Farmers, miners and investors

A colleague (and occasional TRP commenter), Dennis Schafroth, pointed me at a rather good article on Wil Shipley’s blog entitled Success, and Farming vs. Mining.  You should read it for yourself, but in summary his point is that a software house — or anything else, really — has a choice to make, and will always make it whether consciously or unconsciously: it can set itself up either as a farmer (slow but continuous productivity) or a miner (explosive, exploitative profit).  Specifically, “You can either see founding a company as something you’re doing because you want to produce good software, or you can see it as something you do so you can sell your stock and make a killing and move on.

(Yes, there is a Danish pun in the traditional Irrelevant Sushi Photo.)

Shipley goes on to lament:

A big problem with our field is that mining is so glamorized: Not only are we inundated with tales of “Look, Bob Smith made a fortune selling his company after two years, and he’s a bazillionaire!” but if you seek outside investment you are usually required to be a miner: few investors are interested in partnering with someone who is going to retain ownership of his company and just make good products and sell them for a fair price. The very first thing an investor is usually going to ask is, “What’s your exit strategy?”

I’ve had this kind of bad feeling about the industry and about venture capital for some time.  Back in March 1999, I was in Palo Alto for a few days — for a meeting of the Z39.50 Implementors Meeting, since you asked — and got to spend a few evenings sitting alone in restaurants.  For me, this is one of the pleasant benefits of travelling: a bit of time alone makes a nice change from my usual lifestyle with three small and very noisy boys in the house.  But I was staggered by the conversations I was overhearing in the heart of Silicon Valley, that hotbed of technology and innovation.  No-one, I mean no-one, was talking about programming; everyone was talking about money.  Hacking had become a means to an end; these people would have been just as happy making their fortunes in toothpaste as in programming.  But at that time I hadn’t appreciated that this attitude was being forced onto people by the approach taken to investment.

It’s easy to be angry about Money People.  (Of course in light of the Global Banking Crisis, it probably right to feel that way a lot of the time, but let’s be charitable and assume that the people responsible for that were edge-cases.)  For most of my life, I was fundamentally unhappy about the whole financial system — investment, stocks and shares, loans, and all — because I couldn’t see that it actually produced anything — it seemed to be only about moving money from one place to another, with no actual creation.  I guess this is a very common perception, especially among high-school seniors and college freshmen.

But about a year ago, another of my colleagues, Jason Skomorowski, changed my perspective by pointing out to me that the worldwide community of investors acts as a sort of distributed, privately financed granting body — an unorganised organisation to distribute money according to where it thinks it can achieve the most.  And just as people tend to spend their own money more wisely than they spend other people’s, so VCs and other private investors will likely invest their own money more wisely than granting bodies invest their countries’ money.  You can think of investors as providing an evolutionary selection pressure on businesses: they reward those that have good well-thought-through plans to achieve good things, and penalise those that are less fit.  So I went away from that discussion a happier man.

But the problem is — and I say this as a qualified evolutionary biologist, remember — evolution doesn’t select on the basis of what we would consider desirable, but only on survival and success.  Evolution is an optimisation machine, but it optimises on its own criteria, not ours.

In the case of the investment market, as the Farming vs. Mining article shows, it’s not selecting on productivity but on growth — a company that made a million dollars last year and two million this year is a better investment than one that makes three million dollars every year.  And a company that will grow to ten million in two years, then fold six months after the investors sell their stocks is better investment still.

Rats.  Now I am unhappy again.

And I think these reservations apply to free-market economies in general.  While I am certainly not arguing for a Soviet-style centralised and managed economy, I do think that the all-too-common uncritical worship of free markets as the force that will save us all is horribly misplaced.  Free markets optimise.  But for what?


(The last two images taken from Sifu Renka’s Flickr collection.)

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10 responses to “Farmers, miners and investors

  1. In the cited article, Shipley writes:

    Assume a successful company makes, say, four million dollars in profit every year. Year after year, four million dollars. This is great, right? I mean, I’d be happy to own such a company. But this company would be a horrible investment. Its stock price would be stuck, because there’d be no increase in value year-to-year, so there’d be no reason to buy the stock at a higher price than it is right now. You could buy the stock at $100, but it’s staying at $100, and that’s a pretty crappy investment for you.

