Software vs non-software: Digital distractions

Pick any metric – deals done, dollars deployed, ideas discussed – and it will show that pure software plays are an investor’s preferred route to venture capital success. What’s less clear is how it all stacks up from a returns perspective.

In the five years ended 2019, 70% of VC investment in Asia went into IT and computer science-related start-ups, including online platforms and apps, according to AVCJ Research. This compares to 41% for the prior five years.

Liquidity events have followed this trajectory of growth, although the raw numbers call into question whether they are lucrative enough to justify the enthusiasm in deployment. About 47% of the money raised in Asian VC exits came from IT companies during the five years to end-2019, up from 26% during the previous five years.

Granted, many of these stories have yet to play out. A huge amount of money remains tied up in businesses that don’t feel the need to list so early in their lifetimes. Some of them will deliver exits that reflect their current multi-billion-dollar paper valuations. Others will not. Yet more are nowhere near unicorn status and will struggle to generate any exit apart from a write-off.

But the gravitation toward software is even harder to explain when it is viewed as an attempt to access uniquely defensible assets, business models, and intellectual property (IP). According to the Organization for Economic Cooperation & Development, IT consistently represented only 35% of global technology patents during the 10 years to 2016.

This is not to say the growing preference for IT versus other categories is without logic. Software is arguably the least expensive field of technology when it comes to experimentation and iteration. It can also be easier to achieve breakthroughs with a small, independent team, and the talent often comes from business. This implies a certain commercial savvy around issues like negotiations with external parties and recruitment.

The 65% of technology IP that is not focused on programming and code, by comparison, comes from a more bureaucratic world of corporates and universities. These are places where entrepreneurs do not have control over their innovations, raising concerns about alignment. In the university sphere, in particular, investors can also be put off by added layers of regulation, a lack of commercial skills, and the egos that often come with being a scientist who is already peer-recognized as an expert. 

The biggest single investment category here is biotech, although any hardware segment can be counted. Some of the highest-growth areas include cleantech, mobility, food tech, and agricultural science. Many companies in these industries are thoroughly digitized, but novel software creation is not their core value proposition. As a result, they are gradually being marginalized, at least in statistical terms, by the investment industry.

One solution is patience. Starting from the middle of the last decade, VC firms in China – the region’s largest early-stage investment market – have placed more emphasis on hardware, bringing in people with the requisite skillsets. At the same time, GPs have emerged dedicated solely to healthcare. Software will likely remain preeminent, but the gap might close.

Alternatively, ways could be found to incentivize corporate and university incubation programs to the point where the opportunity set becomes un-ignorable. Stoic Venture Partners is chipping away at this challenge. The Australian VC invests exclusively in start-ups sprung from university labs and local science agency CSIRO.

The Stoic thesis is based on the idea that large institutions and universities are the places where most of the defensible IP in the broader technology space is originating. Entrepreneurs are often key opinion leaders in their respective industries, they have better access to resources for experimentation, and they receive much more government funding, which is non-dilutive and helps protect alignment.

“Most people are scared off by universities,” Geoff Waring, managing partner at Stoic tells AVCJ. Waring is a former academic at Hong Kong University of Science & Technology among other schools and claims a natural understanding of his portfolio companies’ frustrations with the private funding. “There are higher costs with clinical trials and regulatory approvals, and it takes longer, but in the long run, there’s a bigger payoff.”

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• Topics
• Technology
• Early-stage
• Asia
• Venture
• TMT