After selling our last company I was surprised that the acquirer went on an even bigger spending spree just months after acquiring us. As a bootstrapper this blew my mind.
This article helps shine a light on how they pulled it off. They acquired us for the free cashflow the company threw off (uncommon in our industry) and the leveraged that to further their expansion.
I've always looked at accounting as "backwards facing" (meaning it looks at what has happened vs where a company is going) but this article has changed my perspective dramatically.
> Most useful article I've read probably this year.
Agreed.
I didn't really care about the should you / shouldn't you raise money part and the whole first principles thing, but the middle half of the article gave me a lot of things to think about and I am guessing I will be checking out the other content on this site for the next while.
If you liked this article, you might like the book The Goal or its application to the “project context” that software companies find themselves in, Critical Chain. They define a lot of business thinking as being focused on controlling costs, when in fact you want to first maximize revenues, and the kind of funky idea of measuring “dollar days” that one eventually gets to is an attempt (which I actually don't think is successful, but maybe it is approximately okay) to start to bring cash flow ideas to consciousness.
I believe The Goal is where I first read about this idea about cash flow being more important than revenue, in a way that can be easily explained to anybody: you have bills, you have a certain amount in the bank, and then you have in accounting a set of invoices that you have sent out to customers but they have not yet been paid. So that money is “as good as earned” on paper but it’s not yet in the bank. And the problem is not revenue, the problem is cash flow. If you don’t have enough in that bank account, then after paying for your materials and rent for your building and whatever else, you suddenly come up short on payroll. “Please forgive me,” you tell your employees, “we have the money and your paychecks will just be a week late, we are so sorry, this never happens normally.” Good way to lose a lot of your best minds that really make your money—your best salespeople, your best engineers, your hardest workers. They got rent to pay. In The Goal I believe the book points out that most companies that go under don’t have a revenue problem but a cash flow problem, the money isn’t coming in fast enough to pay to keep the company running even though it is coming in eventually.
there are a couple of other ways to look at it that may be helpful to the broader community, one of them is that your interest rate on debt actually sets a time scale for your “indefinite future.” If you have credit card debt at 36%/year compounded monthly that’s 3%/month, flip that to (1 month)/(.03) = 33 months. Now if I ask you “hey, how much is that $20 per month subscription worth to you in terms of present value?” you can answer: that subscription runs out into the indefinite future so it gets multiplied by this time scale and it is worth $660 to me right now. Which is another way to say equivalently that if I bought something right now for $660 I would pay $20/month for the indefinite future. Lots of people don’t realize how much present value they can unlock by just canceling out old subscriptions like that, because the cash flow is not there immediately, but it’s true.
Similarly, I ran into cash flow issues at the beginning of this year in my personal finances. With COVID-19 hitting at around the same time my auto loan asked me if I wanted several months deferral. Are you shitting me right now? Yes, the added productivity and lack of stress from having a floating several hundred dollars in the bank and therefore being able to set up auto-pay (and not incurring late fees on all my accounts) pays for itself and then some. Thank you so much! (Of course the bank is a bank, this is cold hard calculus to them, so I don't feel too bad. Imagine that, too, though! Imagine that if you are in a good cash flow position, as the bank is as covid starts, your reaction might actually be to turn away cash flow: you are a sort of landlord collecting rents and you need to mitigate the risk that all your tenants go broke, they need to be able to keep their jobs for your wellbeing. And then you think of the actual landlords and you realize that the system must have left them relatively strapped for cash if they’re not similarly absorbing some of the shock. And that launches into interesting questions about feedback mechanisms in complex systems and their modes of resilience.)
The author creates a false dichotomy when they write that business is either about making profit or managing cash flow.
Making a profit requires cash flow management, but managing cash flow does not require making a profit. This article does talk about managing cash flows in a way that involves never making a profit.
First, and tangentially, it's interesting that real estate developers do this all the time.
Second, it's interesting that this article shows not only why cable companies regional monopolies are extant, but also that their continued existence relies on the preservation of those monopolies.
These and other companies that rely on a strategy of unfettered subscriber growth, in this case leveraged as a marketing tool to creditors to acquire additional debt, is no different than a Ponzi scheme. It makes the fatal assumption that subscriber growth can continue ad infinitum.
But, similar to the amount of free energy in a system, the number of potential subscribers remaining is finite. Eventually, cash flows will fail to meet the projections sold to creditors and established as assumptions in their financial models.
Thus arises a situation that remains tenable only as long as subscribers remain subscribed for as long as is required to service the debt outstanding at the time the growth stopped. Because the debt didn't go anywhere. It hasn't disappeared. Today that debt is sitting on the balance sheet of every one of America's cable providers: the direct result of a flawed line of thinking promoted by the author.
Consider the implications. To remove the regional monopolies of the cable companies is to not only destroy their subscriber base, and thus their cash flows, but also the cash flows promised to their legion creditors. Every one of these creditors now has a vested interest in the preservation of those monopolies, having themselves extended and received credit based on said promises of payment.
I propose that, contrary to the statements of the author, the proof presented by their friend is not "framed incorrectly". Rather, it shows something the author doesn't wish to see.
I don't think he's presenting a dichotomy at all, false or otherwise.
To paraphrase heavily, he's delving into the fact that these are simply different things. Profit, free cash, EBITDA, etc. These have different implications. Particularly, they translate into capital very differently. Ability to borrow. Ability to raise equity. Pay dividends. This translates into radically different trajectories and outcomes.
In 2020 terms, you might also include growth rate, MAUs or the current trendiness of the startup. This also, essentially, translates into real world effects. Big ones.
Most people, including many "business people" don't quite realize the implications of a positive or negative float. The difference between a -20 day float to a +20. With a positive float, growing itself is cash generative. With a negative float, growing is cash consuming. A business might grow, produce less profit but more cash.