    If the company is really making $4 million per year, and the shareholders are seeing no return, then something is wrong. The company should either be able to invest the $4 million in something (its own business? shares of somebody else’s business? government bonds?) and thus see increasing income over time, or it should deliver the money as a dividend to the shareholders for them to invest or spend as they see fit.

    Otherwise, either the $4 million is somehow illusory, or it is being wasted, or it is being redirected to the benefit of management. (One possibility among many: the $4 million profit is used to buy back shares of the company–nominally returned to shareholders–but at the same time the company issues new shares for executive stock plans, so in effect the $4 million has really been given to the executives.)

    Shipley is arguing that profit without growth is worth nothing; but real profit should inevitably bring some kind of growth.

  2. (The blockquote in my last comment is from the Shipley article. I thought putting cite=”Shipley” in the blockquote tag would indicate that, but it seems not to have worked.)

    [Mike says: I added a lead-in line to your comment, clarifying the source of the quote.]

  3. Tagore Smith

    I’ve thought a fair bit about these same issues, and come at them from a similar point of view in a lot of cases. I’m very interested in the problem of how capital gets allocated, since I think the health of an economy is most easily viewed that way.

    A lot of the problem here is that we tend to think that we know best how to allocate capital, and since capital allocation doesn’t always follow our preferences we assume that it is imperfectly allocated (which it certainly is) and that we could do much better (a dubious proposition.)

    I do think that there are some structural problems in corporate governance that encourage the mis-allocation of capital. I am not at all sure that we can, as a practical matter, improve the situation.

    I also think that it is going to take decades to really understand where wealth was created in the recent tech bubbles. Twitter looks dumb to me, but who knows- maybe it will evolve into an AI that cures cancer. OK, so I won’t hold my breath on that one, but…

  4. Mike, both you and Wil Shipley are just scaring yourselves with your own unfamiliarity with this stuff. You probably make as much sense to an investor as an investor barging into a coding discussion asking why people can’t just code in a long-view language like COBOL. Or a creationist saying that obviously something as amazing as the eye couldn’t have evolved incrementally. I mean, just because the explanation isn’t obvious to an outsider doesn’t mean he’s successfully critiqued the expert.

    Which I’m not, but to address the point: VCs invest in newish companies and sell the ones that make it some distance, to people who evaluate and invest in more maturish companies.

    And a company that will grow to ten million in two years, then fold six months after the investors sell their stocks is better investment still.

    No it’s not. Well wait. If it were easier to pull of this sort of scam repeatedly without people catching on, than to just try to invest in promising companies, then that would be a great investment for VCs. If the buyers were uniformly stupid– for instance if they relied solely on measures like last year’s growth to base their decisions on– then the scenario you’re talking about would be more common, until all the later-stage investors went broke and there was no stock market anymore.

    But the people who have the inclination and money to buy (stock in) companies from VCs, are the ones who weren’t stupid about it last year. Backtracing,

    That means later-stage investors can smell a rat.
    That means they don’t pay top dollar for rats.
    That means, the VC can’t make as much money selling rats as you fear.

    So, VCs try to invest in companies that will eventually sell to later-stage investors based on passing the kind of quality, sanity, promise and sniff tests those later folks obsess about (which are of course partially rational, partly irrational, flawed, but statistically successful).

    When the company reaches the closest it will get to that stage, the VC wants to sell, so he will have money to invest in newer, less certain ventures. That’s not strip mining, that’s selling fertile land cleared of trees and boulders, to someone who’s better at farming, and going to hire more tree- and- boulder clearers to clear more land.

    Doesn’t mean I have special love for VCs & I realize there is a steady supply of suckers and market distortions to exploit. But there’s no point imagining VCs with scary magical scam powers.

  5. ” Free markets optimise. But for what?”

    Excellent way to end the article!

    I have always been a firm believer of a regulated free market. There is a bunch of literature (hundreds of books, i’m sure) about this exact topic so i’m not going to really go into anything besides my personal opinion.

    Free markets generally have one end point, if perfectly unregulated… a single, all powerful entity that has a monopoly on the entire market. This is because in the end, having absolute control of pricing and the ability to prevent any competition from entering the market ends up being the highest possible point of profit.

