On Value Capture

The venture capital industry functions in large part on the belief that great innovators capture the lion’s share of value from their breakthroughs.

This view of entrepreneurial success is derived from the Austrian economist Joseph Schumpeter. A Hapsburg artistocrat working in Vienna, Schumpeter rejected Marx’s view that capitalism was a system heading toward inevitable collapse. But, he also rejected the view of his contemporary John Maynard Keynes that an economy was healthy when it was in static equilibrium. Schumpeter argued that capitalism needed to be a dynamic, almost living organism that constantly reinvented itself through entrepreneurial innovation. For Schumpeter, a true businessman was not a careful accountant or risk-averse manager, but the visionary willing to obliterate existing economic structures and thereby win via creative destruction. Henry Ford and Steve Jobs were Unternehmergeist: entrepreneurial spirits and economic revolutionaries who saw the world not as it was, but as it could be.

Today, in Silicon Valley and tech hubs worldwide, Schumpeter's ghost haunts every startup pitch meeting. The mantra of "disruption" is pure Schumpeterian theology—a reminder that true innovation isn't about improvement, but about rendering the existing model obsolete.

So in re-making the world, how much value does the creatively destroying entrepreneur actually capture from their innovations?

2.2%

At least this is the number calculated by Nobel prize winning economist William Nordhaus in his seminal 2004 paper, “Schumpeterian Profits in the American Economy: Theory and Measurement.”

Nordhaus sought to answer the question, how does innovation drive economic progress? At the heart of Nordhaus's analysis lies the concept of “Schumpeterian Profits.” This term refers to the excess profits that accrue to firms that successfully introduce new products or processes. These profits, often substantial, are the lifeblood of innovation. They incentivize firms to invest in research and development, take risks, and disrupt existing markets.

Nordhaus analyzed technological innovations from 1948 to 2001 using a variety of techniques including economic surplus analysis, patent duration metrics, productivity growth measurements, market competition effects, and value chain analysis. Rather than just focusing on private returns to R&D as innovation economics had traditionally done, he examined total social value creation as a better way to understand innovation dynamics. From this work, Nordhaus calculated that consumers and broader economic ecosystems (e.g., productivity gains, knowledge spillovers) capture roughly 97.8% of all technological value creation.

Consider the smartphone revolution. While Apple's wealth is staggering in absolute terms, it pales compared to the total value smartphones have created: the productivity gains for businesses, the convenience for consumers, the entire ecosystems of apps and services that have transformed daily life. The spoils of innovation, Nordhaus showed, flow primarily to society at large rather than to the innovators themselves.

This pattern repeats across industries and eras. The inventors of containerized shipping, the pioneers of antibiotics, the architects of the internet—all captured only modest portions of the immense value their innovations generated. Market competition, imitation, and the relentless march of progress ensure that revolutionary technologies quickly become commoditized, their benefits diffusing throughout society.

Nordhaus’s work was revolutionary (although interestingly, it was not the work that won him the Nobel which came from his thinking about how to integrate climate change into long-run macroeconomic analysis) because it challenged prevailing economic theories about innovation’s reward mechanisms. Nordhaus illustrated how rapid technological diffusion and market competition systematically erode potential monopoly profits, ultimately benefiting society through lower prices and increased productivity.

While Nordhaus’ economic models show that Schumpeterian profits can significantly boost living standards, he has also cautioned that these benefits are not automatic. Governments must create an environment that encourages innovation, including strong intellectual property rights, a well-educated workforce, and supportive regulatory policies. And he has recognized that innovation can very much be a double-edged sword. While it can lead to remarkable advances, it can also disrupt industries, displace workers, and exacerbate inequality. To mitigate these negative consequences, Nordhaus has advocated for policies that promote a just transition, such as retraining programs and social safety nets.

All of Nordhaus's insight carries profound implications for innovation policy. If entrepreneurs capture such a small share of the value they create, are current incentive structures adequate? Should we rethink patent protection? How do we balance rewarding innovation with ensuring its benefits spread widely?

Perhaps most provocatively, Nordhaus's work suggests that our celebration of individual genius entrepreneurs misses a deeper truth: innovation is fundamentally a collective enterprise, its greatest benefits flowing not to its creators but to society as a whole. In an era of mounting inequality and technological upheaval, this insight feels more relevant than ever.

