In the article you will learn:
- why IT investments are less risky than any other industry
- when exactly the investor enters, and when it is too early for him to do this
- why venture happens only in IT and biotechnology and nowhere else
- and a few more interesting things.
Let's go.
When they talk about the digital economy, everyone recalls William Janeway's book Capitalism in an Innovative Economy, which has been part of the Financial Times Gold Library since 2012. The book is based on the study of Dr. W. Genway, where both the device of the digital economy and the sources and mechanisms for its financing are studied.
The main idea of the book is that venture capital went into the digital economy not because there are more risks, but because in fact there are less risks than in other sectors of the economy when it comes to research and development. Venture capitalists are willing to finance innovative companies, not because they suddenly caught fire with the idea of risking everything, but because of a simple fact:
Internet-based technologies have connected states and many large companies so firmly and inextricably that they have to take part in the risks of the IT industry.These are gorgeous guarantees that are not anywhere else.
New technologies carry no risks? Real?
For startups (especially) of the early stages, technology is not critical at all - these are bricks that fall free on the road. Just as you can quietly connect to the transmission network and the supplier will not notice this, the startup with a small reach will quite simply use:
- Internet (free technological infrastructure) By the way, everything is not so simple with GPS, because the military sits tight inside GPS, but it is thanks to their budgets that we have free civilian geolocation throughout the planet
- open source software, the use of which reduces to about zero the technological barrier to entrance of the industry. Open source models have now begun to be used in other industries, such as hardware and biotechnology
- cloud computing, where based on typical resource designers, they will quickly test hypotheses and find (or not) a business. The cost of the cloud begins from scratch and increases linearly in business size
- modern high-level programming languages, which simplifies their use for less experienced programmers. Again: site and application designers allow startups to quickly reach proven solutions in the market
As a result, the word "technology" itself (in relation to early-stage startups) became incorrect.
Too many people still believe that the digital economy, these are single scientists who invent something there and use very incomprehensible technologies for this. In laboratories, this is possible, but in the digital economy - by no means.
The fact that technology is being compromised does not mean that this is not a problem. We need talent to build ideas in an innovative way, but on the basis of available technologies. Real innovation begins when commoditized technologies no longer meet the needs of a growing company.
Although many of our systems are based on the latest computer science research, this is often not enough: Our architects and engineers often use inventions not yet approved by science. Many of the problems we face are not addressed in textbooks, and so we are — with great pleasure — inventing new solutions.
So, the most advanced technologies in the digital field were invented and introduced by large IT companies that faced restrictions, trying to serve hundreds of millions of users: for example, MapReduce, NoSQL or OpenStack technology from Facebook.
Traditional companies
To understand why the venture entered the digital economy despite scientific and technological risks, we will first figure out how the company grows in a non-digital economy.
At first, technological and marketing risks have the same weight: you need to both create a product and tell potential investors, employees and customers about it. It's in theory.
In practice, state budgets (in the form of state programs, grants and subsidies) cover the costs of some product research and allow the company to move faster to the development stage, which compensates for a significant part of technological risk at an early stage. This reduces the need for start-up capital, which often comes from an individual investor or from the free cash flow of an existing company.
At the next stage the weight of scientific and technical risk comes down to zero, and all risk is on other front now: marketing and distribution. It is connected with the fact that the product is completely developed and packed to a conclusion to the mass market. That is, risk not to find the solvent market for a product — the most important. Again research and development goes by.
In traditional economy it is enough to private investors to show the working prototype which can be felt and to add any research of the market from the venerable company where it is visible that the market is also he grows. In total: the investor is ready to give money for marketing and realization. Where here risk of incorrect technology? It is absent.
If marketing and distributor efforts were successful and the startup at last found the solvent niche (I reached "market fit"), it passes to a new stage of development — domination. Usually at this time he is brought to the IPO (we will remind: in traditional economy of the IPO carry out most often at an early stage).
