What is invested in the digital economy
I do not know why the author chose this picture, but she is the original cover of the article.
From the article you will learn:
why investing in IT is less risky than in any other industry
when exactly the investor enters, and when it's too early for him to do
why venture is only in IT and biotech and nowhere else
and a few more interesting things.
When they talk about the digital economy, everyone remembers William Janeway's book Capitalism in the Innovative Economy, which since 2012 is part of the financial library of the Financial Times. The book is based on a study by Dr. W. Jenway, where both the structure of the digital economy and the sources and mechanisms for its financing have been studied.
William Jenway himself.
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 is
risks than in other sectors of the economy, when it comes to research and development. Venture capitalists are ready to finance innovative companies not because they suddenly became fired by the idea of risking everyone, but because of the simple fact:
Internet-based technologies have tied the states and many large companies so tightly and inextricably that they have compulsorily assumed some of the risks of the IT industry.
These are gorgeous guarantees, which are nowhere else.
New technologies do not carry risks? Really?
For startups (especially) the early stages of technology are not critical at all - these are the bricks that are lying free on the road. Just as you can seamlessly connect to the power grid and the supplier does not notice, and a start-up with a small coverage is quite easy to use:
By the way, with GPS all is not so simple, because the GPS is tightly seated by the military, but it is thanks to their budgets that we have free civil geolocation across the planet.
Open source software
, the use of which reduces to about zero the technological barrier to entry into the industry. Open source models have now begun to be used in other industries, such as hardware and biotechnology;
, where they will quickly test their hypotheses on the basis of standard resource designers and find (or not) a business. The cost of the cloud starts from zero and grows linearly in business;
modern high-level programming languages
, which simplifies their use for less experienced programmers. Again: Website and application designers allow start-ups to quickly reach proven solutions on the market.
As a result,
the word "technology" (with reference to start-ups of the early stage) became
Too many people still believe that the digital economy is single-scientists who invent something there and use very incomprehensible technologies for this. In the laboratories, it is possible, but in the digital economy - by no means.
The fact that the technology is commoditized does not mean that this is not a problem. You need a talent for assembling ideas in an innovative way, but based on available technologies. Real innovations begin when commodity technologies cease to meet the needs of a growing company. Jeff Bezos in his letter to the 2010 shareholders of Amazon wrote:
Although many of our systems are based on the latest research in the field of computer science, this is often not enough: our architects and engineers often use inventions not yet approved by science. Many of the problems that we face do not have solutions in textbooks and therefore we - with great pleasure - invent new solutions.
It so happened that the most advanced technologies in the digital field were invented and implemented by large IT companies, faced with their limitations, trying to serve hundreds of millions of users: for example, MapReduce, NoSQL or OpenStack technology from Facebook.
To understand why venture capital has entered the digital economy in spite of scientific and technological risks, first we will understand how the company grows in a non-digital economy.
Risks in the ordinary company. The vertical weight indicates the relative weight of R & D risks at different stages of the startup maturity, and horizontally the company's maturity stages /
First, technological and marketing risks have the same weight: it is necessary how to create a product, and talk about it to potential investors, employees and customers. 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 more quickly to the development stage, which compensates for a significant part of the technological risk at an early stage. This reduces the need for seed capital, which often comes from a single investor or from the free cash flow of an existing company. See how Joe McMillan, in the series Halt & Catch Fire, hack Cardiff Electric to get cash flow and create a laptop.
A shot from the series "Halt & Catch Fire" (season 1)
At the next stage, the weight of scientific and technical risk is reduced to zero, and all risk is now on a different front: marketing and distribution. This is due to the fact that the product is fully developed and packaged even before the release to the mass market (in the series it is seen when Joe Macmillan makes a deal with a network of retail stores only after the product is ready). That is, the risk of not finding a solvent market for a product is the most important. Again R & D goes by.
In a traditional economy, it is enough for private investors to show a working prototype that can be touched (for example, at the computer exhibition COMDEX, see Halt & Catch Fire) and add any market research from a venerable company where it is clear that the market is there and it is growing. Everything: the investor is ready to give money for marketing and sales. Where is the risk of wrong technology? He is not.
