Embedded Growth Obligations in Startups
Buy the rumor, sell the news
Show me the incentives and I’ll show you the outcome. — Charlie Munger
Our society is shot through with embedded growth obligations
Eric Weinstein popularized the notion of embedded growth obligations. He argues that many of our society’s institutions embed unrealistic growth obligations in their operating models. Because the institutionalists who run these organizations can’t be honest with the public about their inability to meet their embedded growth obligations, they lie to us:
Embedded Growth Obligations are the way in which institutions plan their future predicated on legacies of growth. And since the period between the end of World War II in 1945 and the early 70s had such an unusually beautiful growth regime, many of our institutions became predicated upon low-variance technology-led, stable, broadly distributed growth. Now, this is a world we have not seen in an organic way since the early 1970s, and yet, because it was embedded in our institutions, what we have is a world in which the expectation is still present in the form of an embedded growth obligation. That is, the pension plans, the corporate ladders, are all still built very much around a world that has long since vanished.
We have effectively become a Growth Cargo Cult. That is, once upon a time, planes used to land in the Pacific, let’s say, during World War II, and Indigenous people looked at the air strips and the behavior of the air traffic controllers, and they’ve been mimicking those behaviors in the years since as ritual, but the planes no longer land. Well, in large measure, our institutions are built for a world in which growth doesn’t happen in the same way anymore.
You can watch Weinstein discuss this with Dave Rubin:
Weinstein’s argument is part of a larger one, which is that something about America’s economy changed in the early ‘70s. There is even a web site, WTF Happened in 1971?. The web site presents a number of charts, all of which appear to prove the point that something changed, structurally, in the US economy in the early ‘70s, which has resulted in the embedded growth obligation crisis of our institutions.
Orange County, CA’s bankruptcy: a tale of pension fund woe
One example of embedded growth obligations are pension funds’ required returns. Pension funds have to pay out a certain amount of their assets every year to pensioners. In order to finance those payouts, pension funds have to grow their assets under management by some amount greater than those payouts. Stated more concretely, if a pension fund has to pay out $10 million to pensioners, the fund has to increase its assets under management by more than $10 million.
If the fund fails to do this, eventually it will run out of money. This is a pension fund’s embedded growth obligation. And, if a pension fund’s administrator is not honest with pensioners about its inability to generate those kinds of returns, then the administrators’ incentives are to take on a lot of risk to generate the required returns.
And, in fact, this is exactly what happened, in 1994, in Orange County, CA:
Orange County, the fifth-largest in the country, filed for protection in federal bankruptcy court today because its financiers cut off credit in the wake of a recent $1.5 billion drop in the value of the county’s investment portfolio.
The board of supervisors’ vote followed the resignation Monday of Orange County treasurer and tax collector Robert L. Citron, who had aggressively managed the investment fund in ways that depended on interest rates remaining steady or dropping. When interest rates rose recently, the fund, values at $20 billion in January, plunged to an estimated $18.5 billion as of last week.
…
The county’s troubled underscored the risks faced by growing numbers of jurisdictions that have south greater investment returns by putting taxpayer money into complex, controversial derivatives securities, which consist essentially of betting on which way interest rates, exchange rates or other financial market indexes will move The largely unregulated market has been shunned by some conservatively managed companies and has prompted expressions of concern from Securities and Exchange Commission Chairman Arthur Levitt Jr. and other regulators.
In other words, Orange County found that it needed to generate larger returns on its pension fund, and Wall St. sold it a bunch of complex derivatives. If the underlying interest rates declined or stayed the same, Orange County would have generated the returns it sought. But since interest rates rose, Orange County ended up losing money. Robert Citron, Orange County’s treasurer, died in 2013, and his obituary describes him thusly:
A grand jury investigation would later find that the treasurer who over the years won so much praise for his investment skills relied upon a mail-order astrologer and a psychic for interest rate predictions as the county’s treasury began to falter.
…
In a 1997 interview with the Los Angeles Times, Mr. Citron insisted that he was duped into making rashly imprudent investments by Merrill Lynch. He became a key witness in Orange County’s $2 billion lawsuit against the investment giant. The suit said that Mr. Citron was a “pigeon” for greedy brokers at the investment house.
So, to recap: a county treasurer, charged with maintaining his county’s pension fund, consulted with astrologers to divine the direction in which interest rates will move, and then bought interest rate derivatives from Wall St. brokers likely more financially sophisticated than he. This is a classic consequence of embedded growth obligations! Bad incentives create bad outcomes.
So how does this all relate to startups?
Venture capitalists invest in startups on the assumption that their cash will help the startup grow quickly, to a much larger size. Therein is the embedded growth obligation. A startup has an obligation to its investors to grow, and to do so quickly.
What happens if a startup can’t grow at the rate that venture capitalists expect? There are a number of possibilities:
investors may agitate to remove the CEO and install one of their choosing
investors may force the sale of the company
investors may decline to invest additional cash in the company
None of these are great outcomes for the company, and all of them distract the CEO from her core job, which is to grow the company.
As with Robert Citron’s Orange County pension fund, we have a set of incentives which can create bad outcomes. Startups are under immense pressure from their investors to generate top-line growth (i.e., revenue), and if they can’t do it organically by retaining existing customers and acquiring new ones, then they have every incentive to acquire customers unethically. In other words, companies which are desperate to grow their revenues may resort to unethical growth hacking, in order to fulfill their embedded growth obligations.
And, the result is, more often than not, WeWork, Uber, or Zenefits. In each of these cases, the CEOs grew their companies in accordance with investors’ expectations. But they did so at the expense of building sustainable companies. WeWork created a bizarre, almost cult-like devotion to its charismatic founder, funded by cheap cash from Softbank. Uber failed to take sexual harassment complaints by its employees seriously and implemented an Orwellian panopticon to view VIPs’ use of its service. Zenefits ignored states’ regulatory requirements in order to sign up as many companies as possible for its health insurance platform.
In each of these cases, the companies reacted to the incentives foisted upon them by their investors. It would be wrong to conclude from this that investors should invest with a different set of expectations: venture capitalists are in the business of funding companies that can grow quickly. However, understanding how bad incentives can create bad outcomes would go a long way to helping companies (and investors) chart a better course for their companies.