In this episode we examine technology 'unicorns', start-ups that command huge valuations. In particular we look at the different valuations of hardware, software and services companies, and why some are considered more attractive than others, and why this might be heavily influenced by survivorship bias leading to some poor decisions to pivot what companies focus on.
The full transcript of the podcast is available below.
There are a few shining examples of fantastically successful technology vendors. You know who I’m talking about. But why do so many seem to make such a pig’s ear of addressing emerging new spaces?
Last week I talked about hyperscalers who are very successful and very big. Today I want to look at smaller companies. The Unicorns, and wannabe unicorns. And particularly how chasing being a unicorn can have negative consequences for a company.
First up, as we get into the autumn (or fall), the technology news start to come thick and fast. I’ve rather ignored big events over the summer, as there wasn’t a huge amount happening. Never is. But I think it’s now worth having a bit of a dig into some of the news stories of the week at the start of these podcasts.
The first thing I want to cover is an acquisition. Last week Ericsson bought Cradlepoint for $1.1 billion. Ericsson, if you’re not familiar with them, is a massive manufacturer of telecoms network equipment. Cradlepoint makes edge gateways and routers, hardware that sits in particularly vehicles, as well as factories and so on. This is a clear illustration of the changing dynamics of the telecom industry that I talked about in Episode 3 I talked about separation, innovation, explosion and particularly about the telecoms industry, and how there’s a lot of evolution going on in the space, with changing roles for who does what. In this case, it’s about Ericsson directly addressing enterprise customers, particularly for 5G private networks, i.e. a company has a dedicated network all of its own. They can sell them more-or-less a full offering covering hardware, network equipment and some software.
Some will argue that this puts Ericsson back into direct competition with its customers, the telcos. The idea of selling direct to enterprises was dropped back in 2017 to focus on being the operator’s friends and competing with Huawei. It all depends on execution though. Telcos have neither infrastructure nor hardware to sell to enterprise customers. So it doesn’t appear to compete directly on that. But it’s a bit more subtle than that. Once you have network equipment and hardware you don’t need much else, particularly if there’s dedicated spectrum, as there is in some markets.
Two thoughts strike me though. Firstly increasingly we see private 5G offers as being hybrid offers, including both an on-premises service and wide area connectivity when away from the campus. Think about supply chain or similar. Also, in many cases offerings from CSPs are based on a ramp up from using a slice of a public network through to using a private network. Potentially a much more appealing proposition. We shouldn’t necessarily assume that Ericsson wants to sell directly either. Its offer could be a white label solution, giving its operator customers a Private 5G in a box to sell to customers. Just add spectrum.
The other big acquisition is Nvidia of ARM. It has taken on all sorts of political connotations but it’s particularly interesting in the context of AI. So I’ll talk about it next week when I delve into that particular topic. Although I will talk about ARM a little later in the context of its sale to Softbank a few years ago.
Second up is an announcement from Semtech and Amazon. I mentioned Semtech back in Episode 6. It’s the company that ostensibly developed the LoRa LPWA technology. Under the new agreement LoRa will be used in Sidewalk, which is Amazon’s ‘neighbourhood network’ which initially focused on Bluetooth Low Energy to connect devices via so called Sidewalk Bridge devices, which include the Ring Cams and more critically Amazon Echo devices, which are today in half of US households. The range of BLE is about 100m. The range of Lora is several kilometers. 2-3 in urban areas, 7-10 in rural, perhaps. In fact the furthest range that has ever been recorded is 766km. About 500 miles. But that is, shall we say, extreme. The addition of LoRa therefore takes things to another level, creating a crowd-sourced network potentially covering the vast majority of households, at least in the US, whether they’re Echo users, or not. There may be a few issue to be resolved about the extent to which users will be comfortable with their broadband connection being used to connect other people’s devices. But the traffic will be tiny, and there’s good precedent for this type of model. In France the broadband operators used to split their client’s in-home WiFi (with their permission) between half the bands for the household and half the bands for the public. Plenty of other broadband providers around the world also did it. The flip side is whether people or businesses will be comfortable having their devices connected via someone else’s Echo and broadband connection. Obviously there’s issues of security and reliability to be overcome.
Big changes, from both Ericsson and Amazon in terms of the devices at the edge of the network. It’s a hot topic.
