Your Equity is a Product with Luke Constable [Idea Machines #35]

In this conversation I talk to Luke Constable about the complicated tapestry of finance, funding projects, incentives, organizational and legal structures, social technologies, and more.

Luke is the founder of the hedge fund Lampa Capital and publishes a widely-read newsletter full of fascinating deep dives. He’s also trained as a lawyer and historian so he looks at the world with a fairly unique set of lenses.

Disclaimer: nothing Luke says is an offer to buy or sell a security or to make an investment

Links

• Luke on Twitter
• Lampa Capital
• Theory of Investment Value (John Burr Williams)
• 1,000 True Fans (Kevin Kelly)
• Quantum Country Patreon
• Lampa Capital’s Open Questions
• The Empire of Value (André Orléan)
• Who Gets What and Why (Alvin Roth)
• The Mystery of Capital (Hernando de Soto)
• I, Pencil (Leonard Read)
• The Crime of Reason (Robert Laughlin)
• Andrew Lo’s papers

Transcript

0:01:05 BR: So if technology creates a lot of wealth, why does it feel like most people in finance are hesitant to invest in technology?

 

0:01:19 Luke Constable: So that's an interesting place to start. I think you have to understand, no one invests in technology. If you think about investors, investors invest in businesses that use technology, and so that's probably the first frame I would use. Investors aren't hesitant to invest in technology, investors never invest in technology. What investors do is they invest in these products that are going to generate cash flow streams, and so that's sort of the first thing. And then the second thing is, a lot of the technologies that you and I think about, they seem obvious at a macro scale, where you take a high level view and you say, "Well, it would be so much better if we had a blank sheet of paper," and I said, "We should do X."

 

0:02:10 LC: For instance, you could make an argument about housing technology in San Francisco, and you could say, “All of these houses built in SF, they're old Victorians, they don't really have washing machines and laundry machines, you could probably change the structural engineering, probably build them higher”. And if you look at them and said, "Oh, I have a better prefab housing technology," or "I have a better way to do it," you'd miss the point, which is just because you've invented the physics, and this is the other thing, you actually have to sell it into a market. You have to work within the market, and so that's usually where I see a lot of the interesting technical products fall down.

 

0:02:53 BR: So the thing that I want to poke at in the assertion that people invest in businesses is that people invest in things that are not businesses as well, people invest in gold, in currencies and other, I guess, assets would be the high level thing, and so I guess the question is why isn't technology itself an asset, and there's probably a very obvious answer to this, I just...

 

0:03:25 LC: Sure, so let's take a step back and talk about the various asset classes, there's sort of a couple of ways to break them down.

 

0:03:32 BR: Okay.

 

0:03:33 LC: One way people do this is they'll say there are real assets, these are things like real estate, some people put commodities in there, and then there are sort of these yield assets, these are debt that is putting out a cash flow stream, and then you have equities, and there's some argument that cryptocurrency is sort of its own asset class, and then currencies might be their own asset class too. And what you'll quickly find is these things kind of blend together. A lot of them are different ways of financing sort of the same project. And then you have the ones that are just traded for their own sake. So there's sort of two questions you're asking, the first is, why isn't "technology" the same as like gold or silver or real estate, for instance? And so there's a use value to all of those commodities, and that's why they have value, and that actually is a cash flow stream, we actually do use gold, we do use silver, and that's how that works.

 

0:04:43 LC: But if you think about what's valuable, there's sort of something that's value... And I should have started with this. When you think about what value is, there's value in exchange and then there's value in use. So the value in exchange ones, these are often, you could argue, cryptocurrency or a lot of currencies, gold is actually usually thought of as a medium of exchange, that actually is valuable for cash flow purposes just probably not in the ways that you think. So what happens with these currencies and these stores of value is they sort of become Schelling points where I just know there are enough people transacting in that thing that I can find the liquidity, I can actually go convert to cash, and I can go basically get that cash when I need it. That actually is a cash flow need. It's just not often thought of that way.

 

0:05:40 LC: Now, liquidity is really valuable because you might be invested in the best business of all time, and it might have a very, very, very high net present value and be doing a lot of good for the world. But if you take a step back and say, "Wait a second, I have to pay off student loans," or "I have to pay off my mortgage," or "I just want some cash to go on vacation" or whatever you want to do with it, you look at this and say, "Gosh, I do need some liquidity," and that's what those other sort of trading assets are for.

 

0:06:10 BR: So basically, technology contributes to the use value of an equity asset, is that the right way to think about it?

 

0:06:22 LC: I don't think of technology that separate from... It's sort of so baked into the environment that it's just difficult to disentangle. Technology, lazily put, is just ways of doing things hopefully more efficiently than we're already doing them. And so if you think about why certain assets become tradable, either they're creating these cash flow streams, or there is some value in exchange. I mean, the way that I often frame investing for the people who I invest for is there's sort of two sets of flows that determine an asset's price. There is underlying asset's cash flows and then there are the capital flows of all the investors. So you have sellers for some reason, maybe they have liquidity needs, maybe they can't hold an asset for a regulatory reason or a legal reason, and then you have buyers who come in, because they're interested in that asset, and it could be because they think it's an interesting thing to invest in, it could be because the regulators told them that they have to buy it, it could be... You laugh, but this is actually...

 

0:07:32 BR: What sort of things do regulators mandate that people buy?

 

0:07:37 LC: Sure, so if you go look at banks and sovereign debt, well, actually banks and all debt. So you have the bank regulators set risk weightings on various types of debt, which is sort of a nice way of saying, there are all of these different cash flow streams, and the regulators are saying to you that certain cash flow streams are riskier or less risky. And shockingly, they often argue that their sovereign debt is less risky than some other cash flow streams.

