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One of the great misnomers of the investing world today is that software businesses are ‘capital light’, meaning they do not have the high start-up costs and ongoing costs that businesses with a more extensive physical footprint might have. This may have been the case 10 years ago when companies could expand rapidly from a low-cost base but it is seldom true today.
There is a trivial truth behind this: software companies do not need to spend money on sinking metal and concrete into the ground to build factories.
Suppose we measure capital intensity as the amount of money that needs to go into a business relative to the amount of profit that may come out. In that case, we cannot conclude that all software companies of the last 15 years are genuinely capital-light.
Billions of dollars have been raised and deployed across the industry. In some cases, large revenue bases have been built, but the amount of actual profit flowing back has frequently been woeful. Operational spending on headcount can kill profitability in the venture-backed consumer software industry.
Software businesses currently face two problems when it comes to generating profit. One is structural, the other is cultural.
Starting with the structural, the idea of software businesses being capital-light stems from the theoretical leverage that can come once you have sunk a certain amount of money into the salaries and options needed for the engineers to write the code.
Once you've done this, the theory goes, your marginal cost associated with each sale is close to zero and profit flows. This held in the early days of software, but things have changed.
Software has become unimaginably complex, and the pace of technological development alongside ever-rising user expectations means it needs to be updated almost the moment it has shipped. This blows the idea of a modest fixed cost base out of the water. The upfront cost is higher, and the ongoing need for continuous upgrades is never-ending.
At the same time, developer costs have skyrocketed. This is particularly true for the technology hub of the Bay Area, San Francisco, where many high-tech companies reside. ITPro reported that principal engineers at Facebook’s Menlo Park offices could earn over $1m, including salary, bonuses and stock options, with other companies not far behind. Software businesses still look 'high margin' because old-fashioned accounting treatment allocates very little of this cost to the ‘Cost of Goods Sold’ line.
Below gross profit, things get ugly. The sprint to stand still can be seen in inflated ‘Research & Development’ (R&D) lines, replacing the depreciation of ‘Property, Plant & Equipment’ in the old world.
We've been lulled into thinking that R&D lays the foundations for future growth and profitability. In reality, it is often an entirely necessary spend for maintaining relevance and sales under the forward march of technological development.
Profit-crushing ‘Sales & Marketing’ spending replaces physical distribution costs. But because these are annually expensed people costs and not a capital investment in the traditional sense, we persist in telling ourselves that these are capital-light businesses.
But the capital gets spent either way. The sucker punch comes when companies point us towards adjusted numbers for profitability that do not reflect the economic cost of shareholder dilution from employees' option packages. Thereby glossing over that this is a substitute for cash compensation that reduces the value accruing to every shareholder.
The second problem is a cultural one. Venture-backed software companies often have no culture of building toward profitability.
Success for the last 10 years has been defined by raising more capital at ever higher valuations to pour into salaries to grow a revenue base. All of which can then be poured back into wages, which, until very recently, have been something that can only go up.
Why have these costs risen? When companies rightly flipped away from the Friedman doctrine of maximising shareholder value at all costs, the pendulum for tech companies did not come to rest at a more plural approach to stakeholder value. Instead, it became magnetically pulled towards delivering value for employees.
Shareholder monism was replaced by employee monism. The need to retain the best software engineers, who attained almost godlike status, led to egregious pay and options packages absorbing much of the growth being delivered.
As the cost of writing and maintaining code of ever greater complexity has grown and wages have risen, the capital needed to build software companies has spiralled out of control.
More money is going in, and less is coming out than ever before. The idea of the capital-light software business in the venture ecosystem is dead. RIP.
Recent advances in artificial intelligence are already transforming the coding process and may reduce these costs. Will the bottleneck that has been the availability and cost of coding talent diminish as software becomes essentially self-coding? Where will the next bottlenecks appear, and what will the effect on returns be? Will the capital and rewards flow toward hardware or semiconductor businesses instead?
Understanding these dynamics means we don’t idolise pure software companies. They have a role in our portfolio, but we don’t place them on a pedestal as many of our peers do.
This, in turn, makes us more willing to back companies that are upfront about their need for capital. Companies such as Northvolt, Solugen or PsiQuantum, where our clients’ capital goes directly into building industrial capacity in the shape of battery production plants, bioforges or quantum computers. These are competitive moats that can’t simply walk across the road to the start-up next door.
Where we invest in pure software companies, we leverage our experience from public markets to ensure that we fully understand the incentive structures and governance. That includes considering how success will fairly reward founders, investors and employees.
We also look for companies that have evaded the venture capital game and bootstrapped their way to genuine capital efficiency, such as Wise, Grammarly or Bending Spoons. Interestingly, these three examples come from Estonia, Ukraine and Italy, respectively, areas which have not been awash with venture cash.
Beyond the Bay Area, coding talent can be available for a fraction of the cost of that in Silicon Valley. This, and a culture of business building, often leads to a greater focus on efficiency and returns and so to interesting and attractively valued investment opportunities.
These are topics that we will return to in future communications.
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