Labor and Capital Are Old Leverage

Everyone is fighting over labor and capital

Our brains aren’t evolved to comprehend new forms of leverage

Nivi: Why don’t we talk a little bit about leverage?

The first tweet in the storm was a famous quote from Archimedes, which was, “Give me a lever long enough and a place to stand and I will move the Earth.”

The next tweet was, “Fortunes require leverage. Business leverage comes from capital, people and products with no marginal costs of replication.”

Naval: Leverage is critical. The reason I stuck in Archimedes quote in there is… normally I don’t like putting other people’s quotes in my Twitter. That doesn’t add any value. You can go look up those people’s quotes. But this quote I had to put in there because it’s just so fundamental. I read it when I was very, very young and it had a huge impression on me.

We all know what leverage is when we use a seesaw or a lever. We understand how that works physically, but I think what our brains aren’t really well-evolved to comprehend is how much leverage is possible in modern society and what the newest forms of leverage are.

Society overvalues labor leverage

The oldest form of leverage is labor, which is people working for you. Instead of me lifting rocks, I can have 10 people lift rocks. Then just by my guidance on where the rock should go, a lot more rocks get moved than I could do myself. Everybody understands this because we’re evolved to understand the labor form of leverage, so what happens is society overvalues labor as a form of leverage.

This is why your parents are impressed when you get a promotion and you have lots of people working underneath you. This is why when a lot of naive people, when you tell them about your company, they’ll say, “How many people work there?” They’ll use that as a way to establish credibility. They’re trying to measure how much leverage and impact you actually have.

Or when someone starts a movement, they’ll say how many people they have or how big the army is. We just automatically assume that more people is better.

You want the minimum amount of labor that allows you to use the other forms of leverage

I would argue that this is the worst form of leverage that you could possibly use. Managing other people is incredibly messy. It requires tremendous leadership skills. You’re one short hop from a mutiny or getting eaten or torn apart by the mob.

It’s incredibly competed over. Entire civilizations have been destroyed over this fight. For example, communism, Marxism, is all about the battle between capital and labor, das kapital and das labor. It’s kind of a trap.

You really want to stay out of labor-based leverage. You want the minimum amount of people working with you that are going to allow you to use the other forms of leverage, which I would argue are much more interesting.

Capital has been the dominant form of leverage in the last century

The second type of leverage is capital. This one’s a little less hardwired into us because large amounts of money moving around and being saved and being invested in money markets, these are inventions of human beings the in last few hundred to few thousand years. They’re not evolved with us from hundreds of thousands of years.

We understand them a little bit less well. They probably require more intelligence to use correctly, and the ways in which we use them keep changing. Management skills from a hundred years ago might still apply today, but investing in the stock market skills from a hundred years ago probably don’t apply to the same level today.

Capital is a trickier form of leverage to use. It’s more modern. It’s the one that people have used to get fabulously wealthy in the last century. It’s probably been the dominant form of leverage in the last century.

You can see this by who are the richest people. It’s bankers, politicians in corrupt countries who print money, essentially people who move large amounts of money around.

If you look at the top of very large companies, outside of technology companies, in many, many large old companies, the CEO job is really a financial job. They’re really financial asset managers. Sometimes, an asset manager can put a pleasant face on it, so you get a Warren Buffet type.

But deep down, I think we all dislike capital as a form of leverage because it feels unfair. It’s this invisible thing that can be accumulated and passed across generations and suddenly seems to result in people having gargantuan amounts of money with nobody else around them or necessarily sharing in it.

That said, capital is a powerful form of leverage. It can be converted to labor. It can be converted to other things. It’s very surgical, very analytical.

If you are a brilliant investor and give $1 billion and you can make a 30% return with it, whereas anybody else can only make a 20% return, you’re going to get all the money and you’re going to get paid very handsomely for it.

It scales very, very well. If you get good at managing capital, you can manage more and more capital much more easily than you can manage more and more people.

You need specific knowledge and accountability to obtain capital

It is a good form of leverage, but the hard part with capital is how do you obtain it? That’s why I talked about specific knowledge and accountability first.

