Aligning Investment and Humanity
Investors--especially Wall St.--can be both essential and an obstacle to a company’s long-term, sustainable success. How can a company scale while maintaining its purpose and soul? Read on for the fifth part of a series on Service to All Stakeholders.
Investment is a critical part of building a business, especially one designed to scale rapidly, and also provides a source of capital for many people who trust their retirement savings to mutual funds that own equity in publicly traded companies. While Wall Street has rightly come under fire for its self-serving approach to maximizing gains and executive compensation, often at the expense of jobs, businesses, and even entire countries, like what happened to Greece during the Great Recession, the underlying frame of an open market for equity and other securities is of great value. The problem, like other aspects of business, as well as our democratic system, is that it has been gamed by the biggest, most well-connected players for their benefit.
To fix Wall Street will take a long, concerted effort, one that may never be feasible given the entrenched interests in place. Creating a Wall Street 2.0 may be a better alternative. Perhaps the Long Term Stock Exchange that recently launched will be a key part of such a movement. It’s a new entity that is designed to provide businesses and investors with a more sustainable alternative to the traditional markets, with longer time horizons and other elements to eliminate the means for large investors to manipulate markets and create an unfair advantage for those banks and hedge funds.
But Wall Street and the public markets are far from the only investors and shareholders in businesses. Many startup companies rely on investment to scale and turn to individual investors, commonly known as “angels”, and venture capitalists (VCs) for funds. Angel and VC investing is a relatively new concept, starting in earnest in the 1970s and 80s, and growing substantially with the Dot-com boom and then again after the Great Recession. The last ten years leading up to the present has been a long bull market for venture capital returns and has seen the rise of hundreds of new funds, especially focused on very early investments, known as seed stage, as well as the opening up for small individual investors to risk capital on startups.
Investing is a good thing for everyone. The past forty years of venture capital have enabled many businesses to rapidly scale into household names. Companies like Amazon, Google, Netflix, and Facebook all started within the past 25 years. They were all startups with one or two founders who raised VC funding which allowed them to grow their businesses, focusing on building new models and technologies, and not having to worry about generating profits to fund the business.
This is a critical benefit of venture capital that is often overlooked. It allows companies to have a huge leg up over businesses that rely on capital from sales to reinvest in the business. The approach has its downsides as well when companies rely too heavily on the “steroids” of outside funding and fail to build a sustainable business. We saw that frequently during the Dot-com time, with companies like WebVan and Pets.com spending wildly on operations or marketing but not finding a large enough market to sustain their expenses.
Investors are like all other stakeholders. They deserve to be served as best as possible by the company. For most, that means a return on investment, often calculated through a financial metric known as internal rate of return (IRR). This metric describes the amount of return on investment over a period of time. Investors use it to compare different investments, such as risky investments like VC versus conservative ones like US Treasury Notes.
While some VCs become quite wealthy by making good investments, they are typically investing other people’s money. Venture funds are set up with capital from Limited Partners (LPs) and are managed by General Partners (GPs). The GPs typically get fees from the LPs equal to 2% of the total committed capital for managing the fund. This goes to salaries, office expenses, and the like. So for a $100 million fund, the management fees are $2 million per year. That might sound like a lot, but for most funds of that size, there are several GPs, associates, and an operations team, not to mention a nice office for meetings. VCs also have to spend money on marketing and other costs in order to stand out from their competitors in what is now a crowded market. Even larger funds, like Andreesen Horowitz, with billions of dollars under management, spend a commensurate amount on their huge team of investors and support staff. So no VCs get rich from management fees.
VCs can get rich from making good investments, and rightly so. When a VC invests in a startup, they are writing a check from their fund for that business in hopes that the value will increase exponentially over time, typically 7-10 years. But for most, they either fail or return only a small amount. So VCs are always looking for companies that will return 100x or 1000x their initial investment. These are rare, despite what you read in the media about the success stories, and the prominent VCs get the best shot at investing in these companies. Most VCs have to grind it out, meeting with hundreds of companies before hopefully finding the superstar unicorn that makes their portfolio.
