Do start-ups need as much capital today?
Photo: Jade. Source: Morguefile
It doesn’t seem like it anymore. It used to be that a new company or concept needed major financial support. Now, a couple of motivated folks working from a garage can change the world – the way Apple famously did in the ‘70s. Back in the ‘70s, intangible capital was below 30% of the S&P 500’s capital structure. Now it’s over 80%.
And it’s not just computer software. Companies as diverse as pharmaceuticals to coffee shops to seed companies are investing in design, branding, and R&D. Increasingly, firms need to deploy assets that you can neither see nor touch, rather than machinery and buildings. This has had profound effects on the structure of our economy, from the rise of rents in tech-center cities to stagnating productivity.
What are some other effects of the knowledge economy? For one thing, companies are increasingly competing for scarce talent. The skill-set to manage a global value chain is highly specific. Apple’s iPhone was neither the first smartphone nor the most technologically advanced. But they took the concept, applied their own design logic to it, and implemented across a global manufacturing value chain to create an incredibly profitable franchise, generating over $130 billion in sales last year for an item that was brand new a decade ago.
That massive cash flow comes from Apple’s ability to position itself as a premium brand and maintain its position. The same could be said for Facebook or Google. These are incredibly profitable companies – with profit margins of 20 percent or more. Why don’t these excess profits get competed away? It’s because only a few companies have the scale and scope to capture these intellectual externalities. These firms are highly productive – Apple sells $1.8 million of product per employee – but there aren’t very many of them.
Network Effect. Source: Wikipedia
Software runs the world, and the marginal cost of distributing software (via download) is nothing. Companies that can be profitable while selling a free product are the future. We still need tangible stuff – we live in a tangible world. But increasingly, intangible software and brands and patented molecules are what give our stuff its value.
Douglas R. Tengdin, CFA