When I was in high school and looking at the world of business from the outside, I always wondered why companies needed money or capital at all. Wasn't the whole point of a company to generate cash, not use it? There always seemed to be something broken about a company that was a couple years old and raising a round of financing. Imagine how surprised I was when I came to understand the public markets, and found that even large, established companies were raising and using money all the time.

Of course, there are plenty examples of pure bootstrapping, where a founder simply grows the company organically, initially with his own money and then on the cashflow of the business. But as it turns out, using other people's money is something that most companies do most of the time. Why is that? Why don't they just use their own? The reason has to do with the function of capital in a society. And so in order to answer this, we need basic philosophy of capital.

A Philosophy of Capital

There are many kinds of capital. I would roughly define capital as "existing value." You can have relational capital, which is the present amount of good will that another person has toward you. You can have social capital, the present amount of trust and good will that many people have toward you. And most relevantly to this discussion, financial capital is the present amount of good will that nearly everyone in a society has toward you, on the plane of free exchange.

Exchanging capital between types

Types of capital can be exchanged for each other, with some skill. Social capital can be exchanged for financial capital by means of carefully attaching yourself to a product. This is what sports players and actors are doing when they perform in advertisements, or when people who got famous in a viral YouTube video try to sell an NFT. In the other direction, financial capital can be also exchanged for social capital, like when businessmen build community parks or contribute to a new performing arts center. The most difficult and risky direction is between relational and financial. Some people try to buy relational capital with a specific person using money, for instance buying expensive gifts for a girl so that she will agree to go on a date with you, or throwing a lavish party to impress specific attendees. This rarely ever works in the way the purchaser intended. The opposite direction can be even more perilous: trying to cash out relational capital into financial capital. Perhaps the most common example of this is multi-level marketing schemes. The reason that these are broadly disliked is that, while the participants often make money, they nearly always are simply exchanging relational capital they had with their friends for financial capital. Their friend might buy from them, but there is a high chance that their respect for that person decreased by the exact amount of the purchase.

There is almost always a lot of risk and friction involved in exchanging capital between types. The community that receives the park from the billionaire might feel that their affections are being purchased. You probably thought less of the famous actor after seeing them in the toilet paper commercial. And even after spending on a nicer car, only a few people actually respected you more than before.

That's not to say that you should never make these type of exchanges, but there is nearly always loss in the exchange itself. The only reason you should do it is if you have a very good reason to need to hold the other kind, and the gain you stand to using the other form is many times more than the friction loss.

Staking

A much more common practice is to stake capital within the same type in order to gain more. For example, inviting someone over to dinner is a way to stake relational capital. By reaching out to someone, you experience a bit of friction loss, and more importantly, you put your relational capital with that person (respect, good will, etc.) at risk. If the dinner goes well, you could end up having more capital with your guest. If it goes poorly, you will have taken a step backward.

Social media is generally the realm of staking social capital. Every time you post, you are risking your reputation with some subset of people who will see your post. If your post is good, you can gain good will from many people at once. If your post is bad, you can lose a lot of it at once. In my observation, most people when they are new to social media start off by losing a lot of the social capital that they already had from the offline world, since it's really hard to look good in photos, videos, and words. Over time, as they figure out how to do social media well, they eventually tend to gain the capital back, and probably a good bit more than they had at the beginning. After this point, skill and effort will determine whether or not they continue to accumulate capital or will stagnate. Given enough time, everyone on social media will settle into a certain stable amount of capital which is consistent with their character and effort. Some posts might gain capital, but there will be an equal number which deplete it.

Perhaps the clearest type of staking is financial. If you want to make gains on the stock market, you must stake some of the money that you have in order to gain it. If you want to make money in real estate, you have to put some money down on a mortgage or a downpayment in order to realize the appreciating value of the home.

I think you can see by now that absolutely everyone engages in the mechanism of capitalism in some way. The reasons that people do it are varied: greed and vanity are certainly very common. But other motivations are present as well: the joy of building something valuable, the feeling of doing something you're good at on a higher and higher level, and finally altruism, since you can give capital away to other people after you have accumulated it.

Staking is about change. If you want something to be different than the way it is now, you must stake something. If you want more friends, you have to stake your existing relational and social capital, for example by asking to be introduced to new people, or by potentially looking green at a new type of social event. If you want more influence in society, you must use the influence you have now to climb to a higher position, or use it to kickstart a project with great social value.

This is the most fundamental reason that those who have capital stake it: to create change. Most often, the change they desire is to own more of the same type of capital. A capitalist is somebody who stakes what is for what could be. One dollar now for ten dollars later. Ten million dollars now for a better climate later. Ten thousand dollars now for an educated child later.

