Thursday, March 22, 2012

Venture capital and the growth fetish

Felix Salmon has another smart post on venture capital and the way he feels it distorts American business:
Another way to look at this question is to compare US fight-to-be-number-one capitalism with the kind of capitalism practiced in undeniably successful countries like Germany, Korea, Brazil, and Japan. Those countries don’t have nearly as many world-beating behemoths as the US does, but overall their economies and current accounts are doing very well on a bedrock of medium-sized firms and family-owned corporations.

So in a way, Gobry is making my point for me. The IPO market and the VCs who feed off it are playing a game which might make a small number of people extremely rich, and which will create a very small number of hugely successful world-beating companies. They’re not playing a game which is good for founders; they’re not playing a game which is good for healthy, long-lived companies; and they’re not playing a game which is good for the economy as a whole. That’s kind of the point I’m making in the piece when I say that “Silicon Valley is full of venture capitalists who have become dynastically wealthy off the backs of companies that no longer exist”.
I think this fits nicely with one of our ongoing themes here at OE, the growth fetish:
Think of it this way, if we ignore all those questions about stakeholders and the larger impact of a company, you can boil the value of a business down to a single scalar: just take the profits over the lifetime of a company and apply an appropriate discount function (not trivial but certainly doable). The goal of a company's management is to maximize this number and the goal of the market is to assign a price to the company that accurately reflects that number.

The first part of the hypothesis is that there are different possible growth curves associated with a business and, ignoring the unlikely possibility of a tie, there is a particular curve that optimizes profits for a particular business. In other words, some companies are better off growing rapidly; some are better off with slow or deferred growth; some are better off simply staying at the same level; and some are better off being allowed to slowly contract.

It's not difficult to come up with examples of ill-conceived expansions. Growth almost always entails numerous risks for an established company. Costs increase and generally debt does as well. Scalability is usually a concern. And perhaps most importantly, growth usually entails moving into an area where you probably don't know what the hell you're doing. I recall Peter Lynch (certainly a fan of growth stocks) warning investors to put off buying into chains until the businesses had demonstrated the ability to set up successful operations in other cities.

But the idea of getting in on a fast-growing company is still tremendously attractive, appealing enough to unduly influence people's judgement (and no, I don't see any reason to mangle a sentence just to keep an infinitive in one piece). For reasons that merit a post of their own (GE will be mentioned), that natural bias toward growth companies has metastasised into a pervasive fetish.

This bias does more than inflate the prices of certain stocks; it pressures people running companies to make all sorts of bad decisions from moving into markets where you don't belong (Borders) to pumping up market share with unprofitable customers (Groupon) to overpaying for acquisitions (too many examples to mention).
I didn't consider the role of venture capital at the time. Perhaps I missed the biggest factor.


  1. I always figured the VC's are doing a reasonable job of trying to maximize the *expected value* of discounted lifetime profits.

    Given the skewed distribution (mostly failures), maybe that isn't best for founders, I dunno. But it seems like you're going further and suggesting they aren't even doing that?

    1. David,

      Salmon really delves into these issues but for my part, I'm suggesting that the market does have a bias toward certain growth curves and that VCs are capitalizing on that bias.

  2. I'm not so sure VCs are making projections to maximize company profits. They're making projections to maximize the size of their bank accounts in a set number of years.

    The tax system also rewards "growth". Dividends are doubly taxed at the corporate and individual level, so it definitely leads to a bias against them.

  3. One thing that I have trouble with talk about tech companies is the assumption that such businesses have to grow at all costs.