Onto the meat of today’s episode. I want to look a bit at unicorns. Not the fictional beasts but as a term for startup companies as coined in 2013 by Aileen Lee for startups valued at over $1bn. And specifically how some companies get to be unicorns, and how some don’t.
One good starting point is looking at the sale prices that various technology companies have managed to achieve, and the characteristics of those companies.
In this case specifically I want to talk about IoT and the measure of revenue multiples. That being the ratio of sale price to the revenue a company made at the point when it was sold. It’s is a crude benchmark for any organisation’s valuation. It ignores intellectual property, debt, underlying strong or weak management, and demand-side drivers around how desperate the buyer might be for the assets, and many other things besides. However, it does point to a trend.
By doing this analysis of recent sales (there’s a chart on the Wireless Noodle site) one major trend leaps out: hardware vendors (except those making semiconductors) and connectivity companies are valued a lot less than software companies. When Sierra Wireless bought IoT MVNO Numerex in 2017 the multiple on revenue was approximately 1.5x. Numerex had quite a few problems, and a betting man would have said that was probably a low water mark for this particular part of the value chain sector. In comparison, when Kore Wireless acquired Raco in 2015 the comparable figure was around 3x revenue. So a range of 1.5-3x for connectivity providers.
For hardware vendors it was typically even lower. Often little more than 1x revenue, although Ericsson’s Cradlepoint acquisition last week was about 6x revenue. So a significant outlier.
In comparison, software companies can secure a valuation (or sale price) of 15-20 times revenue. This might seem to dictate that software is the route to great fortune.
This is not necessarily true. The multiples of revenue for the successful sales are much higher. However, what is ignored are the hundreds of software start-ups that never go anywhere. Part of the reason for low valuations on the hardware side of the house is that there is almost always some residual business left that has some intrinsic value even if it has long ago drifted away from profitability. For software firms, that tends not to be the case.
Survivorship bias is a massive challenge in the technology world. Those small fraction of software players who manage to hit a demand sweet spot, typically at just the time when a moneybags buyer identifies a gap in its portfolio, can command 10x+ multiples on revenue. Anyone looking at the market opportunity in IoT will tend to focus on that too. For module manufacturers, for instance, who can typically only command 1-2x revenue valuations, the idea of diversifying into the software platform space is clearly tempting. However, the chances of hitting the jackpot and coming up with (by build, borrow or buy) a winning formula in the software space are low.
As ever, recommendations to organisations to diversify outside of their core business area, usually at substantial cost, are only worthwhile if that vendor proves against the odds to be successful at it. Part of the challenge is that it’s not entirely unheard of. The real success story was Jasper which pivoted from MVNO to software platform company, but its overnight success took the best part of a decade. The multiple in that instance was almost 20x revenue. On the hardware side, Silver Spring Networks’ acquisition by Itron was based on a revenue multiple that was edging towards 3x. Despite being predominantly a hardware company it had also developed a strong management platform alongside. However, the analogy with latter-stage diversification is not a great one, as SilverSpring built the platform capabilities much more organically alongside the hardware/networking offering.
The software market has the lowest barriers to entry of any space, but nominally commands the highest multiples on sales. However, what this fails to take into account is the number of software players that have fallen by the wayside in the interim (as noted above). The average multiple is hard to calculate without an effective way of including shuttered start-ups. But safe to say that the 20x+ revenue multiple exits are the exception rather than the rule.
The other variable that needs to be considered is scalability. Software platforms are almost universally scalable, allowing the vendor to sell to every client with almost no incremental cost, other than the direct cost of sales. The manufacture of silicon chips is as close to scalable as the hardware space gets. Module manufacture and reselling of connectivity have been much more localised and less scalable. The least scalable function is that of consulting or systems integration. As a result, valuations of organisations performing such functions will necessarily be lower. However, all of this presupposes that valuation is the ultimate goal. Not every company can be a unicorn, and the space for potential unicorns is crowded. It was interesting to see hardware vendor Libelium decide to diversify not into software, but into consulting and implementation services. That’s where there is money to be made, and real client need.
The final thing to consider is maturity. Any business that has not yet reached a steady-state can not realistically be valued based on a multiple of revenues. This naturally over-inflates the value of fast growing businesses when considered in terms of multiple of revenue; they just haven’t reached a reasonable revenue figure by which to be judged.