If the marketing and distribution efforts were successful and the startup finally found its solvable niche (reached "market fit"), it moves to a new stage of development - dominance. Usually at this time it is taken to an IPO (recall: in the traditional economy, IPOs are conducted most often at an early stage).
It is important to clarify that domination is the only way to protect against the risk of new technologies. Only when the company is a leader in its niche, its scale is large enough to keep competitors at a distance. The leader always has a lot of money for advertising, to rinse out the brains to the clients whose iPhone is the best. Moreover, the company-leader can specifically deal with increasing the barrier for entry of competitors in the niche (patenting, buying up start-ups, deliberately ignoring innovative solutions in their products or even worse). So it keeps scientific and technical risk at a low level: it's just that no one hears more innovative and useful newcomers 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 is taking to implement innovation in the field of efficiency (thus, freeing up capital and making more money for its shareholders) or innovating new product versions (shipment of new products , which help keep competitors at a distance).
During this period, the only danger is the competitor, who is ready to bear a higher level of technological risk and thereby break the barrier to entry with his radically innovative product.
So, for example, Japanese automakers destroyed the American auto industry in the 1970s.
As a result, technological risk is almost never funded by investors:
1) the first stage is partially financed by the state;
2) intermediate stages are associated with more visible risks in marketing and sales;
3) at the last stage, operational efficiency and renewal are financed by the free cash flow of a new start-up.
Now let's look at digital (technology) companies. Here is the corresponding scheme:
In comparison with traditional "digital" start-ups there are 3 main differences:
1) Gray zone on the left - development of MVP. Here, start-ups select the right combination of commoditized technologies and all this time you can not open a legal entity at all. As a result, business begins much later than the development of the product in the traditional economy, and the company's creation falls on a period where the level of technological risk is already very low. And the potential losses of investors - too.
2) Finding a startup of its solvent niche ("market fit") occurs much earlier than in traditional companies. This is due to the fact that technological entrepreneurs have transformed the development of the client into science: hacking the growth of the audience and even croweding are powerful tools that are not in the 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 "valley of death").
3) The digital start-up takes a dominant position before the traditional one for one simple reason: the winner gets 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.
The scale effect, which led to a drop in the value of sales in Amazon.
The effect of scale.
Several centuries of history have shown that the larger the scale of sales, the cheaper the cost of production.
True, there are limits here: demand ceases to grow exponentially, factories reach their maximum capacity, logistics becomes more complicated, new customers become more difficult to convert, scale ceases to be an advantage and becomes an obligation - that's why most companies can not go beyond a certain market share. Well it is, by the way.
The drop in Amazon's sales value (see the figure above) illustrates the economies of scale in the traditional industry, such as retail.
. Most technical companies connect their users to each other, providing a link between them either directly (sharing content with our friends from Facebook), or indirectly (reading another user on the Amazon product page). Such connections turn users into nodes and launch powerful network effects. When they work, the value created for each particular user increases exponentially as the number of these users increases. The more business has grown up, which has a network effect in the development model, the easier and cheaper it is to acquire 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 the company's products and, consequently, a lower cost of ownership for the user
The data is
. The more business grows, the more data it can collect from different sites, especially from its customers. These data can be returned to the company's supply chain for training algorithms that are constantly being improved in terms of accuracy and speed of processing. In other words, the more your business, the more data you collect, and the cheaper and more accurate your internal operations are due to machine learning. That is why machine learning has become the main technology of scale, underlying the business models of technology companies.
The virality of
. This is not the same as network effects. Network effects are about when the more users of the product, the more valuable it is and even more users come to this value. Virality is about when the users themselves are distributing the product for free. For example, Dropbox business model has network effects, but their main growth trick is based on the virality: the new user is given a free place in the cloud storage if he invited friends.
When a company starts to make a profit (a lot of profit), its marketing and sales risks cease to be critical, but the risk of losing flexibility with the urgent need to move to a new technology platform or infrastructure comes to the fore. Well, or the high cost of internal transactions - there, you have to implement machine training, and then competitors from Asia will overtake :)
In the end, it turns out that technological risk rises with the market share of the dominant company.
