What is a Tech Company?
Digital Leverage as Software Eats the World
We’ve all heard Marc Andreessen’s epochal prediction that “software is eating the world,” but in recent years, that phrase has come to mean so much more in the venture business. We started seeing companies consume their technological advantages, rather than selling them to the market. Companies started attacking legacy incumbents head-on, raising venture capital and leveraging many of the same tactics of high-growth software companies to steal share. It’s impossible to understate the significance of this shift as it broadens the investible scope from simply software companies and applications (which are high growth and high margin, but relatively small with respect to global GDP), to EVERYTHING. It’s also added a ripple of complexity to investing. I was recently with one of the partners of a major VC firm and he asked “are these really tech companies?” As always, the answer isn’t binary. Some of these companies are simply copycats of legacy business models with a license to burn. Others will leverage technology to create unprecedented economic advantages and consumer surplus, transforming their industries.
To be clear, no one believes in this trend more than us, Equal Ventures. We built our entire firm on the transformation of legacy sectors. In some cases, that means selling software to incumbents and in others it means competing against them head on (“enable” or “disrupt”). Those who are enabling tend to build software or marketplaces, well worn business models in the venture world. For those attempting to disrupt legacy asset-based competitors, building and funding themselves like a software company is simply ridiculous. Attacking these competitors requires more than digital wrapping paper on a legacy business model and we saw this bear out during the dot com days where companies appended a website to their legacy business and were deemed more valuable overnight. In today’s markets, the behavior may be even worse with many “disruptors” launching de novo without a path toward sustainable competitive advantage against incumbents. Worse yet, if you stacked the metrics against a legacy company in that category, the digital competitors are often inferior in almost every respect save for growth and losses. We’ve seen this play out in several industries - Real Estate (WeWork), Logistics (“digital” freight brokers), Insurance (“digital” carriers/MGAs/brokers) - and are seeing the reckoning for these companies in the public markets.
These are all incredibly exciting categories experiencing dynamic change and some of these markets are the ones that we track most closely. Insurance is probably the one of these that I am closest to and my mind is blown by the numbers some of the recent “disruptors” have been putting up. Those who know insurance, know that your combined ratio and loss ratio are ALL THAT MATTER. Any company can grow at an incredible rate if it prices its product below market or spends enough on CAC. Not only have most of the digital disruptors had to abandon digital acquisition channels, realizing that the agent channel represented a more efficient path, but their loss ratios are simply inexcusable. These ratios are not merely in-line with industry stalwarts, they are significantly worse. If there were a path to ”winner take all” dynamics, the growth at all cost strategy would be justified, but for most that’s not the case. More likely is that it’s a lack of understanding and appreciation for these markets layered onto a simplistic reliance on multiples. Investing in a software company growing at 150% YOY at 20x revenues may be “interesting.” Doing so in an insurance company that loses money (on a gross margin basis) on every policy it writes, is not. Nonetheless, these companies trade at amazing premiums to legacy competitors.
With all that being said, you might think I’m not terribly optimistic about the future for disruptors. In actuality, it’s the complete opposite. Each of those categories listed above is going to produce companies that transform their sectors and generate not only hundreds of billions of dollars of value, but potentially trillions of dollars of consumer surplus. This is what Amazon has done to the retail category and I suspect we will see Amazon-sized competitors in each of those markets listed above (and I hope we are on their cap table!).
To accomplish this we need to think like industry insiders, not software investors. We need to understand the competitive dynamics of the market and we need to identify chinks in their armor (this is why we are such fervent believers in a prepared mind). We need to identify opportunities where network effects can outpace the advantages created by economies of scale and verticalization. More important than anything, we need to identify opportunities for digital leverage. We define digital leverage as the ability to leverage your core capabilities to create a durable, sustainable competitive advantage against your competitors (i.e. a moat). We ask this as part of our investment process and we use the slide below as part of our onboarding with each company. In doing so, we ask the companies to 1) define where they believe they can create an initial economic advantage in COGS, OPEX, CAC or willingness to pay (WTP), 2) how interactions with their customers produce data or network assets that further those advantages and 3) how does the flywheel of those assets create sustainable value.
While great companies can be created absent of this playbook, this is the method that we believe creates the opportunity for category monopolies (much like Amazon is in domestic retail). These monopolies have the opportunity to generate tremendous long term cashflow and warrant the premium multiples paid in the market. Those that don’t have that potential ultimately need to align with the long-term multiples of those in the category since margin / cashflow will likely settle in-line with others in the industry once the ability to fuel growth at all costs ends.
Great companies and total farces alike will be minted in this age. We’re seeing a truly pivotal moment in the innovation cycle that expands the aperture of venture beyond anything we’ve seen. The brightest days are still ahead of us for technology to transform the way we work and live. As this aperture widens, it’s going to invite different classes of investors with different expertise - venture is not just engineers underwriting other engineers any more, it’s a real asset class and needs to be treated as such. With that, we need to make sure we are critical in asking the tough question - “is THIS a tech company?” The root of the answer will be in understanding the competitive landscape and opportunity for digital leverage in that market. We take tremendous time and pride in helping answer that question and helping founders solidify their path toward category monopoly status. If you are looking to do so in any of our core sectors, we’d love to partner with you.
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