I think people who understand compounding act in fundamentally different ways than those who don’t. A person with a foundational grasp of compounding would resemble a venture capitalist. They would probably wear a Patagonia vest, live in California, and like abalone. Their favorite story is probably about rice.
Why Understanding Compounding Makes you Different
When you understand compounding you understand that small things can get big really fast. You internalize that interest on interest or growth on growth becomes ludicrously large. Understanding compounding fundamentally changes how people evaluate opportunities and make decisions. When you truly grasp how small advantages multiply over time, you start thinking like a venture capitalist – always searching for exponential rather than linear growth. Let me give you some examples.
Exponential vs Linear Growth
Linear Growth: Add $1M revenue a year and after 5 years you are making $5 million a year.
Exponential Growth: A company growing at a 50% CAGR from $1 million a year will be making $7.5million a year. The difference becomes even more stark over 10 years. The linear growth company reaches $10M, while the exponential growth company hits $57.7M. This is why VCs obsess over growth rates rather than absolute numbers.Exponetial growth comes from the mechanism where today’s growth creates tomorrow’s growth.
Think about a growing creative agency. It can only grow it’s revenue based on its capacity. It’s capacity is tied to its staff, so any growth is limited by the number of employees it has. But take a company like Slack. Their growth comes not from more staff, but from more users. Users create the value on slack, which attracts more users, which compounds and grows large very quickly.
Venture Capital and Compounding
VCs love companies that can compound revenue over long horizons. Revenue can compound a couple ways.
SaaS ARR – It compounds (given low churn) as new cohorts stack on top of retained ones. Salesforce was initially $5million ARR, but now after two decades of compounding generates $30B a year in ARR
Network Effects – each new partcipant increases the value of the network which accelerates growth. The Airbnb supply of hosts and demand of guests each pushed each other higher in a flywheel effect. Consider LinkedIn: When it launched in 2003, having 100,000 users was nice. But with 875M+ users today, each new connection creates exponentially more potential relationships. One new user in 2003 could connect with hundreds; today they can connect with millions. That’s why we have to pay stupid amounts of money to use it.
Marketplaces – more liquidity compounds. eBay, Etsy, Uber all have marketplaces where more buyers attact more sellers, reinforcing growth. This is basically the same as the above.
Metrics That Compound
So if you are an entrepreneur or a VC what exactly are you looking for? Customer economics that compound are the best sign of a business that compounds. Satisfied customers are gold to any business. The LTV / CAC Ratio is a great example. If your LTV is growing faster than your Cost of Acquisistion, you know you can spend more on marketing. Pour money into it! Another good example is when your retention & expansion both grow. So if your Net Revenue Retention is higher than 100%, that means the existing base is growing itself. Basically, your current customers are spending more than they did last year. Lock that in and recruit aggressively.
Operating Leverage
finally a word on operating leverage. I think it’s one of the most misunderstood ways companies compound profits faster than revenue. The way it works is that initially your fixed costs grow faster while you are scaling. These include HQ, R&D, platform, data centers and other infrastructure. Your variable costs always grow along with revenue, so scale whatever rate you are growing at. But once your fixed costs are covered, each new dollar of revenue “falls through” to profit at a higher percentage. Because you already paid for the costs, your margins are going up, meaning your leverage goes up. Think about Amazon Web Services. Building the data centers was a massive fixed cost. But once that infrastructure exists, incremental customers cost almost nothing to serve. Growing operating leverage will have the effect of massively increasing your cash flow. You will be exploding your cash flow even faster than your revenue. This is why software companies command such high valuations – their operating leverage means each new dollar of revenue generates more profit than the last, creating a compounding effect on the bottom line.
Conclusion
The true power of compounding isn’t just in understanding it intellectually – it’s in deliberately structuring your business to harness it. The most successful companies don’t just grow; they grow in ways that make future growth easier and more profitable. If you are building a business scour your metrics for the ones that are compounding. Put as much effort as possible to grow the positive ones. Compounding fundamentally the most value producing law in all of business. Find where it exists in your business and use it.