The other day, I was discussing a private technology company with a friend that also works in venture capital. The company was about five years old and had recently grown its revenue 100 percent to about $20 million.
We had both discussed an investment with the company in the past and had done research on it. So we debated the product, competition, market, CEO and his team, etc.
His conclusion was that the product wasn’t a good fit given the needs of the target customers and the alternatives available from large incumbents.
I disagreed, partly for reasons that directly addressed those points but more for the fact that the growth spoke for itself. My explanation didn’t feel as rich, though.
Both of us have done deep, rigorous research when evaluating whether to invest in a company like that with the goal of answering precisely those questions. We speak with lots of people in the market—current customers, potential customers, product managers, sales people, industry analysts, etc. Everyone shares their opinion, and we get “smarter.”
But it’s a noisy process. Some people, product managers at other companies, say, are “deep in the weeds” and can offer insights about product, performance, etc. Others, such as industry analysts, are “higher up” and can offer insights about trends and general perception of different firms.
So, the question I’m struggling with: To what extent does the story that emerges from that research actually matter?
The company in question is a disruption taking place on a small scale when the revenue is compared to the market. $10 million going to $20 million in a $2 billion market is a drop in the ocean so to say.
Yet, the narrative we create draws from various parts of that entire market. How much does it actually explain whether the company will go on to become a large, successful company, generating significant returns on the investment?
After the discussion, I recalled a story from Nassim Nicholas Taleb’s book Antifragile, the lesson from which he calls “The Green Lumber Fallacy.” (Added bonus: the passage below captures Taleb’s signature style—direct, confrontational, and colorful.)
In one of the rare noncharlatanic books in finance, descriptively called What I Learned Losing a Million Dollars, the protagonist makes a big discovery. He remarks that a fellow named Joe Siegel, one of the most successful traders in a commodity called “green lumber,” actually thought that it was lumber painted green (rather than freshly cut lumber, called green because it had not been dried). And he made it his profession to trade the stuff! Meanwhile the narrator was into grand intellectual theories and narratives of what caused the price of commodities to move, and went bust.
It is not just that the successful expert on lumber was ignorant of central matters like the designation “green.” He also knew things about lumber that nonexperts think are unimportant. People we call ignorant might not be ignorant.
The fact is that predicting the order flow in lumber and the usual narrative had little do with the details one would assume from the outside are important. People who do things in the field are not subjected to a set exam; they are selected in the most non-narrative manner—nice arguments don’t make much difference. Evolution does not rely on narratives, humans do. Evolution does not need a word for the color blue.
So let us call the green lumber fallacy the situation in which one mistakes a source of necessary knowledge—the greenness of lumber—for another, less visible from the outside, less tractable, less narratable.
One has to read Taleb with a grain of salt, recognizing the caricatures he presents for what they are. The passage doesn’t stick with me because it advocates not learning about an investment. For the record, I do believe investors should learn these details. They should know the market well before investing, in fact, and learn as much as they can while evaluating an investment. Those are necessary steps to the insight needed.
Rather, I take it to mean that those insights aren’t necessarily the important aspects of the decision and that, often, the things that are the most important feel less satisfying as narratives. In other words, just because something sounds significant doesn’t mean that it is the most significant factor in a decision. If something is unknowable, making it feel more knowable by wrapping it in a narrative that sounds plausible, doesn’t make it more predictable.
If we think about the future of the company my friend and I were discussing it is very possible that his assessment of customer needs is correct and the company could still be a smashing success.
It is very possible that the company has found a niche in a subset of the market, where its products satisfy those customers’ needs. That niche could be large enough to sustain a high growth rate. That high growth rate allows it to improve its marketing, raise capital at attractive rates, and improve its products. The products then become attractive to more customers, and the company through improved marketing gains credibility and “mind share” with buyers. It continues to grow. Eventually, it’s an established player and a process that was unusual begins to become an accepted process and it’s the market leader. Its revenue continues to grow, and it goes public at the premium multiple typical of high growth market leaders. The investors make a killing.
It’s not clear yet that the company we were discussing will end up that way. But it’s certainly on that path. And, more importantly, many, many enterprise software companies that did end up successful heard those same arguments early in their lives and many investors passed on investing because of those arguments.