A year ago when we first re-launched our web site as a blog, we did so because we felt that the environment was too volatile for a fixed investment thesis. Instead we suggested that our thesis evolves in a dialogue with the market and that it made more sense for us to publish the conversation.
Over the past year we have realized that some of the characteristics we look for in an investment opportunity have remained constant even as the market has continued to evolve. We though we would list those characteristics on separate posts over the next few days with an eye to reexamining them.
The first constant is our focus:
INFORMATION TECHNOLOGY ENABLED SERVICES
We invest in information technology. We do not invest in energy, biotech, materials science, or nanotechnology. Information technology is the world we know. We believe that when it comes to start up investing, success is dependent on understanding the forces shaping a developing market more than knowing the trade of investing. That conviction keeps us close to the markets we know best.
Within the broad category of information technology, our current focus is on IT enabled services. We rarely invest in companies that sell technology to others. We would prefer to invest in companies that use technology internally to deliver a service to other companies or to consumers. Google hires lots of PHD computer scientists who build lots of information technology systems but they sell very little technology directly. Instead they use this very sophisticated technology internally to deliver deceptively simple services. Our portfolio company TACODA began life licensing targeting technology to media companies, but really took off when it began use its technology internally to deliver behaviorally targeted advertising for marketers in partnership with media companies.
We focus on IT enabled services because we believe that commoditized (cheap) IT infrastructure and ubiquitous connectivity have only begun to disrupt large markets like media, entertainment, marketing, information services, and financial services. Where there is disruption there is opportunity for start ups.
We also believe that as the technology industry matures, it becomes more difficult to build value in a business that sells technology directly to others. I spoke to an investor over the weekend that put it this way… “50% of my portfolio is in communication equipment. It has become very hard to make money there. There are only 5 companies to sell to. They increasingly demand really substantial innovation before they even agree to evaluate a new box. That innovation requires a huge capital investment. Then before they agree to put it in their network, they take you around to Cisco, Nortel and Alcatel and tell them to OEM the box because I am not going to buy it from a start up. By the time the buyer negotiates their discount , and the distribution partner takes their pound of flesh, there is nothing left for the start up or its investors.”.
By comparison, information technology enabled services are more capital efficient and can, if they have a compelling value proposition and/or a great search engine optimization strategy, avoid the tax of a distribution partner by reaching customers directly over the web.
Finally, because the market for IT enabled services is still in its infancy, the business models are not well understood, and therefore the economics of financing these businesses have not been codified. By contrast, the model for financing core technology companies is so well understood (and so stable) that text books have been written about it. This means that more capital tends to compete for deals that fit that model bidding up valuations especially in comparison with early stage IT enabled services deals.
We focus on IT enabled services because, 1) it is a market we know, 2) the market is still in its infancy and 3) there is less competition.
Thoughtful people have questioned the attractiveness of IT enabled services as an investment opportunity because of concerns about the size of the opportunity and the defensibility of new services. These are legitimate concerns. We will describe how we try to identify scalable and defensible businesses in the next couple of posts.