Counterfactual Theory of Value
perell.com
perell.com
There is a really straightforward answer to this - equity isn't distributed according to a theory of value and nobody ever claimed it was. I own some equity in the Australian company CSL. It is unfair to claim I've ever added any value whatsoever to the company at any point, so obviously I don't get that equity because of a value theory. Even on the basis that people anticipated my buying of that equity - I bought in because I believed the value had already been created.
Who gets equity isn't based on value, it is based on power and who has it right now. Value is for working out whether you, the valuer, should make a trade or not.
You don't receive any profit, realized or otherwise, unless the company appreciates in value, and if the company appreciates, that means you provided capital to what was an undervalued company, or a company that could produce a positive return on the investment of that capital.
Either way, your investment would likely have a net positive economic effect, and so the profit you received would be earned.
In Book 1, Chapter X, "Of wages and profit in the different employments of labor and stock", "Inequalities Arising from the Nature of the Employments Themselves":
The five following are the principal circumstances which, so far as I have been able to observe, make up for a small pecuniary gain in some employments, and counter-balance a great one in others: first, the agreeableness or disagreeableness of the employments themselves; secondly, the easiness and cheapness, or the difficulty and expense of learning them; thirdly, the constancy or inconstancy of employment in them; fourthly, the small or great trust which must be reposed in those who exercise them; and fifthly, the probability or improbability of success in them.
It's an interesting set of factors, one that many economists and markets-advocates seem wholly unaware.
It does not reflect other arguments, notably marginalist analysis, or power dynamics as mentioned elsewhere in this thread. Still, it's worth some consideration, and explicitly references the roles of both risk and training.
https://en.wikisource.org/wiki/The_Wealth_of_Nations/Book_I/...
It has been a long time since I have read it, but it's nice to see Adam Smith was so close to the answer centuries before people started distorting the problem politically and got all those obviously wrong but mainstream answers.
He's prolux and the language is somewhat alien to a modern reader. He does make errors and has some of his facts wrong; see his advice to the American colonies, and his origin story of money, especially. But he is a keen observer with a shrewd mind, and recognises that fundamentally the purpose of an economic system is the support of the people (and specifically the poorest) and the state itself, and that wealth confers power which itself is distortionary. These messages are suppressed, whilst others given incidentally are ascribed undue significance.
Read Smith. Really.
https://old.reddit.com/r/dredmorbius/comments/4cyroa/adam_sm...
Since then, pricing using a replication portfolio in this way has been a cornerstone of financial maths - the price of a thing and a perfect hedge/replacement for the thing must be the same.
And the reason for this is arbitrage. If you can perfectly hedge your position in Asset A using Asset B (and vice versa), then you can make a profit by simultaneously buying the lower-priced asset while selling the higher-priced asset[1]. Thus causing the prices of the two assets to converge.
[1] Many of these assets are simply contracts, which means you don’t have to buy the asset before you can sell it: you simply create a new instance of by “writing something on a piece of paper” and sell that.
Is it possible that automation provides that arbitrage opportunity?
Something intrigues me about this idea.
The film / book "Moneyball" showed how to re-create great players "in the aggregate".
I think that we will soon enter a phase of "MOOP" - measuring our daily activities on a deep basis, phone calls to colleagues and clients, tonality, agreements and actions etc.
And at this point redesigning an organisation to recreate CFOs or salespeople "in the aggregate" becomes ... possible?
And if you can do that you get close to the ability to create that fungible option - and close to valuing the job.
Moneyball to me was a lesson and framework on how to make great teams, not great [individual] players. Focusing on under-valued qualities allowed the A’s to build a pennant-winning team on a low budget, by selecting free-agent players the baseball operations groups at other teams were over-looking/under-valuing.
Coming back to software, I think many of us know the three people we’d go form a startup with and the 50% of people who might be okay but we’d never sign up to start a company with. I don’t know if that is amenable to a Moneyball-style spreadsheet analysis though. If it is, VC firms would pay billions in aggregate for a working system.
Conversely niche skills would mean a large variance in compensation due to price uncertainty ("I can't just go out and hire an exact replacement for sokoloff!"), and if there is demand for those niche skills it should mean high comp overall. And that's what we see in general in the labour market.