 

0:08:13 BR: I'm shocked.

 

0:08:14 LC: In practice, that may or may not be true. It's a weird thing to think about, but, in some cases, a multi-national corporation might actually be a better credit than a country. But that's not how these things work, and so what happens is a bank regulator will sometimes go to a bank and say, "The risk weighting on the sovereign debt is far lower than the risk weighting on this corporate debt,” which effectively is pushing the bank to go buy a certain type of debt, which then goes and funds all of those projects. So then coming back to all of this, if you think about investing in sort of these two sets of flows, like that underlying asset's cash flows and then the capital flows of all the investors, you basically, in practical terms, want to think about markets in terms of what's driving someone's action.

 

0:09:05 LC: And when you think about that, that's when market prices start to make sense. They won't make sense to you if you think that you're just going to sit down and solve an analytical equation where you just sort of put in a few inputs, you make a few estimates and then the price gets spit out. It's much more of a socially constructed thing.

 

0:09:25 BR: And going back to your point about liquidity, it feels like there's this... I don't know how to describe it, like sort of a weird effect where it feels like there's a consensus that investing in... I won't say technology, I'll say investing in a business that is proposing to build a technology with a very long-term time scale, there's consensus that that will eventually create something... Will eventually create a lot of value, but then at the same time, because of these liquidity constraints, very few people are doing that, and that's the argument for why people are not making those investments, but it seems like that would be a point where you could arbitrage. It seems like there should be some people who are willing to not get cash flow for a couple of decades, and they would be able to reap the rewards of making these sorts of investments, but you don't see that, so I assume that those people are smarter than I am. And so the question is, why don't you see people doing that?

 

0:10:50 LC: So you actually do see people doing this literally all the time, but it's not for the sexy technology concepts that you are thinking of. So go look into the public markets right now. You'll see a handful of software businesses that are trading at very high multiples to sales. So the idea is that you sort of have this trade-off: you could get free cash flow after taxes right now, or effectively more free cash flow down the line from some company that's growing quickly, and so what you do is you pay some price based on that free cash flow multiple. What happens when the free cash flow is really, really far down the line, we don't even use the free cash flow number, we actually just use the sales number. And sales is obviously much higher than just free cash flow, 'cause free cash flow is after all of your expenses and taxes. So when you go look, and you see some company that's trading at 15 or 20 or 25 times sales, the stock market is betting on that business being around and generating free cash flow over a 25 or 30-year period. That's the only way that math works. In practice, the reason the stock gets priced that way has something to do with those cash flows and also a lot to do with the capital flow landscape, but that is what's happening.

 

0:12:15 LC: These companies are getting funded on a 30-year time scale, and so the right question shouldn't be, "Why aren't good projects getting funded?" They actually are. The right question is, "Why aren't other good projects getting funded?" And so I think it comes down to... I think it comes down to what is legible to institutional finance, and so you might look out into the world and say, "There are trillions of dollars of capital... " I mean, there's just oceans of money out there, and it seems like someone could raise billions of dollar to go trade a building with someone else or something else that seems like it isn't actually moving the world forward and this sort of simplistic take. But why can't we take that billion dollars and put it towards some technology, something that might be obvious in your opinion toward moving the world forward?

 

0:13:15 LC: So the first thing is you have to understand what matters is, in practice, even though it looks like there are trillions of dollars of capital out there, risk-adjusted or uncertainty-adjusted, there's actually very little capital available. And the right way to think about it is to say, what type of product are the capital allocators buying? And so this isn't, again, a place where we have an analytical equation and you just pop your numbers into the equation and you say, "Well, the return to society would be X percent higher if we invested in this type of technology that will have a payoff in 25 years." The right way to look at it is to have empathy with the person who is in this capital allocator's seat, in this investor's seat...

 

0:14:08 BR: I.e you.

 

0:14:08 LC: Well, me or anyone else. But again, I'm not trying to paint myself upfront, there's the intellectual side of capital allocation, and then there's the reality that a lot of people are using an element of gambling in this. But it's to understand what they're buying. And so the reason people are comfortable investing in that real estate or investing in an enterprise software company is someone has come up with a set of metrics that has convinced the market that those cash flow streams are durable, that they will exist and be predictable 20 or 30 years out. And so what you've done is you've created this yield product, and what you've really done is you've created a sense of certainty. And I think what people don't like is uncertainty, they really want to essentially have something that they don't have to do too much intellectual work to understand and that they feel like they can trust. And so the problem is actually sort of one of search costs.

 

0:15:20 BR: A really dumb question is, What does it mean for something to be risk or uncertainty adjusted? Because you said that there's trillions of dollars out there, but there's actually not that much when they're risk or uncertainty adjusted, and is that basically just say that capital allocators don't have the incentive to spend most of that money on anything that they perceive to be risky or uncertain?

 

0:15:50 LC: Not exactly.

 

0:15:51 BR: Okay.

 

0:15:52 LC: It's two things. So first, in terms of how most people think about risk, so the way that you might think about this before you start really looking at it is you'd think, Well, we're just trying to sort of predict the future, the future is relatively predictable, and we can make some educated guesses about probabilistically what is going to happen, and then we can sort of model out those payoffs, those defaults, and sort of go from there. And so sort of the canonical text in finance for equity evaluation is called The Theory of Investment Value, and it's written by a guy named John Burr Williams. I can send you links after this. It's written by a guy named John Burr Williams after the Great Depression, and he was basically trying to sort of scientifically estimate the value of all free cash flows. You may have heard of this concept of discounted free cash flows?

 

0:16:48 BR: Yeah.

