I believe that COVID-19 is merely a catalyst, an accelerant thrown atop the fire of economic instability that was already a growing concern. With +30 million Americans now unemployed, it is imperative that we start to build again, but for who?
Yes, some may claim that we are building for “future generations,” but the truth of our current economic system is one that builds to benefit a select few and at the expense of future generations!
Stakeholder Over Shareholders
The traditional view of free market capitalism is that the responsibility of the entrepreneur is to allocate capital appropriately such that she maximizes the return on investment for her shareholders. Those entrepreneurs who generate the highest returns will attract more capital and grow. The businesses they build will reward shareholders by creating economic value for which they are later compensated.
That all makes sense, but shareholder capitalism is imperfect.
Under shareholder capitalism, it is completely justifiable for a hospital administrator to focus on cost-cutting measures that lead to a reduced supply of hospital beds. However, the problems with this is exposed when the demand for hospital beds increases in a global pandemic. Hospital capacity and overwhelm becomes a major concern for the collective, and the #1 limitation to getting our society back to work.
We can do better.
In 1984, Edward Freeman introduced the “Stakeholder” model of capitalism. Stakeholder Theory stresses the interconnectedness between a business and its customers, suppliers, employees, investors, communities, and the natural environment. The theory argues that a firm should create value for all stakeholders, not just shareholders.
This time when we build, we need to build with a stakeholder mindset. We need to understand the complex systems that our businesses both create and connect.
Shareholders and Time Preference
In addition, the shareholder model of capitalism has led many investors to a higher time preference.
If you are the portfolio manager of a public pension fund, you might manage billions of dollars on behalf of an increasingly aging population. In order to remain solvent and pay what you owe these pensioners, you need to post returns today (not tomorrow)! The focus on short term gains means you have a higher time preference.
So you decide to invest in companies that prove short term returns, even if they do so using financial engineering such as share buybacks. These companies may have performed well last year, but as we have seen, their heavy emphasis on the short-term left them without savings to weather a future storm. Ultimately, this was value destructive for future shareholders (and generations).
A truly robust stakeholder model of capitalism would consider future stakeholders as much as it does current ones.
What About Private Markets?
Venture capital falls within the “alternative asset manager” or “private market” pool of capital. This is the industry in which Marc Andreessen (whose post inspired this series) works. In fact, it’s the industry that he built!
And it is one that also suffers from high time preference, ignores some stakeholders, and generates negative externalities.
Under shareholder capitalism venture funds that invest in startups must also generate positive returns for their shareholders known as limited partners or LPs. After all, these LPs invest in venture capital to gain risk exposure and outsized (mid to high teen) returns.
Most early stage venture investments take 5–7 years (and rising) until there is a “liquidity event” — when a venture-backed company returns capital to its investors.
This often occurs via an acquisition or initial public offering on the stock market.
However, most venture funds are fully deployed in only 2–3 years. While his limited partners wait for a liquidity event, the venture investor must somehow prove positive returns or “paper gains” in order to raise his next fund.
Thus the venture investor, who typically sits on the board of his portfolio companies, pushes the entrepreneur to grow faster and at all costs. If the entrepreneur can prove growth, she can have an “up-round” in which her company receives new investment at a higher valuation. The venture investor can then show paper gains and raise his next fund.
Though this was not what the system initially intended, we are in a sort of “ponzi scheme” situation in the venture capital industry as average returns lower. This has resulted in an over-emphasis on growth versus building sustainable businesses.
Under this model, the company’s growth might destroy a ton of stakeholder value!
This manifests when venture funds continue to pump capital into companies with negative unit economics — each unit sold generates a loss before general and administrative expenses are taken to account.
VC-backed companies generating negative unit economics, are impossible to compete with (so long as they continue to raise capital). In the short term, this unfair competition can bankrupt incumbents who must fire their employees.
In rare instances like WeWork / Regus, the incumbent will survive long enough to see the newcomer implode from the malinvestment.
If we want to build differently this time, we will need to come face-to-face with the shadow side of early-stage investing.
The Tragedy of the Commons — Socializing the Costs, Privatizing the Gains
While these shareholder-centric measures in both the public and private markets have juiced returns for a select few, they have also expanded the socialization of costs.
In the public markets, the US tax holder is now bailing out corporate executives (see US airlines) who decided to buy-back shares instead of preserving capital for a rainy day. One example of socialization of costs in private markets is the rise of anxiety, depression, and isolation in the US as more of our collective attention is captured by
Facebook and Google to fuel their advertising revenue.
The effect of privatizing gains, while socializing costs is known as the Tragedy of the Commons. The beauty of the Tragedy of the Commons is that it does not villainize individuals for acting, but instead shows that these individuals (like venture investors misallocating capital & CEOs buying back shares) are acting perfectly rationally within a broken system.
Actors incentivized to maximize short-term shareholder value can end up destroying all of the resources they need to continue operating their business and generating returns in the long run (see overfishing as an example).
Shareholder Capitalism & Populism
Shareholder capitalism + high time preference has led us into a precarious position. Entrepreneurs and shareholders have focused entirely on returns. If returns are not generated via innovation and growth, they are juiced via cost-cutting and financial engineering.
The cost-cutting measures have a disproportionate effect on employees as many are asked to accept reduced salaries or are fired in favor of a “carry trade” in which US-companies export their supply chain to countries with lower labor costs.
Over the last 40 years this pattern has accelerated with the bulk of US manufacturing moving to Asia. As Chief Economist at Nomura, Richard Koo, highlighted one year before the COVID crisis, we are in uncharted territory. The negative impact of decades long cost-cutting measures has expanded to ever larger numbers of Americans.
The result so far: rising populism and anger.
Steve Bannon has cited the “inevitable” rise of China to be 1 of 3 root causes for Trump’s election. Regardless of your politics, I believe that it is important to at least understand Bannon’s views because he basically wrote the playbook for right-wing populism in the west.
Employees are Also Consumers
And as unemployment grows, so too will radical populism both on the left and the right.
In the last 6 weeks, 30 million Americans filed unemployment claims. Nearly 1 in 5 Americans is now jobless and many more have taken meaningful salary reductions.
While 37 million Americans lost their jobs during the last recession, this damage was spread over 2 years from 2008–2010.
We’ve almost hit that number in a mere 6 weeks!
Cutting headcount to reduce costs in the face of $0 projected revenue is a perfectly rational act at the individual company level, but as we know from the Tragedy of the Commons, it can create a systemic crisis.
These jobs will not come back immediately, and these employees are also consumers!
So who is going to be left to consume the Casper mattresses and Allbirds loafers?
The answer is no one.
How We Build
In sum, the last few decades have been driven by an over-emphasis on short-term shareholder returns without considering long-term stakeholder value.
So yes, it’s time to build.
And it’s time to build with a stakeholder model of capitalism.
It’s time to build with a lower time preference — focusing on long term investment rather than short term gains.
It’s time to build with a respect for our employees (including gig workers)
It’s time to remember that these employees are also the end consumers
The great consumption engine of the United States that helped to lift the world out of poverty is breaking. We have millions unemployed who lack adequate social safety nets — we can no longer expect consumerism to bail out the world.
With this in mind, let’s determine HOW we build.
Until next week!