Outside of accounting, there's a tendency to dismiss this nuance as trivial and convergent in the long term. In reality, the future never comes. It's always the present.
> Outside of accounting, there's a tendency to dismiss this nuance as trivial and convergent in the long term. In reality, the future never comes. It's always the present.
So long as you're running a profitable business, cash flow management does seem to be a pretty trivial problem. The difference between positive and negative float is just a loan. And, if you can show a bank that cash is guaranteed to come in at a future date, you will have no problem bridging the gap with a loan or line of credit.
This is exactly the fallacy this article is challenging. It is simply not true in business reality, whatever the chalkboard fungibilities.
The difference between a positive and negative float is a structural difference that has long reaching implications. On that chalkboard, the difference between a publicly listed company and a family owned business is trivial or esoteric.. best explained by portfolio theory or somesuch. Sometimes abstractions miss the point.
There is no such thing as "cash is guaranteed to come in at a future date". Counterparty risk is pretty much impossible to remove, only to trade away to another party.
Or said another way, the model is not reality. It is a way of reasoning about reality, approximate reality, etc. Reality is not arbitrage-able without artifacts.
There are some flaws within your argument that i like to point out.
> why cable companies regional monopolies are extant, but also that their continued existence relies on the preservation of those monopolies.
it's a moral judgement about monopoly that you imply (it being bad). But the article makes no such judgements at all, and that by bringing in this you direct the argument towards one of ethical behaviour, rather than logical deduction and application of such for businesses.
> no different than a Ponzi scheme. It makes the fatal assumption that subscriber growth can continue ad infinitum.
That's not the defining feature of a ponzi scheme - which is that it is using the investment of new investors to pay out existing investors (and only doing so, rather than undertake a business). The cable companies _do_ produce something, that of cable provision, maintenance and services. Even if they assume infinitely growing subscriber base, it is not a ponzi scheme.
And growth doesn't have to be ad infinitum - just large enough to last long enough until the next disruption (e.g., starlink might disrupt cable companies). There's nothing wrong with a company dying - the bag holders and creditors who hold them last will lose out when they are disrupted, and this is a good outcome. Investment has risks, credits has risks.
Yes, I've thought about this too. But almost all successful businesses eventually go under[1]. Whoever was holding the potato last gets an egg on their face. That doesn't mean that the business was a "failure" though. It succeeded wildly during its heyday, making livelihoods and sometimes fortunes for many people, employees and shareholders alike.
I'd love to read something more about this line of thinking from someone more knowledgeable in the area.
[1] I think, but maybe not! It would be interesting to trace the "capital lineage" (made-up term) of various successful businesses from the late 1800s through today, for example.
> Making a profit requires cash flow management, but managing cash flow does not require making a profit. This article does talk about managing cash flows in a way that involves never making a profit.
Isn't the exact opposite true?
I work with businesses which import goods and sell them.
The vast majority of these make a steady profit without any thought to cash flow management.
Accounts receivable are a mess, payment terms are long and they have a lot of cash tied up in working capital - but they are making enough of a profit to make up for this.
In contrast, you can stay in business making a loss with clever cash-flow management, but not forever. Equity will decrease year over year, and new sources of cash (lending, selling shares) need to be found to finance the continued operation of the business.
The opposite isn't quite true either. Cash flow management can allow, e.g., a growing business to continue to operate even without additional sources of cash. So long as the business can turn a profit before growth has stalled for too long there will be no issues.
Great Article. A lot of people don't understand how important cash flow is. Even Elon pointed out that having factories close to customer is very important for a fast growing company like TSLA because if you grow too fast you'll be putting so many cars on boats before they are paid for that you will have no cash.
I disagree with the framing of both articles somewhat. The question should be "What is limiting your growth?" Is raising money going to distract you from making a product customers need and love? Then skip it. If being too small for enterprises to take you seriously is a blocker then you'll need to raise money.
Musk definitely understands the importance of (incoming) cash flows. Being paid upfront for functionality that may or may not be ever available is genius.
Is it really genius? Especially when you put it quite so bluntly? I've been wondering if a class action lawsuit around this could end up being a significant risk to Tesla.
Similarly, he doesn’t want his space ships to be in transit or grounded for repairs for a long time because that represents inventory.
There were some old ideas about how an interplanetary civilization would work, and in particular shipping, and now I understand better why we are still stuck on the ground. We are a long way from having ships so cheap that we can have them just floating around on ballistic orbits.
"What is limiting your growth?" is a myopic view of this problem. An injection of capital provides runway at a minimum and leverage in many cases regardless of a company's situation at nearly every stage. Your suggestion of "growth" as the metric to be maximized is the main issue. If an enterprise wants to generate maximum short-term profits for the owner, establish a large market share initially, or generate maximum cash flows long-term, each presents a very different view of when and how capital can solve problems.
This is a pretty good article but missed an opportunity to comment in more detail on the 2020 startup/unicorn ecosystem.
"Malone’s entire strategy was built around a single fact: that you have to pay up front for cable systems, but then earn back your money via a stable stream of cash for years and years afterwards. Notice how this extreme demand for capital drove Malone to embrace debt, over other sources of capital. Now notice how closely this resembles the Software as a Service (SaaS) business model, which is the primary business model in today’s startup world."
Gotta spend money to make money. But I wish he had commented further on businesses that do this incorrectly, based on wishful thinking. He talks about the strengths of TCI, with an engineered "loss" that saves them money on taxes, or Amazon, whose decades of "unprofitability" helped them to build a long-term-profitable empire.
But what about Uber or DoorDash? Burning investor cash, chasing long-term revenue that will never come? How on Earth are they keeping this scam going? Why do people believe in it?