 

0:16:48 LC: He's arguably the person who invented it or at least codified it. In practice, though, you quickly find it is unbelievably difficult to figure out and to actually estimate the cash flows of something, even four, five or six years out. The world just changes really quickly, competitive positions tend to change really quickly, and so you actually could come up with this range of outcomes, but they become somewhat uncertain. So you take that as sort of the investing reality, and now let's look at sort of the funding reality. A lot of the people who fund investment funds or who are making investments, they have cash flow needs. They have sort of real cash flow needs, and then they have sort of intellectually forced cash flow needs. The real cash flow needs are, look, we have to fund our endowment, we pay X percent out per year so that the college can function, so that the hospital can function.

 

0:17:53 LC: And then the intellectual cash flow needs are, look, here are the risk models that we use, and when we see the prices of our investments fall 8%, we consider that as fundamental information that our investments aren't performing well, and so we need to sell out. And so they actually don't just need cash flow to look good, they need the pricing information in the market to look good. So we're talking about arbitrages. This is probably one of the biggest arbitrages that exists in the market, but it's unbelievably difficult to capture. So let me give you an example, imagine that you had a row of 10 houses in a neighborhood and they were all... Let's just say for these purposes, valued at $100. So let's say one of the neighbors, they are in a rush and they need to sell their house because they got a good job offer somewhere else, so she sells her house for $97 because she'll just get whatever she can get. And then another neighbor gets a similar job offer, and she sells her house for $95, and suddenly some other neighbor along the street looks around and says, "Oh no, prices are falling on our houses, everything else is getting sold off, we need to sell." And so they might sell just because they're scared, because they think there's sort of fundamental information in those transactions, in saying, "Okay, the market price has fallen."

 

0:19:22 LC: So you've seen the marked prices fall from a $100 down to $95. The problem is the market shows the prices of transactions, they don't necessarily tell you the fundamental value behind those transactions. So as a result, you being a portfolio manager, say you're invested in houses, you might have a view and say, I think that those houses that sold off, those were forced sellers. That doesn't mean that the price of the assets have actually fallen, these prices will come back up. Someone else might say, "No, no, that's pretty arrogant of you. The market has spoken and job opportunities have changed and people are going to leave the neighborhood." Now, it's really difficult to capture that sort of arbitrage, and arbitrage isn't even the right word, but capture that valuation spread, because it actually comes effectively down to who is right, and that ends up being a grounded matter of opinion, but effectively a matter of opinion.

 

0:20:32 LC: You can do a lot of diligence, and then you can maybe figure out if you're generally more right or generally more wrong. Ideally, if you get really, really good at sourcing information on the asset cost that you're investing in, and then you go around looking for these situations where the market has sold them off, but you recognize that they're sort of incorrect in doing it. But for the big portfolio managers, again, there's an information search cost. Every single time one of their fund managers underperforms, fund manager is of course, going to come back and say, "No, no, it's temporary. We're right, the strategy will come back. Don't pull your money."

 

0:21:12 LC: And so the difficult thing for the allocators to funds is they sort of have to diligence the fund managers who are then diligencing the investments. And so you can see that as you sort of go down this line of information being passed from person to person, the search costs just rise. Whatt it really comes down to is basically trust, where the investor is investing in a company or in some operator, and then the allocator is investing with the investment fund. And all along those links in the chain, it's so expensive from an information perspective to figure out who's being honest and who isn't. That trust is actually the fastest way to figure out what is a good investment and what isn't.

 

0:22:06 BR: Yeah. Correct me if I'm wrong, but then I sort of extrapolate that to the thought that it's actually very hard to build up trust in someone who's proposing to make, say, a 25-year bet, because you would need 25 years to build that trust, right?

 

0:22:31 LC: Sure, and this is actually the problem. And so if you look at it, most fund cycles for the investment funds themselves, they typically have about a three-year window to prove themselves. So if they can't show marked prices rising within two to three years, or they can't show cash flows coming out in those two to three years, it's in practice really difficult for that fund manager to go raise more money from an allocator. The best allocators, they really get it. But in practice, most people are sort of looking at each other trying to understand what we all think is valuable and what we don't, and people are actually pretty good at it. But if you're not seeing results within three years, it's difficult to go raise the next VC fund, the next private equity fund, or just to raise more money for whatever your next fund vehicle is. And so what happens in practice is, people don't go spend their time investing in projects that are going to take a really, really long time and won't get marked. So what that means is, for an entrepreneur or for someone who's trying to get funding for something, getting that asset mark is unbelievably important because that's what lets the great investors go invest in you.

 

0:24:00 LC: So it's really important that for the VC company to get that Series B or the Series C or the Series D done. That single mark in time is hugely important because everyone can sort of concentrate on that, take it as a market price, even if it's not a perfect market price, and then write that in their books, measure it, sort of trust it to some degree, and everyone can sort of coordinate around that because you have a market clearing price there. And so if you think about it, just on the equity side of it, every founder's equity actually is a product in and of itself. I always find this interesting because I think most people don't think of it this way.

 

0:24:42 BR: I don't.

 

0:24:45 LC: But when you start a company, you're actually... You're selling two products. The first is sort of your individual product. This is the thing that you think you're starting. And the second is your company itself. And so your company can turn into a product where you sell your debt or you sell your equity or you sell some other sort of financing scheme, but that's a product, too. And the way that product is priced is, in the private markets, you have one-off auctions where you sort of game the options as much as you can to get the highest price. This is where everyone in their C, Series A, B, C... Well, not so much in C, but in A, B, C, you basically create auctions where you try to get all of the partner meetings on Monday morning to be talking about you, put all of your meetings into a week, and then you get everyone to bid all at the same time, and then you maybe don't go to the highest bidder, but you go with some mix of the highest bidder plus the people that you want to work with.

