Leverage and gearing (E)

0:00When I was a little kid, we had a toy in our house. It was a bongo board. It consisted of a long board and a cylinder, and the board rolled back and forth on the cylinder. My sister was two years younger than me. I was standing on one end of the board. She ran across the room, jumped on the other end. I flew through the air and broke my wrist. Hey, it's Kevin Beach, and this is a special archived episode of Akembo.

0:32Of course, it wasn't Marjorie's fault. She didn't mean to break my wrist, but it was a perfect example of leverage. As Archimedes probably didn't say, if you give me a lever that is long enough and a place to stand, I could move the entire earth. A lever gives you leverage. It gives you the chance to exert far more power than you would be able to on your own. And so leverage has been around for a really long time, but leverage has been changing our culture just for a few hundred years. And I think in these times in particular, it's worth understanding how leverage works and how we got here and what happens when it goes in the other direction.

1:17Back in the early days of corporations when colonialists wanted to put together ships to go on long perilous journeys, one method would be take your life savings, buy one ship, go on a journey. If it works, you do well. If it doesn't, you're completely wiped out. But there's an alternative, and the alternative is to borrow money. When you borrow money, you have to pay it back with interest, but all the winnings belong to you. So the easiest way to get rich for a very long time has been in real estate. If real estate prices are going up over time, there are banks waiting in line to loan money to investors who want to buy real estate.

2:08Typically, you could buy some real estate for only 20 % down. That means if a piece of real estate is for sale for a million dollars, you need$200 ,000 in cash to buy it, and the bank puts up$800 ,000. Now, the bank is taking a small risk. The risk is that you won't pay them back, and if you don't, they get the piece of property, which today is worth a million dollars, so they feel pretty secure. But what happens if the value of that property goes up 20%. If the value of the property goes up just 20 % to$1.2 million, you can pay back the bank$800 ,000 and you get to keep the rest. You have doubled your money.

2:57A 20 % increase in the value of that real estate led to a 100 % increase in how much money you have. That is called leverage. In Australia and the UK, they call it gearing. They call it gearing because you can see the gears working, turning in one direction. And so anytime we have a chance to buy assets that are known to be of value, that we think are going to go up in value, Leverage, gearing, gives us the chance to multiply that. A really productive way to think about this is what happens if you buy an asset. If, for example, you are surrounded by people in the 1890s who make pins for a living, making a pin, turns out, used to be a skilled craft, and a typical pin maker could make a pin in six minutes, ten pins an hour.

3:57but you could buy a pin making machine. If you could buy a pin making machine, you could make a thousand pins in an hour. If you can make a thousand pins in an hour, you can pay back what it costs to buy that pin making machine. So you could go to the bank, again, using leverage and say, I want to buy this asset for a hundred bucks and I'm going to be able to pay you back because it's going to pay for itself. The bank takes a risk. on loaning you the money, perhaps guaranteed by your house, and you go buy a$100 pin-making machine, which pays for itself in five days. You pay back the bank, and the rest of the profit belongs to you.

4:40We have machines that have improved productivity only because of this leveraged transaction. It makes sense. It benefits all parties. But what happens when we start speculating what actually caused the crash on Wall Street in 1929. It's generally accepted that what happened was people were over leveraged. If you were sure that the stock market was going to go up every day, you could take the stock you wanted to buy and borrow against it from the bank and use the money that you borrowed to buy more stock. And around and around and around it goes. And as long as the price of the stock keeps going up, you have no trouble paying off the bank.

5:31But the minute it stops, the bank calls in the debt. You can't pay the debt. Now the bank has a problem. And the problem they have is they can't pay back the people they need to pay back because leverage goes in two directions. And we'll talk about this in a second, but first we need to talk about how this has affected all of our culture. Because when competitors start getting leveraged, the ones who don't feel pressure to do so. And so it spread to the media. So it spread to every chain you've ever done business with, to every industry that we're aware of, that getting leveraged became not just a way for a solo, greedy entrepreneur to make extra money.

