“The good news is you came a long way. The bad news is you went the wrong way.” — J. Cole
* * * * * * *
What happens when money grows on trees (for a period of time)
Bull markets teach bad lessons. Typically, when token prices go up for a long period of time, people get conditioned into thinking money grows on trees (think no further than DeFi Summer).
When money turns from a finite to infinite resource, teams start spraying and praying — why not spend $150k on merch, $300k on sending the whole team to conferences, and $1M on a swanky office?
During these frothy times, people begin to think differently. The inner monologue turns from “I may get fired for losing money” to “everyone else is doing it and the token price is still going up so I should spend money too.” It’s an extremely dangerous way of thinking, and yet, very common too.
With the bear market finally upon us, we wanted to write a brief piece on how to spend money more effectively than the next guy. The purpose isn’t to get into the details. Rather, it’s to explore a well-established mental model for spending money that will help you spend more effectively than your peers.
What is capital allocation?
Put simply, capital allocation is a fancy term for three related concepts: (i) figuring out what options you have to invest money into, (ii) estimating the expected return for each option, and (iii) deciding which option(s) you want to put money into.
Why is capital allocation important?
In short, when resources (typically time and money) are finite, it’s important to put resources to their best use. In this case, the “best use” is one that generates the highest financial return on those resources.
It’s also worth noting that if you don’t allocate resources effectively while your competitor does, over time, your competitor will outperform you, and over a very long time horizon, your competitor will beat you out of business.
How does capital allocation work?
For example, imagine you’re a defi protocol like Uniswap. The first step in capital allocation is figuring out what options you have. Uniswap’s options could be:
The intuition behind the first step is straightforward: before you’re ready to spend money, you need to develop a sense for what options you have to spend the money on.
The second step in capital allocation is estimating the expected return for each option. This step is more art than science, but then again, everything about building a company/protocol is more art than science.
An “artistic” way of estimating expected returns for each option could look as follows. (Note: the options below, as well as the numbers, are completely made up for illustrative purposes; to simplify, we also assume Uniswap charges fees that accrue to the protocol).
Having figured out what options we have and estimated the expected return on each option, we can now decide what option we want to deploy money to over the next year.
Out of the options above, Option 1 provides the best bang for your buck — put in $5.5M today, and get $10.5M out in 24 months (12 months to build and 12 months to generate the return). Assuming money is finite, the return-seeking founder would choose Option 1.
Is it really that simple?
In short, no. There is a lot more nuance that goes into the decision.
That said, the purpose of this post is to develop a mental model, or a way of thinking about things, that helps teams make complicated decisions.
Having a well-developed mental model for putting money to work is an incredibly powerful tool. Teams that have the tool and use it well will, on average, win out over teams that don’t have the tool or have the tool and use it improperly.
We think it was Seth Klarman (the notable founder of Baupost Group) that said “in bull markets we learn bull market lessons and in bear markets we learn bear market lessons.” Capital allocation is certainly a bear market lesson, and one worth studying deeply.
* * * * * * *
Other things to consider
A big thank you to Anders Larson, Getty Hill, and Tina He for reviewing drafts of this piece.