 

0:25:35 LC: Then the public markets are actually a totally different mechanism, it's a different distribution method where it's a continuous auction, where there's bids and asks continuous in time, at all times. And so you can't actually create these small little one-off auctions where you can rig the price up because the bids and asks, they just keep coming. But the benefit is, if you know how to... If you do well in that channel, you then have a lot of liquidity and you can usually get a higher price and arguably more capital. It's not actually even clear that you need to do that, but that's sort of the argument. And so I think if you start thinking about it that way, you can start to recognize, "Alright, that's why some projects are getting funded and some aren't." It's because the projects that are getting funded, they are products that work well in that market, and they are actually products, it's not just a throwaway phrase.

 

0:26:37 LC: I was chatting with someone about this earlier. I think it's probably good to take the emotion out of whatever project you're working on and think about this for unemotional things. So one of my friends is trying to get a research project funded, sort of like an arts VR research project funded. And we're talking about this and she's like, "Oh, now I get it. I should think about this like soap." So imagine you are a soap manufacturer, and you have made the best soap in the world. You think it's better than any other soap. You wouldn't expect to sell that just because you've created it. You'd think, "Okay, how am I going to get it out there? Am I going to get it on to Amazon? Am I going to start a store on Shopify? Am I going to go to the people at Costco or Walmart and cut a deal with them so it's distributed?” Because I might have the best soap in the world, but some mediocre soap that gets into the Costco channel and then works with those constraints, they are going sell more than I am. That product is going to do better. And if you care about people using your product and you're sort of not just cash flow-driven, but you actually care about the impact, you really, really need to think about that distribution channel and how you're going to get it out there.

 

0:27:50 LC: What you quickly find is that often the constraints that people place on their products, it's not that they don't realize they're making their products worse, it's that they want those products to get distributed and they think the tradeoffs are worth it. And so the really interesting new products, they recognize that, "Oh, there's some constraint or there's some tradeoff that a lot of other people made with their existing product lines, and I don't have to do that," because the way you distribute it has changed, or some assumption that they've made, they actually don't have to make that tradeoff. And I use something like soap because it's boring and unemotional to at least most of us, but it's almost definitely true with research funding. And so you and I talk about this a lot, but I mean, if I were trying to go raise money for research, it would depend what I was trying to do, but I think there are probably new distribution channels out there, so I mentioned with small scale... Sorry, you were saying?

 

0:28:50 BR: Oh, there's just three different directions that are really exciting to go with this.

 

0:28:56 LC: Oh, please.

 

0:29:00 BR: Yeah, so I think what I'm going do is I'm going to lay... Actually, I will lay out the places that I think are all tied into this that are all really interesting, and you let me know how you want to weave through them. So one is actually this... So both this point about a project as a product is a little bit mindblowing, and I think that it's tied to an earlier point that you made that I wanted to dig into about what it means to be legible to institutions. And if I am understanding correctly, the marking of valuations is one of the ways in which... At least, in the startup world, venture capitalists make themselves, their firm, as a product legible to other institutions. And so Shopify comes along, and you can now distribute your soap through an online store that you never could. What would be the project funding equivalence of that new distribution channel?

 

0:30:17 LC: So I absolutely don't think that this is that new, but it seems to have come somewhat in vogue, and I think it's just patronage. And so if I were trying to go do research where I was trying to make, say, call it $100,000 a year or something along those lines, basically enough that you could live a really good life, afford rent in any city and sort of have basically time to yourself, I think the obvious way to do it is to try to build an online following. And this is not a new idea. Kevin Kelly wrote that old essay, I think it was 1000 True Fans, where he said, “Look, at 1000 True Fans paying you $10 a month, that's enough.” I think a mutual friend, Andy Matuschak, who has Quantum Country has done a great job with his Patreon. I think it would be really, really, really difficult to do this. But I would think a lot about what really causes someone to say, "I'll pay $5 a month to go read this newsletter, or to go basically fund some research I find interesting." And this distribution mechanism didn't really exist before, and so I actually think in some ways, we're still pretty early on. And all I would do is think, "Alright, I need to get 2000 people to sign up all over the world." The Internet rewards niche behavior, and so how do I get into the community of these people find it just sort of interesting, and this is sort of entertaining to them, and I would think a lot about how I could create something around there.

 

0:32:01 LC: For the larger amounts, I would actually do the opposite. So for the larger amounts, I would go become friends with everyone in the funding world. So they have incentives too. And what you'd want to think through is normally... I guess I'll put it this way, and I was chatting with my friend about this. Normally, the way that the great researchers I know think, they're almost... They're quite dogmatic, to be honest. They say, "Okay, my project is the best project. This really will advance the field." But in practice, what might make it easier to sell the project is to understand what gets the person funding the project promoted? What makes the funder feel good?

 

0:32:40 LC: What will get to that next level of funding for the person above them too? And then if you're able to map that out, you can represent it in a way that basically works for everyone. And she was actually pushing back on me and saying, "Look, I don't want to lie. I don't want to represent my project that way. That seems sort of fake or it seems like a veneer." But the truth is, is that the project that she has in her head only exists in her head and doesn't exist in anyone else's head that way. And if she doesn't communicate it in a way that actually makes sense to them, then it's not going to get anywhere.

 

0:33:21 LC: So I think the really frustrating thing to come out of this is that basically everyone's in sales in some way, shape or form, and I think a lot of people don't want to be in sales or think that it is a sort of a difficult thing to go do. And so as a result, they just sort of shy away from it. And so this is, again, why I think the distribution analogies really, really can work well, because it sort of takes the emotional weight out of it. And then if you look at this and say, "Oh, this isn't the best grant maker in the world, this is just Costco, and I'm just trying to get into the new line," I think it can feel a lot less heavy. And you can maybe treat it, and maybe the field might open up to you a little bit more.

