In his classic essay "Want to start a start-up?", legendary venture capitalist Paul Graham describes the way in which investors arrive at their decision to back a company:
“The most important ingredient is formidable founders. Most investors decide in the first few minutes whether you seem like a winner or a loser, and once their opinion is set it's hard to change. Every start-up has reasons both to invest and not to invest. If investors think you're a winner they focus on the former, and if not they focus on the latter. For example, it might be a rich market, but with a slow sales cycle. If investors are impressed with you as founders, they say they want to invest because it's a rich market, and if not, they say they can't invest because of the slow sales cycle.”
As my grandfather told me when I was 11 years old, this way of thinking is universal human nature, not rocket science. However, rocket scientists such as Nobel Prize winner Daniel Kahneman have spent a great deal of time thinking and writing about it. In a nutshell, and after decades of work, their research has confirmed that people are biased and that this bias persists because it has evolutionary advantages.
The problem is that while gut instinct and pattern recognition were helpful to Stone Age man, they are less helpful to investors trying to make judgement calls about complex business opportunities that may have taken years to refine and develop.
I have seen this problem of cognitive dissonance in dozens of private funding pitches and pre-initial public offering roadshows, where a complex technology or business model must be pitched to bored-looking growth fund analysts in a 30-minute slot. The selection filter that predominates in these meetings is the 'chemistry' of the presenter, not the intangible value of the underlying technology asset. Sometimes the investor may even exacerbate the problem by bringing in an expert, whose entire career has been spent following orthodoxy within a multinational. That really is the kiss of death. Given this paradigm, are all complex technology investment projects doomed?
The short answer is that outside 'fail fast' software businesses, the appetite for technology risk or complexity is minimal for most investors in most industry sectors – but it need not be that way.
For businesses with proprietary technologies or insights there is a tremendous risk mitigant that is rarely given weight – namely, it is possible to separate the value of the technology asset underpinning the business from both the inventors and the operational management team. This bifurcation of asset from platform solves the problem that McKinsey posed decades ago in its seminal paper “Which is worse: poor strategy or poor execution?" Or to paraphrase, which is worse: poor intellectual property or poor management?
Investing in assets rather than people
When something truly wonderful is invented, it can be protected. This protection may take various forms, including patents and copyrights, but often the secret is the ephemeral knowledge of the founders and their network. This is called know-how or, for something more definitive such as a recipe or technique, a trade secret. These latter elements of the intellectual property are invaluable but hard to articulate or transfer – which is one reason why service businesses are hard to invest in without the founders. In fact, it is axiomatic that service businesses such as consulting cannot be scaled.
But although capturing the secret is hard, it can be done, and when it is the user manual developed can allow an effective licensing programme to be developed – which for service businesses in particular provides a scalable revenue model that is otherwise impossible. This is what is known as productisation.
People as widgets
I once sat with a private equity firm discussing an investment in the spin-out of a spectacular patent-protected technology from a semiconductor firm that could be licensed to dozens of willing participants globally. Despite experience in the industry sector and the geographic region, the investor's due diligence team was struggling. When it finally decided not to proceed, I asked why. The answer was very direct: "we love the business and the management team, but we like businesses where we can fire the management and replace them if things are not working out – and in this case we would not know where to start."
This honest answer is at the crux of the venture capital paradigm: investors say that they back people, but prefer the people they back to be replaceable. It seems that people are widgets.
Technology businesses where deep domain knowledge is critical are less amenable to this approach and, despite often compelling economics, they thus represent a higher risk for the capital since experience has shown that founders often need replacing. To put this in perspective, in 2008 Harvard Business Review reported that 50% of founders stepped down within three years of starting a company, and 60% within four years. Fewer than 25% of founders lead their companies’ initial public offerings.
This realisation has led me down a very different path over the past 15 years, as I have worked with technology and science-based businesses, particularly where the quality of the intellectual property is the real differentiator for value. My approach is based on a simple observation: a great technology may be more valuable to shareholders, inventors and society if it is widely available and the operators are diversified. This essentially turns the classical venture capital model on its head. I am not investing in people; I am investing in technology and diversifying my execution risk by allowing multiple management teams to adopt my intellectual assets.
Market conditions are critical
There is a classic quote about the importance of the market for success. It has been attributed to various people over the years, but I believe that it originated with Don Valentine of Sequoia, who backed Steve Jobs to build Apple.
Valentine's rule is thus:
- When a great team meets a lousy market, the market wins.
- When a lousy team meets a great market, the market wins.
- When a great team meets a great market, something special happens.
The take-home message? The market determines success, not the management.
Marc Andreesen has refined this idea to focus on the product/market fit, which could be said to be splitting hairs. It is the product and the market, not the people.
Be a landlord, not a developer
Therefore, as a business strategy my approach to investing in technology is to reduce or diversify execution risk by backing multiple horses in the same race. This approach effectively moves my risk position from developer to landlord, I acquire and own the fundamental intellectual property that underpins the business, which I then lease to operators (in similar or different industries) and support them until I can see where the winners lie.
This approach offers investors all sorts of benefit.
The biggest opportunity lies in industry
Ironically, the domain where I have found the greatest opportunity lies within the universe of large corporates which are seeking to generate new revenues from their intellectual property. I have worked with companies in many industries since 2005, including telecommunications, pharmaceuticals, advertising, television and film, publishing, semiconductors and financial services. In every case there was an opportunity-rich environment.
Most R&D-intensive companies over-invent and overprotect their intellectual assets. This is incredibly expensive (leading to inflated aggregate costs for new product development), but also hard to avoid since predicting the outcome from research is antithetical. Ironically, most multinationals are perpetually searching for ways to monetise their intellectual property. The notion of 'Rembrandts in the attic' is a bit tired now, but for investors which are open to actually building businesses and sharing risk with the original developer, there is huge value here.
Investing in an asset that has a significant sunk R&D cost (which you do not pay for) and a commercial opportunity that does not trip the revenue threshold for the developer is a wonderful strategy. In risk terms it lies between the extremes of capital allocation prevalent in the funding world – with risky venture capital at one end and predictable securitisation at the other. But it is in this middle ground where the real opportunity lies. Some industries are more amenable than others to this type of engagement – for example, pharmaceutical companies or film studios – but it applies across the board.
The next issue to consider is how this approach has worked out in practice. With several hundred million dollars invested and 10 years of investing, I think the experimental phase may be over.
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