This is an important point. For this to work, step 0 is: have a functioning business. That’s what gives you the opportunity to then change the curve on your cash flow.
Another factor is your vendors. The cable business expanded (and expanded into) an existing ecosystem: tv mfrs, film studios etc. The restaurant already had vendors it could afford to lend 300K up front knowing that they would deliver reliably over the next four months. Also an operating business.
Likewise Amazon.
But the Ubers etc start without a viable business. In fact they start by skimming the cream of an existing market. The problem is, you get good at what you do. If you don’t build a viable business it becomes harder and harder to move your company into that mode as the environment changes.
Yea, the functioning/viable business piece has a place in this discussion. I can understand why the author wouldn't include it but it serves us here. To take on debt like mentioned, you have to have some confidence in the business model and not be searching for product/market fit like many early-stage companies. If you already have cash flow then you can leverage it.
I think it's harder to draw the line as to who's doing it incorrectly than it seems, without the benefit of hindsight.
Give an example from the telecoms world - I had a friend who worked for a telecoms startup, bootstrapping for funding and undercutting the local incumbent by using better technology. The incumbent responded by offering free service for a year to all the startup's customers if they switched back. An unsustainable move but hardly a bad decision - it had very deep pockets, and my friend's employer ran out of money first.
If Uber didn't have any competition, it could raise prices to profitability today. Investors still believe in it because they believe that Uber, like the Telecoms incumbent in my anecdote, can bankrupt the competition and then have its way with the consumer. Investors in Uber's competitors presumably have their own reasons for a similar thesis.
I forget where I read it, but some article described Uber's business model as "sell a dollar for 80 cents". You get a LOT of customers that way, and report huge growth, which brings in investors, and everything is great - until the pyramid scheme collapses.
After a "collapse" you are still left with mindshare and a market. If you increase prices by 30% you'll still be the largest player. Maybe later investors are not making returns but you are not going bankrupt.
The thing is, if you have lots of takers for dollars for 80 cents, that doesn't tell you very much about how many takers you'll have for dollars for $1.04.
If you charge too much for food delivery, you won't have very many customers. How much is too much, and does it leave you a profit is the big question.
maybe they can make it work, but probably not in a lot of markets.
In my experience as demand has increased due to the pandemic, prices are reaching the point where I'm not willing to pay them, and I make good money like most people on this site.
If that's any indication of what's to come when they need to stop bleeding cash... not looking great.
I agree for the mindshare, in some cases at least. Pets.com is still in the minds of many of us. And we will still remember MoviePass in 20 years. But, hey, WeWork still exists!
Uber or DoorDash are just extreme examples of the same line of reasoning. You're just moving cash flows not only across time but based on probability. You start by trying to create a business that moves the most cash possible to generate float. Now you might say, that this doesn't work because if you sell $1 for $.80 you'll run out of money. But that's not true, you just have a drag on your timeline that pulls you to zero without further capital inflows, or until you sort out your margins. In a world with very low interest rates (now, and past few years), capital doesn't have many useful places to go. And as we've seen, it has flown a lot into equities and a lot into private funding. That is the inflow of capital that keeps extending Uber and DoorDash's timeline, such that even with a 20% drag, you still have another fool to pull in and keep the party going. If the music stops everyone cries, but if it keeps going long enough, you actually increase your chances of remaining alive. For one you might outlive your competition, but there's many more things that can happen. You can improve your margins (Uber's pipe dream with self driving), you can can have a shift in consumer demands in your favor, or a pandemic that shifts consumer spend super fast, etc. You basically keep growing and extending the timeline and you may get a big pay out.
Sure they don't have subscription like predictability for their revenues. But they have a lot of data, and machine learning, so they may get pretty close in predicting how many people will order steak next month.
And let's say they partner/own a chain of ghost kitchen restaurants who offer a large variety of food(which is a much more competitive business model than restaurants). And that chain can suddenly get steak(and the other stuff), for half the price ?
I think the argument he's knocking down is more flawed than he's letting on - specifically, just because the extra cash makes it easier to make bad decisions doesn't mean that those bad decisions will be made. The argument treats those as inexorable. If the argument had been passed through a truth checker and given a few more eyeballs, that flaw would have been obvious. That particular inner syllogism just doesn't inexorably flow from the truth of its lemmas.
More generally, the "flaw with first-principles analysis" is generally as you'd expect. Your premises might appear true when they're not, or your inner reasoning structure might appear valid (logical definition) when it's not, or you might be making assumptions (in the omission of other premises) that are false. It's just really hard. So that's where a slow painstaking process of repeated review will help you. And it's also not a panacea - first-principles analysis does not guarantee your solution, it's more a process that helps you surface your assumptions and learn your argument.
Agree - and a related is that because you don’t have 100% ownership, you have less skin in the game. The reason to tkae money is that you believe that the 80% of the company you still own will be worth more than 100% of the company without funding. So you end up with more value at stake, not less. And more incentive not to make bad decisions (and of course more people around the table with skin in the game that are motivated to help you avoid bad decisions).
IDK... In theory, choices are good and you can just choose the better one. In practice, the financial dynamics of a business tend to create head or tail wind forces that become a part of the company's character.
All else equal (including the decision maker), a positive float business will tend to be more growth oriented than a negative float business. In theory, not so much. Float is just a type of capital (working capital). In practice, it's different.
Other people's money businesses will tend to take more risk. Publicly listed companies tend to be risk averse and quarterly report focused. These aren't carved in stone. Some publicly listed companies (eg amazon, tesla) have sailed against this wind. But, the wind is still there.