 

0:34:05 BR: Okay. I guess, the tension I see there is building up trust with the people who are the capital allocators, almost feels like the opposite of figuring out a different way of making yourself legible to an institution. Institutions are obviously made up of people, so these aren't two separate things. But I think that there's something to the fact that you need trust when you're doing something that is not institutionally legible. So it's like you don't actually have trust with a lot of the companies that are publicly traded that you invest in, but they are... They've packaged themselves in a way that is sort of institutionally legible if that's... And I think this might actually be a good point to really... What do you mean by something being institutionally legible? What does that mean?

 

0:35:20 LC: It's a vague handwavy way of saying you just need to be recognizable to the people who are buying your product, and you just have to understand, in practice, how those relationships work. And once you understand the practicalities of whatever market you're working in, then you'll be able to understand how to craft a product for the people who actually want it. And, again, I think the difficult thing here, this is not intellectually that challenging, it's much more of an ego thing where we have to put aside what we think are the best products that everyone should be buying or what everyone should be doing. So if you think about it, since we're talking very abstractly here, what capitalism really rewards is, and actually this is true of all non-violent selection, it rewards behavior change. And so what we're really saying is how do you get someone to sort of change that behavior. And when you think about it that way, what's legible in your head, if someone else hasn't learned all the same things you have, they're going to end up using some sort of abstraction, some sort of shortcut.

 

0:36:41 LC: And that's sort of what I mean by saying intellectually... Or sorry, institutionally legible, is you understand the abstractions they use, you understand basically the mental models they're using to try to understand what's going on, and then you are able to fit your product into that. So I can give you a couple of examples and findings that are...

 

0:37:02 BR: Yeah, please.

 

0:37:04 LC: So I don't know how deep into accounting you are, but there is a metric that's really commonly used called EBITDA. And effectively, it is a free cash flow proxy metric. And it was invented by some people in the cable industry who wanted to raise a lot of money to go roll out cable systems all across the US. And they wanted to be able to quickly raise debt to go buy these sort of small cable operators and then put them all together. And with this metric that they invented, all of these other investors suddenly had a Schelling point. Suddenly, all of these investors had a new unit of measurement to look at this type of business. And because they accepted it, they were willing to go fund those purchases. Suddenly, a whole wave of those purchases were done, and basically a whole wave of these projects were financed because someone figured out a way to make that institutionally legible.

 

0:38:11 LC: And a similar thing has happened in the last 10 or 15 years with what we call enterprise SaaS companies, where we now have a new set of metrics that weren't really in use 20 years ago. These are metrics, I'm not sure if you're familiar with them, these are metrics like...

 

0:38:26 BR: The CAC.

 

0:38:27 LC: Gross churn... CAC, gross churn, net dollar retention. And if I went to someone today and I said, "Oh, I'm investing in a business that has an average customer life time of six years, an LTV to CAC of 4:1, it has 98% gross retention and 127% net dollar retention, and I think those numbers are going to persist for the next four or five years, that is something that I almost wouldn't even have to explain what the product is. If something met those metrics and truly met those metrics, it's a company that would get a huge valuation in today's markets. And it's again, it's because it's now institutionally legible. Someone has basically convinced the world of that. So then the question should probably be, why do these things get institutionally legible? And what I find is that, we're actually re-using the same math over and over again and finding new situations where we didn't realize that math applied. And so usually what's happening is, we're finding relationships that are really durable, that are really, really, really resilient.

 

0:39:40 LC: So I have this little questions page on my website, and the first one is, "What is the next durable customer relationship that we haven't really seen yet?" So what happens is, once the market recognizes that there is a durable customer relationship, and you can build that into our models. These models actually should come from how we model these bonds that last 20 or 30 years. If you can fit the customer relationship into that model, suddenly, all of the bond investors and sort of the bond valuation metrics that we used as proxies, they drift into the financing world. And people say, "Oh, this is also a durable relationship, so we should go fund it." And coming back to your first question to say, how do some of these huge technology projects get off the ground, it's because someone has convinced a set of investors somewhere that there is this long durable, and that's important, resilient set of cash flow streams 20 or 25 years out, and then we discount that forward, so that's how that works.

 

0:40:45 BR: Oh, man. Okay, so to riff on that and to go back to your analogy to products and distribution channels, what basically... You could almost think of it as someone coming in being really good at sales and arguably like marketing, and basically changing taste and creating a new product category where people didn't know they wanted gluten-free things, and then they go and they create that new marketing category, and now customer tastes change, would that be...

 

0:41:29 LC: And it's funny you use the word taste, that is... It's both fundamental reality of, Oh, in a true Bayesian universal sense where we're updating our priors correctly, imagine we had all knowledge, that does matter. But then taste does matter too, that's exactly right. There's another book I'd recommend called "The Empire of Value" by a guy named Andre Orlean, who is this really interesting French economist. And so in this book, he makes this argument that prices are completely socially constructed, and it's like you're saying, it's taste. As a side note, it's totally unclear to me why all of the people who are coming up with the socially constructed value theories are all these French people. It makes one wonder what's in the water in Paris. But similar is to say, actually, I think, and everyone else thinks, and we're all sort of self-referentially thinking, therefore, the thing exists, the price exists, the value exists.

 

0:42:32 BR: Yeah, yeah, that makes sense.

 

0:42:33 LC: It exists as this organizing principle, which everyone else then cites as a real reference and then it takes on a momentum of its own.

 

0:42:44 BR: And what... And so, I guess, do institutional structures like C-corps and LLCs, do those relate to institutional legibility? In my head, they do, but I might be going a step too far.