    To be honest, i suppose that in the long, long run, the market would correct itself… unfortunately, that would come at the price of massive human suffering and inefficiency.

    The basic point is that what is good for profit is frequently not good for the public in the short to mid term. (queue toxic waste dumping etc etc etc…). Sure, after half the consumer base was dead from poisonous waste maybe companies would self-regulate themselves to be more ecologically friendly. hahaha :)

    Free markets *effectively* regulated by governments are absolutely the way to go. The sad thing is that in pursuit of profits, the free market in america is slowly subverting the regulatory agencies and political process that is supposed to regulate them. It’s easy to see why this might happen… it’s simply to increase their profit.

    Our world is sad to think about sometimes. :(

  6. Steve, thanks for this more long-term perspective. What you say makes sense and is somewhat reassuring. This kind of discussion (A) makes me grateful to have such informed and literate commenters, and (B) makes me think perhaps I should make some kind of formal study of economics.

    Unfortunately, I also found Leland’s comment compelling. Although Steve may be right that the specific problem of venture capitalists investing in mines rather than farms isn’t such a problem as it appears, the last line of my article does still seem to point to a broader problem: “Free markets optimise. But for what?” might become my next email-signature quote.

  7. And another thing: why are the verbs “farm” and “mine” nouned by appending “ers”, but “invest” by appending “ors”? You can’t explain that.

  8. The short answer is that free markets optimise for volatility, as Portugal, Ireland, Iceland Greece and Spain have already discovered to their cost.

  9. Tagore Smith

    I think that a “perfect” free market would actually optimize the creation of “wealth” (though defining wealth is a bit tricky.) It wouldn’t necessarily distribute that wealth very evenly, but you could come in after the fact and redistribute to the degree you wanted, though in doing so you would make the market less perfect, and less optimal. That’s a basic trade-off, and how much wealth should be traded for more equal distribution is a normative question.

    I wouldn’t worry much about monopolies in a perfect market- any entity with enough advantage to dominate some sector would be so good that you would want them to. And they would be very constrained in how they were able to (ab)use that domination without opening the door to competition.

    The problem is that the perfect market is a fiction. Any real market is going to have transaction costs, unequal distribution of information, non-rational actors, and externalities.

    The obvious answer here is to regulate markets such that you ameliorate their deficiencies, and make them closer to perfect. Given a perfect regulatory scheme you ought to be able to make markets behave much more perfectly… well, you see where this is going.

    Regulatory regimes are as necessarily imperfect as markets are, and in a lot of cases distort markets so badly that they become more imperfect than they would be in the absence of any regulation. I’d suggest that in the real world it is very hard to hang onto a monopoly for very long without government intervention, for instance.

    In particular, I don’t think you can avoid regulatory capture- you can only try to minimize it. People often think that big corporations hate regulation. This isn’t true. If you are one of the major players in a market, and if regulation erects high enough barriers to entry to keep new competitors from entering that market, you’re going to love it- of course you will also lobby to be exempt from it, and to have it apply as punishingly as is possible to your competitors. But even if you don’t succeed there the costs of that regulation are easy to bear if they keep competition out.

    I’m not arguing against regulation. I would argue that the best way to keep regulation from doing more harm than good is to be chary with it. The more opaque, the more complicated the regulatory regime the easier it is to get away with gaming it. I’d also suggest that a lot of people argue about this as if perfect (or nearly perfect) outcomes were possible. But this is an insoluble problem. If the perfect is the enemy of the good, the good is often the enemy of the tolerable.

  10. Tagore Smith

    And, by the way, if I had an email signature I would consider setting it to “If the perfect is the enemy of the good, the good is often the enemy of the tolerable.” I am very good at quoting others, IMNSHO, but haven’t said much that I would think quotable. That, though, is mine (though I am sure someone has said it before me.) Is it bad form to quote yourself?

    I’m not sure that most people would find that idea as much a touchstone as I do, particularly as regards public policy. I think I first said it to a friend of a friend at a bar. She looked at me as if I were insane and said “You can’t possibly believe that.” When I told her that I really did she looked as if she pitied me for a moment. Incidentally, we had come there directly from the memorial service of our mutual friend’s father, who had died much younger than anyone who knew him thought he should have.

    As Leland says: “Our world is sad to think about sometimes. :(.”

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