It is important to explain here that dominance is the only way to protect against the risk of the emergence of new technologies. Only when the company is the leader in niche, its scale is large enough to keep competitors at a distance. The leader always has a lot of money for advertising to brainwash customers whose iPhone is the best. Moreover, the leading company can specifically increase the barrier to entrance of competitors in the niche (patenting, buying startups, deliberately ignoring innovative solutions in product or worse). So it keeps the scientific and technical risk low: simply no one hears more innovative and useful beginners in the shadow of a huge leader.
Technological risk here can grow, but it still remains below 50%: this is the risk that the company takes to introduce efficiency innovations (thus freeing up capital and making more money for shareholders) or innovating new versions of products (shipping new products that help keep competitors at a distance).
During this period, the only danger is a competitor who is ready to carry a higher level of technological risk and thereby break the barrier to entrance a radically innovative product.
So, for example, Japanese automakers destroyed the American auto industry in the 1970s.
As a result, technology risk is almost never financed by investors:
- the first stage is partially financed by the state;
- intermediate stages are associated with more visible risks in marketing and sales;
- at the last stage, operational efficiency and renewal are financed by the free cash flow of the new startup.
Digital Companies
Now let's look at digital companies.
Compared to traditional ones, "digital" startups have 3 main differences:
- Gray zone on the left - MVP development. Here, startups select the right combination of commoditized technologies, and all this time you can not open legal entities at all. As a result, business begins much later than product development in the traditional economy, and the creation of a company falls on a period where the level of technological risk is already very low. And potential losses of investors - too.
- Finding a startup a solvent niche ("market fit") occurs much earlier than in traditional companies. This is due to the fact that technological entrepreneurs have turned the development of the client into science: hacking audience growth and even crowdfunding are powerful tools that are not in a non-digital economy in principle. Instead of winning the market by mass marketing (= deferred market fit), it is enough to find early followers (= early market fit) and grow on the feedback of this community (= crossing the "death valley").
- A digital startup occupies a dominant position before the traditional one for one simple reason: the winner receives everything.
In the digital economy, the leader is the one who runs faster. Therefore, IT startups have such a big return on investment.
There are at least four reasons why digital companies tend to grow exponentially.
Scale effect
Several centuries of history have shown that the larger the scale of sales, the cheaper the cost of production.
True, there are limits: demand ceases to grow exponentially, factories reach maximum capacity, logistics becomes more complicated, new customers become more difficult to convert, the scale ceases to be an advantage and turns into an obligation - so most companies cannot go beyond a certain market share. Well, it is, by the way.
The drop in Amazon's sales value (see figure above) illustrates economies of scale in a traditional industry, such as retail.
Network effects
Most tech companies connect users to each other, providing communication between them either directly (sharing content with our Facebook friends) or indirectly (reading another user on the Amazon product page). Such connections turn users into nodes and trigger powerful network effects. When they work, the value created for each particular user increases exponentially as the number of these users increases. The larger the business that has a network effect in the development model, the easier and cheaper it is to purchase new users. In addition, the more users the application has, the easier it is to save current users. The result is a growing barrier to the user leaving the ecosystem of company products and, therefore, a lower cost of user ownership for her..
Data
The more business grows, the more data it can collect from different sites, especially from its customers. This data can be returned to the company's supply chain to train algorithms that are constantly improving in terms of accuracy and processing speed. In other words, the more your business, the more data you collect, and the cheaper and more accurate your internal operations through machine learning. That is why machine learning has become the main technology of scale underlying technology companies’ business models.
Virality
This is not the same as network effects. Network effects are about when the more users of a product, the more valuable it is and even more users come from this value. Virality is about when users themselves are engaged in the distribution of the product for free. For example, in the Dropbox business model there are network effects, but their main growth trick is based on virality: a new user is given a free space in the cloud storage if he invited friends.
When a company begins to make a profit (a lot of profit), its marketing and sales risks cease to be critical, but the risk of losing flexibility when there is a sharp need to switch to a new technology platform or infrastructure comes to the fore. Well, or the high cost of internal transactions - there, you have to introduce machine learning, otherwise competitors from Asia will overtake.