Diversifying out of core business and into an adjacent part of the market is an overly simplistic solution to any organisations’ woes, particularly if all it is trying to do is boost its valuation. Diversifying to secure synergies is a far more defensible strategy. Having eyes on the unicorn prize means that most hardware and connectivity vendors will miss the fact that high value software exits are the exception rather than the rule.
Vendors trying to be unicorns created a whole lot of extra friction in the market. One of the things I tried to do in the book I wrote recently, The Internet of Things Myth is provide instead some recommendations for how vendors can help to nurture a progressive ecosystem, as well as make a buck or two for themselves. I’m happy to share a brief summary of that here.
Make sure you’re not just following the herd. You can’t just plunge into IoT and expect to make money just because it’s a growth area. An undifferentiated ‘me too’ approach drives out value and ultimately doesn’t benefit the arriviste organisation: for instance, it’s hard to structure your organisation to sell new products, and margins are compromised. There is nothing wrong with building a set of capabilities to be useful in IoT. But it does have to be useful. SAP, for instance, has done a good job of pivoting a set of capabilities aimed at ERP towards IoT, a natural development.
Focus on your own piece of the value chain. It’s hard to be good at someone else’s job. As a complement to the previous point, most companies find it hard enough to be good at properly addressing the needs of their own market, let alone someone else’s. If you want to move into another part of the value chain you had better be at least 50% better than the incumbents. That generally means the application of scale, extension of capabilities through acquisition, or significant investment in building new capabilities.
Value, not valuation. Stop worrying about being a unicorn and look at where the gaps are. Some IoT companies will be valued at billions of dollars. Probably yours isn’t one of them. Stop worrying about finding the infinitely scalable universally adopted platform play. Start looking at where there are gaps to be filled and problems to be solved. A lot of the value that can be delivered in IoT in the next 10 years is in companies with know-how helping organisations with the practicalities of their deployments.
Steer your clients. The biggest potential pitfalls in deploying IoT in the enterprise are with the clients that are deploying rather than with the vendors that are developing. There are numerous challenges associated with implementing truly transformational IoT. Vendors need to steer their clients in the direction of making good decisions (as outlined below), for instance by ensuring that there is some commercial grounding for a PoC. It’s not good enough just to have a great product, you also need to provide leadership for your clients.
Show that you’re in it for the long haul. Most IoT investments, both consumer and enterprise involve some kind of long-term commitment to a particular product set whether it be an application development platform or a garage door. Everyone wants to be sure that their chosen provider/partner will continue to support the technology or product for the foreseeable future. Setting a precedent by abandoning products does not help with long-term certainty.
Secure by design. The single biggest concern for most people or organisations adopting IoT is security. This is worthy of a book in its own right. Put your product through penetration testing and honeypot trials. Following the introduction of the IoT Security Law which came into force in California at the beginning of 2020, it’s likely that lots of other countries will follow suit to introduce requirements for IoT devices to have “a reasonable security feature or features” anyway. Follow best practice such as the UK’s Code of Practice for Consumer IoT Security .
By following these simple rules, we think vendors will be much better placed to create an IoT ecosystem that works for everyone.
This week’s final thought isn’t a final thought at all. It’s an opportunity. Specifically it’s an opportunity to win a copy of my book The Internet of Things Myth. I won’t lie to you, I expected when I had boxes of books delivered to my house earlier this year that I’d get ample opportunity to hand them out. For obvious reasons that has proven not to be the case. So I have 20 to give away. To get hold of one, just follow the @TransformaTweet account on Twitter. Further details and links are on the Wireless Noodle website.
Next week, as mentioned, I will be talking about AI and particularly the extent to which we might or might not get to Artificial General Intelligence.
I hope you can join me.
Links to some of the research that I’ve refered to in this week’s show, as well as a transcript of the recording, will be available on the podcast website at WirelessNoodle.com
Thank you for listening to The Wireless Noodle. If you would like to learn more about the research that I do on IoT, AI and more, you can follow me on Twitter at MattyHatton and you can check out TransformaInsights.com.
Thanks for joining me. I’ve been Matt Hatton and you’ve been listening to the Wireless Noodle.