For a personal example, take the difference between having a trainer vs exercising yourself. It's theoretically possible to do the same training and have the same results, or do better. The tendency though, is meaningful, and when you pay a trainer there's a tendency to be disciplined.
Returning to the "friend's argument," it is observably true that structural constraints affect business owners.
That is all true, but you wouldn't use those "probability" statements to support a boolean outcome. For instance, a trainer might be better, but you wouldn't use that to conclude that someone shouldn't exercise without a trainer.
Not all problems that startups are solving are equal. If you want to build a Tesla competitor you're not going to be able to do that without raising money (unless you happen to already be a billionaire).
If you are building an app, yes the author may be right sometimes, where you can often find product market fit without the need of a large influx of cash.
There's a simpler failure mode to pay attention to that the author gets close to but doesn't notice. The original claim is "Companies should not raise capital." Any time you see a "should" claim, try adding this to the end: ", and should instead do X."
Now, when evaluating the pros and cons of the "should not" half, you have an actual relevant benchmark to compare to. It doesn't matter how awful an idea it is to raise capital in some absolute terms. What actually matters is whether it's worse than what you'd have to do instead.
Almost all decisions are about choosing one from several options, so if you find yourself making an absolute evaluation, that's a sort of "decision smell" that you should instead be doing a comparative analysis.
Could someone explain the core example about prepaying restaurant vendors?
(Kokonas again): That’s what I said! I went, “I’ll pay you $20 if you tell me why.” And he said, “Well, it’s very simple. I have to slaughter the cows, then I put the beef to dry. For the first 35 days I can sell it. After 35 days there’s only a handful of places that would buy it, after 60 days, I sell it $1 a pound for dog food.” So his waste on the slaughter, and these animals’s lives, and the ethics of all of that, are because of net-120! Seems like someone should have figured this out! As soon as he said that, everything clicked, and I went “We need to call every one of our vendors, every time, and say that we will prepay them.”
It seems like the value to the beef vendor is not from actually receiving the cash flow earlier, but rather from just knowing the order quantity in advance to optimize inventory.
Part of the reason is because it's a set order. Consider that in pricing his beef normally, the vendor has to account for three things:
1. Beef that sells within 35 days at regular price
2. Beef that sells within 60 days as a discounted price
3. Beef that sells after 60 days for a loss.
The beef's regular price has to be somewhat higher than in an efficient market because some of it will be sold at a loss.
Getting an order for a set amount per week allows him to disregard the losses he normally has from beef that has to be sold for dog food, because the purchaser is guaranteeing their quantity, smoothing their expectations on how much beef to purchase in the future.
It's possible that at $18 a pound, without any waste, he's making the same margins/profit as he would at $34 with some waste.
Right. So the value add here is not actually about moving cash flow forward in time through reservation deposits, but rather just having a predetermined order size. Am I misunderstanding, or is this a complete non-example for the point of the article?
I'd guess in the restaurant game, net-120 also has the risk of the restaurant going out of business, so any "predetermined order sizes" are less than guaranteed (a very long way from the guarantee the pre paying gives).
By the restauranteur having reservation deposits which allow them to offer to pay upfront (moving that cash flow 120 days earlier) - the wholesaler reduces both uncertainty (I wonder how much beef I need to order and how much extra I should add that I'll later sell for a loss to make sure I don't run out if sales increase?) as well as risk (What if this restaurant shuts down owing me for 4 months worth of beef?)
This doesn't really add up though because in reality the butcher would just use invoice finance to get the money ahead of time at a way lower cost than a 50% discount he's offering, which would probably include some insurance if the restaurant went under. It doesn't make sense. Invoice finance might cost 5-15% of the invoice. Why wouldn't you do that rather than giving customers 50% off? I can get a small discount but half price doesn't seem realistic.
The point is that improving the cash position of the restaurant (traditionally a low float, low margin business), by moving customers payments forwards in time, allows them to improve their margins by pre-paying their food vendors. This is in contrast to the example right before, where speedy deliveries from a lean manufacturer motivates downstream distributors to switch suppliers, despite taking a margin hit, because they can improve their cash position by doing so.
So why isn't there a futures market for selling these meats?
The farmer/producer would like certainty of sale, at a certainty of price. This is exactly what a futures option gives them - they can offload the risk of price fluctuations (and demand reduction/changes) in the future, and someone else can speculate on this (and make more profit, or loss).
It seems stupid for a farmer/producer to take on this risk, rather than sell these futures.
Futures markets work for commodities where what you get from one seller is essentially interchangeable with what you get from another seller.
There are futures markets for livestock, but that's not going to cut it for the high-end restaurant market that this example comes from--the restaurants this story is about are internationally famous and will have exacting food quality standards that are hard or impossible to meet from a futures market. The suppliers they work with are in turn focused on supplying high-quality meat and produce that isn't really interchangeable enough for a futures market.
Farmers who grow commodity crops (corn, soybeans, etc.) or commodity livestock often do use futures markets in the way you describe, or work with financiers who essentially do it on their behalf.
I assume the beef vendor doesn't have much cash on hand. So he can take the prepayment and give it directly to the cow farmer who also doesn't have a lot of cash and is happy to prioritize the preorder.
The linked article "How First Principles Thinking Fails" [0] , which states
"..But I think there's a more pernicious form of failure, which occurs when you reason from the wrong set of true principles. It is pernicious because you can’t easily detect the flaws in your reasoning. It is pernicious because all of your base axioms are true...In other words, the only real test you have is against reality. Your conclusion should be useful. It should produce effective action."
reminds me of the quote by Eric Zemmour:
"When principles are in contradiction with society’s survival then the principles are false, for society is the supreme truth." [1]
I am unconvinced that "first-principles thinking" is the problem here. Surely one can refute the original argument without having to debunk axiomatic logic itself.