If you have specific knowledge in a domain and if you’re accountable and you have a good name in that domain, then people are going to give you capital as a form of leverage that you can use to then go get more capital.

Capital also is fairly well understood. I think a lot of the knocks against capitalism come because of the accumulation of capital.

Product and Media Are New Leverage

Create software and media that work for you while you sleep

Product and media are the new leverage

Naval: The most interesting and the most important form of leverage is this idea of products that have no marginal cost of replication. This is the new form of leverage.

This was only invented in the last few hundred years. It got started with the printing press. It accelerated with broadcast media, and now it’s really blown up with the Internet and with coding.

Now, you can multiply your efforts without having to involve other humans and without needing money from other humans.

This podcast is a form of leverage. Long ago, I would have had to sit in a lecture hall and lecture each of you personally. I would have maybe reached a few hundred people and that would have been that.

Then 40 years ago, 30 years ago, I would have to be lucky to get on TV, which is somebody else’s leverage. They would have distorted the message. They would taken the economics out of it or charged me for it. They would have muddled the message, and I would have been lucky to get that form of leverage.

Today, thanks to the Internet, I can buy a cheap microphone, hook it up to a laptop or an iPad, and there you are all listening.

Product leverage is where the new fortunes are made

This newest form of leverage is where all the new fortunes are made, all the new billionaires. The last generation, fortunes were made by capital. That was the Warren Buffets of the world.

But the new generation’s fortunes are all made through code or media. Joe Rogan making 50 to a 100 million bucks a year from his podcast. You’re going to have a PewDiePie. I don’t know how much money he’s rolling in, but he’s bigger than the news. The Fortnite players. Of course Jeff Bezos and Mark Zuckerberg and Larry Page and Sergey Brin and Bill Gates and Steve Jobs. That is all code-based leverage.

Combining all three forms of leverage is a magic combination

Now, the beauty is when you combine all of these three. That’s where tech startups really excel, where you take just the minimum, but highest output labor that you can get, which are engineers, and designers, product developers. Then you add in capital. You use that for marketing, advertising, scaling. You add in lots of code and media and podcasts and content to get it all out there.

That is a magic combination, and that’s why you see technology startups explode out of nowhere, use massive leverage and just make huge outsize returns.

Product and media leverage are permissionless

Nivi: Do you want to talk a little bit about permissioned versus permissionless?

Naval: Probably the most interesting thing to keep in mind about the new forms of leverage is they are permissionless. They don’t require somebody else’s permission for you to use them or succeed.

For labor leverage, somebody has to decide to follow you. For capital leverage, somebody has to give you money to invest or to turn into a product.

Coding, writing books, recording podcasts, tweeting, YouTubing, these kinds of things, these are permissionless. You don’t need anyone’s permission to do them, and that’s why they are very egalitarian. They’re great equalizers of leverage.

As much as people may rail on Facebook and YouTube, they’re not going to stop using it because this permissionless leverage, where everyone can be a broadcaster, is just too good.

The same way you can rail upon Apple for having a slightly closed ecosystem in the iPhone, but everyone’s writing apps for it. As long as you can write apps for it, you can get rich or reach users doing that, why not?

The robot army is already here—code lets you tell them what to do

I think of all the forms of leverage, the best one in modern society … This is glib. This is a little overused. This is why I tell people learn to code. It’s that we have this idea that in the future there’s going to be these robots and they’re going to be doing everything.

That may be true, but I would say that the majority of the robot revolution has already happened. The robots are already here and there are way more robots than there are humans, it’s just that we pack them in data centers for heat and efficiency reasons. We put them in servers. They’re inside the computers. All the circuits, it’s robot minds inside that’s doing all the work.

Every great software developer, for example, now has an army of robots working for him at nighttime, while he or she sleeps, after they’ve written the code and it’s just cranking away.

