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A Crude History of the Debt-Equity Paradigm

Prehistoric funding, whaling expeditions, and two-bucket thinking

Apr 14 2021

7 min read

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I still remember the "Intro to Business" class where I learned the two ways to fund a company–debt and equity.

This seemed really rudimentary to me–insultingly "intro" level. Those can't be the only ways? That is so lazy.

Having now invested in over 50 companies (yes, with mostly equity), I can confirm my suspicions. Debt and equity are simply the first methods we've come up with to fund a company.

We're now entering what I call Funding 2.0. Funding 2.0 abandons the debt/equity paradigm–what I call "two-bucket-thinking."

Before diving into Funding 2.0 though, it helps to understand how we got here.

A Brief History on Two Bucket Thinking

Loans

Around 2000 BC, the first loans were made to merchants and farmers. The thinking then, as now, was simple. With some outside investment, new business value can be unlocked–enough to compensate the lender too.

Loans have continued their run as the predominant funding mechanism for about 4000 years now. We have repackaged it in countless ways: lines of credit, sub-debt, senior debt, etc, etc. It is all still the same product - a principle and an interest rate.

Keep in mind, the original businesses that received loans still exist today. We need them. Think: storefronts, hard goods, services, and agriculture. All of these businesses have one key thing in common–they serve their locality.

For simplicity, I call these Locality Businesses.

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Over time, humans got better at trade. Empires were built shipping goods from one end of the earth to another. Businesses could serve well-beyond their locality. The underwriting got slower, the terms more complex, the numbers larger. However, loans still dominated. At the end of the day, whether you purchase tea from India and sell it to the French, or purchase tea from the local grocer and sell it at your bodega, it is the same business. And a loan will do.

Equity

For understanding the history of equity, I'll skip straight to the fun part–whaling.

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Fishing for whales was very risky and took a lot of resources. You needed a boat, fishing equipment, a dedicated crew, whaling expertise, boating expertise, and a ton of time out on the sea. If successful, was is very lucrative. Just like VC in Silicon Valley today, in 1853, New Bedford, Massachusetts, was considered one of the wealthiest places in the US thanks to whaling.

Fast forward to 1957, American Research and Development Corporation invested $70,000 in Digital Equipment Corporation (he would also lend them $2M). ARDC's ownership was worth $38M when they IPO'd 11 years later. This is credited as the first successful VC funding.

More importantly, this codified a new type of business in stark contrast to Locality Businesses.

Why whaling expeditions and venture capital are the same business

While lenders love to see an obvious use of their funds, quick turnaround, and easy recourse if things don't go well. Whaling and high-tech companies have none of that. They are expeditions.

As Fred Wilson noted while readingVC: An American History, the organizational structure, compensation, portfolio strategy, and distribution of returns of the whaling industry were nearly all inherited by venture capital.

An expedition, in the truest sense of the word, embarks into the unknown. There is a real risk of failure or letdown. This is Zebulon Pike searching for the headwaters of the Arkansas only to get distracted climbing a prominent peak (and failing), getting stuck out for winter and losing a crewman, and eventually, getting captured by the Spanish.

When expeditions are successful, the upside is exponentially larger than your average endeavor. Like thousands of pounds of valuable whale meat. Or ARDC's 500x investment in DEC thanks to DEC's groundbreaking semiconductor innovation.

So why equity for expeditions?

Speculative

No one can predict which expeditions will be successful. Investors speculate on the crews and territory they believe in.

Debt is often tied to a very obvious and tangible use, such as an equipment purchase. It is easy to estimate what efficiencies are gained by owning the equipment, and if it fails, the lender likely reclaims the equipment and resells it themselves.

With equity, investors (for the most part) don't get a say in how their funds are spent. They simply trust the team to spend their funds appropriately. It is a blind bet.

Lucrativeness

Author's Note - Yes, "lucrativeness" is actually a word.

Given the low success rate of expeditions, the upside must be enormous.

For VCs, the common calculus is, "how big of an exit will return my fund?" Keep in mind, the resulting giant number is just returning the fund. This doesn't even get into the 3-5x return on the entire fund that VC's investors want.

The lure of hugely lucrative returns answers for the speculative, nearly blind, nature of expedition investment.

However, founders and investors, by definition, have strong opinions. Ones they believe more than others. So how do you keep them from squabbling over endless speculative opacity and opportunity navigation?

Ship captains are fortunate to have hundreds of miles of sea to separate them from their investor's daily critique. Tech company founders don't have this luxury–and much longer expeditions. It took DEC 11 years for ARDC's original investment to become returns at IPO. For over a decade, DEC was working on computing breakthroughs and how to commercialize them.

Equity ownership is the answer.

But how?

Mutual Return Variable = Share Price at Exit

First off, one must accept share price as a legitimate company performance metric. Valuation and term trickery aside, it sets the price for every shareholder's slice of the pie and tracks progress over time.

Debt, in contrast, is not reliant on company performance (dive into this here if you want). A lender is compensated based on how much they lend, with an interest rate to assess the risk involved. This is why credit card companies love to over-extend credit; they're not compensated by your success.

Sidenote - what about dividends to shareholders? Given the sheer risk involved in funding an expedition, every dollar spent on dividends is a dollar not spent on increasing how lucrative the expedition's exit could be. This is a whaling expedition returning a week early with leftover supplies instead of spending another week in the far-off sea where the largest whales swim. Or Amazon distributing dividends in 2005 instead of launching AWS, worth $12.7B in Q4 2020 revenue.

So again, why share price?

The exit.

The exit is when both founders and investors can get cash for their slice of the pie. After a speculative, gut-wrenching journey, the exit is a transaction that can provide the lucrativeness both parties are looking for.

Long-term Lock-in

Aligning around an exit removes time pressure from investors and founders.

Debt is not designed this way. The longer the loan is outstanding, the more the lender makes off of interest. However, extending the term of the loan isn't the point of the loan. Rather, interest rates serve as a penalty on time, incentivizing quick repayment so the lender can make another loan.

In contrast, no company can predict if it will IPO or who its acquirer will be. Equity investors can't play the turn and burn game like debtors.

By aligning around a transaction that will take place well-beyond the predictable future, payday urgency is futile. Thanks to the lucrativeness of exits, neither the captain nor the investor are incentivized to return early.

Expedition Funding Summary

  • Speculation is rewarded by Lucrativeness.
  • The mutual return variable of share-price at exit keeps both parties locked-in for the long-term journey of increasing the lucrativeness.


We now know how to fund locality businesses and expeditions.

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Thousands of companies founded today are NOT Locality Businesses or Expeditions.

Welcome to the absurdity of our current debt-equity paradigm.

We'll dive into Funding 2.0 and emerge from two-bucket thinking in the next post.

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