Don't let Diseconomies of Scale Kill Your Idea

Last Updated Sep 12, 2008 5:38 PM EDT

One of the main challenges to breakthrough ideas happens because these ideas sit outside the most efficient financing structures. That's the theme of a long response to my post Silicon Valley is Dead, about the new book "Closing the Innovation Gap," by Judy Estrin. In my post, I mentioned the problems of diseconomies of scale, when a company or entity becomes so big it starts costing it more to produce goods. I cited Jeff Angus, who runs the Management by Baseball blog. He sent me a further note on Silicon Valley and its diseconomies of scale, and allowed me to repost it here.

A quick summary, since it is a long note: He says a problem with something like the Sand Hill Road model of venture capital as it stands is that its stuck in its own structure.

The scale they are willing to work in is "diseconomic", their structures too rigid for them to morph to meet the inconvenient structures of these high-growth potential areas. To break the impasse, I suspect, it will take the government creating borrowing/buying alternatives to traditional market structures (as they did w/Arpanet, the fledgling airline industry, the fledgling auto industry, and so on). As inconceivable as it seems in the current bi-partisan political commitment against such a thing, it's more conceivable than the Sand Hill Dudes changing their protocols.
In other words, if you have a breakthrough idea, you might find you're going to need to get creative about getting it financed. That doesn't have to be a daunting thing. Since 2001, 55 percent of companies that went public did so without raising any money from venture capitalists, according to the Center for Venture Research (11 percent of those firms did raise money from angel investors).

Here's his full note:

There's another challenge in the Estrin view, though it may *indirectly* support her.

When the finance infrastructure (venture, investment funds, etc.), which are essentially janitorial (support services) start running the show, the overall business system suffers/works ineffectively. The finance teams Estrin refers to are looking for technologies that work for their existing way of investing and biases (first to market cult; many losers+a few big winners protocol; etc.).

They are structured for their own convenience, not maximum overall results. They are not looking for a $1MM investment that nets $5MM in three years, or a thousand such deals. They are not looking (generally) for a $5MMM investment that nets $10MMM in five years. You already know what they are looking for, because their protocols push them to specific size/shape deals that fit in a range they already know.

So what happens when the blockbuster (that is, benefit/cost) gains to be made are outside of the very specific scale and structure their blinders allow them to see? Well, those prospective blockbusters either get funded by alternative, non-market means (Governments, Gates Fdn, et.al.) or not at all.

The renewable energy field is one of the areas where the Diseconomies of Scale have been a barrier to deployment forever, at least since 1974 when I started working at the U.S. Senate on policy and programs. The technology is there, and has changed very very little in the last 31 years (outside of photovoltaics, but even there, the price/performance ratios are roughly the same). BUT THE PEAK EFFECTIVENESS OF MOST OF THESE TECHNOLOGIES ONLY HAPPENS IN DECENTRALIZED SETTINGS, smaller installations close to consumption.

You probably already know, for example, that ~2/3rds of all electricity generated is waste, "transmission loss". So the vast photovoltaic arrays in the desert that deliver juice to cities 75+ miles away are doomed/constrained to lose more juice than gets delivered. The same $ investment on individual neighborhood arrays or individual house arrays deliver more juice for less complexity & the same money, high *system* returns. But from the Sand Hill Dudes' view, the latter is complicated, because how do they make it fit their protocol. Wind generation has roughly the same factors.

Like Arpanet, the best 75% of Alternative/renewable energy projects/ideas are generally nothing that fits the protocol. Instead of getting things moving three decades ago, the finance guys waited for subsidies or set-asides that would make these endeavors fit their narrow protocols. They don't *want* to change protocols (¿well, who does if they don't have to?) so they instead "complain" that there aren't great mega-deals out there (I'm not sure they're complaining...just sitting on their hands, probably).

The scale they are willing to work in is "diseconomic", their structures too rigid for them to morph to meet the inconvenient structures of these high-growth potential areas. To break the impasse, I suspect, it will take the government creating borrowing/buying alternatives to traditional market structures (as they did w/Arpanet, the fledgling airline industry, the fledgling auto industry, and so on). As inconceivable as it seems in the current bi-partisan political commitment against such a thing, it's more conceivable than the Sand Hill Dudes changing their protocols.

Sometimes The Diseconomies of Scale lead to a proliferation of effective small-scale solutions; when captialism is flushed out of the system by the finance guys, it can lead to a dysfunctional systemic paralysis.

Cheers,
Jeff Angus
Management by Baseball

  • Michael Fitzgerald

    Michael Fitzgerald writes about innovation and other big ideas in business for publications like the New York Times, The Economist, Fast Company, Inc. and CIO. He’s worked as a writer or editor at Red Herring, ZDNet, TechTV and Computerworld, and has received numerous awards as a writer and editor. Most recently, his piece on the hacker collective the l0pht won the 2008 award for best trade piece from the American Society of Journalists and Authors. He was also a 2007 Templeton-Cambridge Journalism Fellow in Science and Religion.