A rule of thumb known as Price’s Law can help explain why some companies fail. It reminds us how important it is to understand the nature of the businesses in which we invest.
Price’s Law says that 50% of work at a company is done by a small number of people. Specifically, it says that 50% of work is done by the square root of the number of employees.
There’s no need to break out the middle school math book to understand this. If a company has ten employees, three of them will do 50% of the work and the other seven will do the rest.
If there are 100 employees, only 10 will account for 50% of the work. And if there are 10,000, only 100 will do half. That leaves 9,900 people doing the rest.
Can Businesses Keep Their Stars?
As companies grow, it can become harder to identify who the most productive employees are. Other issues spring from the fact that key employees may be creative, “outside the box” thinkers. They may be difficult for others to work with, and their innovative ideas may be hard to evaluate.
When a company faces a setback, key employees are likely to be the first to leave. Other employers will be glad to offer them jobs. Hiring companies can be expected to offer stock options that are more valuable than what the employees have at their current, faltering company.
Losing 100 employees may not seem like much in a company with 10,000, but the consequences can be catastrophic if these key people can’t be replaced.
The impact of Price’s Law can be brutal in companies that are prone to fast-changing technology or fashion. The very survival of such businesses may depend on the work done by a handful of people who can’t be replaced. We much prefer to own companies without such risk.
Barry Dunaway, CFA®
Executive Vice President & Director of Research
America First Investment Advisors, LLC
This post expresses the views of the author as of the date of publication. America First Investment Advisors has no obligation to update the information in it. Be aware that past performance is no indication of future performance, and that wherever there is the potential for profit there is also the possibility of loss.