 

0:43:04 LC: Yes, they do, but I want to backtrack in terms of what you're saying.

 

0:43:12 BR: Yeah, do it.

 

0:43:14 LC: So what they do is they basically... The legal structure sets the landscape for markets. I should completely confess my own bias here. I am massively, massively pro-markets. I think virtually, no other social mechanism that we know of has raised so many people out of poverty. But as much as I love markets, I recognize that it's not sort of this shallow teenager's love of markets where I overdosed on Ayn Rand. It's more of on the lines of...

 

0:43:45 BR: Be nice to the little libertarians.

 

0:43:49 LC: No, I was once one when I was 14 too, I get it. And I think the problem is, you have to understand markets are these amazing and emergent phenomena that pop up basically naturally everywhere, people trade with each other. But efficiently functioning markets are actually very, very expensive public goods to maintain. And that means that you're depending on the bias of all the regulators to try to make the best guess as they can to create and maintain these liquid markets to make sure that people are transacting fairly. To give you another book recommendation, there is an economist named Alvin Roth, who wrote a book called "Who Gets What and Why," and a lot of his students went on to go work at Uber and Airbnb to sort of create these marketplaces. And if you look at it, they're actually quite intentional about how they're sort of creating the markets. So now, let's take one step further back and say, “Alright, all of the countries are creating markets themselves, too, and they're creating the balance of these markets.”

 

0:44:54 LC: So as you know, I'm a lawyer and was a history major and sort of loved looking into this stuff. I would argue that one of the least appreciated social technologies of the last few centuries is the concept of limited liability. And so it used to be, before we had easy access to creating limited liability organizations, if you started a business and it went bankrupt, you personally went bankrupt. Maybe you were thrown in jail, maybe your family went bankrupt, and so you couldn't go that far out onto the risk curve. And so, socially, if you were thinking about this sort of like an agent-based modeling perspective, if you could basically increase the variance of what agents could do, if you could basically socialize some of the risk, then you let people take a little bit more risk. Maybe it doesn't work out as well for a few people, but socially, you get to that higher hill in the hill-climbing analogy. And so you're asking about how C corps work and LLCs work. Do you want me to just run through the history really quickly?

 

0:46:01 BR: Well, I guess more what I'm poking at is just talking about how, at the end of the day, these aren't laws of nature, the structure of organizations and...

 

0:46:14 LC: Not at all. So why do we have Delaware C corps? Coming back to limited liability, in the late 1800s, New Jersey created a charter that let anyone go get a corporation. And then after that, later in the 1800s, New Jersey passed a set of laws that are colloquially known as the “Seven Sisters,” And these were these terrible laws in the view of all the businesses who were registered there, so they were looking for other places to register. Delaware saw this as an opportunity, so around 1900, Delaware lowers their taxes, lowers their registration fees, and they bring a lot of corporate registrations in. And then they set up their court systems so that they specialized in registrations, at which point Delaware becomes the de facto place. You get a runaway phenomenon, then all of the good corporate lawyers want to go practice in Delaware or they want to be corporate judges in Delaware, and all of the interesting cases go to Delaware. And it's literally gotten to the point where everyone in the US references Delaware corporate law, and non-US companies will create charters saying they'll defer to Delaware corporate law, and countries who are still forming their legal systems will effectively copy and paste a lot of Delaware corporate law. And so coming back to your point, it's not a law of nature. These are people doing the best they can to optimize the landscape, and that's how it works.

 

0:47:47 BR: And so my thought would be that that does relate to institutional legibility, because if I went to someone and said, "I'm using a B corp structure," they'd be like, "What the heck is that? I'm not touching that with a 10-foot pole." But if I say that I am using a Delaware C corp, then that is a legible abstraction, so I guess that would be my argument for why institutional structures matter.

 

0:48:24 LC: They do, and I think what it comes down to is you have all these degrees of freedom when you're starting any organization or any project, and you just want to think about where you want to innovate and where you don't want to innovate. So you look at US business organizations, I should say this, since I'm a barred attorney, this is not legal advice. There are basically four options. You default into being a partnership where you actually have unlimited liability. You can be a limited liability company, which is done state-by state. You could be an S corp, which is a tax status of LLCs, or you can be a C corp, which is the one that you're talking about.

 

0:49:03 LC: And what you go see when you run through all of these things is, well, there might be a better way to do this, but for the company that I'm starting or the project I'm starting... So the fund that I run, we have a Delaware LLC. I could argue to you that there are things we could do that would actually be better for the investors and better for the whole strategy, but you then look at this and say, "Hmm, it's just not worth the marginal effort given the payoff of actually trying to overcome that sort of legibility hurdle." And so I think what ends up happening is you end up getting these innovations around the edges where someone says, "Okay, here is one use case that's a little bit better, and we'll keep everything else the same except for that," and then the new standard arises. I don't think it ends up being worth saying, "I want to create a new legal structure and a new product and do physics research all at the same time," just because there's not enough time in the day.

 

0:50:11 BR: Yeah, I guess it just... It makes me wonder, because it feels like these legal structures do impose certain constraints, it just makes me wonder out in the landscape on a completely different optimization mountain what other constraints could be imaginable.

 

0:50:40 LC: So probably the most difficult cost to measure out there is opportunity cost, because it's so difficult to say, what could things be if we organized everything differently? And one hopes that when you have 50 states, that's how federalism works in the US, one hopes you get people experimenting with regulation, and you can get maybe a new project started off the ground somewhere else, if not in the state that you live in, and then of course, with more countries, you can maybe go overseas and do it too. And it's interesting, you brought up Spotify a little bit earlier, it's unclear to me that Spotify could have gotten started in the United States, given the state of music laws at the time. But then what happens is all of these European customers start using the product, and that has an institutional legibility of itself, and people say, "Oh, okay, I can see it's working in that country, it will probably work here," and I wasn't involved in the record label negotiations, but I assume that's basically what they were looking at. And then you look and say, "Oh, okay, then the laws can change."