What Successful Capitalists Do

The nature of staking is lossy by default. You no longer control the capital, and it is at risk. In order for staking to be successful, it has to be applied to an advantage. This is the context which is carried in the phrase, "to capitalize on something." Perhaps you've heard a friend say something like, "hey, you're really good at talking! You should capitalize on that and get into sales!" To capitalize on an advantage means to ascertain some kind of inefficiency, find an agent who has a unique ability to solve the inefficiency, and to then to double down on him so that he has the specific resources to solve it.

Here's the key: the knowledge of what is inefficient and who has the advantage is the true value behind successful capitalizing. (Any gaggle of MBAs can start and run a commodity business which already has generally known procedures. The returns on this will be marginal.) Truly great capitalists do three things. First, they can see inefficiencies in the market. Second, they can identify actors who have a unique advantage which will help them solve the inefficiency. Finally, they put their capital in the hands of those actors.

Capitalism and Companies

So, a capitalist is someone who stakes what is for what could be. Those who do this successfully do it by giving capital to motivated agents who have an advantage in solving a market inefficiency. But what does this look like from the side of the agents? Why do agents need capital?

The reason is that market inefficiencies or "problems" have a certain size which is correlated with the nature of the market, not the nature of your solution. This sounds obvious enough, but really let it slosh around in your head a bit. I see young potential founders make this mistake all the time. They have a vision for owning a company which looks a certain way, and that company vision is somewhat static. (50 employees, a building downtown, golfing on the weekends). They also have a variety of startup ideas, and they imagine this theoretical company solving the issue du jour.

The problem is that different market inefficiencies have different natural sizes in the market. If you believe that groceries should get into people's hands differently, that is a multi-billion dollar problem. If you think that your small town could use a gas station on 3rd and Main, that is of course much smaller.

Agents that are advantageously positioned within a market to solve a given inefficiency do not necessarily have the correct size. In fact it's very unlikely that they currently do, or that their liquidity lifecycle is aligned properly. The two things are completely uncorrelated.

That is why outside capital is needed. Capital helps you to accelerate the reality of a bet by right-sizing your resources to solve it. Using other people's money allows you to efficiently convert a potential advantage into an actual one, at the correct size.

In the next section, I'll discuss how each stage of company raises money, who they raise it from, and why.

Idea Phase

This is perhaps the least understood capital transaction. There seems to be a mindset among young founders-to-be that capitalists are ready to write a check to anyone with a good enough idea. While it is true that the quality of your idea matters, who you and your co-founders are matters just as much. Idea-phase capital must underwrite two risks at once: that the inefficiency or problem is real, and that the agents in question have the ability to execute. Remember, capitalists are people who stake what is for what could be by right-sizing an existing agent with a particular advantage. Whereas other companies have advantages pertaining to the company, in the idea phase all advantages must lie in the people.

That's why you'll often see high-profile or repeat founders raise large institutional money for their ideas, whereas less high profile or less experienced founders must work in smaller tranches.

In this phase, capitalists want to see a big problem and a competent team. The exact solution to the problem matters much less; it will likely change in later phases. It is easy to spot green founders in this phase. They talk about their solution as if it is an incredibly valuable thing, worth investing in, rather than talking about how big the problem is and why they are the right person to go and solve it.

What does the idea-phase capitalist look like? I would break them into two categories. The first is angel investors, high net worth individuals who have some specific knowledge about the industry. The risks that the idea-phase capitalist needs to underwrite are team competence and size of problem, and so angels will often have some technical experience that allows them to evaluate the team, or industry experience which helps them size up the problem.

It's very difficult for institutions to benefit from idea-phase capital over time due to legibility. An individual angel might be able to take the highly dynamic set of variables involved in a founding team and an idea, but institutions which are naturally limited by the principal-agent problem have a very difficult time making repeated good judgements in this space.

To solve this legibility problem, institutions tend to provide capital to the idea phase in the form of accelerators. An accelerator does two things for the capitalist. First, it brings the founding team close enough to analyze over a longer term by junior people. Second, all accelerators push founders to describe their startup in terms of pre-defined metrics. These two things help increase the legibility of your startup for the capitalist, and investment will generally happen after a few weeks or months of this "reading" process. In exchange for this, accelerators offer resources that might help you push your startup forward, and a clear path to funding.

