No Such Thing As Short-Term Value
In Boardrooms and Zoom rooms, an unspoken tension exists between short-term and long-term incentives. Nowhere is this more poignant than when an exit lingers just beyond the horizon for some nascent venture.
Incentives
Whether a venture capitalist, an investment manager for a PE firm, or a startup employee, the exit looms like some opulent judgment day. And on that day, fortunes will be made, long nights of blood, sweat, and debugging will be justified, and the next investment will occur. Everything before and everything after reduces to a singularity, and every incentive steers us towards this reductive thinking. Or so we think.
This thought process often begins in an economics classroom at some august university, with an acronym: EBITDA. “Earnings Before Interest, Taxes, Depreciation and Amortization.” In other words, add up all the revenues and subtract the operating expenses. Theoretically, the value of any company is some multiple of this value.1
Unfortunately, this type of thinking leads to short-term greedy behaviors.
The Road to Riches and Ruin
When companies begin to prepare for an IPO, practices and processes emerge that make good employees quit. Decisions of all sizes slowly percolate upward from ICs to the exec team. There is the creation of additional “process” in the pursuit of a higher EBITDA (and the KPIs that lead there). A higher EBITDA means a higher share price when the IPO arrives. Easily-accessible gains in revenue have already been explored, so now the magnifying glass is focused upon costs. Developers are expensive, and the light from that magnifier burns. Scrutiny is enhanced, commits are counted and logged, and suddenly everyone needs to provide detailed reporting on each hour’s activities. Reporting requirements expand, supported by burdensome reporting infrastructure and a litany of unnecessary tests and other managerial career-sustaining CYA.
The best and brightest are suddenly discouraged from exploration, innovation, and other activities that cannot be demonstrated to produce immediate impacts. They depart. And the EBITDA increases. The IPO’s value rises. VC, PE, and the remaining employees rejoice.
The long-term prognosis is clearly less rosy.
Internal Insecurity
Industry is typically aware of the need for “innovation”, “process transformation”, “continual improvement”, etc. However, capturing these ideas from employees, and other stakeholders requires a deeply-held belief in the value of thinking long-term. Realizing compound gains over longer periods requires that a managing structure sticks around, or at a minimum, is concerned with what occurs after their departure.
For many enterprise clients, the same Agile methodology that sparked the innovations en route to a successful IPO, if applied to long-term growth, will yield equally-impressive returns. An Agile approach that focuses upon solving problems rather than merely defining a roadmap, closing tickets, and adjusting scope ensure that the thing is built right and that the right thing is built.2
Our developer equity plan encourages each employee to take the long view on behalf of our clients, the skunkworks projects we incubate, and of course, ourselves.
Outside our walls, the perspective is less sanguine, and the manner in which having “added value” is assessed is dubious at best and outright dangerous at worst.
Lost Agency
The fundamental thesis of a big33 consulting firm is essentially “a small group of highly-credentialed individuals should be wholly responsible for innovation, strategy, and transformation…and everyone else is a coin-operated drone.”
This is a natural conclusion after spending a few years exhausted from intense consulting work/travel, then taking out loans for an MBA, and then navigating treacherous corporate politics during an ascent to senior management. Moreover, it is (short-term) cheaper (higher EBITDA) to thin out the layers of management that accrete in large organizations and allow a small number of internal or external “elites” to make decisions.
The big3 (and their alums who lead other entities) conclude that they’re fit for such decisions and everyone else is not. In turn, they’re steering a battleship. Ten people in a coffee-and-danish-filled room can decide anything, but they’ll decrease the agency of the 10,000 who must adopt the implications of that decision. This is highly demotivating for those masses.
Closing the Sale
But hiring a big3 firm (or importing an alum) is a form of CYA4 for executives who can deflect blame by saying “look, we didn’t say you all needed to do this, they said so…”
A better business model demands of our employees and clients alike, “no, you all have skin in this game, and you all must have agency to act.” We push our clients to learn this lesson early in their growth — by the time ten are dominating the will of 10,000, it’s far too late.