 

0:51:52 LC: The other thing that I just want to point out is that when a law is set, that's a much more fluid thing than I think most people realize who haven't spent a lot of time looking at this. So in practice, a lot of times, there are sort of these gray areas of the law, and I'm not saying people should go break the law. But there's a gray area of the law where the products that you're working with don't really fit into the regulation, or customer demand is just so massive that the regulators will actually change their mind once they see that demand. Now how far you want to push that boundary is really up to you. There are arguments that Uber or Airbnb were illegal when they were first started. There are arguments that they're illegal right now. I don't think so, and I think they did the right thing, and I think the world's a better place for giving everyone the options. But it’s also really, really important to realize is there are these constraints, but the constraints, when you read a law, it's not a law of physics. And the other thing that you have to understand is laws are executed by regulators, so understanding why they are enforced or what they actually want to enforce is also really, really important.

 

0:53:09 BR: Yeah, and do you think there's... So to your point about there being different regulations in different places, do you think that it's then problematic that you see so much copying of Delaware law and sort of copy-pasting that around the world? 'Cause wouldn't that then sort of make everything... Wouldn't that be a very strong attractor?

 

0:53:37 LC: I think what ends up happening is it's a good enough baseline. So I can't remember what the book is called right now, but there is another famous economist named Hernando de Soto who wrote about just the importance of property rights and how if you are able to sort of import the property rights regimes from the US into a lot of different countries that don't have them right now, it would be a huge driver [0:54:00] ____.

 

0:54:00 BR: It wouldn't necessarily work.

 

0:54:01 LC: And so I don't think we live in a world where we figured everything out so perfectly that all we need to do are these sort of minor experiments. I think we live in a pretty uneven world where if we just had relatively good legal functioning across the world, not just in terms of the laws that are written down, but sort of culturally how they're practiced, we could make life a lot better off for a lot of people. So it does make a lot of sense to me that if you and I were trying to start up a corporate law and corporate practice in some small country somewhere that was just starting to figure it out, or just decided they really wanted to change their system, I think we would go look at best practices. I think that's normal. It's unclear to me though that we are actually doing enough experimentation on the regulatory side, it's just really, really hard to say how much because it's just sort of this abstract opportunity cost question.

 

0:55:03 BR: Yeah, it's... And I guess these are sort of the same thing where I think of it as it's very hard to talk about counterfactuals, and actually, to riff off of the point about opportunity costs, my impression about... Of one of the reasons that large long-term projects don't get funded is because the opportunity cost is so high in that if I see that the stock market is increasing at a... It's like the number in my head is 5% of... I think of stock market 5%, I'm not... Is that roughly...

 

0:55:47 LC: I think nominally, the numbers, depending on the timeframe you look at, are along the range of 8%-10%.

 

0:55:56 BR: Oh, wow, okay.

 

0:55:57 LC: But there are actually a lot of people who right now think that 5% is what you're going to see for the next 10 years.

 

0:56:03 BR: Okay, well, let's...

 

0:56:05 LC: Anyway, doesn't really matter. Let's say 5%.

 

0:56:06 BR: Yeah, exactly. So in order to make the argument for something like the opportunity cost of investing in an illiquid thing is the compounding returns that you would get from 5% growth in the stock market, plus the amount that... Like the liquidity that you're giving up, which is, as you pointed out, a really big deal. And so it's... And then put uncertainty on top of that, so it's not even a guaranteed in the future compounding... Like you need to be... So it just... It seems like it's a fairly straightforward... It's actually a very, very large opportunity cost to propose an alternative investment to just the stock market.

 

0:57:07 LC: So I think it is and it isn't. First of all, I think you framed all of that correctly, that everything is subject to an opportunity cost. And so, of course, when I'm looking at whatever investments I'm making, and you are too, or deciding where to spend your time, you're going to look at your other alternatives and then choose. I don't think that necessarily should mean that it's impossible to go find a project worth working on. I think what it means is you just need to really, really understand what you're building. So that you understand why it's really valuable, and you have to go after sort of basically big projects or you have to have really, really fast experimentation, so you can just try out a lot of things and say, "Okay, maybe the opportunity cost is high over five to seven or eight years or 10 years, but I am going to try 2,000 different types of Shopify stores programmatically, I'm going to figure out which ones work, and then I'll have the revenue stream that I want once I've tested out and pulled out to the best 25, and then go on from there."

 

0:58:16 LC: So I do think that that it's definitely doable, you just have to recognize the opportunity cost. But you're right, there is an opportunity cost. I just think you shouldn't sell yourself short. I think implicit in what you're saying is that the world is relatively efficient, and because the world's relatively efficient, how on earth could I earn more than 5%? But I have to say, I look around everywhere and see a lot of products that, they were built on the constraints of the past distribution channels, they were built on the constraints of the past production approaches, or they were built on social relationships that have broken for whatever reason.

 

0:59:04 LC: So you look at this and say, huh, I think there's probably a better way to do it. And if I'm right, and if I really, really focus on figuring out what's wrong and how we can do this better, you're going to find that the returns you earn are massively more than the stock market. I just think you have to be really focused and intentional in how you're doing it, and I think you have to spend a lot of time understanding the people behind the process. If you ever... I'm trying to think. Have you ever read that essay "I, Pencil" by Leonard Read? There's this idea that if you look at any sort of product in front of you, so you look at a pencil, an uncountable number of relationships went into building that product. So for the pencil, someone had to chop the wood, someone had to mine the metal, someone had to refine it, someone had to put it all together, someone had to paint it, someone had to build the eraser, and someone had to invent all of that and patent all of that, and start all of those companies and then figure out how to market it, and then figure out how that distribution channel worked, and then figure out how consumer tastes were changing, and just look through all of that.