For a Subway sandwich artist, not only is the production process standardized (making “exact [practical] replacement” possible), but the value is also capped by how many sandwiches are sold on a given shift. No sandwich artist will make 5x as many as another. Rarely will excellence in an individual employee result in a sharp uptick in sales.
For a company that sells online ads, cloud computing, streaming services, or software that cap is so much higher as to be practically irrelevant for many roles.
> The Shapley value is the average marginal contribution of a feature value across all possible coalitions. [2]
EDIT: There are efforts to decompose that attribution of value into Synergy, Redundancy and Independence components [3], which I believe could also have meaning the context of business.
[1] https://en.wikipedia.org/wiki/Shapley_value
[2] https://christophm.github.io/interpretable-ml-book/shapley.h...
He starts out by talking about the value of a product (commodity) determined by the labor theory of value. Then he jumps to how much someone is compensated in salary. Then he jumps to a company's value and the ease at which someone at the helm can raise capital.
In terms of comparing two systems of value, this is jumping all over the place. How value is added to a specific nascent commodity going through an assembly line is a different thing than the ability of one person versus another to raise capital and how that affects a company market cap and is different than what they should be compensated.
People like Eugen von Boehm-Bawerk wrote well-reasoned arguments against the labor theory of value, which might be right or wrong, but at least they have a clear line of reasoning. This piece talks about value but jumps all over the place. There might be an interesting phenomenon being pointed to, but there is no well reasoned argument.
According to the labor theory of value, our bookshelves are worth the same amount, because you put 50 hours into making yours, and I put 50 hours into making mine, and we have the same prior experience.
Another follow-up question, then: How did you manage to spend 50 hours making it? Did you sit there, painstakingly, making one leg thinner than the rest for some reason? Did you sleep? Did you spend 20 hours of it browsing HN? In either case, this would likely fall under the category of unproductive labor: https://en.wikipedia.org/wiki/Productive_and_unproductive_la...
There's also the distinction of "socially-necessary labor", which feels (to me) like Marx's parallel to subjective value - the more socially-necessary, the more valuable the labor (a nice table vs. a crappy one).
In any case, the value is not just a measure of "hours put in" as you're making it out to be here; clearly I put more labor into it than you if mine looks/performs better in the same amount of time.
You should have other problems with it. Value that would be lost in the absence of a thing is unrelated to the value gained by its presence, because you have more choices than "pay for the thing" or "do without".
The theory of value espoused in this post would tell you that you should pay more for the oxygen you consume than you do for your computer.
(There is some self-contradiction in the post - it defines counterfactual value thus:
> what if pay is determined by asking: “How much would this company be worth without this individual?”
But then it provides an example of something very different:
> Baseball managers use the Counterfactual Theory of Value all the time, using a statistic called “Wins Above Replacement.” It predicts how many more wins a player gives their team, compared to whoever would replace them.)
Usually when you buy something, the value (to you) is greater than the price, which is greater than the cost (to the seller).
Edit: this question was raised by Adam Smith, known as the diamond-water paradox, or paradox of value:
https://en.wikipedia.org/wiki/Ceteris_paribus
In practice, regression analysis ("econometrics" to economists) and similar analytic methods allow for evaluating multiple factors.
The moneyball theory of value is not terrible, is actually pretty sound. But this kind of analysis works well in a context like sports because there's only so many players in a team and the team is basically just struggling in a win or lose world against other similar teams. Your wins come from someone else's losses.
The sports metaphor is also applicable because sports are reproducible. It's the same little world over and over again, with the same people. And there's just an enormous amount of stats to back up or reject some hypothesis. Goalkeeper is good or bad? Let's check how many shots he faced and what quality they were.
In the general market this is not the case. The firm only launches its first product once, in a world where you don't get to repeat the conditions. We also do have a history of each contributor's actions. Basically it's very hard to make comparisons.
In the sports roster case, a soccer/baseball team would be in trouble if they lost one of their average-talent players if they didn't have anyone on the pitch but there might be a plentiful supply of low-cost players willing to work for a similar amount.