Startup Phase

The startup phase is all about product-market fit. The capitalist at this phase is still underwriting the risks from the idea phase (can the team execute and is the problem real), but at this stage the solution also comes into play (does the team have a product which fixes the problem?). Product-market fit at this stage is usually described in terms of "early traction." Some examples of this are pre-orders or other forms of early revenue, email list subscriptions, and customer LOIs. Capitalists capitalize advantages. The advantage being analyzed in this phase begins to be the positioning of the actual company and product in the market, rather than simply team competence.

Unlike the idea phase, the startup phase (which I would loosely describe as pre-seed through series A) has a deep bench of institutional resources available to qualified startups. The best VCs of our generation such as Sequoia have made all of their greatest wins in this phase. It is early enough that the company still cannot be comprehensively described in terms of metrics, which means that well-networked or high-reputation players stand to benefit. Capitalists in this space stay deeply embedded in the startup ecosystem, constantly consuming and understanding the nuances that will allow them to correctly identify the winners in team, problem, and product.

A startup-phase company is laser focused on creating a product which solves the problem, selling it to a small set of initial customers, and then observing what happens next. A company can enter this phase once they are capable of talking to customers every day and writing code every day. If you cannot do both of these things every day for any reason, you are still in the idea phase.

To graduate from the startup phase, you will have shown a product that is currently being sold to customers at a high margin, which is measurably fixing their problems or providing much more value than it costs. Ideally, you are also showing a strong path to acquiring these customers at a much lower cost than the amount of money you make from them over time. If you can demonstrate these things, your company is in the growth phase.

Growth Phase

The growth phase is the sexy phase. This is where everyone is having the most fun and bragging about their success on social media. Rounds in this phase, series A or B to IPO, range from the tens of millions to hundreds of millions.

The purpose of the growth phase is to pour gas on a scalable business model, with a proven product, fixing a big problem. It is not inaccurate to say that both of the previous phases were really just attempts to mix all the right ingredients together to reach this phase. Now is when the advantage that was initially conceived of in the idea phase is clearly demonstrable and actionable to outside capital. There will still be rapid product iteration during growth, but the main focus will be scaling the product that has been developed in startup phase to as many customers as possible without degrading the acquisition economics.

Interestingly, in the growth phase, the attention switches back to the "team" again as it was in the idea phase. The question is now, can this team create a company that triples in size every year for many years in a row? Can they hire good executives? Can they build processes that scale? Can they keep a level head with hundreds of millions in the bank?

Capitalists at this phase are almost entirely institutional. Growth-stage companies can be described by their metrics (MRR growth, CAC:LTV, churn, etc) with increasing accuracy, making it much easier for institutions to capitalize your company with larger amounts of money. Institutional money tends to crowd into the growth phase, which can create some perverse incentives to look bigger and raise more than actually makes sense. Remember, growth is sexy. Growth stage companies just seem to go up and to the right. LPs desperately want to have their money in tech startups, but the startup phase takes too much work and is very difficult to apply large amounts of money while beating the indexes. On the other hand, mature, post-IPO companies are obsessed over by hedge funds and retail investors, creating ruthless efficiency.

The growth stage is the landing pad for the hopes and dreams of every LP who just saw the YoY return of Apple stock since 1980. For this reason, the growth stage is constantly in danger of being overheated. Founders in this phase must be very careful not to develop a preference overhang by listening to the hype of everyone around them.

Mature Phase

In the final phase, companies have an ongoing cycle of liquidity that can last for hundreds of years in some cases. The cycle goes like this:

1. Current management spots a new market or opportunity.
2. Management raises capital, either by selling its stock or raising debt secured against it.
3. Management attempts to execute.
4. If all goes well, they now have excess cashflow to payback the loan, or can sell stock at a now higher price to pay it off. If the market recognizes this positive movement, the move will pay off in terms of a higher share price. If the market lags in this understanding, the company can capitalize on that, too, by executing a stock buyback and then waiting.
5. However, if the opportunity goes poorly, the company now has debt with no excess cashflow to pay it, or has sold shares to raise money, with no new added share value to match that dilution.
6. Shareholders are either happy with or angry with steps 4 or 5 respectively. That anger translates into board elections which translates into officer elections, and the liquidity cycle starts over again with new management.

The story of a public company is the story of its managers' battles with changing market conditions and successful or failed execution of new opportunities. Companies that consistently win see an increase in the overall value of each share over time. (As an aside, don't be fooled by an increase in market cap. If a company raises money by issuing new shares and selling them, the market cap will increase by the amount of money added to the company, without any change in the share price yet. The move will only have been a success if the money that they receive from doing this capitalizes an advantage such that the company is able to realize more value than they gave away by selling stock.)