For example, one could argue something like this: Even though increased access to other people's money can cause founders to make irresponsible decisions, raising money has other advantages that tend to offset this.
I think the idea is, when you argue from first principles, you are implicitly assuming that you know all of the relevant first principles. Since you're human and imperfect, there is always a chance that you don't. How to know?
Well, empirically, check whether the conclusions you get, seem to hold up to reality. The author's experience was that taking investment $$ was necessary (or at least often useful) in a startup, so this put him on the lookout for what missing first principle would explain this.
It doesn't mean axiomatic logic isn't useful, it means that just because the logic seems sound, doesn't mean the conclusion is reliable, because there could be missing axioms (in this case, that profitability is the objective of a company, when cash flow is a more fundamental fact and profit is often either present or not depending on how you do the accounting).
The logic isn't sound though, that's the issue. Let me try to simplify it even more and annotate
1. Not raising money give you more skin in the game (valid observation)
2. Skin in the game is an advantage (valid observation)
3. There exists at least one advantage of not raising money (valid conclusion)
4. You should not raise money (NOT VALID conclusion)
You can't go from a single argument in favor of something to that thing being favorable overall.
Let me just add to this. Discovering new information (or new "axioms") will not change the truth of your previous conclusions if you did everything correctly, but you may find that the information you believed before was incorrect. In general, I believe it will be better to use a probabilistic model for most real-world cases since it is very difficult to find "axioms" for almost anything.
Thanks Ross for the reply. I believe that this is a misunderstanding of how propositional logic works. If the propositions or axioms that you start with are sound, and if you correctly apply all inference rules, then the propositions that you derive will also be sound. "Missing axioms" that you did not use do no matter, regardless of their soundness.
Of course they matter. We're discussing arguments that apply in the real world, not in math theory.
In math, if you have this axiom:
f(x) > 5 for all x >= 20
you are not then allowed to change it with a later axiom
except when x is divisible by 240
However, in real life this happens a lot. I have a company that is taxed a fixed amount per year... except for the years where I make over 100k euros, in which case things become quite complicated. If I omit the second part (which is not impossible, given that I never made over 100k euros a year with that company), and suddenly get a big payout from someone, the result will be very different from my initial estimation - as sound as it was WITHOUT that additional axiom / assumption / rule.
A "missing" axiom, in my experience, is not truly a missing axiom that otherwise has no impact on other axioms. A "missing" axiom is one that exposes a bad assumption in another axiom currently being relied upon.
For instance. Socrates is a man, all men are mortal, therefore Socrates is mortal.
But then you discover that a couple of eons have passed and Socrates is still alive. Clearly there must be a "missing" axiom. And after some investigation you realize that Socrates is a Venusian man, and Venusians are immortal.
"Socrates is Venusian" is a missing axiom, but really the problem is that "All men are mortal" is actually false, since it had implicit assumptions that "All men are human" (false) and "All humans are mortal" (true).
Again, I am sorry for being direct, but this does not make sense. If a Venusian man is immortal, then the "axiom" (preposition) that all men are mortal is false. In other words, the issue is not that the preposition "Socrates is Venusian" was missing but that the preposition "all men are mortal" is false.
It is possible to develop significant mathematical theory without using some axioms. For example, mathematicians sometimes choose not to use the "axiom of choice" when working with Zermelo–Fraenkel set theory. That does not mean that mathematical theorems proven without using the axiom of choice are invalid, even if you later assume that this axiom is true (or false).
The point is that the axiom that all men are mortal was thought to be true, and then was later discovered to be false. My comment was actually in agreement with your previous comment.
I think this is the difference between a valid argument and a sound argument. A valid argument means the conclusion follows from the premise, kinda like the quoted argument in the article which seems to be valid.
A sound argument is one whose premises are also true. This is where the quoted argument in the article fails. The premises either are false or don't apply to all startups. This is basically what the author means by a argument that is missing premises. It's not really that a premise is missing, but that without additional into it may seem like the argument is sound,but with additional into you realize it is not sound and therefore leads to a different conclusion instead.
Isn't it sort of like Gödel's incompleteness theorem, there's no way to prove your first-principle was a correct axiom to start from. Experience will guide this.
>debunk axiomatic logic itself
He's not though. Your assumptions can be wrong, even if your incremental logic is correct according to the first principle. He's saying the correctness of axiomatic logic will lead you down the wrong path.
No, he is saying that he agrees with the assumptions and the way they are used to construct other propositions, but disagrees with the outcome, and therefore there must be something wrong on a higher level with the logical system itself that is being used here. I think what's actually happening here is much more banal.
>Isn't it sort of like Gödel's incompleteness theorem
Forgive me for being curt, but no, this is absolutely nothing like either of Gödel's incompleteness theorems.
He's saying there's something wrong with getting fooled by a series of valid logical assertions into thinking the original axiom applied to the context in which one is making it... there are "unknown unknowns". There's something wrong with trusting that principled thinking will always hold because it held before, in what might have been a different context.
He's not debunking the validity of the chain of truth statements, but "first principles thinking"...letting this logic guide one down a path that doesn't comport with reality (which might have context one is unaware of).
I think it matches up with incompleteness quite well.
Any set of axioms can never tell you for sure if you're in a context that has other missing and more valid axioms.
You can modify your axioms with experience, but then you're back in the position of not knowing if this is the final set of axioms that will always comply with reality.
The bit about TCI (a cable company with a lot of debt in the 70s) is super interesting. I've read before about how companies don't always see debt as a bad thing, and how they can move money around, but it always seems like magic. From the article - "And indeed, Malone’s strategy required TCI to show a loss for pretty much forever; for the next 25 years, it was never in the black". As the article mentions, Amazon followed a similar strategy for a long time.