This means that the counterfactual of 'lose average player and replace with noone' suggests that the player has a very high counterfactual theory of value, but 'lose average player and replace with similar average player' suggests that the counterfactual value is not high.
There might be a star player such that they are not replacable by anyone, or by anyone also able to demand a high salary from an alternative team, and they would have a very high value according to both counterfactuals.
It seems to me that many sports teams operate with the 'similar average player' counterfactual.
I think you could draw analogies to businesses and employee pay.
Because on day zero, 100% of the company must be owned, and the founders are the only ones there.
Equity to founders isn't handed out based on an arm's-length negotiation, or on the basis of work done.
Why dont seed fund demand 16% instead of 8%? Why doesn't the 6th employee demand 5% instead of 3%?
The founders can only retain as much equity as the marketplace allows. Each side has a threshold to do a business transaction.
>Why dont seed fund demand 16% instead of 8%? Why doesn't the 6th employee demand 5% instead of 3%?
The parties can demand any percentage they want but the ultimate resolution is will the other side agree to it? In other words, the question is, "Why do angels _agree_ to 8% instead of 16%"? Because an offer requiring 16% would be rejected by the founder and lose to other angels only requesting 8%.
E.g., back in 1999 during the dot-com craze, VC Sequoia Capital offered MP3.com (founder Michael Robertson) $10 million for 45% of the company. He said no deal. They later negotiated it down to 20% ... which is in the more reasonable ~15% to ~20% range of other VC deals.
Lesson: Demanding a high 45% so that the founder only retains 55% instead of 80% doesn't automatically mean the founder will say "yes" to the reduced equity. People can still voluntarily choose not to do business with you at all. All "demands" are competing in the marketplace. Can an employee demand a higher 10% equity? Sure. Whether the founders _agree_ to it depends on the marketplace and the employee's particular leverage (e.g. a very rare skill).
Essentially: what is the marginal contribution of some factor X. Including the case where X is some individual contributor.
The question Dave Perell asks needs to be augmented by one other: What is the cost, and value, of an alternative input factor?
If X provides 100 units of value at 20 units of cost, and Y provides 90 units of value at 9 units of cost, then the net advantage is to utilise Y (net benefit: 81) rather than X (net benefit: 80).
Of course in the real world, neither benefits nor costs are quite so readily assessed, but the principle remains: you want to account for both the productivity* AND the cost of the input or contributor.
Opportunity cost gets conditioned on the investor. If you’re a maker, or a player with leverage on the board or something, your opportunity cost is different.
opportunity cost = (returns on best forgone option) - (returns on chosen option).
This is the "mud pie" argument. You may disagree with the theory but please check what it is first .
The modern approach is called the opportunity cost, and by definition is a counterfactual scenario. It is triggered by a choice you actually have. Otherwise it's called science fiction.
This article does a very average job at explaining the whole thing... Even the Elon Musk example is not accurate. The value of Tesla in the ''without Elon'' scenario is wrong, because in that case Elon would be *replaced* by another overconfident nerd. Just think of Apple without Steve Jobs ; he got replaced by something different, and the firm is still standing strong today...
Good counterfactual thinking is super important, but I do not feel that the author is a master of the art.
Similarly, if the stock is undervalued, it becomes more costly to raise capital in public markets. So hiring a CEO with poor market perception limits a company's options, even if they're internally very effective.
I raise this in part because one of the problems with counterfactuals is evaluating a state of affairs that you dont have access to. In fact, evaluation of that alternate state is necessarily biased by the currrent state.
Yes it would. Mark Tarpenning and Martin Eberhard founded Tesla. They were later forced out by Elon.
They were arguably quite poorly compensated for their part in starting this company.
This speaks to the fundamental problem with this theory - it's all very well saying that Elon is worth his money because Tesla would be nothing without him, but what if it actually would have been wildly successful without him and he mostly rode the wave with his $6 million series A investment?
Of course, you cant prove what "would" have happened, you only know what actually did, so your valur is measured by whomever tells the most compelling story.
The rest is...meh.
In SpaceX's case they picked up on rocketry research where NASA left off because its budget was squeezed.