When they are successful, the amount invested is first returned to the LPs, and then the profits are split 80% to the LPs and 20% to the GPs. So the large majority of the investment returns go to LPs. This is important to note because LPs are often large public universities or public pension plans, like CALPERS, the California Public Employees Retirement System, the largest LP among Silicon Valley VCs. Our social welfare system in the US is greatly benefitted by the success of venture capital investing. So while VCs are predominantly white men from elite universities and privileged backgrounds, their work not only supports entrepreneurs who are building businesses that provide better products and services for everyone but is also used to support many ordinary workers’ retirements and public university endowments.
This structure also makes it difficult for VCs to consider anything other than providing their LPs with a large return on investment. That means that issues related to diversity, the environment, or other social benefits are a distant second to the all-important IRR. It means that it is hard to criticize VCs for not making a greater effort in this regard unless their LPs are also interested in making such an effort. From discussions with VCs on the topic, we have been told that the LPs see their jobs as only being about the return on investment and that other parts of their organization focus on social issues.
The opportunity then is to continue to educate upstream to those leading these LPs on the benefits of Evolutionary Business, including for IRR. That we can either have a good financial return or an impact is a fallacy. Unfortunately, this false dichotomy has been supported by many who have strived to make a positive impact in the world by presenting themselves and their organizations as different from conventional businesses, and thus not a good source of traditional capital or financial return. This is a mistake that has slowed the progress toward improvement, by limiting the interest and influence that these companies can have, whether as B Corps or social ventures. We aim to change that perception.
A key aspect of this is for companies of all kinds--including those that would consider themselves focused on impact--as well as social entrepreneurs who may be considering starting non-profits or alternative structures, to recognize the benefit of building large, scalable companies that are of service to investors along with all other stakeholders. It is entirely possible to do this without sacrificing any other aspect of your business or your values and principles.
One reason is that investors are becoming increasingly interested in the long-term benefits of Evolutionary Businesses. Recently, Larry Fink, the Founder/CEO of the world’s largest money manager, BlackRock, said that “companies that focus on all their stakeholders – their clients, their employees, the society where they work and operate – are going to be the companies that are going to be the winners for the future.” Even if Wall Street analysts remain conventionally opposed to long-term approaches and short-term losses, great leadership and great businesses can succeed in the end. We have seen that in the market successes of two companies that have taken evolutionary approaches to their businesses: Amazon and Tesla.
For nearly 20 years, Amazon did not generate a net profit. It focused entirely on providing its customers with incredible service through low prices and rapid delivery, then reinvested all the capital it could into new areas, like Kindle e-readers and Amazon Web Services (AWS). After an initial run-up during the Dot-com boom, the stock fell on Wall Street’s disappointment with the lack of net profit. Without net profit, analysts can’t calculate the price-earnings ratio (PE) because earnings are negative. In conventional Wall Street, PE ratios are critical for determining whether a company’s stock is undervalued or overpriced. Wall Street, and its conventional salespeople (“stockbrokers”), didn’t know what to do with something like this, since it is so unconventional.
The response? The stock dropped precipitously and the company lost many of its supporters on Wall Street. But founder and CEO Jeff Bezos remained steadfast in his vision--a long, long-term vision--for Amazon. Rather than backing down like many CEOs and moving to a more profit-focused, short-term approach, Bezos double-downed on reinvesting and ignored the stock price. Eventually, in just the past few years, Amazon has started showing net profits based on newer, high-margin businesses, such as AWS and advertising. But Bezos continues to share plans to invest even more so that the business will keep innovating, as well as to provide more service to other stakeholders, including workers, the planet, and local communities in which it operates.
Amazon is leading the way in how to counter Wall Street’s short-term thinking, with profit-maximization at its core. This shows that a strong leader of a strong business has quite a bit of pull on Wall Street, despite the Street’s power and influence in using its long-held beliefs of how to value a company. It takes a leader’s commitment to principles and a long-term vision, and an aligned Board that is not afraid to take criticism from Wall Street analysts and media.
