't designed to grow fast. Whereas a search engine, for example, is.
If you still have Braudel’s categories in mind, you immediately recognize the difference between the “market economy” (that of “restaurants, barbershops, plumbers, and so on”) and “capitalism” (startups).
7/ Capitalism changes as we shift from one techno-economic paradigm to another. The levers you need to pull in order to deliver increasing returns to scale are different depending on the state of technology and the current way of life. It used to be about mass production. Then it became all about brands. And now it’s about technology and entrepreneurship, “the ability to serve a customer at the highest level of quality and scale, simultaneously”. But there’s a common thread, that of capitalism.
In fact, before tech companies came to dominate the world, the companies most successful at pursuing increasing returns could be found in another, very different segment of the economy: manufacturing. Here’s what I wrote in November in Does Manufacturing Matter?
Standardized parts (the “American system of manufacturing”) and scientific management (otherwise known as “Taylorism”) were the two keys that helped unlock unprecedented productivity gains from the early 20th century onward. Thanks to these, assembly lines emerged as the segment of the productive economy generating superior increasing returns to scale: the larger those assembly lines were, the more productive they became (up to a certain point, of course). We tried to apply this recipe of mass production to every sector, but it really was in manufacturing that this mode of production thrived. As a result, manufacturing created an economic surplus that could then be redistributed (through the market, taxes, and regulations) to the rest of society. Even if most people were ignorant about the microeconomic details, we as a society collectively felt how important those factories were to our well-being.
8/ Recently, I realized something about this great article by W. Brian Arthur that many people, including me, use when discussing increasing returns. There’s a paradox to it. On one hand, it’s the best explainer of what increasing returns are about and how they transform the economy. On the other hand it obscures our understanding of increasing returns because a superficial reading of the article suggests that there’s a radical opposition between manufacturing (supposedly marked by diminishing returns to scale) and technology (which changes everything with unprecedented increasing returns to scale).
Yet that’s not true. There are increasing returns in manufacturing, which explains why it has been the prime contributor fueling the capitalist engine for decades. It’s just that manufacturing reached such a large scale of production that many businesses in that sector exhausted their potential for further returns on invested capital. This exhaustion of the old Fordist Age explains the productivity slowdown since the 1970s and our retrospective impression that manufacturing is deprived of increasing returns, especially when compared to tech companies with their scalability and all.
9/ Meanwhile something has been happening for more than a decade: software is eating the world. And in that process, entrepreneurs are starting to use technology in industries where it’s more difficult to generate increasing returns to scale—either because scale is more difficult due to the fragmentation of the market, or the returns are simply lower because the economic equation is less favorable, notably in the presence of tangible assets or a larger workforce.
So while we’re still far from the point of exhaustion in the Entrepreneurial Age, this explains why things are slowing down. The bad news is that the growth curves will be less spectacular in the future. The good news is that it will be easier to orchestrate that convergence between the frameworks of venture capital and those of private equity. This is what Younès was alluding to in his first Chasing Paper issue, and this is what I’ll explore in further detail with paying subscribers. If you’re interested in learning more, either as an investor or as an analyst, you know what to do! 👇
10/ There are so many moving parts right now that upgraded frameworks are urgently needed, especially with the COVID-19 pandemic further complicating the equation. Here are some of the dimensions I will discuss regarding making sound investment decisions in the Entrepreneurial Age:
Modelizing returns. I have this model of the Northern Side and the Southern Side which aims at dividing a company’s business into elementary activities: those that come with diminishing returns to scale, and those that come with increasing returns. I’m still convinced that approach can be modelized and translated into financial terms.
Analyzing a company’s positioning in its value chain. This was already described at length in my 14 Rules & Practices for Corporate Strategists (for paying subscribers only). But that concept of the ‘grip’ deserves a bit more digging, as it appears to be the other pillar of capitalist success throughout the ages. What are the implications for capitalists today?
Accounting for how the state influences doing capitalism. Recently I had a conversation with friends of mine who were interviewing industry insiders for their clients. I said that the COVID-19 pandemic would lead to two outcomes: the world will get more fragmented, and the state will become more influential in how business is done.
This last point, I think, is the key to analyzing investment decisions with geographic lenses. Back in December I was quoting Dani Rodrik’s idea that “capitalists need the state more than the state needs them”. It’s even truer after the COVID-19 crisis and it’s high time investors get interested in policies, especially industrial policy and those related to building a new social contract. Subscribe if you want to participate in that ongoing conversation! 🤗
⚠️ A few days ago I was interviewed over Zoom by my friends at With Company, a Lisbon-based firm focused on transforming organizations through design. The interview covers unbundling the social safety net, entrepreneurship in uncertain times, and differences between Europe, China, and the US. You can read the complete transcript of our discussion following this link: Interview with Nicolas Colin.
⚠️ Raphaële Leyendecker, partner & chief operating officer of Pathfinder, The Family’s corporate innovation arm, was interviewed by Sifted, and it was published yesterday. Read it here: The three reasons innovation projects get shelved.
Pathfinder helps corporations build ventures. 10% of them get funded, 10% are rejected and 80% get shelved. These are the three main reasons why.
Ryan Avent. In his book The Wealth of Humans, the Economist columnist points out the misunderstanding at the heart of many discussions over economic policy: we can have jobs or we can have productivity—and capitalism is about favoring productivity over jobs. This was summed up in an article/extract Ryan published in 2017.
Clayton Christensen. In his last years, the late Harvard professor and theorist of disruptive innovation was focused on articulating a theory of economic growth. In a landmark article, he brings home key learnings about capitalism and how capitalists can be misled by the confusion between short-term profits and long-term returns on invested capital.
Mary O’Sullivan. Back in 2017, I had the privilege of listening to a conference by this professor of economic history at the University of Geneva. It was this ‘aha!’ moment when I realized I finally had the key to understanding some important topics: capitalism, private equity, value creation, and economic development. I wrote an article summing up Mary’s argument and linking to her research.
Venkatesh Rao. In a long-form article published almost ten years ago, one of the tech world’s most influential thinkers invites us on a journey back in time to rediscover the origin of corporations and understand why they’ve been so successful as a vector of value creation, with references ranging from to British history to naval strategy.
To discover these articles and many others related to today’s edition, become a paying subscriber! The package will be sent to paying subscribers only with the forthcoming Friday Reads edition 🤗
And in case you missed it:
14 Rules & Practices for Corporate Strategists—for subscribers only.
The Future of Consulting (Round 1)—for subscribers only.
11 Notes on McKinsey—for everyone.
Notes on Germany in the Entrepreneurial Age—for subscribers only.
Principles for Capital Allocation (Round 1)—for subscribers only.
11 Notes on Y Combinator—for everyone.
Marc Andreessen on Building Things—for subscribers only.
From Normandy, France 🇫🇷