In the end, it turns out that technological risk increases along with the market share of the dominant company.
Obviously, there is a correlation between very high competitiveness in the digital economy and the small amount of technological risk that is present in the early stages of startup development.
Marketing risks are very high, because customers of the digital economy are by orders of magnitude more difficult to attract and retain than in the traditional economy.
Therefore, the more actively startups minimize technological risks and use ready-made technologies such as the Internet or open source (a low barrier to entrance of the digital economy), the more marketing and distribution risks become, and competitive pressure grows in any niche of the digital economy. Here are the reasons the software eats the world.
A traditional company will cope with this pressure by creating a barrier to entry. Companies from the digital economy are much more difficult to build a barrier - you need to have a truly colossal profit compared to competitors. Amazon is protected by buying up retail chains and building stores at home, but it also has higher profits than its digital competitors, such as Google or Facebook.
Netflix also creates a barrier to entry, since it creates original content, but again it operates in a market where profit increases are difficult to maintain, mainly due to the current restrictions of copyright holders and established rules.
Technically, the method of erecting entrance barriers is based on two pillars:
- closed ecosystems such as Google (Search, Gmail, Maps, Chrome, YouTube) or Apple (iPhone, App Store, iTunes);
- a business model of a two-way platform developed by companies such as Google (users/advertisers), Amazon (sellers/buyers) and Uber (drivers/passengers).
How do technology companies cope with unprecedented levels of technological risk on a large scale? This is another difference from traditional types of business.
Because entry barriers are not as high as in traditional economics, companies cannot rely solely on efficiency and frequent product renewal. They need to take seriously innovation dominance over long planning horizons in principle. This means that they must attract and retain talent.
Google, Facebook, Amazon, Apple — I think these are the four great leaders of the Internet race. They really set the pace. They are not limited to the market. They're limited to the number of hired smart men and smart women.
Because it is so difficult to innovate radically within a company, dominant technology companies have to constantly buy innovative startups: That is why digital acquisitions are more frequent than traditional ones.
Okay, there's another industry in the digital economy that's over it, but it's not about IT and it's special.
Biotechnology companies
In general, the process is similar: Suppose the scientist discovered the formula of a drug using a government grant (like the NIH program in the United States), and then he (or another entrepreneur) started a biotech startup to try to create an effective drug based on this work, and to start a business attracted venture money, that is... however promising the market, the drug should be approved by the authorities + included in the list of eligible for reimbursement in the health insurance programs, only then can the company be opened. And invest in it.
The situation of biotechnology companies is very different from IT companies, although both are based on venture capital:
Since the entire market for biotechnological innovations is heavily regulated by the state, the demand for the product becomes inelastic. That is, the startup faces unmanaged risks of sales and marketing in a situation of huge risks of unsuccessful R & D.
Thus, the very fact of starting a business in a biotech is already an event: from this moment on, it is possible to assess the fundamental value, the current value of net cash flows from investments - and, only in this case, the scientific and regulatory obstacles to entering the market are overcome.
The fact that investors have repeatedly bet in the biotech only confirms the rule: either low technology risks and high - marketing (digital startups), or vice versa (for example, biotech) and then the free market will not work, the state needs.
Biotech is the only sector outside the digital economy where venture capital exists. In the early stages, investors are ready to abandon the quick expectation of profit because the companies in which they invest do not risk the market for sales and distribution (after all, the approved drug is very easily put on the market and paid for by social insurance, and sick and dying people buy drugs no matter what).
You do not have a business until there is no medicine and vice versa, if you have a medicine - you can earn a fortune. Therefore, it is important, as Index Ventures blog wrote, to focus on only one thing (and one risk): the development of one (correct) molecule.
Key findings
Venture capitalists deal with the market under two conditions:
- There is a need for funding for only one category of risk (marketing in the digital economy or technology in biotechnology) and
- The potential success is so huge that it will cover both the possible losses from the realization of the risk and all the losses of the investor's portfolio.