The robot army is already here. The robot revolution has already happened. We’re about halfway through it. We’re just adding in much more of the hardware component these days as we get more comfortable with the idea of autonomous vehicles and autonomous airplanes and autonomous ships and maybe autonomous trucks. There’re delivery bots and Boston Dynamics robots and all that.

But robots who are doing web searching for you, for example, are already here. The ones who are cleaning up your video and audio and transmitting it around the world are already here. The ones who are answering many customer service queries, things that you would have had to call a human for are already here.

An army of robots is already here. It’s very cheaply available. The bottleneck is just figuring out intelligent and interesting things to do to them.

Essentially you can order this army of robots around. The commands have to be issued in a computer language, in a language that they understand.

These robots aren’t very smart. They have to be told very precisely what to do and how to do it. Coding is such a great superpower because now you can speak the language of the robot armies and you can tell them what to do.

Nivi: I think at this point, people are not only commanding the army of robots within servers through code, they’re actually manipulating the movement of trucks, of other people. Just ordering a package on Amazon, you’re manipulating the movement of many people and many robots to get a package delivered to you.

People are doing the same things to build businesses now. There’s the army of robots within servers and then there’s also an army of actual robots and people that are being manipulated through software.

Product Leverage is Egalitarian

The best products tend to be available to everyone

Product leverage is a positive-sum game

Naval: Labor and capital are much less egalitarian, not just in the inputs, but in their outputs.

Let’s say that I need something that humans have to provide like if I want a massage or if I need someone to cook my food. The more of a human element there is in providing that service, the less egalitarian it is. Jeff Bezos probably has much better vacations than most of us because he has lots of humans running around doing whatever he needs to do.

If you look at the output of code and media, Jeff Bezos doesn’t get to watch better movies and TV than we do. Jeff Bezos doesn’t get to even have better computing experience. Google doesn’t give him some premium, special Google account where his searches are better.

It’s the nature of code and media output that the same product is accessible to everybody. It turns into a positive sum game where if Jeff Bezos is consuming the same product as a thousand other people, that product is going to be better than the version that Jeff would consume on his own.

Status goods are limited to a few people

Whereas with other products, that’s not true. If you look at something like buying a Rolex, which is no longer about telling time. It’s a signaling good. It’s all about showing off, “I have a Rolex.” That’s a zero-sum game.

If everybody in the world is wearing a Rolex, then people don’t want to wear Rolexes anymore because they no longer signal. It’s canceled out the effect.

Rich people do have an advantage in consuming that product. They’ll just price it up until only they can have Rolexes. Then poor people can’t have Rolexes and Rolexes resume their signaling value.

The best products tend to be targeted at the middle class

Something like watching Netflix or using Google or using Facebook or YouTube or even frankly modern day cars. Rich people don’t have better cars. They just have weirder cars.

You can’t drive a Lamborghini on the street at any speed that makes sense for a Lamborghini, so it’s actually a worse car in the street. It just turned into a signaling good at that point. Your sweet spot, where you want to be, is somewhere like a Tesla Model 3 or like a Toyota Corolla which is an amazing car.

A new Toyota Corolla is a really nice car, but because it’s mainstream, the technology has amortized the cost of production over the largest number of consumers possible.

The best products tend to be at the center, at the sweet spot, the middle class, rather than being targeted at the upper class.

Creating wealth with product leads to more ethical wealth

I think one of the things that we don’t necessarily appreciate in modern societies is as the forms of leverage have gone from being human-based, labor-based and being capital-based to being more product and code and media-based, that most of the goods and services that we consume are becoming much more egalitarian in their consumption.

Even food is becoming that way. Food is becoming cheap and abundant, at least in the first world, too much so to our detriment. Jeff Bezos isn’t necessarily eating better food. He’s just eating different food or he’s eating food that’s prepared and served theatrically, so it’s almost like more of again the human element of performance.

But the labor element out of food production has gone down massively. The capital element has gone down massively. Even food production itself has become more technology-oriented, and so the gap between the haves and the have-nots is getting smaller.

If you care about ethics in wealth creation, it is better to create your wealth using code and media as leverage because then those products are equally available to everybody as opposed to trying to create your wealth through labor or capital.