You might be wondering why I'm assuming that all "mature" companies are public. There are many reasons to want to stay private, but they mostly have to do with the owner's specific goals and desires for the company. All else being equal, being a public company massively increases your options, and generally lowers your costs, when it comes to liquidity. Private companies must continually work with banks or other large financiers to manage their liquidity, rather than simply disclosing their progress to the public markets and trading in their own securities. Even if a public company wants to use debt, the process is simpler since they can secure the debt on stock rather than arguing to the bank about why they should underwrite the next phase of growth.

So who is the capitalist in this final phase of a company? Well, you are. The market is. Everyone who has a 401(k), a pension, or of course owns a stock or piece of a mutual fund is a public investor. At this phase, companies have their greatest level of legibility, which means that inefficiencies in liquidity and pricing are solved with ruthless accuracy and speed. The two main categories are so-called "smart money" buyers and retail investors. Smart-money buyers are institutions full of smart analysts which trade the public markets with deep professional analysis that helps them make good bets over time. Their capital function is to provide accurate pricing to each company, and they are rewarded in proportion to how correct they are versus anyone else. A hedge fund that has consistently great returns was simply consistently correct about the true value of the companies that they traded on. This pricing allowed other retail investors to make better decisions about where to put their money, and the institutions are rewarded for that service.

The other group of capitalists in this phase are "retail investors." These are individuals who buy stocks in small quantities in order to see gains in the value of their assets or cashflow over time. Their function in the market is to analyze the growth claims of individual companies, the value of their products, and to contribute to or detract from the price of those companies. Once again, they are rewarded in proportion to their judgement about the correlation between the company and its share price into the future.

The mature phase, characterized by the public markets, experiences the most efficient and liquid capitalization. This has some profound benefits and dangers to all involved. The benefits to the capitalists are the fact that all companies in the public market are required by the SEC to disclose information material to the position and quality of the company. This means that public companies are at peak legibility, which allows high level investment decisions to be made. Investors at this level can easily invest in "trends," can de-risk or "hedge" other investments, and can rapidly shift capital around as their judgement dictates. The downside is that all inefficiencies are highly competed over, and you must be very smart or very lucky to make serious gains.

For companies, having your stock available on the public market means that you can right-size your company and capitalize on advantages at a much lower cost. Stock-secured corporate bonds have some of the lowest interest rates after treasury bills. And selling your stock and then buying it back can, with some skill, create enormous value with no downside at all.

On the other hand, there are two major disadvantages to being public. The first is that you have an increased regulatory burden imposed on you by the SEC and other trade organizations. This can slow your organization down, and it can also limit your ability to make moves in secret. The other is the principal-agent problem. Company officers are often compensated with company stock. This is good in theory; the leader of the company should make it more valuable over time. But the issue is that it can incentivize officers to do things in the short term that increase share value, but harm the company in the long term. Unfortunately, some form of this problem will always exist for mature companies, except perhaps for closely held multigenerational family-owned companies.

Final Note: Capital and Time

One of my greatest learnings over the last two years is that I am not a capitalist. I don't mean this in the ideological sense, I mean it in the functional sense. Capital is present real value. Here are some examples of things which are not capital:

• Skills
• Time
• Experience
• Wisdom

All of these things represent the potential for value, not value that has already been created in the past and can now be used. Many of my business failures have come from thinking in terms of supporting businesses as a capitalist, but I don't have enough capital to do that effectively yet. Instead, my value comes from being an agent. I can use capital as a tool while finding efficiencies, building advantages, and then scaling. But skills and my time spent applying them are not themselves capital. I showed earlier how capitalists are people who stake what is on what could be. In contrast to this, founders stake what could be on what else could be.

This has several interesting implications. The first is that I must be far more picky than a capitalist is about what I involve myself with. A great capitalist can deploy capital into hundreds of companies. But if the value you bring to the table are things like skills, experience, or wisdom, there is an extremely limited subset of opportunities you can transact with. Don't be confused by the people who are in a different category. While people whose main function is applying capital jump from company to company on a weekly or daily basis, you should focus on only a couple of things where your talents are leveraged maximally and allow the capital to yield over time.

An interesting question that occurs to me every so often is whether I will ever be a capitalist, or if I will always want to build things myself. I can't imagine not being the builder, the agent. But I suppose many young people have felt similarly, and then, proportionally to the count of gray hairs, find that they prefer to operate at a more abstract level. I suppose that time will tell! Either way, I think I'll enjoy the ride.

-IT