Elon Musk of Tesla provides another example. For years, critics claimed that Tesla would fail and that its shares would be worthless. So-called “shorts”--investors who bet that a stock will decrease in price--did their best to make their case and create the market conditions they wanted. It wasn’t hard since Tesla was struggling to produce vehicles and garner enough sales to keep the company afloat. But Musk had a vision and he stuck with it. Eventually, after a horrid year that saw him sleeping in the office while the company improved its manufacturing process, and the Model 3 became available at scale, the scales tipped and the majority of investors believed what Musk had always believed: that Tesla could be the most successful automobile company on the planet. As of this writing, the company is valued at $600 billion, nearly ten times the amount at the start of 2020, and greater than all other car manufacturers, including Toyota and GM.
Both Amazon and Tesla are examples of public companies that have been of service to their shareholders without focusing on Milton Friedman’s principle of net profit above all. But they also are not obvious beacons of Evolutionary Business. Amazon is seen by many as being harmful to its workers, small businesses, and to local communities and society, in general. While the company argues that there is much that it does to be of service in these areas, like provide a $15 minimum wage for its warehouse workers--twice the national standard--there is no doubt that there is more it can do.
The point here is that all companies could do much more to be of service to all stakeholders if they are less concerned with profits, transcending Milton Friedman’s outdated sentiments. Companies should not feel forced to choose between reduced wages or lowest-cost partners and a favorable stock price. This made-up “law” of Wall Street, that only increasing net profits can produce shareholder value, is now proven to be overstated and leaders are free to spend on what really will drive the company’s long-term sustainable success. Sure, that can include a sense of service to those same Wall Street bankers, since they provide all-important working capital. But there are all of the other stakeholders to also consider equally. And the companies that do this the best will be the most successful. There are many examples of this--just compare Whole Foods to a previous generation’s supermarket like Safeway. If Whole Foods doesn’t evolve, another store that is of greater service will eventually take its place.
Individual investors (or individual leaders of investment firms) can choose to back Evolutionary Businesses with a reasonable belief that they will see outsized returns over the long term, given the growing interest in such companies and the virtuous cycle that is created in being of service to all stakeholders. We can help the cycle speed up by putting more money into these firms, making “impact” investing the norm for all kinds of businesses, not just for companies that make sustainable materials or the like. Given the basic structure of stock markets, the more demand there is for a stock, the higher its price will be, which then determines the company’s valuation. This then enables the company to raise more capital to invest further in scaling its business and should create further demand for its stock, continuing the cycle of providing greater returns for investors.
Let’s not forget that workers can (and should) also be shareholders by means of stock options and employee stock purchase plans. As discussed earlier, providing these means of equity ownership to all workers at all levels in a company can be of great service to them through an increasing stock price, while creating alignment with investors. All companies should set aside at least 20-30% of its equity for such a purpose so that there is enough stock available to share with workers.
Founders of a business are also shareholders and can be thought of in the same light as other workers. They are often quite underpaid from a cash compensation perspective while their businesses are in the early stages, even through as much as $50 million of funding. So when a company succeeds in reaching the public markets, or in the extreme case of Amazon, founders can become very wealthy on paper due to their stockholding. It isn’t typically from outrageous salaries; it is from the stock that they still hold after giving out enough to investors and workers.
Most if not all Silicon Valley companies like Google, Facebook, Apple, and the like provide all, or most, of their workers with stock options as part of their compensation. That means they have the ability to benefit from the stock price going up without having to pay upfront for the stock. Options work by giving the holder the right to buy the stock at a certain price, say $1 per share, based on the company’s fair market value at the time of issuance, such as when they start working for the company. With the options, a worker can wait until the stock price increases, say to $10, and then exercise the options and sell the shares, capturing the $9 of gain per share without any risk or cost. Other investors don’t enjoy such a benefit. They need to pay the $1 at the time of investment and hope that it goes up and not down, in which case they might lose their investment.
Most Silicon Valley startups provide their workers with stock options as a part of their compensation and a way to support their alignment to the company’s desire to grow and become more valuable--something that is critical to the VCs who have funded it, as we explained above. This makes many workers, including those in entry-level positions, able to become far better off financially if the company is successful. This is a policy that all companies--not just Silicon Valley startups--should follow.
-----
Next, we’ll look at how companies can be of greater service to their local communities.
Next, we will look at how a company that strives to be maximal service to all of its stakeholders can be of service to investors and other shareholders.