You want to use the product that is used by the most people

What I’m referring to here is scale economies. Technology products and media products have such amazing scale economies that you always want to use the product that is used by the most people. The one that’s used by the most people ends up having the largest budget. There’s no marginal cost of adding another user, and so with the largest budget, you get the highest quality.

The best TV shows are actually not going to be some obscure ones just made for a few rich people. They’re going to be the big budget ones, like the Game of Thrones or the Breaking Bad or Bird Box, where they have massive, massive budgets. They can just use those budgets to get to a certain quality level.

Then rich people, to be different, they have to fly to Sundance and watch a documentary. You and I aren’t going to fly to Sundance because that’s something that bored rich people do to show off. We’re not going to watch a documentary because most of them just aren’t actually even that good.

Again, if you’re wealthy today, for large classes of things, you spend your money on signaling goods to show other people that you’re wealthy, then you try and convert them to status. As opposed to actually consuming the goods for their own sake.

Nivi: People and capital as a form of leverage have a negative externality and code and product have a positive externality attached to them, if I was going to sum up your point.

Capital and labor are becoming permissionless

I think that capital and labor are also starting to become a little more permissionless or at least the permissioning is diffuse because of the Internet. Instead of labor, we have community now, which is a diffused form of labor. For example, Mark Zuckerberg has a billion people doing work for him by using Facebook.

Instead of going to raise capital from someone who’s rich, now we have crowdfunding. You can raise millions and millions of dollars for a charity, for a health problem or for a business. You can do it all online.

Capital and labor are also becoming permissionless, and you don’t need to necessarily do it the old fashioned way, where you have to go around and ask people for permission to use their money or their time.

Pick a Business Model with Leverage

An ideal business model has network effects, low marginal costs and scale economies

Scale economies: the more you produce, the cheaper it gets

Nivi: One more question about leverage. Do you think a choice of business model or a choice of product can also bring a kind of leverage to it?

For example, pursuing a business that has network effects. Pursuing a business that has brand effects. Or other choices of business model that people could manipulate that just give you free leverage.

Naval: Yeah, there’s some really good microeconomic concepts that are important to understand.

One of those is scale economies, which is the more you produce of something the cheaper it gets to make it. That’s something that a lot of businesses have, Basic Economics 101.

You should try and get into a business where making Widget Number 12 is cheaper than making Widget Number 5, and making Widget Number 10,000 is a lot cheaper than the previous ones. This builds up an automatic barrier to entry against competition and getting commoditized. That’s an important one.

Zero marginal cost of reproduction: producing more is free

Another one is, and this is along the same lines, but technology products especially, and media products, have this great quality where they have zero marginal cost of reproduction. Creating another copy of what you just created is free.

When somebody listens to this podcast or watches a YouTube video about this, it doesn’t cost me anything for the next person who shows up. Those zero marginal cost things, they take a while to get going because you make very little money per user, but over time they can really, really add up.

Joe Rogan is working no harder on his current podcast than he was on Podcast number 1, but on Podcast number 1,100 he’s making a million dollars from the podcast whereas for the previous one he probably lost money; for the first one. That’s an example of zero marginal cost.

Network effects: value grows as the square of the customers

Then, the most subtle but the most important is this idea of network effects. It comes from computer networking. Bob Metcalfe, who created Ethernet, famously coined Metcalfe’s Law, which is the value of a network is proportional to the square of the number of nodes in the network.

If a network of size 10 would have a value of a 100, a network of a size 100 would have a value of 10,000. It’s not just 10 times more, it’s 100 times more, because of the square; the difference is the square.

You want to be in a network effects business, assuming you’re not number two. If you’re number one in network effect business, you win everything. Example: if you look at Facebook, your friends and family social networking protocol. Who’s their competitor? Nobody, because they won everything through network effects. Which is why when people say, “Well, I can just switch away from Facebook,” they don’t realize that network effects create natural monopolies. They’re very, very powerful things.

