In Technology, Markets, and Valuations
All venture returns come from investing at or before inflection points. The closer to the infection point, the better (optimal risk). But inflection points can be hard to predict.
Here’s the three basic types of inflection points I look for:
Technology — is the technology at or nearing an inflection point with respect to tech readiness level (“TRL”) that substantially reduces its risk of commercialization (software-defined radio hardware or nuclear microreactors are two examples)? Are the underlying or interdependent technologies at or nearing a point that could enable the business in question to be built (think AI applications built on top of cloud infrastructure)?
Market — has there been or will there be a material shift in market supply/demand for a given product/service? Why? Is this company positioned to corner (or cheaply create!) that new supply / demand (think AirBnB and short-term rentals vs existing hotel stock)? How defensible is this market position?
Valuation Basis — does the company in question have the potential for a material shift in valuation basis as it grows and executes? Maybe today it’s valued on a future EBITDA multiple, but in the future could be valued in a revenue multiple. Might one be able to invest today in a business valued on hardware IP (i.e. “low multiple”) but in the future be valued on the basis of a more capital efficient, high margin recurring revenue use case of that hardware IP (i.e. “high multiple”). NVIDIA leaning into its hardware advantage to create a recurring revenue software business on top is one example of this.
I think the valuation basis inflection point is one of the more predictable (yet still underutilized) ways to generate venture returns. These businesses often initially look like low/no revenue and require equity capital investment well in advance of demonstrating a high ROIC use case. However, with patience, these businesses can develop significant intangible assets (talent, IP, customer relationships) which can be used as leverage to build more equity efficient, high margin, and high growth revenue lines of business. As this transition happens, the valuation basis shifts in favor of the early investors.
In addition to NVIDIA, here’s a few more examples:
Amazon / AWS — cloud compute generates way more enterprise value today than their core logistics / consumer business.
SpaceX / Starlink — the launch business is a key national capability and cash cow, but relatively low margin and low growth relative to the higher margin, higher growth satellite internet business.
Apple / App Store — this is an old store, but selling iPhones creates tons of equity value by allowing the tack on of the App Store and recurring service revenues.
Cheers to the pursuit of Valuation Basis inflection points (and much more) in 2024!
Photo Source: https://www.baybridgebio.com/blog/anatomy_of_a_decacorn