6:22It became a cost of doing business. Imagine a community where there are two businesses. One of them has embraced leverage. Every chance they get, they borrow as much as they can. They use those borrowings to open more outlets. They use those borrowings to buy more machines. They use those borrowings to become ever more competitive. Their competitor, the one who is going slow, step by step, and has no debt, discovers that they are losing market share because their well-financed, highly leveraged competitor has become a growth machine. They have no choice but to grow. because they have to pay off the people they borrowed the money from.

7:09And so the less leveraged competitor faces a choice. Get smaller and become more resilient, or follow the lead of their competitor and borrow more. And so what we end up with are companies that don't have six months' worth of cash in the bank. They have six weeks or six days. What we end up with are institutions that are betting that tomorrow is going to be just like today, but more profitable and don't have the resilience to weather and interruption. And then it hits the media companies. The media companies, the ones that might be willing to say, you know what, we've published this magazine for 30 years and we're going to publish it for 50 more.

7:52We don't have to worry about clickbait. We don't have to worry about maximizing today's profit because we don't have to pay off an investor. We don't have to please the stock market. We are running something that we are proud of, not running a machine that has to maximize return every day. Well, if that media company has a competitor and that competitor has borrowed money with leverage to grow and needs to grow in order to pay off the money that they have borrowed, They will do a different sort of media, a media that maximizes attention or panic, a media company that is focused on how much money did we make today?

8:36What shortcuts can we take in the way we treat our people? Because next year doesn't matter if we can't make this week work out. And so what happens is this. Number one, leverage spreads. It spreads because if you have a competitor who is leveraged, you feel the need to be leveraged. Sometimes the market demands that you act like a company that is leveraged. And number two, leverage works in both directions. Positively, the gearing works beautifully when things are going up because more leverage makes things go up just a little bit faster. And because debt doesn't share in the winnings, the person who collects, it's the entrepreneur, the capitalist, the person in the center who gets to keep all the prizes until it goes in the other direction.

9:30And when it goes in the other direction, a cascade effect appears. And that cascade says, we lost a little, now we owe more. And then the bank or the person who gave you the debt says, wait a minute, this is going in the wrong direction. I am withdrawing this debt. And then it's harder to get new debt. And then it starts going the wrong direction. And if you've ever seen a machine where the gears start going the wrong direction, the thing to worry about is sometimes the teeth fall off. Sometimes things don't go as elegantly backwards as they go forwards. So what to do about all of this? Well, the first thing is to see it, to see the leverage.

10:13The second thing is for the powers that be and for us, the voices that influence the powers that be, to speak up and to slow things down. Because if we can slow down the reverse turn of the gears, it is possible for the wind to come back into our sails, to mix two metaphors there, and then maybe, just maybe, we can make the gears go forward again. But going forward, as individuals who have the chance to load up on credit card debt, as individuals who have the chance to borrow to buy a new car or to borrow to buy something else that goes down in value, we need to think hard about whether we as humans want to be leveraged.

10:57And as people who engage with the culture and engage with corporations, we need to think about the fact that it is our choice to do business with someone who is leveraged or not. and that part of what it means to buy local, part of what it means to engage with people we can look in the eye, that we are making a choice to head toward a culture and an economy that is looking farther down the road than the next week or the next quarter. That part of the mania and stupidity of Wall Street is that Wall Street often believes that the purpose of culture is to enable capitalism when the opposite is true.

11:38And that Wall Street too often embraces a cycle of destruction because that is where the leverage pays off. Turn the gears in one direction and then switch to the next project. But we are not projects. We're people. And this is our culture. And what it is possible to do is build for resilience instead. I hope that resonates. Thank you for listening. Here's to health and peace of mind for everybody. Hey Seth, it's Maria. Hey Seth, my name's Kyle. Greetings, Seth. This is Stephen out in Madison, Wisconsin. Hi, Seth. Alicia from Charleston here. Hi, Seth. This is Anupam. Hi, this is Caitlin. Hi, Seth.

