Technology companies are disrupting industries, one after another. Yet, most traditional companies have no clue about the way technology companies operate and create value. As traditional strategy and investment analysis frameworks don’t help either, companies are turning from long term planning to agile experimentation. Whilst this is a positive and necessary direction, still lacking is a model that frames investment priorities and venture funding strategies once experiments are gaining traction. In the search for such a framework, I believe that the ‘value stack’ concept provides insightful perspectives on the development of technology companies.
The concept of the value stack was introduced to me by Mike Maples Jr. during his talk at the Stanford Entrepreneurial Thought Leaders program. Mike is partner at Floodgate, a renowned venture capitalist with investments in amongst others twitter, Lyft and Twitch.tv.
The value stack builds upon the notion that the technology industry is subject to three laws: Moore’s law, Meltcafe’s law and the Power law. Taking the impact of these laws into account, Floodgate sees four hierarchical powers that make up the value stack. Similar to the ‘technology stack’ – a common approach to distinguish the different technology layers that together enable the functionality and performance of a system – the value stack differentiates the key powers that drive the value creation potential of a technology company.
In this blog, I will explain the concept of the value stack and the learnings the framework provides for investment priorities and venture funding strategies. For a first-hand explanation of the value stack concept, I refer to the Stanford Entrepreneurial Thought Leaders podcast by Mike Maples.
I The three laws of tech entrepreneurship
“Technology eats the world” once said Marc Andreessen. Yet, the combination of three laws make technology entrepreneurship very different compared to running any other kind of business. For those who foregot, a short summary of Moore’s Law, Meltcafe’s law and the Power law:
Moore’s law – the power of exponential growth
Gordon Moore, co-founder and former CEO of Intel predicted that that the performance of computers would double every 24 months at a given price point. Since then, the semiconductor industry lived up to that expectation, resulting in an unprecented growth of the technology sector. Computing performance, internet, data & mobile networks and open source spurred innovation at an exponential rate. Moore was the first to recognise the ‘power of exponential growth’, a concept further being explorerd by Singularity University in a wide range of applications such as robotics, 3D printing and cloud services.
Meltcafe’s Law – the power of network effects
Robert Meltcafe, researcher at the Xerox Palo Alto Research Center (Parc) and founder of 3Com stated that the value of a network is a function of the square of the nodes. Social networks clearly benefit from the network effects. The more members a network has, the more relevant the network will become for each member. Another good example is a crowdfunding such as Kickstarter that succesfully applies ‘the power of network effects’ to unleash the hidden potential of communities to fund creative ideas.
The Power Law
‘The winner takes it all’. The Power law explains why there is often only one dominant player in industries that have become technology enabled. You will find elements of the Power Law in any sector. Yet, in technology sectors the impact of the Power law on competivess is huge with the number one often having a valuation that is more than the rest of the entire industry and the same applies for the number 2 and so forth. To illustrate the relevance of the Power law, Mike Maples gives the exampe that out of the 10,000 start-ups (nowadays an exeptional 20-30k), start-ups account for 97% of the value creation. Also making the point why the CAPM (capital assest pricing model) is not applicable for valuation of start-ups. I will come back on this later.
Once technology makes its inroad into an industry, the three laws will sooner or later drive industry change. If Moore’s law, Meltcafe’s law and the Power Law are important for start-ups, they are critical for today’s largest corporations.
II The value stack
Now you understand the impact of the three laws of tech entrepreneurship, you may ask yourself how to apply these insights to assess ventures more effectively. As there is no single right answer to this question, the Value Stack provides an interesting point of view by splitting the value creation process of technology companies into a hierarchy of four powers: proprietary power, product power, company power and category power. By looking through the lenses of these four powers, technology entrepreneurs, VCs and corporate executives are presented a framework to prioritise investment roadmaps and related actions. Let’s discuss the four powers and see how this works out in practise.
Proprietary power finds its roots in hard core technology and Moores law. It creates structural competitve advantage. Through innovation technology companies can create an unfair advantage and it helps to avoid the trap of competition. Being different is better than being better. Unique technology creates the basis for unique products and it opens the possibility for companies to seek IP protection and to file patents. Mike Maples recommends us to ask the following fundamental questions:
- “What is the advantage of the technology”?
- “Do we expect Moores law to happen and why is it that the technology will take-off now?”
The essence of Product power is product-market fit. It starts with the simple notion that companies need to build products that people want. In this respect, an interesting development is that some early stage investors started to make their investments conditional to succesfull crowdfunding campaigns at Indiegogo. This works out two ways: VCs will only invest once positive support from the crowd which can be considered as an early indication of market proof; for crowd funders, it is gives comfort that professional investors and standing behind a start-up they are funding. Yet, no matter how great the product, it is the market that determines its success. In great markets, the market pulls the product. Or as Mark says “Product power takes place in the tango between product and market”.
A scalable business model and scalable management systems are the key drivers of Company power. To realise growth technology companies need to consider the level of ‘management debt’ and ‘technical debt’.
Management debt is the capacity to scale such as having a founder/management team in place with the right experience and expertise needed for the job. Yet, in addition to the quality of the team, a high performance team will only function if the culture and practises of the organisation are in line with the company’s values. Think of for example the employee compensation structure and related KPIs’s. Are they aligned with the company’s values? Another important element of the DNA of an organisation is the purpose it serves. Purpose gives a company a meaning that goes further than profit alone. It gives direction on bith strategic as well on a every day operational level. This is importanf for fast growing start-ups where time and resources are a constant constraint.
Technical debt is the capacity of the technology systems to scale. A very straight forward question in the respect is whether the applications are sufficiently scalable and prepared for high volume processing? Or do we need to rebuild the system?
A scalable business model often makes use of network effects (Meltcafe law). Mark Maples recommends to ask yourselves the following questions to asses the effectiveness of the networks effects a start-up a looking after:
- What is my network?
- Where are the nodes?
- How do they connect?
- Where are they strong and where are they weak?
- Is it a global or hub & spoke?
- What does it mean for me to be the network operator?
Companies with category power don’t just sell things. They introduce the world to something new. Kevin Maney recently published a book on category kings with the title ‘Play Bigger’. Kevin researched the US venture captital backed start-ups from 2000 tot 2005 and found that category kings are responsible for 76% of the market capitalisation of their market categories (source Newsweek, no 45 2016).
Category power changes our point of view on how we send money. Companies with category power are capuring a significant part of the value the industry they shaped themselves. It speaks for itself that the Power law is most applicable for technology companies with category power. Starbucks, Facebook, Uber and Alibaba and Tencent are just a few examples of leading technology companies that have category power.
III A note on fundraising
You may have noticed that the power laws will start to play out once a technology company makes its way up through the hierarchy of ‘powers’, a fast forward with tail wind from the power laws only to occur by timely navigating the powers. That’s why I believe that the value stack is very applicable for investors and corporations to assess the phase in a company or start-up in, each requiring a different investment strategy.
Proprietary power is seldom developed by start-ups on its own. Often, universities or R&D labs are involved. The development of product power is typically funded with seed capital, whereas company power is being developed with A/B rounds. Category power, finally, is the domain of late stage investors.
I hope you will benefit from the concepts in this blog. I am looking forward to learn from your reactions.