Frank Thoughts: The Law of Large Numbers
Dave Canal
May 28, 2019

For all the presumed sophistication of Wall Street investment banking firms, I have yet to see a mention of a simple financial law.  The law states the faster a company grows, the harder it is to maintain the same percentage of growth.  We now have dozens of “unicorn” companies (billion dollar valuations) ready to go public.   Many are 10 billion or more in size. Some have been in existence for 10 years or more and most (80%) have not made money.   They’re following the Amazon model.    “Build it and they will come.” Gaining market share is not the same as gaining profitability.  The belief is that once you “own a space,” profits will follow.   But that ignores the Law of Large Numbers.

This phenomenon impacts stocks quickly in a knowledge economy because of the rapidity of its impact.  A knowledge business doesn’t need hard assets.  It needs knowledgeable workers.  In an industrial economy, entrepreneurs (Andrew Carnegie, John Rockefeller et al) had partners, but in a knowledge based endeavor you also need a big team.   Consider the recent pictures of a black hole.    One young (29) M.I.T. professor got much of the credit for creating the necessary algorithms to obtain those pictures, but over 200 others were involved.  These were not hourly wage earners.  If you’re creating a new tech company, the only way to adequately compensate them is through stock options.

Under accounting rules, this is “free” money.    Using Non-GAAP (Generally Accepted Accounting Principles) stock options are not considered an expense.    Companies publish both GAAP and Non-GAAP numbers but put the focus on the Non-GAAP.  The result is technology companies can go for years showing a profit – though they have to buy back the stock they’re been giving out as options – until they run out of money.   We have seen this movie before.  It last played out in 2000-2002, but this time companies are later in their life cycle and facing the Law of Large Numbers.  

The creation of the internet changed the historical business valuation rules.  It was a whole new opportunity for entrepreneurs and investment bankers.   Companies such as CMGI – a previously obscure college book publisher - became hot stocks and got to name the New England Patriots football stadium … until they went out of business.   It became a “land rush” much as Uber is today.  But the private market value of companies going public is much higher. There are currently over a 100 unicorns!  Forgotten is when Amazon went public, it was valued at $400 million, far less than the $10+ billion current standard.   But it remains, undeniably, the poster child of the modern business model.

So why are unicorns going public?  It’s not for the traditional purpose of raising working capital.  For the past 10 years that has not been necessary.  There are two reasons.  First is the need of venture capital firms to monetize their investment.   Second is the desire of employees to also monetize their knowledge, and time of employment, by exercising stock options.  Otherwise, they’ll leave and take that knowledge to another company.  This whole concept of revenue growth - not profit - is like looking through a telescope the wrong way.  The initial public offering issuer instantly becomes a large capitalization stock, with low if any profitability and added risk, which works against future stock performance.  The current experience favors private venture capitalists and company employees.   The investing public faces not only the Law of Large numbers but its concomitant risk.

-Francis Patrick Boland

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