“Ponder for example that the leading technological companies of this age, I think for example of Apple and Google, find themselves swimming in cash and facing the challenge of what to do with a very large cash hoard. Ponder the fact that WhatsApp has a greater market value than Sony with next to no capital investment required to achieve it. Ponder the fact that it used to require tens of millions of dollars to start a significant new venture. Significant new ventures today are seeded with hundreds of thousands of dollars in the information technology era. All of this means reduced demand for investment with consequences for the flow of - with consequences for equilibrium levels of interest rates.” - Larry Summers (2014)
The above comment was made last week and everybody on the twitter-and-blog-sphere had their own opinion on Larry’s remarks. I wanted to make some replies on twitter to add my take on the discussions but it proved somewhat tricky to convey the bigger picture in fragmented chunks of 140 characters. So I think it’s time I returned to Microbytes.
A particular comment on twitter about Larry Summers’ speech got me thinking. It stated that WhatsApp’s skyrocketing M&A value was only made possible by big capex spend by the telcos. The thesis was that creating giant companies with little investment is a misnomer. I don’t necessarily disagree with this view - indeed, WhatsApp (and other start-ups) do depend on telcos updating and expanding the existing Internet infrastructure.
So what I want to do in this post is to draw a picture for you to show why this is normal, and why it doesn’t discount the fact that you’ll be able to create giant (valued) start-ups with very little investment. Just like WhatsApp.
Imagine a pyramid. The lower end (the base) is large, and will probably be costly to build out, in terms of investment cost and time. After the base is ready, others can build higher up the structure - faster and cheaper. Note, also, that the people who choose to focus on the lower end of the pyramid will most likely have to maintain the base (let’s ignore the Google fibre model for now), which remains costly. Remember, we haven’t even mentioned the soil on which this structure is built. Who put time and effort to create this? I imagine this took a lot of time, a lot of trial and error. And a lot of risk.
Let’s translate this pyramid metaphor to the example of a modern corporation, like WhatsApp. Start with the lower end, below the base - the soil and more or less the foundation. This is akin to the US government having funded an agency that today is commonly known as DARPA. During the Cold War, the American government wanted to establish different methods of maintaining communication with command and control, in case a nuclear strike were to knock out communication towers. So they spent a lot of intellectual capital, money and time developing protocols that would eventually morph into what we today call the Internet. It was only natural this kind of large-scale project was executed by a government body - which, unlike the investor-backed corporations existing within capitalism, required no immediate return. They were in a position of making large bets with an indefinite time horizon of fruition.
At the base of this pyramid sits the telcos. They enable the pipes where our trillions of bits and bytes flow - which translates into Netflix movies, iTunes songs, Flappy Bird-like games, Snapchat photos, WhatsApp messages, Facebook posts and Tweets. The telcos buy spectrum, own/buy patents and build out physical hardware infrastructure. This isn’t cheap. Last year, AT&T alone stated they would invest 12 billion USD in expanding out new greenfields of infrastructure. AT&T’s market cap stands at 166 billion USD. So this capex was about 7% of its market cap. This is compared to 58.3 million USD in funding (including a Series C round of 50 million USD by Sequoia Capital) that was used up by WhatsApp before its exit - eventually valued with cash and stock at 19 billion USD. That is 0.3% of funding relative to its exit valuation.
This example (albeit oversimplified) of 7% vs. 0.3% in capex vs. market value is the difference in being at the lower end of the pyramid versus being higher up in the structure. Since the 1990s, the costs associated with starting up a modern corporation (with its software driven internet delivered model) have steadily fallen. For example, look at how Instagram, Netflix (the streaming segment) and the countless newer start-ups are reliant on the emergence of cheap dynamic scalable server hosting like what AWS (Amazon Web Services) provides. Jeff Bezos’ Amazon itself spent a fair amount of capex and time developing the tools to reach mass scaled infrastructure the company could sell cheaply. During the dotcom era, if you wanted to start a modern web company, you had high start-up server and scaling costs. Whereas today, a two-man team on a laptop can launch the next online-based disruption with minimal costs (at least, relative to the to the dotcom era), piggybacking on the infrastructure provided by services like AWS.
I have read a few comments arguing that the era of capex spend isn’t over. No it isn’t. It never will be. It’s just that the most valuable companies by return on investment live in the present Internet space due to the pyramid we’ve built over the last 60 years. What we need is new capex to build new verticals. New pyramids. But this requires not only a lot of capital but to accept high risk.
Very few people currently seem willing to take the suitable risks - instead issuing share buybacks. One of the well-known examples of a pro-capex investor is Mr Elon Musk (PayPal, Tesla, SpaceX, Solarcity). He took a huge personal financial risk to make a play in a historically tough area with a lot of economic (hence government subsidies etc.) and technological issues: electric cars. Up until very recently, it wasn’t a sure thing he would win with Tesla. Now we see his bigger play - disrupting the energy pyramid - with Tesla’s newly announced lithium ion giga factories - to reduce the cost of batteries. Imagine how many future start-ups will be able to leverage off of this kind of capex. This potentially turns Elon Musk’s company into the Amazon Web Services of battery technology. So capex spend isn’t over - but we need more risk takers out there to emerge and create newer pyramids for future generations.Robotics has seen a lot of capex spend in the new millenium to build out this vertical.
In the early part of the 21st Century, the pyramid on which society has depended on and lived off is the Internet. And this pyramid has been taking shape since the Cold War and the days of ARPAnet. The pyramid we’ve built for our era is maturing. A mature pyramid means that newer corporations sit high upon this structure feeding over the protocols and physical pipes which came before them. Not requiring much capital to thrive, as Larry Summers indicated in his speech. This diminishing requirement for capital vs. value created (for shareholders) is partly one of the reasons why interest rates should remain lacklustre and low in the near future.
However, these physical pipes/protocols need refreshing every so often, which undoubtedly costs a lot. Back in the day when this pyramid wasn’t mature, the companies building the base created a lot of jobs for workers, generating a nice income for themselves and their employees. AT&T currently has about 250,000 workers. WhatsApp has around 50 employees. Another example is Kodak vs Instagram. Did someone whisper income inequality skew? That’s a whole separate pyramid we’ve managed to build…
I will leave you with the words of President Obama from a speech at Roanoke, Va., heavily misunderstood when uttered in 2012:
“There are a lot of wealthy, successful Americans who agree with me—because they want to give something back. They know they didn’t—look, if you’ve been successful, you didn’t get there on your own… If you were successful, somebody along the line gave you some help. There was a great teacher somewhere in your life. Somebody helped to create this unbelievable American system that we have that allowed you to thrive. Somebody invested in roads and bridges. If you’ve got a business—you didn’t build that. Somebody else made that happen”
We need more risk takers out there to emerge and create newer pyramids for future generations. Robotics, nano-tech, energy, material sciences, space exploration and more.