Everyone, (the 10,000) must participate in A/B tested baby steps. The collective growth mindset needs to be embedded in those individuals, not simply reduce them to guinea pigs for internal experiments. Companies like Wise and AirBnB famously attempt to avoid this trap by offering agency to their ICs.5
Sure, the smoky-backroom6 decisions deliver a certain comfort to the HBS grads therein. Large proclamations might feel good at the moment, but generally fail to deliver the desired change, hence the CYA from hiring outside consulting firms, etc.
PE
Similar to the short-term thinking of consulting firms is a slightly different form of myopia. In this case, a private equity (PE) firm acquires a stake in a nascent venture, then begins to hollow out its ranks (higher EBITDA in the short-term).
Soon, a combination of voluntary and involuntary attrition has increased the profit margins. The company is sold, or an IPO occurs shortly thereafter. The PE firm’s investors realize a tidy profit.7
Indeed, there is historical evidence that private equity outperforms other private asset classes and public market performance by many metrics.8 Of course, the salient question is not whether a combination of leverage, financial engineering, and removal of costs can yield short-term gains and thus, higher valuations.
The question is: What happens after the PE firm is gone? Do those companies continue to outperform the market? Certainly, there are horror stories penned about bankruptcies of former Bain portfolio companies.
To be fair, not all PE firms are reprising the corporate raider, leveraged-buyouts of the 80s. They aren’t all barbarians at the gate. Done well, PE firms create value through innovation, discovering efficiencies, creating new roles that leverage new technology, and accessing capital that their portfolio company otherwise wouldn’t sniff. In these cases, we are always eager to partner with PE firms to increase the agency of their portfolio companies and build long-term value.9
A Better Path
AE believes in A/B tested baby steps. We apply this iterative approach to our clients, our incubated skunkworks, and our own internal structures. Each iteration ought to improve the day-to-day work of employees meaningfully. Experiments are small and incremental, but the attitudinal adjustment is not. We provide the proper amount of bureaucracy - enough documentation and structure to ensure that the org stays agile and maintains the innovation that brought them this far…and no more. Management exists to serve and enable those doing the work, not the other way around.
No more multi-million dollar panaceas sold to executives at the behest of consultants. No more one-off acquisitions and sales with indifference to the arc of the business.
And to be clear, while this is certainly a kinder, gentler way of doing business, we are also firmly of the longtermist view that this will yield higher returns over a sufficient period of time.10
A growth mindset is among our core values. So too are A/B tested baby steps. We collect feedback from our team on improvements our enterprise clients can make. We synthesize, present, and rank available steps by effort and impact, within the framework of A/B tested baby steps. We agree on priorities, set a roadmap, and treat each as a small experiment. And we overcommunicate11 and discuss with the client’s employees throughout the process.
We will grow better, more agile, more dynamic companies. We already built and sold a startup with exactly this mentality. When employees retain agency and are incentivized to think like founders, the long-term gains can be truly astounding.
1 Your mileage may favor, no legal promises, some exceptions may apply, etc. Somewhere embedded in this idea is that rapidly growing business generate higher multiples, specific industries (*cough* tech *cough*) generate higher multiples, and in some cases, even a negative value (*cough* Uber/Lyft *cough*) can yield massive overall valuations.
2 Much has been written about the structures of technology projects at large companies. Holy wars still rage, but regardless of the approach, engineers require autonomy and transparency, and any approach that redirects focus from long-term problem-solving will lead to some unhappy developers and shareholders.
3 McKinsey, Bain, BCG. Though frankly, there’s no good reason why Deloitte deserves to be excluded from this particular line of inquiry.
4 “Cover Your A$$”
5 A description of this ethos can be found in this video.
6 Or fancy-background-Zoom-rooms.
7 And if all else fails, a dividend recapitalization makes the PE firm whole at the expense of, well, every other party (employees, clients, and other non-dividend-receiving stakeholders) holding the debt-filled bag.
8 Read more here.
9 It’s no accident that long-dated PE funds are becoming more common and the biggest names are often the ones leading those shifts.
10 Yes, I know, Keynes said “in the long run, we are all dead.” Even without some cryonics-related argument, we believe increasing agency is good business over time spans far shorter than a human life.
11 Another core value!