Last year, The Information proclaimed the software investing playbook has gone from an exclusive recipe amongst VCs to common knowledge amongst all investors. That, in addition to cheap money, has turned software investing into a low-margin finance game.
Yet, traditional VCs are still stuck with their now low-margin businesses, unable to move forward and invest in the next big thing: deep tech.
But perhaps that’s for the best. After all, unless software investors can unlearn their own playbook, they’ll continue struggling with the innovator dilemma while they slowly go extinct alongside the companies they’re so eager to fund.
In other words, the software playbook is dead, not just doomed to fail. Here are three things software investors must relearn before investing in deep tech.
Counting on one or two companies to return the entire fund is not only foolish, it’s a good indication of an investment team that shouldn’t be investing in deep tech.
The market is king. Your founder has no power here
Software investors’ founder-first mantra is simply wrong in the world of deep tech. This type of magical thinking is exactly why their software playbook is doomed to fail.
Deep tech takes decades to bear fruit, not years, and it is virtually impossible for deep tech companies to do a hard pivot. Expecting founders to overcome physical and technological constraints is downright bad investing, especially in an era where cheap money tends to evaporate.
If you’re a software investor looking to invest in deep tech, you need to understand that the market is king here. A charismatic founder cannot be relied upon to “figure it out” along the way and a company’s team is only as good as its ability to exist inside its market.
With pivots out the window, a deep tech company needs to get the market right from day one. A half-baked, superficial hypothesis about product-market fit and go-to-market strategy is child’s play in the world of deep tech. Companies need to understand everything from the entire market structure and the incentive system amongst the entire market ecosystem down to the budget approval limit, the willingness to pay and all marginal economic benefits from technology adoption.
Deep tech companies require a different, more refined startup muscle, one that can preempt product-market fit now, not later. Without this muscle, well, I feel sorry for their LPs.
A quick aside on deep tech founders and their teams
Don’t get me wrong: A company’s team and founder are still important, but your goal cannot be focused on finding and worshiping the next Mark Zuckerberg. This is more of that magical thinking so prevalent in software investment circles.
Deep tech founders are less likely to be your stereotypical visionary or larger-than-life entrepreneur. In my experience, they’re more likely to be an introverted Ph.D. who struggles to tell entrepreneurial stories. Most of these founders will not be able to grow out of their Ph.D. mentality and will need to eventually step aside so the board can bring in a commercially minded professional who can scale the company.
So while it is ideal to invest in a deep tech team that has world-class commercial and technical co-founders, it is extremely unusual. The right team is one led by a technical mind who can piece together the right path to market while remaining humble enough to step aside if/when the situation calls for it.
Since software investors don’t generally like humility (even if they say so), this will be a lesson learned the hard way if they can’t catch on quickly.
IP means nothing. Business lock-in means everything
A common but incorrect assumption is that deep tech defensibility lies in IP. That’s a novice — dare I say, naive — assumption. Sure, IP buys you time, but it’s hardly a means of defending a company’s long-term advantage.
At the end of the day, any technology can be reversed or replicated with enough time and money. Even with IP protecting a technology, a determined and well-funded competitor will eventually figure out a way to achieve similar results through different means.
But this will take time, making an IP — or any kind of proprietary information and knowledge — a stepping stone. It buys the startup the time to get its technology implemented and embedded into customers’ business processes and technology stacks.
Implementing deep tech is an audacious process that requires countless proof-of-concepts and pilots, not to mention an even more audacious roll out plan. It takes a really long time. Moreover, deep tech does not usually work well at first, and scaling a solution right away can be costly from both an implementation and maintenance standpoint.
Still, once a customer is in, they’re there to stay. After all, can you name one person in their right mind who would want to reimplement something like Oracle for a slight incremental benefit?
Deep tech portfolio construction is different
Compared to software companies, deep tech exits don’t take nearly as long. These exits also tend to be smaller and usually happen through M&A with incumbents with deep pockets and a distribution channel.
For the acquirer, deep tech companies are successfully commercialized R&D. Once a company has proven that its product works in its market (at scale), they’re likely to be scooped up by companies that can leverage their existing sales channels to push the products out.
As a result, deep tech investments require an entirely different portfolio construction process. Counting on one or two companies to return the entire fund is not only foolish, it’s a good indication of an investment team that shouldn’t be investing in deep tech. A good number of companies within the portfolio must perform well, and follow-on investments need to be sufficiently diversified rather than plowed into one or two companies.
Every element of deep tech is different from software. An investor who does not know that or cannot explain how or why that is certainly isn’t ready for investing in such companies. LPs and founders alike, consider this your warning.