– Geoffrey W. Smith



First Five
First Five is our curated list of articles, studies, and publications for the month.

1/ Haystacks of Needles
Nicholas Carr recently republished a piece where he unpacks the idea of informational overload. “Information overload takes two forms, which I’ll call situational overload and ambient overload. They need to be treated separately. … Situational overload is the needle-in-the-haystack problem: You need a particular piece of information—in order to answer a question of one sort or another—and that piece of information is buried in a bunch of other pieces of information. … Situational overload is not the problem. When we complain about information overload, what we’re usually complaining about is ambient overload. This is a different beast. Ambient overload doesn’t involve needles in haystacks. It involves haystack-sized piles of needles.” Read more here >

2/ Complexity and Philosophy
“One might think that, once we know something is computable, how efficiently it can be com- puted is a practical question with little further philosophical importance. In this essay, I offer a detailed case that one would be wrong. In particular, I argue that computational complexity theory—the field that studies the resources (such as time, space, and randomness) needed to solve computational problems—leads to new perspectives on the nature of mathematical knowledge, the strong AI debate, computationalism, the problem of logical omniscience, Hume’s problem of induction, Goodman’s grue riddle, the foundations of quantum mechanics, economic rationality, closed timelike curves, and several other topics of philosophical interest. I end by discussing aspects of complexity theory itself that could benefit from philosophical analysis.” Read more here >

3/ The Middle Path to Innovation
“An innovation crisis is brewing in the United States: Too many firms, both large and small, are failing to innovate. As a result, problems remain unsolved, technologies are never invented, and meaningful jobs go uncreated. According to one estimate, lost productivity cost the economy more than $10 trillion between 2006 and 2018, roughly equivalent to $95,000 per U.S. worker. We believe that a primary cause of this crisis is the polarized approach companies take to innovation. At one end of the spectrum, corporations increasingly focus R&D efforts on product refreshes and incremental line upgrades. … At the other end, venture capitalists favor high-risk “transformational” innovations that seek to upend industries and generate outsize returns. … [W]e suggest targeting the large gap in the middle of the innovation spectrum.” Read more here >

4/ Ramsey Theory: order from chaos
“When he died in 1930 at just 26 years old, Frank Ramsey had already made transformative contributions to philosophy, economics and mathematics. John Maynard Keynes sought his insights; Ludwig Wittgenstein admired him and considered him a close friend. In his lifetime, Ramsey published only eight pages on pure math: the beginning of a paper about a problem in logic. But in that work, he proved a theorem that ultimately led to a whole new branch of mathematics — what would later be called Ramsey theory. His theorem stated that if a system is large enough, then no matter how disordered it might be, it’s always bound to exhibit some sort of regular structure. Order inevitably emerges from chaos; patterns are unavoidable.” Read more here >

5/ The Information Theory of Aging
“Information storage and retrieval is essential for all life. In biology, information is primarily stored in two distinct ways: the genome, comprising nucleic acids, acts as a foundational blueprint and the epigenome, consisting of chemical modifications to DNA and histone proteins, regulates gene expression patterns and endows cells with specific identities and functions. Unlike the stable, digital nature of genetic information, epigenetic information is stored in a digital-analog format, susceptible to alterations induced by diverse environmental signals and cellular damage. The Information Theory of Aging (ITOA) states that the aging process is driven by the progressive loss of youthful epigenetic information, the retrieval of which via epigenetic reprogramming can improve the function of damaged and aged tissues by catalyzing age reversal.” Read more here >



Did You Know?
In this section of our newsletter, we seek to demystify common terms and practices in our work as investors.

Pre/Post Money Valuation
Pre-money valuation refers to a company's valuation prior to external funding or not including the latest round of funding. This gives investors an indication of the current value of the business as well as the value of each share that has been issued.

On the other hand, post-money valuation refers to a company's value after is has received outside funding or the latest round of financing. Post-money valuation is equal to the pre-money valuation plus the amount invested. The distinction between the two matters because it affects equity ownership percentages of investors.

– Haiming Chen & Dylan Henderson

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