Lately, I’ve been thinking about linear vs exponential thinking as I’ve changed my focus from investment in publicly listed companies to early stage businesses, where the pay-off from being able to identify ideas with the potential to have exponential growth is more evident.
Linear thinking, could be defined as thinking in a sequential manner. One thing follows the next and by moving from one event to the next, we can determine what a probabilistic outcome could be. An example of this is thinking about a factory making widgets. To be able to build more widgets, the company would require a larger production line and more working capital. All of these factors could be easily modelled in a spreadsheet.
Exponential thinking, could be defined as being able to conceive things that have the ability to compound. Where the effect of a cumulation of events is greater than their aggregate parts. An example of this could be a platform with network effects, whereby the benefits of joining the platform increase with each incremental user, which further increases the draw for users that aren’t already on the platform. The terminal value of the platform would be significantly greater than what could be modelled using a linear approach above.
Kurtzweil suggests that the reason we have a linear frame of reference is because for a majority of our evolution the key drivers of our lives were “local and linear. Not much changed generation to generation.” Thinking about life in these terms, it’s as if we were sitting on a rocking chair, staring out into the evening sunset while we whittled life away out on the prairies. Whereas now we’ve been jettisoned into big city living where there are far more people, networks and opportunities surrounding us all the time. It feels as if the pace is hectic because of the increased noise that surrounds us.
Executive summary
It’s prudent to be aware of the changing business models that can be implemented as a result of lower marginal costs of production that technology enables. It would also pay investors to be aware of how the accounting treatment of software development expenses can mask the value that can be accruing to technology businesses that have exponential tendencies.
Why is an exponential frame of reference important in investing?
As mentioned previously, moving from publicly listed equities to early stage investing has driven me to think more about linear thinking vs exponential thinking. Traditionally, listed companies were producers of goods and services that grew incrementally with marginal costs growing at a slightly lower rate due to economies of scale. As mentioned above, if a company wanted to produce more widgets then it needed to buy more raw materials and at a certain point it would reach a step change, where it would need to build another factory.
This linear trajectory makes it relatively easy to work out how well a business could do from one year to the next, as the top line/revenues won’t move around substantially unless more production capacity is increased. Generally, if you knew what a business had been producing for the last five years, you could probably have a relatively good guess at what it’s going to be producing over the next five years.
This is no longer the case and there are a number of businesses that can be created today that are able to scale far more quickly than widget producers. Investors need to be able to adapt their criteria of what building a franchise can look like if they want to be able to outperform in an age of increasing connectivity and speed of adoption.
What framework (linear/exponential) do people typically look at investments?
It’s relatively easy to model out linear businesses on a spreadsheet and there is little reason to expect anomalies to occur from one year to the next. However, if an analyst was to build a model that had an exponential jump in profitability or widgets in any given year, it’s unlikely that the model would be given any credence. I’d argue that an increasing proportion of the growth companies at present are more reliant on exponential technologies, which traditional investors are ill-suited to understand unless they’re able to expand their mindset.
Software As A Service (SAAS) companies are good examples of exponential models. These are businesses that are able to build out a platform, ploughing any cashflows from operations back into further developing the features and building an ever-larger barrier to competition. This gives the illusion that they aren’t earning anything at the bottom-line because the accounting rules typically require them to expense the software development annually.
At first instance this looks like a fair way to treat the wages paid to developers but if the business is truly creating a franchise that will generate value for an extended period of time, there could be an argument made that the expenses should be capitalized because they are no different from the goodwill that accrues on an industrial company’s balance sheet when they acquire another brand under their umbrella.
Anyway, that’s not how the accounting rules work and the end result is a SAAS business that’s able to build an ever-widening moat while producing limited or no profits until it has reached maturity. At which point, it’s able to flip the switch and generate consistent future cashflows without any requirement for additional capital. These businesses will follow an exponential trajectory; an extended period where it looks as if nothing is happening prior to eventually seeing earnings explode higher once they have achieved terminal velocity.
While this might intuitively appear to be the preferable path for businesses to take if they have the access to the technology, skills, and capital, it’s not so simple. The path is very uncomfortable because there is no visual progress at the early stages.
It will appear that the business isn’t moving forward as quickly as it could be if they were taking the well-trodden path. People dislike uncertainty and are inherently impatient, especially when the opportunity cost is generating incremental profits as business traditionally has. It takes a lot of vision and leadership to be able to position companies to be able to take advantage of exponential trends. It appears that there are few people that are willing to walk the path of uncertainty to put themselves on the path for exponential returns.
There’s another issue with businesses that grow exponentially. The success is scary. Managers typically don’t like to deal with exponential growth because it means there is too much work for them to do if they need to constantly supervise all of the additional activity. The way around that is to replace the control of people with the control of principles, Mark Bonchek covered this in a Harvard Business Review article. Interestingly, this is what some of the fastest growing companies have been doing, look at Netflix’s culture deck. Other companies like Google and AirBnb put extreme emphasis on hiring the right people early on so they would be able to create and preserve the cultures that would allow them to scale exponentially. Letting go and focusing on culture feels like a soft way to create an organization that could potentially grow exponentially but the techniques have had far more success than traditional hierarchical management techniques.
Conclusion
Life is no longer local and linear. The mental models that were previously used to analyse the growth in linear businesses are less applicable today. There will always be a need for old world businesses that produce goods and scale linearly. However, it’s likely that the companies that will underwrite the next wave of productivity growth will be capital-light with long periods of development before they see earnings erupt exponentially. Finding businesses that are able to scale exponentially is hard. When you consider that for that business to succeed, they will need to find the right investors and the right staff as well, that task becomes even more difficult. Therefore, foresight and risk management is required when thinking about exponential businesses from an investors perspective. However, the upside can far outweigh the downside if they’re successful so it’s worth keeping an eye out for the companies that have the potential to follow an exponential arc.
