Platt Perspective on Business and Technology

Innovation, disruptive innovation and market volatility 16: considering a wider range of stakeholders 2

Posted in macroeconomics by Timothy Platt on September 15, 2015

This is my 16th posting to a series on the economics of innovation, and on how change and innovation can be defined and analyzed in economic and related risk management terms (see Macroeconomics and Business, posting 173 and loosely following for Parts 1-5 and Macroeconomics and Business 2, posting 203 and loosely following for Parts 6-15.)

I began discussing a wider range of stakeholders in a business in Part 15. And as a key part of that, I listed a variety of categorical stakeholder types there, prefacing that with a two point set of criteria for identifying relevant stakeholders, and certainly for this context:

• Relevant stakeholders are actors in business and marketplace processes, who by their actions enhance or limit a business in being able to meet marketplace needs, and in ways that market-participating consumers would see as impacting upon the level of value offered to them.
• And coordinately with that, these stakeholders also seek to derive personal value-creating returns on their own investments of time, effort, money and/or risk, in making the first of these two points work.

Even a casual reading of these points would highlight the potential for conflicts of interest there. And my primary goal for this posting is to clarify and explain how congruence and alignment of goals and priorities between stakeholders, and divergence and conflict between their goals and priorities can and do both arise, and even when overt business competitors are not included as stakeholders per se in a business under consideration. And more than that, I will delve into how stakeholder actors in these systems can take actions that are at odds with each other and even when they at least nominally hold to the same basic goals and priorities.

Let’s begin this discussion with investors, and with venture capital investors in particular. Venture capitalists invest their funds in businesses that their due diligence analyses would indicate, are more likely to yield large returns on their investments for them. They take calculated risks, knowing that to cite a perhaps cartoonish calculation, if they carefully and selectively invest in 10 businesses then on average:

• 1 might achieve breakaway success, yielding very large profits for all who hold shares in it, large investor venture capitalists definitely included.
• 2 might show more modest but still significant success and profitability after 5 years,
• 3 might break even after 5 years, bringing in enough revenue, with perhaps a very modest profitability to keep their doors open, and
• 4 are likely to fail within 5 years – and even, as noted above when all of these new ventures are all selected with great care for their investment potential.

So investment success is measured in terms of overall investment portfolio performance, with overall gains across sets of investments balanced against overall losses. And a premium is placed on deriving as much value as possible from those top 3 businesses and ones like them, and particularly from that top 1 runaway success. Where did I get those success distribution numbers? I initially learned this rule of thumb success spread model from active, successful venture capitalists who I have worked with, as I have sought to better understand them and their specific due diligence processes and considerations.

Venture capitalists in general, seek to identify those top 1 out of 10 businesses to invest in, and when they do find them they seek to maximize their returns from them, and both to cover their expenses and their losses from their less successful ventures (e.g. their bottom 4 out of 10), and to realize a profit from all of this risk taking – and as large a profit there as they can achieve.

So far I am writing essentially entirely in terms of alignment of goals and priorities, as a business that performs at that top 1 of 10 level or even as just one of those next level 2 out of 10 successes, is going to create value for all concerned: owners, employees, investors and anyone else who would gain value from success. But now I add timing considerations here. Some venture capitalists are willing to enter into longer-term investments and particularly where a highly successful new venture that they have backed, looks to yield a steady and reliable high level of ongoing returns on their investment. But it is commoner for venture capitalists to seek a quicker payout. They often and even usually seek to realize a large short-term profit from a venture, to then exit from it and invest their newly gained funds elsewhere in a next venture capital round of activity.

Owners and founders who seek to remain with their new businesses long-term and who are building them for long-term success hold to very different timelines. And short versus long timeline considerations here can and do create very significant potential for conflicts of interest, and if in no other way, in differing understanding as to how much value should be rolled back into a young business and when, and how much can be taken out as profits and how soon and at how quick a rate.

Sometimes common ground and common understanding can be reached, resolving these sources of potential discord, but this is an area of detail where a business founder and owner who seeks venture capital support in particular, has to be very careful and thoughtful as to what they sign, in exchange for the capital development funds that they receive. And as a final note for this working example, I add that both owners and founders as one stakeholder category, and venture capitalists who buy into their businesses as a second, essentially always all want to see those businesses succeed, and long term. And that holds for venture capitalists who actively seek to draw out as much value from a new venture that they invest in as quickly as possible as short-term profits, to then walk away. It would not help such an investor if they were to gain a reputation of gutting and killing off the businesses they invest in. And that point of argument can be fruitfully used in negotiating terms of investor payout, where they are linked not just to the calendar per se, as to actual realized business performance metrics, and to realized business financials that result, and with agreed to deadlines included as bilaterally arrived at.

Now let’s assume that this business goes public through an initial public offering (IPO). Clearly, anyone who would invest their funds in a business by purchasing stock in it, is betting that it will succeed, so their investment goals and priorities align with those of the business’ owners and its employees, and with those of other investors. But as a special category here, consider investors who as a market strategy seek to short sell shares of businesses, and particularly when those businesses are in transition and more likely to see market valuation shifts. They are in fact betting against the businesses that they invest in, and only gain a profit from their investments when those businesses lose value and see drops in the marketplace price of their shares. There are in fact a number of scenarios in which investors can and do bet against companies as a means of gaining profits from them. And even the seemingly simplest of investor stakeholder categorizations can hold within them exceptions to simple alignment and agreement.

But let’s take this one step further. I just wrote above of how stakeholders can hold conflicting goals and priorities for a business that they would both in some sense invest in, and I noted that conflicting underlying assumptions as to timing and I add other “implementation parameter” considerations can create collisions too and even when all parties hold to basically the same goals and priorities. I have just at least briefly discussed how these types of conflict can arise, by way of a couple of fairly common investor stakeholder scenarios. But I also wrote at the top of this posting that stakeholder actors in these systems can take actions that are at odds with each other and even when they at least nominally hold to the same basic goals and priorities, and I add even when they do not significantly disagree as to investment parameters such as timing. And this brings me to the notes I added to the end of Part 15 where I began discussing friction in the context of this series.

I am going to continue this discussion in a next series installment, where I will focus on friction and how it impacts upon and shapes both businesses and stakeholder considerations. And I will do so in terms of both this installment and Part 15. Meanwhile, you can find this and related postings at Macroeconomics and Business and its Page 2 continuation.

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