Cash flow is a fact. Profit is an opinion.
One way that first principles thinking fails is when you build your analysis up from a deficient set of base principles. Everything is correct and true, but you still end up mistaken. Here’s how that looks like in practice.
Capital Thinking • Issue #1036 • View online
In my last post I examined how first principles thinking fails.
This post is going to be about a single, concrete example — about an argument that started me down this path in the first place.
The Games People Play With Cash Flow
A couple of months ago, a friend sent me a blog post titled Startups Shouldn’t Raise Money, over at a website called ensorial.com.
I thought that the post was tightly argued and reasonably put together, with each proposition leading logically and coherently to the next. I also noticed that the author had taken the time to construct their argument from first principles … which meant it was difficult to refute any individual clause in their chain of reasoning.
But I also thought it was wrong. I told my friend as much.
“How is it wrong?” he immediately challenged.
“Well …” I began. And then I stopped. I realised I didn’t have a good argument for why it was wrong.
Every axiom and intermediate proposition were ideas that I agreed with. And it wasn’t so simple as the conclusion being flat out mistaken — you could probably run a small, successful internet business using the ideas laid out in the posts’s argument (internet-based businesses tend to be simpler to manage, and there are many niches you can occupy).
But I felt uneasy because I thought the framing wasn’t as useful. This was a more complex thing to debunk.
The Setup
It’s easy to think that arguments have just three terminal truth values: right, maybe, and wrong.
In practice, arguments (and in particular, the sort of argument that we use to justify actions) have many possible truth values. These include things like ‘got the details wrong, but is by-and-large correct’, or ‘is correct but for a different level of abstraction; doesn’t apply here’, or ‘is partially correct, but isn’t as useful compared to a different framing of things.
’The ensorial.com piece is interesting because I think it is an instance of that last one. It was what pushed me to start thinking about all the various ways first principles thinking could go wrong.
The author’s argument unfolds as follows:
- Startups are risky.
- Raising capital to do a startup reduces skin in the game (you’re spending other people’s money, after all).
- Once you have less skin in the game, it is easier to make bad decisions. The author argues this is due to a) having a capital buffer to cushion you, and b) having more time to waste.
- The alternative is to forego raising venture capital and to create a sustainable business from the beginning, ‘growing linearly with the number of people that give you money for your product.’
- This aligns incentives: you grow only by solving customer problems that they would pay you for. And you’ll pick the shortest path, because you don’t have the luxury of time given to you by an infusion of other people’s money.
- Therefore: startups shouldn’t raise money.
At first glance, there doesn’t seem to be anything that’s explicitly wrong with this argument. I agree with all the base ideas, and I found myself nodding to the intermediate propositions.
The logical correctness of the argument wasn’t a problem. No, my unease stemmed from experience: I knew this wasn’t the right way to think about raising capital. But I couldn’t begin to construct an argument that went against it.
My friend and I spent no more than 10 minutes discussing this piece. But in the months after our conversation, I continued to return to the author’s argument.
I thought it was interesting because it represented a type of thinking error that you and I are likely to encounter in our lives. The form of the error is subtle, and therefore more difficult to detect; the best description I have for it is: ‘perfectly rational, logically constructed, and not really wrong — but not as useful or as powerful as some other framing.’
Of course, my obsession was for instrumental reasons: how might you recognise a better framing when you found one?
I’ll admit that I was a little naive here: I thought that if I could generalise the structure of this argument, I would be better able to recognise similar errors in the future. Alas, I have not been able to do this to my satisfaction.
(In practice, most of the older entrepreneurs I know seem to understand the problems with such sensemaking. Plausible arguments are dealt with in a simple manner: you try the recommendations that unfold from the analysis, but you remain alert to see if they give you exactly the results you want.
If they don’t, you keep the frame for the time being, but you continue to look out for a better explanation. And how would you know if you have found a better way of thinking about your situation?
Cedric Chin
One way that first principles thinking fails is when you build your analysis up from a deficient set of base principles. Everything is correct and true, but you still end up mistaken. Here’s how that looks like in practice.
Amongst business people and savvy investors, Malone’s logic dovetails with a famous saying: ‘cash flow is a fact; profit is an opinion’.
Even today, there are people who do not fully understand the games you can play with cash flow. Or — more importantly — they do not understand the things businesspeople would do for better cash flows.
In the ‘misunderstood’ bucket, take Amazon, for instance. In 1997, a 33-year old Jeff Bezos announced that he was essentially adopting the same playbook, firing a shot across the bow with his first annual letter to shareholders.
For the next two decades, Amazon grew its revenue and made no profits, leading journalist Matthew Yglesias to write, in 2013: “Amazon, as best I can tell, is a charitable organization being run by elements of the investment community for the benefit of consumers.”
Bezos enjoyed it so much he put it in his annual letter the same year. Bezos knew what he was doing; Yglesias didn’t get it.
So, you might ask, what does John Malone have to do raising venture capital? The answer: more than you might think.
The core idea that you should take from Malone’s story isn’t “oh, it’s possible to build a valuable company with no accounting profits” — though that is a valuable insight — but instead “there is a whole genre of games that people play with cash flow” and also “cash flow is often more important to grok than profits.”
Photo credit: Giorgio Trovato on Unsplash