 

1:00:11 LC: There are so many relationships there, and if you think about it, there's just... There's no... It's extremely unlikely that we've reached the global maximum for almost any product, because you only need one of those relationships not to have been done perfectly, not to have been optimized, to have an opportunity to do things better. And then you look at the constraints that they used to have 80 years ago versus what we have now... Software has changed so much in the last 15 or 20 years, the Internet has changed the world a lot in the last 20 to 30 years. You look at this and say, there probably are better ways to organize these things or to sort of optimize things. And I think that's true... I'm looking around my apartment now, when you look at, I don't know, a glass, or you look at a countertop, or you look at any art or any hardware, I actually think this is true for almost the most mundane object in your life.  And actually I find... Once you start getting into the details of all of these mundane objects, it's not mundane, it's totally...

 

1:01:19 BR: My concern is actually the opposite, where I think that there are tons and tons of dollar bills on the ground, but the payoff you need to convince someone of becomes inordinately larger, the better the stock market is doing, it feels like, because of the opportunity cost.

 

1:01:45 LC: So yes and no. If you look, for reasons that are separate from this conversation, at demographics and the way that capital is structured, interest rates are low and look like they're going to stay low for a while, which means the required return for a project is going to keep falling. So yes, when the stock market is doing really well... Imagine the stock market were returning 40% a year, it would be harder and harder to get new projects funded because people would just put their money in the stock market. But as those returns fall from 8% to 5%, or you used to be able to get 6% or 8% over a 10-year period in a 10-year bond and now you're getting 2, 2 1/2% a year, you actually are more and more willing to go out onto that risk curve and sort of fund something new. So I actually don't think the problem is as much opportunity cost, especially today. Socially venture capital is so popular that I don't think the problem is opportunity cost. I actually think the problem is alpha. And so if you think about what alpha is in the finance world, it's basically, you're looking for an information advantage, and it's going back to cash flows and capital flows.

 

1:03:07 LC: You're looking for an information advantage on what's going on with those cash flows, with the product, the customer sort of thing, or what's going on with capital flows. So your alpha could be, you understand there's going to be a forced seller here or a forced buyer there, and then you bridge the liquidity into that market. And to throw one more book out there, the best book I know of to think about information sourcing is a book by a Nobel Prize-winning physicist named Robert Laughlin, it's a book called "The Crime of Reason." Have I ever mentioned this one to you?

 

1:03:39 BR: No.

 

1:03:39 LC: So it's really interesting. Frankly, it's a shocking book when you really process it. He basically argues that all economically valuable information is kept secret. And so you think that you really understand a lot about the world, but you actually understand, say, 98% about some topic, but that last 2% that really matters to get the project off the ground, to get the product built, to actually get funded, that's really kept secret. So the reason I think this is interesting is we've turned an opportunity cost problem of, "Well, there's really nothing I can do about it, I hope I come up with a good idea," to an information sourcing problem. So the way I think about this is I say, okay, there are really two places that you find information in the world. It can either be recorded or it can be in someone's head. So recorded could be like written and natural language, or in numbers in a database. And I often find, unless we're talking about you going and coming up with some new fundamental algorithm, all you really need to be doing is collecting all of that data and joining tables. It's not actually that complicated from an intellectual perspective, but it's really about finding those tables and joining them. And then on the side of, oh, it's in someone's head, it just ends up being about building relationships with people.

 

1:05:01 LC: And to your point about there being lots of dollar bills on the sidewalk, there are, but it's almost like they're invisible, so you need to go find the information to really understand, oh, that's a real one, that's a fake one. And it just ends up being a shoe leather exercise where you say, "Okay, I'm just going to go reach out to a lot of people, become friends with a lot of people, talk to them about their work, really try to understand what they're going through, and then I'll recognize what they want and what they don't want, and then I'll find effectively that alpha." And I think that's probably a more useful way to think about it than opportunity cost, because it's more empowering once you think about it that way.

 

1:05:38 BR: I like that. To change tracks a little bit drastically, but to just get to a point that I think it is really important to talk about... So you invest primarily in public equities, right?

 

1:05:52 LC: Mostly public, but public and private companies, yeah.

 

1:05:55 BR: Yeah, and so there is a argument that... I'm on like... There's basically an argument that short-term is like short-term thinking on the part of public investors has sort of pushed public companies to slash R&D costs and basically caused the fabled death of corporate labs. I think it is pretty clear that corporate labs don't sort of have the sort of world-changing output that they used to. However, I'm agnostic about the cause and still trying to figure that out, so... What do you think about that argument?

 

1:06:42 LC: So, I think it's complicated. I also think I'm not sure, but I can think it through with you.

 

1:06:50 BR: Yeah, let's think through it.

 

1:06:51 LC: Sure, so if you look at the valuations in the public markets today, they are very high by any historical measure. And so high valuations do not imply short-termism. They imply that the market is placing very, very high prices on companies. Now, it just turns out that a lot of that has to do with the way capital flows work today, not just with cash flows. And so what's going on effectively is we changed the retirement system in 2005. So we default decided to put a lot of people's money into index funds. Index funds just blindly buy a set of equity as a set of stocks, just as capital flows into them, and so we've had more and more retirement flows, so you see all of these stocks get bid up. That has been a huge reason for valuations going up. But anyway, you look at this and say, alright, so just on a project basis,