Network effect businesses are natural monopolies

One of the dirty secrets of Silicon Valley is that a lot of the winning businesses are natural monopolies. Even ride-sharing tends towards one winner-take-all system.

Uber will always have better economics than Lyft, as long as it’s moving more drivers and more riders around. Something like Google, there’s basically only one viable search engine. I do like DuckDuckGo, privacy reasons, but they’re just always gonna be behind because of network effects. Twitter: where else would you go for microblogging? Even YouTube has weak network effects, but they’re still powerful enough that there’s really no number two site that you go to, to consume your video on a regular basis. It even turns out in e-tail, Amazon Prime and kind of the convenience of stored credit cards and information creates a powerful network effect.

In a network effect, each new user adds value to the existing users

What is a network effect? Let’s just define it precisely. A network effect is when each additional user adds value to the existing user base. Your users themselves are creating some value for the existing users.

The classic example that I think everybody can understand is, language. Let’s say that there’s 100 people living in the community and speak 10 different languages, and each person just speaks one of those 10. Well, you’re having to translate all the time; it’s incredibly painful. But if all 100 of you spoke the same language, it would add tremendous value.

The way that community will play out is, 10 people start off speaking 10 languages, and let’s say one extra person learns English. Well, now all of a sudden, 11 people know English, so the next person comes in to learn a new language is probably going to chose English. At some point, let’s say English gets to 20 or 25 people, it’s done. It’s just going to own the entire language marketplace, and the rest of the languages will get competed out.

Which is why, long-term, the entire world is probably going to end up speaking English and Chinese. China’s closed off on the Internet, but the Internet itself is a great leveler, and people who want to communicate on the Internet are forced to speak English because the largest community of people on the Internet speaks English.

I always feel bad for my colleagues who grew up speaking foreign languages in foreign countries, because you don’t have access to so many books; so many books just haven’t been translated into other languages. If you only spoke French, or you only spoke German, or you only spoke Hindi, for example, you would be at a severe disadvantage in a technical education.

Invariably, if you go and get a technical education, you have to learn English just because you have to read these books that have this data that has not been translated. Languages are probably the oldest example of network effect.

Money is another example. We should all probably be using the same money, except for the fact that geographic and regulatory boundaries have created these artificial islands of money. But even then, the world tends to use a single currency as the reserve currency at most times; currently, the US dollar.

Zero marginal cost businesses can pivot into network effect businesses

Network effects are a very powerful concept, and when you’re picking a business model, it’s a really good idea to pick a model where you can benefit from network effects, low marginal costs, and scale economies; and these tend to go together.

Anything that has zero marginal costs of production obviously has scale economies, and things that have zero marginal costs of reproduction very often tend to have network effects, because it doesn’t cost you anything more to stamp out the thing. So then you can just create little hooks for users to add value to each other.

You should always be thinking about how your users, your customers, can add value to each other because that is the ultimate form of leverage. You’re at the beach in the Bahamas or you’re sleeping at night and your customers are adding value to each other.

Example: From Laborer to Entrepreneur

From low to high specific knowledge, accountability and leverage

Laborers get paid hourly and have low accountability

Naval: The tweetstorm is very abstract. It’s deliberately meant to be broadly applicable to all kinds of different domains and disciplines and time periods and places. But sometimes it’s hard to work without a concrete example. So let’s go concrete for a minute.

Look at the real estate business. You could start at the bottom, let’s say you’re a day laborer. You come in, you fix people’s houses. Someone orders you around, tells you, “Break that piece of rock. Sand that piece of wood. Put that thing over there.”

There’s just all these menial jobs that go on, on a construction site. If you’re working one of those jobs, unless you’re a skilled trade, say, a carpenter or electrician, you don’t really have specific knowledge.

Even a carpenter or an electrician is not that specific because other people can be trained how to do it. You can be replaced. You get paid your $15, $20, $25, $50, if you’re really lucky, $75 an hour, but that’s about it.

You don’t have any leverage other than from the tools that you’re using. If you’re driving a bulldozer that’s better than doing it with your hands. A day laborer in India makes a lot less because they have no tool leverage.