It reminds me of a quote by the WWI French field marshal Foch - "My center is giving way, my right is retreating, situation excellent, I am attacking."
This sort of thing is one reason you might want to tax revenues over profits.
Compare https://en.wikipedia.org/wiki/Hollywood_accounting , in which all movies show a formal loss and the concept of "profit" as opposed to revenue exists only to scam parties who agree to be paid out of profits.
Or you might prefer not to tax corporations at all, only distributions to shareholders. “Profits” or “cash flow” kept in the corporation is reinvested capital. It’s creating jobs and growing businesses, even if it’s kept in an interest bearing bank account.
So I've always been confused by this argument of just start taxing the money that goes to shareholders because the business will reinvest it and create jobs and what not.
What keeps the company from reinvesting in the form of company luxury cars for the executives, a company home that they let the CEO live in, and executive compensation. Essentially redirecting the money that would've at least gone to index holders to the shareholders that we felt were getting too much of the pie to begin with.
Can someone explain this to me?
EDIT: just to clarify I don't mean they actually sign over the deed to the house to the ceo but rather the company maintains the house as an "executive" hq that the CEO just happens to live in, and the company doesn't give the execs luxury cars they have company cars that the executive just happen to have they keys to and only the execs. Things like that, the company claiming as corporate assets that are really only used by execs. And I am sure there are baskc laws to try and prevent something like this but there are also highly motivated CFOs to find loopholes.
> company luxury cars for the executives, a company home that they let the CEO live in, and executive compensation
All those should be taxed like the equivalent of income for those executives, which is a higher rate than the corporate tax rate. If these benefits in kind are not taxed as income, then it is fraud.
True, but I don't think that lodging is "something that never goes on the market". In this example, the mortgage or rental payments for an equivalent property would be pretty straightforward to determine.
I disagree. Lodging goes on the market all the time, but its market value is highly specific. There is no equivalent property to compare the corporate housing to.
Until the business just uses the cash flow to buy back their stock, making everything look great until the day a pandemic hits and they need government bailouts.
I’m a big fan of taxing both capital gains and dividends at ordinary income rates to help restore fairness and progressivist to the tax code.
But to do this you absolutely need to index capital gains for inflation. That’s the reason they get special tax rates in the first place, because when inflation is high a significant part of capital gains are illusionary and you don’t want effective rates to reach over 100% in real use.
So don’t tax profits if reinvested. Task them as income if returned to shareholders (or used as excess compensation).
I'm actually fine with effective rates approaching 100% in higher brackets in real use. Inflation is a sunk-cost. If the investor were instead to put their money under their mattress, they have negative real returns, so effective tax rates of 100% would still incentivize investments to offset inflation.
You are right about the sink cost, but ignoring a very real risk. Taxing capital gains to the point where the investor has negative returns drives capital offshore to places where it will be taxed far less or not at all. It turns honest citizens into tax cheats, and we already have too many of those.
Long-term capital gains and qualified dividends (most of them) are taxed the same. The closest alternative to share buybacks is declaring dividends IMO, so share buybacks are not a loophole otherwise.
That's always been my conflict with the deficit the US government runs.
- I believe we are approaching unsustainable levels of public debt
- If a CEO were offered debt on the terms that the US Government gets, they would be fired for not taking it
- If a CEO allocated funds the way the US Government does they would probably also be fired.
- Using debt for growth capital is great
- Using debt to get better terms from suppliers can be good too; particularly when you have access to more favorable credit than your suppliers do.
If the US were investing in infrastructure, I would be much less worried about how much of it is debt financing. However (and this is partly a function of it being a democracy), there's not much rhyme or reason to how the capital is allocated with regards to plans for actually growing the tax base to a point where the US will be able to service the future debt.
The cynic in me wants to say that the government acting like this is merely democracy reflecting a public that finances their lifestyles with debt, without plans for increasing future income to service said debt.
People always compare government finance with business finance or household finances. It's an analogy everyone seems to just love.
Problem is government finances work completely differently in ways that are so fundamental as to make the analogies completely useless.
It would take more than an HN comment to enumerate every subtlety of why that's the case, but if you were to start you could probably begin with the fact that a government can print money and extract any resource it wants from any entity it wants to at any time at the barrel of a gun, and you and your CEO friend can't.
A government can print money, however the very value of it will decrease because there will be more money for the same amount of products to buy, and inflation will quickly offset the effect of this newly printed money. Moreover many citizens, especially those who have savings, hate inflation and will fight against such a trend. Taxes and various other "resource extraction" also are limited because more and more citizens will fight against such measures, up to deliberately reducing their income or living the country.
A business can in a way "print money" and "extract resources" by raising its prices. In many trades their customers will remain customers because switching would be more expensive. But there is also an obvious limit there: the amount of prospects will decline and at a given point more and more customers will depart.
> ...that a government can print money and extract any resource it wants from any entity it wants to at any time at the barrel of a gun, and you and your CEO friend can't.
This is just factually false. The French government can't extract any resource it wants from California. The US government cannot extract any resource it wants from China.
The ultimate limit of what a government can extract value from is the land it owns, whatever fraction it can extract from its residents without starting a revolution, and whatever land and residents it can conquer of its neighbors.
That's why I suggested debt financing to fund infrastructure makes sense; infrastructure investments can increase the wealth of the residents, which is the ultimate limiting factor in the future revenues.
Yes that’s correct, governments and sovereign states cover specific regions. I’m fairly confident all that information was contained already in the word government.
That's just utterly false. The ability to print currency and the maintenance of a monopoly on the legal use of violence are extremely qualitative differences between the powers of businesses and sovereign states.
It's like comparing apples and oranges. Or accounts receivable departments and nuclear weapons.
