IE: On bits and blockchains

© Tero Vesalainen

IDENTITY ELEMENT writes:

In the period leading up to the 1990s, sound business models were predicated upon deploying capital to produce assets which in turn generated more capital; in essence, to generate a dividend. Homeowners who rent their properties out have deployed capital for accumulating a return on this investment via rent payments. Consequently, tangible (and productive) assets played a key role in driving economic output in the pre-1990s world.

The utility of capital has undergone drastic changes since the rise of the modern Internet in the 1990s. In the modern world, capital alone is not a significant driver of economic progress. Rather, capital is deployed to fund individuals who perform R&D to solve existing problems (Biotech) or to scale software companies so that they may address larger markets. In each of these cases, the talent of the entrepreneurs capital underwrites is the main driver of the economic machine, and the initial investment required to realize outlandish returns is minimal since these assets exist in abstract space; they are not rooted in physical reality.

Software companies can maintain massive margins for precisely this reason – these businesses are not capital intensive. The analog of physical capital in the digital world is superior design and/or a widely adopted network. If certain software is superior in addressing a problem, and the methodology the application leverages is challenging to replicate, users are more likely to choose that software over its competitors since competitors will be incapable of imitation. As a result of this initial adoption, it becomes more convenient for new users to choose that software as well since the technology’s initial adopters have likely established an ecosystem. Thus, software leverages network effects: a self-reinforcing feedback loop whereby “adding a new participant to the network increases the value of the network to all existing participants. Network effects thus create a winner-take-all dynamic. The leading network tends towards becoming the only network.” [1]

It is no surprise that venture capital firms seek to identify software companies that can capitalize upon network effects accordingly. Since these investments are not capital intensive, the risk-reward ratio of establishing a dominant software network is extraordinary. Software that becomes the dominant network in its space monopolizes a vertical of the digital economy, enabling companies to theoretically generate profit ad-infinitum. In this context, the P/E multiples of growing software companies are not so unreasonable given an environment of low-interest rates, minimal amortization of assets, wider gross margins since costs scale with users, and the non-zero probability of developing a dominant network.

Once a software establishes itself as a dominant network, it continues to generate economic value by deploying humans to advance the network’s objective. Facebook employs software engineers to drive user engagement, providing advertisers the ability to target specific consumer segments seamlessly and at low cost; Google hires engineers to enhance our ability to obtain useful information from all corners of the internet; Spotify recommends new music to listeners and generates unique playlists based on historical listening patterns. These networks are owned by companies that compensate engineers in dollars (or other fiat currency) for the sake of advancing the goal of their respective networks. The better the network is at performing its function, the more economic value it has, and the more profitable these software companies become. The stock market then reflects this increase in value through higher share prices…

To read the full post, please click here.