Equity, debt, revenue, and sweat
I learned this rhyme for the four kinds of capital to drive a small or starting business. Most financial products for companies are one or some combination of these four.
The press often celebrates raising equity. To my mind, this is nuts. Equity is the most expensive kind of money - which means it’s the worst deal for the founder. It is like real estate deals in which financiers brag about buying some skyscraper for billions of dollars. Buying high doesn’t ring “good business” to me!
Debt is a claim on the business that one must repay. The main block is often the willingness of the lender to issue a loan at all to a startup making software or SaaS. They see an applicant with too little asset and a scant track record. They face a legitimate challenge: how does one manage default risk?
“Sweat” is investing one’s time in the business. Outside income, personal debt, or a reduction in lifestyle fund this time. The outside income is often the “day job.” When people talk about “self-funding,” this is usually the mechanism.
True bootstrapping uses revenue as capital. Money from customers supports the overhead of the business. Revenue is generally the cheapest form of funding on this list. To move it forward, prepayment by early customers - even for a discount - is one of the healthiest ways to get early funding.
Of course, most of us use some combination over the lifetime of the business. We take on a little recoursed debt (almost always regretting it). We work extra hours to create and then to avoid out-of-pocket expenses. We get customer revenue. Sometimes someone else believes in us, putting in equity-ish money, as in a SAFE or forgivable debt.
The relative perceived costs of these sources of capital distort our decision-making. For example, it’s easier to “sweat” on the weekend. And some contributions are more natural fits for the off-hours than others. Coding in a dark room works in the hours where you decide not to sleep. Talking to customers requires invading daylight hours. I’ve discussed this particular dynamic elsewhere.
Another distortion is the over-use of equity financing. The entrepreneur prefers equity even when debt is cheap. The United States government subsidizes much of small business debt, making it even more affordable. Even so, my cohort of entrepreneurs is reticent to take on that obligation. Why? Equity is more expensive than debt. But the lack of recourse in equity - if the company loses, the investors lose too - feels safer to the entrepreneur.
Financial innovation mixes up these sources to create new products. Revenue-based financing, for example, is an intersect of debt kinda-sorta secured by revenue. This financial Frankenstein’s monster behaves, in the Clearco case, like equity. This “alt-finance” is a growing field in which I invest.
The Almanack of Naval Ravikant opened my eyes to the fifth kind of capital: code. At one level, the idea of intellectual property as a durable and financeable asset of a business is not new. Code executes operations and creates enduring value disconnected from the application of most of the other three arms.
Build your machine on the cheap, then let it do the work. What makes this new is the ratio of automation to work required to build it (labor) and execute it (capital). No longer do we need to construct iron foundries - code runs for micro-pennies. Ray Dalio at Bridgewater Capital writes about this strategy at length. He turns insight learned once or over a few experiences into an “another one of those” ruleset. He and his team express this model in company computers to execute in the market - repeatedly.
The promise of AI is elevating this kind of judgment automation from mechanical rules to mental models. The latter are probabilistic frameworks. Automatic rules are recipes: “if this, then that.” The potential of automated mental models is to derive the appropriate course of action and take on risks.
Few seem to understand this whole field of using code as capital - and I am still learning. It will change the way companies can get built and valued. We will need new research in the market to see how these five sources of capital interact in the coming years. It seems pretty likely that we will need a new mnemonic for this quintet. My start needs work:
Equity, debt, revenue, sweat - and robots!