The Fifth Source of Capital
"Equity, debt, revenue and sweat"
This rhyme reminds us of the four kinds of capital that drive a business. Most financial products for companies are one or some combination of these four. Most entrepreneurs use some mix over the lifetime of the business. But do we use them well?
Equity is a claim on company profits and residual assets after paying the creditors. One "raises" equity by selling part of that claim to outside investors. Because it is junior to other claims, this money is usually the most expensive for a startup - which means it's the worst deal for the founder. To raise more funds, founders give up more of their claim to the rewards of their efforts. The press often celebrates raising equity. To my mind, this is nuts.
Debt is a claim on the business that one must repay. The main block is often the willingness of the lender to issue a loan at all to a startup making software or SaaS. They see an applicant with few assets and a scant track record. They face a legitimate challenge: how does one manage default risk? An often-undesirable way of addressing this underwriting problem comes in credit cards, which charge (usurious) rates for unsecured consumer credit.
True bootstrapping uses revenue as capital; cash - ideally presale or advance payment - from customers supports overhead. Income is generally the cheapest form of funding on this list. To move it forward, prepayment by early customers - even for a discount - is one of the healthiest ways to get early funding.
"Sweat" is investing one's time in the business. Outside income, personal debt, or a reduction in lifestyle are what fund this time. The outside income is often the "day job." When people talk about "self-funding," this is usually the mechanism.
The relative perceived costs of these sources of capital distort our decision-making. For example, it's easier to "sweat" on the weekend. And some contributions are more natural fits for the off-hours than others. For example, coding in a dark room works well in the wee hours when you decide not to sleep, whereas talking with customers requires working in the daylight.
Another distortion is the over-use of equity financing. The entrepreneur prefers equity even when debt is cheap. The United States government subsidizes much small business debt, making it even more affordable. Even so, my cohort of entrepreneurs is reluctant to take on that obligation. Part of this is fear of failure: the thought of ruin arising from a pile of debt that they must now repay - or work out in ways that will affect them for years.
Financial innovation mixes up these four sources to create new products. Revenue-based financing, for example, is debt kinda-sorta secured by revenue. The resulting product can behave much more like equity in aligning incentives while being lower-risk for the investor. This broad area of "alt-finance" technology is a field in which I invest.
But beyond the realm of financial engineering, there is a newer, fifth source of value available to us in the information age: code.
The Almanack of Naval Ravikant opened my eyes to code as a source of capital. At one level, the idea of intellectual property as a durable and financeable asset of a business is not new. Indeed, a classic question from a venture capitalist speaking to an entrepreneur attempting to sell their equity is, "what is your IP?"
But code transcends IP. Mere property is inert and is to be traded or exploited. Code is in motion, executing operations and creating enduring value autonomously and with near-zero marginal cost.
What makes this new is the ratio of automation to work required to build it (labor) and execute it (capital). No longer do we need to construct iron foundries - code runs for micro-pennies. Build your machine on the cheap, then let it do the work almost for free.
Ray Dalio at Bridgewater Capital writes about this strategy at length in Principles. He turned each insight learned through (often brutal) experience into an "another one of those" ruleset. He and his team express this model in company computers to execute in the market - repeatedly.
The fact that Dalio has been applying this approach for over thirty years means the idea of code as a capital contributor is not intrinsically new. But the opportunities grow greater as information technology simultaneously advances and grows cheaper.
Code driving value for a business is central to how many people see the software business - especially "software as a service." In one view, this is code running to create value for customers while not commanding the time of the company's staff behind the service. Such a setup can fulfill the promise of "making money while you sleep" - an attribute of return-generating capital.
Another example is event-driven automation. Services like Zapier and Integromat make assigning decision responses to machines much more effortless. One can implement both the conditions and the recommended action in some mix of code and no-code tooling. The answer to "another one of those" then happens automatically - without marginal labor.
Even today, advances in technology extend the potential for code to generate returns. For example, AI technologies can elevate this kind of judgment automation from mechanical rules to mental models. Rules are recipes: "if this, then that." Mental models are probabilistic frameworks: "this is similar to that and the other thing, but not exactly." The potential is to derive the appropriate course of action and take on reasonable risks. The applications are not far in the future - but the results can be fantastic.
Few seem to understand this whole field of using code as capital - and I am still learning. It will change the way companies get built and valued. We will need new research in the market to see how these five sources of capital interact in the coming years. It seems pretty likely that we will need a new mnemonic for this quintet: My start needs work:
Equity, debt, revenue, sweat - and robots!
My thanks to the foster.co community for their support and helpful feedback on this essay. As always, errors are my own.
Photo by Pepi Stojanovski on Unsplash