The increase in profits, as a rule, protects it, but:
technological risks reach a maximum when the company occupies the entire market (see article McKinsey), and
Since the customers of the leader company in the IT industry almost instantly change the product or service if desired, it has to endlessly improve productivity, create new functions, produce new products and constantly improve the usability of all this (the hypothesis of Red Queen).
Obviously, there is a correlation between the very high competitiveness in the digital economy and the small amount of technological risk that is present in the early stages of the startup development.
Marketing risks are very high, because customers of the digital economy are more difficult to attract and retain than the traditional economy.
Therefore, the more active start-ups maximally reduce technological risks and use ready-made technologies such as the Internet or printers (low barrier to entry into the digital economy), the more risks of marketing and distribution become, and the competitive pressure in any niche of the digital economy grows. Here are the reasons why the software is eating the world.
The software eats the world because it is commoditized.
A traditional company will cope with this pressure by creating a barrier to entry. Companies from the digital economy to build a barrier is much more difficult - you need to have a truly colossal profit in comparison with competitors. Amazon is protected by the purchase of retail chains and builds its stores near the house, but it also has higher profits than its digital competitors, such as Google or Facebook.
Netflix also creates a barrier to entry, as it creates original content, but again it works in a market where it is difficult to maintain a profit increase, mainly because of the existing restrictions on rights holders and rules.
Technically, the method of erecting barriers to entry is based on two pillars:
1) closed ecosystems like Google (Search, Gmail, Maps, Chrome, YouTube) or Apple (iPhone, App Store, iTunes);
2) 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.
Since entry barriers are not as high as in the traditional economy, companies can not rely solely on the efficiency and frequent updating of the assortment. They need to take seriously the dominance of innovation on long horizons of planning in principle. This means that they must attract and retain talents. The war begins for the Talans, which John Doerr points out:
"Google, Facebook, Amazon, Apple - I think that these are the four great race leaders on the Internet. They really set the pace. They are not limited to the market. They are limited to the number of hired clever and clever people. "
John Doerr: talent is the only growth limit for digital companies
Since it is so difficult to implement radical innovations within the company, the dominant technology companies have to constantly buy innovative start-ups: that's why acquisitions in the digital world are more frequent than in traditional ones.
Okay, there is another branch of the digital economy where there is a venture, but it's not about IT. And she is special.
In general, the process here is similar: say, the scientist opened a drug formula using a state grant (such as the NIH program in the US), and then he (or another entrepreneur) founded a biotechnological start-up to try to create an effective drug based on this work and to run business attracted venture money, then no matter how promising the market, the drug should be approved by the authorities + get on the list of allowed for reimbursement in health insurance programs - only then the company can be opened. And invest in it.
In the diagram, the picture with risks is disclosed in more detail.
As Dr. Janeway puts it, the situation of biotech companies is very different from IT companies, although both are based on venture capital:
Since the entire market for biotech innovations is heavily regulated by the state, the demand for the product becomes inelastic. That is, a startup is faced with unmanageable marketing and marketing risks in a situation of huge risks of unsuccessful R & D.
Thus, the very fact of launching a business in biotech is already an event: from that moment it is possible to assess the fundamental value, the current cost of net cash flows from investments - and only in this case - the scientific and regulatory barriers to entry to the market are overcome.
The fact that investors have repeatedly made biotech bets only confirms the rule: either low technology risks and high-marketing (digital start-ups), or vice versa (for example, biotech) and then the free market does 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 rapid expectation of profit because the companies they invest in do not risk selling and distributing (after all, the approved drug is very easily marketed and paid for by social insurance, and sick and dying people buy drugs in spite of no matter what).
You do not have a business, as long as there is no medicine, and vice versa, if you have a medicine - you can earn a fortune. Therefore, it is important, as Index Ventures wrote in his blog, to concentrate only on one thing (and at one risk): on the development of one (correct) molecule.
Venture capitalists work with the market under two conditions, when:
there is a need for funding for only one risk category (marketing in the digital economy or technology in biotechnology) and
the potential success is so huge that it will cover both possible losses from the realization of risk, and all losses of the investor's portfolio.
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