classical vs innovative businesses

As you move away from zero-to-one processes, economic activities become more and more sensitive to macroeconomic dynamics.

Think of the economy as a universe. Innovative startups correspond to quantum mechanical phenomena rendering something from nothing. The rest of the economy works classically within the general relativity framework where everything is tightly bound to everything else. To predict your future you need to predict the evolution of everything else as well. This of course is an extremely stressful thing to do. It is much easier to exist outside the tightly bound system and create something from scratch. For instance, you can build a productivity software that will help companies increase their profit margins. In some sense such a software will exist outside time. It will sell whether there is an economic downturn or an upturn.

In classical businesses, forecasting near future is extremely hard. Noise clears out when you look a little further out into the future. But far future is again quite hard to talk about since you start feeling the long term effects of innovation being made today. So difficulty hierarchy looks as follows:

near future > far future > mid future

In innovative businesses, forecasting near future is quite easy. In the long run, everyone agrees that transformation is inevitable. So forecasting far future is hard but still possible. However what is going to happen in mid term is extremely hard to predict. In other words, the above hierarchy gets flipped:

mid future > far future > near future

Notice that what is mid future is actually quite hard to define. It can move around with the wind, so to speak, just as intended by the goddesses of fate in Greek mythology.

In Greek mythology the Moirae were the three Fates, usually depicted as dour spinsters. One Moira spun the thread of a newborn's life. The other Moira counted out the thread’s length. And the third Moira cut the thread at death. A person’s beginning and end were predetermined. But what happened in between was not inevitable. Humans and gods could work within the confines of one's ultimate destiny.

Kevin Kelly - What Technology Wants

I personally find it much more natural to just hold onto near future and far future, and let the middle inflection point dangle around. In other words I prefer working with innovative businesses.

Middle zones are generally speaking always ill-defined, presenting another high level justification for the barbell strategy popularized by Nassim Nicholas Taleb. Mid-term behavior of complex systems is tough to crack. For instance, short-term weather forecasts are highly accurate and long-term climate changes are also quite foreseeable, but what is going to happen in mid-term is anybody’s guess.

Far future always involves “structural” change. Things will definitely change but the change is not of statistical nature. As mentioned earlier, innovative businesses are not affected by the short term statistical (environmental / macro economic) noise. Instead they suffer from mid term statistical noise of the type that phase-transition states exhibit in physics. (Think of turbulence phenomenon.) So the above two difficulty hierarchies can be seen as particular manifestations of the following master hierarchy:

statistical unpredictability > structural unpredictability > predictability

Potential entrepreneurs jumping straight into tech without building any experience in traditional domains are akin to physics students jumping straight into quantum mechanics without learning classical mechanics first. This jump is possible, but also pedagogically problematic. It is much more natural to learn things in the historical order that they were discovered. (Venture capital is a very recent phenomenon.) Understanding the idiosyncrasies and complexities of innovative businesses requires knowledge of how the usual, classical businesses operate.

Moreover, just like quantum states decohere into classical states, innovative businesses behave more and more like classical businesses as they get older and bigger. The word “classical” just means the “new” that has passed the test of time. Similarly, decoherence happens via entanglements, which is basically how time progresses at quantum level.

By the way, this transition is very interesting from an intellectual point of view. For instance, innovative businesses are valued using a revenue multiple, while classical businesses are valued using a profit multiple. When exactly do we start to value a mature innovative business using a profit multiple? How can we tell apart its maturity? When exactly a blue ocean becomes a red one? With the first blood spilled by the death of competitors? Is that an objective measure? After all, it is the investor’s expectations themselves which sustain innovative businesses who burn tons of cash all the time.

Also, notice that, just as all classical businesses were once innovative businesses, all innovative businesses are built upon the stable foundations provided by classical businesses. So we should not think of the relationship as one way. Quantum may become classical, but quantum states are always prepared by classical actors in the first place.

What happens to classical businesses as they get older and bigger? They either evolve or die. Combining this observation with the conclusions of the previous two sections, we deduce that the combined predictability-type timeline of an innovative business becoming a classical one looks as follows:

1
(Innovative) Near Future
Predictability

2
(Innovative) Mid Future
Statistical Unpredictability
(Buckle up. You are about to go through some serious turbulence!)

3
(Innovative) Far Future
Structural Unpredictability
(Congratulations! You successfully landed. Older guys need to evolve or die.)

4
(Classical) Near Future
Statistical Unpredictability
(Wear your suit. There seems to be radiation everywhere on this planet!)

5
(Classical) Mid Future
Predictability

6
(Classical) Far Future
Structural Unpredictability
(New forms of competition landed. You are outdated. Will you evolve or die?)

Notice the alteration between structural and statistical forms of unpredictability over time. Is it coincidental?

Industrial firms thrive on reducing variation (manufacturing errors); creative firms thrive on increasing variation (innovation).
- Patty McCord - How Netflix Reinvented HR

Here Patty’s observation is in line with our analogy. He is basically restating the disparity between the deterministic nature of classical mechanics and the statistical nature of quantum mechanics.

Employees in classical businesses feel like cogs in the wheel, because what needs to be done is already known with great precision and there is nothing preventing the operations to be run with utmost efficiency and predictability. They are (again just like cogs in the wheel) utterly dispensable and replaceable. (Operating in red oceans, these businesses primarily focus on cost minimization rather than revenue maximization.)

Employees in innovative businesses, on the other hand, are given a lot more space to maneuver because they are the driving force behind an evolutionary product-market fit process that is not yet complete (and in some cases will never be complete).

Investment pitches too have quite opposite dynamics for innovative and classical businesses.

  • Innovative businesses raise money from venture capital investors, while classical businesses raise money from private equity investors who belong to a completely different culture.

  • If an entrepreneur prepares a 10 megabyte Excel document for a venture capital, then he will be perceived as delusional and naive. If he does not do the same for a private equity, then he will be perceived as entitled and preposterous.

  • Private equity investors look at data about the past and run statistical, blackbox models. Venture capital investors listen to stories about the future and think in causal, structural models. Remember, classical businesses are at the mercy of macroeconomy and a healthy macroeconomy displays maximum unpredictability. (All predictabilities are arbitraged away.) Whatever remnants of causal thinking left in private equity are mostly about fixing internal operational inefficiencies.

  • The number of reasons for rejecting a private equity investment is more or less equal to the number of reasons for accepting one. In the venture capital world, rejection reasons far outnumber the acceptance reasons.

  • Experienced venture capital investors do not prepare before a pitch. The reason is not that they have a mastery over the subject matter of the entrepreneur’s work, but that there are far too many subject-matter-independent reasons for not making an investment. Private equity investors on the other hand do not have this luxury. They need to be prepared before a pitch because the devil is in the details.

  • For the venture capital investors, it is very hard to tell which company will achieve phenomenal success, but very easy to spot which one will fail miserably. Private equity investors have the opposite problem. They look at companies that have survived for a long time. Hence future-miserable-failures are statistically rare and hard to tell apart.

  • In innovative businesses, founders are (and should be) irreplaceable. In classical businesses, founders are (and should be) replaceable. (Similarly, professionals can successfully turn around failing classical companies, but can never pivot failing innovative companies.)

  • Private equity investors with balls do not shy away from turn-around situations. Venture capital investors with balls do not shy away from pivot situations.