12:16Warm greetings from Curacao. Hey, Seth. My name is Nick Ryan from Pittsburgh, Pennsylvania. Hey, Seth. This is Rex. Hey, Seth. Hi, this is Vasilis from Greece. Hi, this is Roberta Perry. My question is... And that completes my question. I really love to hear from you. If you've got a question about this episode or anything else, please visit akimbo.link, that's A-K-I-M-B-O dot L-I-N-K, and press the appropriate button. We got a couple of juicy questions. Here we go. Hi, Seth. This is Reid Christensen from Minneapolis, and I have a couple of questions regarding creative destruction in a capitalist market.

12:55Should individuals and companies specifically market and position themselves to succeed when creative destruction occurs? Or would this emphasis on the inevitable simply leave them vulnerable to the current competition? And what barriers must be overcome for these new innovations that come out of creative destruction to actually succeed? Right. This ties in with the business model discussion we had just a little bit earlier. The question is, what's the change agent? What happened in the world that allowed creative destruction to even occur? For a long time, for most of my life, it's been technology.

13:34Someone comes up with a better way to solve a problem, and the new technology creates more productivity, creates a different interaction, creates a change in the marketplace. And so a business coming along that seeks to grow embraces technology to cause the destruction of the assets that allowed their competitors to win. But for the last 20 years, the biggest shift has been the network effect. The network effect is the reason that almost every single industry that we encounter is different now than it was 20 years ago. The network effect is simple. Something works better when more people are using it.

14:20That is not true for most things. A pedestrian plaza is not better when more people are using it. A forest is not better when more people are using it. But if Wikipedia only had one user, it wouldn't work very well. And so the network effect is adopted by people who are trying to make a change. It is the change agent of our time. And the network effect can, of course, have downsides, as we are seeing with a virus pandemic that is all around us. That's nothing but a network effect. But for the positive, what the network effect enables is the community to benefit from the community doing business in a new way.

15:06Hey, Seth. It's Alex from Bulgaria. And I've been listening to Akimbo since day one. and I took it across countries and continents. Now I'm back home. Now cut to the chase to the question. I want to ask a delicate one regarding friendship. I started this blog with my friends and quite frankly, I've been pondering about, you know, some people are really hesitant to start a business with friends, but other ones are very much into business and are really taking the opposite side. How can I do business with you if you're not my friend? So I was curious, what is your stand on this one? Thanks for this question and for the kind words.

15:56We've not talked about this on the podcast previously, but I will highlight two pieces of it. The first piece is this. It is very tempting when organizing a new project to decide to have a 50-50 split. Or if there are three of you, split it even, a third, a third, a third. This is essentially always wrong. Unless you are Lennon and McCartney, this is not a good way to establish how to split responsibility or income from a business. It pushes off a difficult conversation when the best time to have that conversation, and the easiest, is right now. And my suggestion is pretty simple. Instead of allocating the winnings at the beginning, allocate them as you go.

16:46Make a list of what needs to be done, what needs to be contributed, what responsibilities you would imagine people needing to take. And then, as wins come in, each partner gains more and more equity based on her contribution to what you are building. So having the original idea, that's worth basically nothing. But going forward, who did what? How can you keep track? Because if you can agree on how to keep track, then each of you has responsibility, not just authority. And the second half of it, which is also important, every partnership is going to end sooner or later. It's going to end when one of you decides to walk away.

17:37It's going to end when you can't work together easily anymore. It's going to end when one of you gets hit by a meteor. The thing is, what will you do about the ending? The best time to decide is before you begin. My favorite way to do it, super simple, is a shotgun clause. At any point, either party can offer to buy out the other one. And the second person has a choice. accept the buyout or match it and buy out the person who just made you the offer. It forces both parties to put a value on what's going on. Neither one of them has to labor under working with somebody who they can't work with anymore.

18:18It makes it much cleaner. Knowing that there's an exit forces both parties to behave in a much more mature way. So yes, There are beautiful partnerships. The partnership I had in college with the amazing Steve Dennis is one of the best business relationships I had. It was easier for us because we both graduated and neither one of us owned the thing. But I also know it's fraught and spending the time before you begin during those happy rosy days to outline who's going to do what, what they're going to get when they do, and how to wrap it up when we're finished, it's worth it. It's worth the two hours.

19:02Because if you can't have that conversation now, you're certainly not going to be able to have it later. I hope that helps. Here's to health and peace of mind to everyone. We'll see you next time.