I don't see the difference between issuing more stock and printing more money. Of course you can do it, but the value of what you get goes down.
As far as a monopoly on the legal use of violence goes:
1. I don't see how this makes a big difference in the question of financial solvency. Sure you can use violence to acquire more property (and the threat of violence to renegotiate terms with your creditors), but the amount of property you can acquire this way is bounded, so from an accounting point of view, the ability to do so is merely just another asset. Obviously it makes a big difference in terms of morals, externalities, &c. but at the end of the day, you either have or do not have enough resources to service your debt.
2. From the point of view of the victim, it doesn't really matter if the violence used against them is legal or not, only the extent of their injuries. From the point of view of the aggressor, it doesn't matter if the violence they wield is legal or not, it just matters if they think the consequences will be less than the gain.
Where do people store their money but in government bonds? There is just a finite amount of gold and company shares and commodity available. If you want people to save money for the last part of their life, they need something to buy.
It is (unfortunately) more efficient for those of limited means to buy lifetime annuities than hold Treasuries. (Those will, in turn invest in bonds, but typically not exclusively government bonds.)
It is much more efficient for those who will leave an inheritance to invest primarily in equities (meaning they will invest relatively little, perhaps 0-30% in government/municipal bonds).
The problem with equity is that if everybody does that, a company is not worth 15 times their profits but 150 times. That would turn company shares into a form of fiat based money.
Or if everybody is starting companies, competition would be so fierce that nobody would be making a profit.
This article is great and actually comes to one of the core tenets from the book "The Outsiders."
If you had to choose a single core task for the CEO of a company, it is to create free cash flow and decide best how to spend it, aka capital allocation.
The article is very good, but to me it is normal finance. Many points raised by the author are discussed in undergraduate business classrooms every year. Very good application of existing theory.
As a working scientist, I read the OP with great interest (no pun intended).
In essence from my perspective, the axiomatic approach is like "theory" and the operational approach is like "experiment" or "observation" in the sciences.
There's a very good reason why experiment/observation trumps theory in the scientific method.
Good point. That said, the more distance from hard science you have, the likelier this is to go wrong.
If you're dealing with psychology, economics or such experimental observations can have the exact same problem. They're true in this case, at this level of abstraction or otherwise "not really wrong but not — but not as useful or as powerful as some other framing".
Framing is the key point here. What's in model or not. What questions are your trying to answer. etc. The harder the science, the less flexibility scientists have in framing.
Debt is not only cheap but almost “free” nowadays. It’s so interesting how the people I work with take advantage of this on a personal level as well. They leave the interests on their debt and leave and extra income on other avenues (stock market, real estate, etc). Another interesting idea is that tax is (relatively) low. So it’s smarter to invest in a Roth IRA rather than a 401K to take advantage of the tax rate.
TCI wasn't a startup.
So it can't be compared to 2020 startups in this way.
Because...you are starting the comparison at a different point in the companies life.
This is comparing markets almost 50 years apart.
Motives and reasoning just aren't what they used to be.
TCI had assets to borrow against.
TCI had a monopoly in their areas, and existing customer base.
They gamed the tax system for profit.
They weren't looking for over valuations from Wall Street with a view to selling out for the $$$
The proposition can be disproved very early in the chain of logic, actually.
1. Startups are risky.
True.
2. Raising capital to do a startup reduces skin in the game (you’re spending other people’s money, after all).
Arguable, but not a given. Raising capital does not eliminate risk, especially if one has their own money in it, and/or are using it as a job. Just because someone else invested doesn't necessarily reduce my incentive. I lose money, time, face, and opportunity with or without investment.
3. Once you have less skin in the game, it is easier to make bad decisions. The author argues this is due to a) having a capital buffer to cushion you, and b) having more time to waste.
100% false. It is no easier or harder to make bad decisions with outside money. It is ALWAYS easy to make bad decisions, having more money simply makes it easier to make costlier bad decisions faster. Buying real estate in late 2006 was a bad idea regardless of whose money you used. If anything, having that outside money means you have people to be accountable to, people to run decisions by, and thus it's HARDER to make a bad decision.
It can also (at the same time) vastly increase the set of _bad_ choices available to you.
How many stories of startup founders blowing money on booze, cocaine, prostitutes and lavish parties do we need to read before we realize that startup founders are humans and behave, well, like humans always have?
The logical fallacy in the original post discussed is simply here:
> Therefore: startups shouldn’t raise money.
The therefore doesn't apply. The original post makes a good argument that there is a certain detriment to raising money. But he doesn't actually proof that this detriment outweighs the benefits of raising money.
I used to be afraid of debt, but understood this principle ever since an accounting friend told me about a luxury cruise liner he worked for. It was started buy an immigrant, and quite successful (pre Covid). I was confused how anyone could launch a cruise company when the cost to buy (or even lease a cruise liner) must be 100s of millions.
When I asked my friend about their debt, he said “don’t worry, they’re doing just fine”. It was at that point I realised it’s not the debt that matters, but the rate (time wise) at which you can repay it, i.e., debt itself is fine so long as you have sufficient cash flow, and debt can be cheap.
Unfortunately I’m just a software engineer, who has never been able to put this in practice.
There is an important point about reasoning here which is worth stating explicitly. You can reason perfectly about the things you have thought of and know, but they things you didn't think of and don't know might still change the correct answer.
I caught that too. It is false in several ways that destroy the rest of the argument.
First because less skin in the game doesn't make you make bad decisions, it just makes it easier. As such every argument following this point is destroyed by "assume we make good decisions anyway", which is just as valid as "assume we make bad decisions from now on".
Second, because your skin in the game probably doesn't change, instead the total amount of skin in the game gets larger. Most founders (at least in the early days) have invested enough of their own money AND time (more valuable than money to founders!) that they have enough skin in the game as to not find it easier to make bad decisions.