You don’t have much accountability. You’re a faceless cog in a construction crew and the owner of the house or the buyer of the house doesn’t know or care that you worked on it.

General contractors get equity, but they’re also taking risk

One step up from that, you might have a contractor, like a general contractor who someone hires to come and fix and repair and build up their house. That general contractor is taking accountability; they’re taking responsibility.

Now let’s say they got paid $250,000 for the job. Sorry, I’m using Bay Area prices, so maybe I’ll go rest of the world prices, $100,000 for the job to fix up a house, and it actually costs the general contractor, all said and done, $70,000. That contractor’s going to pocket that remaining $30,000.

They got the upside. They got the equity but they’re also taking accountability and risk. If the project runs over and there’s losses, then they eat the losses. But you see, just the accountability gives them some form of additional potential income.

Then, they also have labor leverage because they have a bunch of people working for them. But it probably tops out right there.

Property developers pocket the profit by applying capital leverage

You can go one level above that and you can look at a property developer. This might be someone who is a contractor who did a bunch of houses, did a really good job, then decided to go into business for themselves and they go around looking for beaten down properties that have potential.

They buy them, they either raise money from investors or front it themselves, they fix the place up, and then they sell it for twice what they bought it for. Maybe they only put in 20% more, so it’s a healthy profit.

So now a developer like that takes on more accountability, has more risk. They have more specific knowledge because now you have to know: which neighborhoods are worth buying in. Which lots are actually good or which lots are bad. What makes or breaks a specific property. You have to imagine the finished house that’s going to be there, even when the property itself might look really bad right now.

There’s more specific knowledge, there’s more accountability and risk, and now you also have capital leverage because you’re also putting in money into the project. But conceivably, you could buy a piece of land or a broken-down house for $200,000 and turn it into a million dollar mansion and pocket all the difference.

Architects, large developers and REITs are even higher in the stack

One level beyond that might be a famous architect or a developer, where just having your name on a property, because you’ve done so many great properties, increases its value.

One level up from that, you might be a person who decides, well, I understand real estate, and I now know enough of the dynamics of real estate that rather than just build and flip my own properties or improve my own properties, I’m gonna be a massive developer. I’m going to build entire communities.

Now another person might say, “I like that leverage, but I don’t want to manage all these people. I want to do it more through capital. So I’m gonna start a real estate investment trust.” That requires specific knowledge not just about investing in real estate and building real estate, but it also requires specific knowledge about the financial markets, and the capital markets, and how real estate trusts operate.

Real estate tech companies apply the maximum leverage

One level beyond that might be somebody who says, “Actually, I want to bring the maximum leverage to bear in this market, and the maximum specific knowledge.” That person would say, “Well, I understand real estate, and I understand everything from basic housing construction, to building properties and selling them, to how real estate markets move and thrive, and I also understand the technology business. I understand how to recruit developers, how to write code and how to build good product, and I understand how to raise money from venture capitalists and how to return it and how all of that works.”

Obviously not a single person may know this. You may pull a team together to do it where each have different skill sets, but that combined entity would have specific knowledge in technology and in real estate.

It would have massive accountability because that company’s name would be a very high risk, high reward effort attached to the whole thing, and people would devote their lives to it and take on significant risk.

It would have leverage in code with lots of developers. It would have capital with investors putting money in and the founder’s own capital. It would have labor of some of the highest quality labor that you can find, which is high quality engineers and designers and marketers who are working on the company.

Then you may end up with a Trulia or a RedFin or a Zillow kind of company, and then the upside could potentially be in the billions of dollars, or the hundreds of millions of dollars.

As you layer in more and more kinds of knowledge that can only be gained on the job and aren’t common knowledge, and you layer in more and more accountability and risk-taking, and you layer in more and more great people working on it and more and more capital on it, and more and more code and media on it, you keep expanding the scope of the opportunity all the way from the day-laborer, who might just literally be scrappling on the ground with their hands, all the way up to somebody who started a real estate tech company and then took it public.