Observer or Participant: Can the invisible hand sow the seeds of its own destruction?

As discussed in the previous post, companies in rapidly developing markets need to run effective idea factories - organizations of extremely talented and motivated humans arranged to bring new ideas to market. While markets often reach a "peacetime" state of equilibrium in which a few key winners dominate, the transitional "wartime" state is often marked by intense competition (e.g. the Browser Wars or Cloud Wars).

This competition happens between competing idea factories as capital gets injected into a company and intellectual property comes out the other side until one of the factories achieves some kind of "moat," at which point the war concludes and the winner has a defensible business which can produce attractive profits for a long time.

Different organizations have different inherent talent - as described by Matthew Ball, Disney and HBO regularly outperform Netflix in the efficiency of their content production. And that talent is distributed between employees and the organization. But regardless of the distribution, no matter how talented the organization may be, unlike a traditional company, IP-driven companies at war still rent huge percentages of their idea factory from their employees and depend on that talent retention to continue fighting.

So what happens as the market gets involved? Investors look into the future and pick a winner - the company which they believe will emerge as one of the dominant "peacetime" players. They do this, often, by looking at momentum and velocity: which organization is moving more quickly, taking more ground, developing more features - which idea factory is more efficient?

Then they discount that victory into the present (with a historically and unsustainably low interest rate) so that capital flows into the winner. This creates a uniquely low cost of capital for the presumed victor, all but ensuring their victory. Perception becomes reality as optimistic prognostications become the assumptions that drive present value calculations. In this model, victory itself is a self-fulfilling prophecy.

But underneath all of this lies a key question about incentives: in a war that depends on human capital, where that same human capital is compensated with stock in the enterprise, what happens when investors pay the factory workers so much for the factory's potential that the market shifts from playing the passive role of an observer into an active role, as a participant.

What happens when individual employees - not founders, or even executives, begin taking home 5-10x more than they expected? Do they continue to fight with the hunger that is necessary to win? Do they keep burning with the passion that is required for true innovation? Or do they, individually and collectively, take their foot off the gas? Does the hyper-capitalization of the idea factory perversely result in a factory that becomes less capable of victory even as it becomes more expensive?

And if so, what does that mean for capitalism - if capital can destroy value, how can we insulate small teams from capital and enable them to commit to long-term change, long-term success? What types of compensation mechanisms can we develop that are more stable, that result in more self-binding, more Ulysses Pacts where liquidity is available, but without the corrosive effect of hyper-liquidity? How could we design a compensation system in which the workers had stakes in their outcomes even in excess of their investors, where by deferring liquidity today, collective organizations could agree to provide liquidity only after victory was assured?

Today, we distribute the spoils of a future war to a present-day army, and too few people have thought through the unintended consequences as newly rich soldiers quietly leave the field in the midst of battle.

Human Capital Development: Renting an Idea Factory

The past thirty years have seen a massive shift in valuation, from an emphasis on value investing based on tangible assets towards momentum investing based on intangible assets. This, in turn, has led to broad based consternation within the investment community as conventional financial and economic models are outperformed by superficially less sophisticated approaches. Empirically, though, something is going on - it doesn't seem like our current models are working and in this scenario, new theories are required.

This essay is a reflection on the oddities of human capital, the production of ideas, and the complex relationships between employees, markets and firms in the modern economies. As the economy shifts from a focus on physical goods towards a focus on more abstract intangible goods, more and more companies are de facto becoming idea factories.

However, compared to actual factories, in which labor is rented from employees to operate high-cost machinery owned by a firm, idea factories rely on high-cost labor carefully arranged in order to produce finished products (e.g. software and content). The output of this idea factory is "owned" by the firm, but the firm itself is also owned by humans, many of whom may be key employees in the firm. This fact - that individual humans play many different roles in the context of a modern idea factory (founder / factory manager / idea producer / owner / investor) - is wildly under-discussed.

Too often, valuation models focus too much on a given firm's stock of intellectual property with too little emphasis on the half-life (depreciation) of that IP - here, we attempt to reflect on the flow of intellectual property; the capacity of a firm to create novel IP, which is a function of the organization's ability to recruit, retain, and grow talent (atomic human capital) as well as the organization's ability to organize that talent productively (emergent human capital) - in other words, it's stock of human capital.

Unlike other forms of capital, atomic human capital is owned by the individual and rented by the corporation. Its productivity is wildly variable, hard to measure, and subject to power-law dynamics: the productivity of a single human within a complex idea factory varies tremendously. More importantly, though, individual humans have non-linear atomic growth. This growth, over time, increases the capacity of a given human to produce value. Perversely, though, this growth also increases the bargaining power of that human to lobby for higher wages. As such, the return on investment in human capital development is much different and complex than the return on investment in traditional capital - labor, not capital, should be able to extract some large percentage of that created value, and firms end up competing with one another for access - in some sense, the value of human capital investments accrues to the individual, not necessarily to the firm.

But aside from Substacks / Newsletters, there aren't that many great projects where the value is around the sum of the parts - most great idea factories require the management of brilliant individuals together, not to make them replaceable, as in a traditional factory, but to make them irreplaceable as in a great championship winning team.