Third, because the investor now has skin in the game and has incentive and leverage to prevent you from making bad decisions. You can be forced to make better decisions because of this.
There are many reasons to not take investors, that is a complex trade off decision. However your less skin in the game is not one of them.
"Second, because your skin in the game probably doesn't change, instead the total amount of skin in the game gets larger."
But the dimensions of the game grow as well, and that is where mistakes can be made.
Some founders are probably better bosses/managers in a collective of five than in a collective of fifty. If the company grows slowly, they may improve their skills/catch up. If it grows in a sudden leap, which is well possible with a large injection of cash, the space for making bad decisions from ignorance or lack of experience grows as well.
A related study I did. This sheet compares cash flow for Build to Order (BTO) vs Build to Stock (BTS) for a very popular widget sold at $100. BTO is not sensitive to Cost of Goods Sold (COGS); BTS is.
If, for example, your COGS approaches half your unit price and you use BTS, you'll have almost no chance of getting your business off the ground. But with BTO your cash flow explodes.
Wow what a great read. The other article about where first principles fails [1] is absolutely amazing as well. The debate about experience vs first principle is a heavily recurring theme in the tech industry. I couldn’t structure my thoughts about it in words and the article perfectly sums it up in a succinct manner.
Funny, I had a boss do the converse. We were a very young company with zero customer, and we had a small net 30 bill to pay. The boss said: I have to put a reminder to pay it. Well, without any hope of earning money in the mean time, there is no point in trying to optimize the cash flow pay now and be done with it. Free your brain and don’t adopt complex behavior if the reason is not here.
This post is making an error, or at least a poor choice in terminology, when thinking profit only means GAAP accounting or taxable profit.
Malone cut costs by reducing tax liability, getting better prices on programming, and increasing the subscriber base (revenue). What's that word for revenue minus expenses again?
A more honest explanation: Accounting depreciation != the actual change in value of things, and the cash flow statement can let you know when GAAP accounting isn't giving an accurate picture of success.
And about Malone's insight on leverage: Leverage ups your return on investment (when things don't blow up). Paying interest doesn't help you hide money from the tax man any better than setting dollar bills on fire would, but leverage can make big things happen from small amounts of investment.
> But those who actually run businesses know that running a business is all about managing cash flows.
This is the golden line. The richest person on Earth (Jeff Bezos) followed this principle religiously since Amazon's inception (or should I say, Cadabra's inception?).
If you liked this article and want to learn more about the games played in corporate finance, I would strongly recommend a book a colleague of mine recommended, "The Quest For Value". This single book had completely changed my view of the business world more than any other, and it gives one a much clearer understanding of the massive debt load that the United States operates under. I grew up and lived through the 08 financial crisis, losing a home in the process, and hated debt of any sort. Now that I've read this book cover to cover multiple times, my view has completely shifted, and my understanding of stock valuation and cash flow analysis has done nothing but improved.
The reason to to take the money now from venture is because it is more valuable now than it is later. The way this author is describing this though reminds me of the folksy, whimsical way some business books are written which makes this article so applealing: e.g. The Goal, How to Win friends and influence people, etc.
Like many others in this thread I thought this was an incredibly well written and elucidating article.
I just happened to be trying to learn more about David Friedberg before stumbling upon this article and I watched this lecture he gave on entrepreneurism which I think complements the contents of this article incredibly well. Highly recommend for those looking to learn more
Had to stop reading, could the author be any more pretentious? The obvious flaw in the reasoning is step 3, having more capital results in you making worse decisions. Uhm, no, having more capital can also give you more options, allowing you to make potentially better decisions sooner.
Nice piece. If you have the basis of a business that can prove strong cash flow then you should definatley look at financing with debt over equity. In startup land its not really the done thing but in this long term low rate environment I suspect thst might change.
echoing the common opinion, this is a great article at both practical and theoretical levels. The discussion on cash flow is insightful but the summary about the flaws of first principle thinking is what makes it complete.
Great article. One thing that it made me think about - instant payment clearing will have an enormous impact on cash flow, and thus on the wider economy, if the US can ever get it together and finally deprecate ACH.
I think the article is itself an example of broadly correct but for the wrong reason.
the problem with the argument from first principles that the article attempts to refute, is that the "first principles" given carry an implicit assumption that the minimum viable product is a a null product.
If in reality the mvp or, later, the infrastructure for growth take more to create than the resources you command, you need to raise capital.
The "first principles" also ignore time to market and competitive pressures. They are more "spherical cow on a frictionless plane" principles than actually useful ones.
This may be true for small lifestyle type businesses.
But some problems can only be solved with VC money. Because of time limitations.
You may only have a small window of opportunity to capture a certain market.
If you grew linearly, and built up product idea A, in order to fund product idea B, in order to fund product idea C, then by the time you’re done with product idea B, a decade may have passed by. You’ve also grown older, and may not have the energy of your younger self anymore.
Also, a competitor, one with a larger funding pool, may have jumped in and captured that market, right in front of you.
I agree. I can use the example of flappy bird for this. Overnight development teams pumped out 3d versions of his game with better controls than the original. Sometimes timing is important for small players because other teams can take your idea and execute better and faster once they know the market is there for such a program or product.
After selling our last company I was surprised that the acquirer went on an even bigger spending spree just months after acquiring us. As a bootstrapper this blew my mind.
This article helps shine a light on how they pulled it off. They acquired us for the free cashflow the company threw off (uncommon in our industry) and the leveraged that to further their expansion.
I've always looked at accounting as "backwards facing" (meaning it looks at what has happened vs where a company is going) but this article has changed my perspective dramatically.