Traditionally, a tech company stood for an entity which dealt in building hardware, and/or writing software and applications, and providing services such as maintenance and training. IBM fitted that description perfectly—of building and engaging in an ecosystem around technology.
Zero marginal cost of the software made for a unique characteristic of the tech companies. Salesforce and cloud computing heralded another era in the evolution of technology companies. With Software-as-a-Service (SaaS), all that the customers needed was an email address and a credit card. Easy to try, free to buy, by anyone, anywhere became other unique characteristics of the tech companies in addition to zero marginal costs, increased returns to scale, and ecosystems.
As per an HBR article by Harvard professor Vijay Govindarajan and University of Calgary professor Anup Srivastava, a tech company may rightfully qualify as one if “it can transform whole industries, achieve expansion of scale, scope at breakneck speeds, make enormous profits without requiring significant capital investments”. Alternatively, as per tech strategist Ben Thompson, who writes the Stratechery newsletter, a tech company may be considered to check-box the following attributes: “Software creates ecosystems, has zero marginal costs, improves over time, offers infinite leverage, and facilitates zero transaction costs.”
Netflix has no real software created ecosystem. Netflix disintermediated the traditional distribution channels (cable, satellite) to create an OTT streaming industry and delivers product at zero marginal costs (not counting the internet bills to the customers). The product does improve over time with more robust library (original, new releases and catalogue). Netflix has tremendous leverage with a worldwide footprint owing to the software. The consumers engage with Netflix on a self-serve model with zero transaction costs. With four checkboxes delivered, Netflix qualifies as a tech company.
Uber and Airbnb—the poster boys of sharing and platform economy—also check out most of the boxes. The platforms improve over time, they serve the entire world with great leverage and transact seamlessly with a self-serve model. Both have a software created ecosystem. Both smartly position their businesses with minimum/low marginal costs even as large shell-out of 80-85% of revenues to hosts/drivers may not qualify as zero marginal costs. Overall, both do qualify as tech companies even as on-boarding and engaging drivers in the case of Uber is substantial additional costs.
And WeWork—a real estate company that uses tech. The software created ecosystem may not merit as a steering factor for the business. There are build-out costs and lease obligations like a substantial percentage of its revenues as rent. Its offerings do have the possibility to improve over time. The number of locations it builds out may however be a constraint. Instead of being self-serve, even a one-person rental demands a consultation while large business dealings rely heavily on brokers.
The narrative-stretch game
Wall Street views traditional media companies as being worth 9 to 14 times their enterprise value (EV) to EBITDA. The tech companies, on the other hand, get valued on a price-to-sales (P/S) basis. Example—Salesforce’s price-to-sales (P/S) ratio is 9.49 as on Jan 21, 2020.
Smart companies across industries have successfully played the narrative card to move from a P/E based to a tech-led subscription-based valuation employing a price-to-sales (P/S) basis. The result – huge benefits to shareholders.
Examples abound. Adobe from a one-off license-based software package seller to a publicly pronounced subscription-based business model in May 2013 led its P/S ratio to shift from 4X to 15.4X today. Microsoft from a pre-Satya Nadella era of ‘take-all-the-money-upfront’ software seller to subscription-based services for cloud and office 365 shifted its P/S ratio from 3.3 then to 9.93 today with a stock price of 166.5 after hovering at around 28 median average for the preceding decade. The biggest product-based (and P/E anchored) company not far behind, Apple from a P/S ratio of 2.2X in early 2016 when it began reflecting ‘services’ revenues to 5.71 today—more than two and a half times of what it was 3 years ago.
Comcast, declared as the world’s biggest media company as per 2019 Forbes Global 2000, has a price-to-sales (P/S) of 2.01, Disney, the second biggest, 3.37, Alphabet 7.15, while Netflix, the world’s fifth biggest media company, sits at a high 8.09.
To be sure, investor-logic for backing subscription or services-based revenues is not hard to fathom. The revenues reflect stickiness and greater margins.
Being defined as a tech company counts too. The other upsides consist of appealing to talent, attracting funding, accessing tax incentives and subsidies, and avoiding or delaying tax regulations and taxes.
Being labelled a tech company is not just about looking cooler. Other sinister advantages abound too when you adopt the label. Like systematically shirking inconvenient laws or regulatory frameworks where the Theranos scandal is a case in point. Or opening up new avenues of investment being classified as a tech business that qualifies companies like WeWork to gain unprecedented access to capital.
The conventional meaning of technology is attributed to producing things more efficiently which works for sustaining technologies. Disruptive technologies, on the other hand, are cheaper, simpler, smaller and frequently more convenient to use as per Harvard professor Clayton Christensen of the disruptive innovation fame.
Netflix, Uber and Airbnb fit the bill here as they digitised a core customer need, be it time or trust. The marketplace playbook leverages today’s exponential technologies - smartphones and cloud computing – and is itself software and thus interminably leverageable and perpetually-enhancing.
Whether it also applies to WeWork, or mattress maker Casper, or ‘streaming video workouts enabled’ stationary bike maker Peloton Interactive, or salad restaurant chain Sweetgreenor, direct-to-consumer online bra retailer Harper Wilde, is difficult to say. Technology makes them different than the incumbents in the space, perhaps great disruptors too, but they may not necessarily qualify as tech companies even as WeWork and Peloton cite technology a 100 times in their prospectus.
Creating value is not the only attribute of being a tech company. A successful business needs to capture and extract that value to deliver profits. True software companies with hefty gross margins of 75% know it and deliver it too well. Goosing up value by selling the tech moniker is a different game, however.
Genuine tech companies need to be differentiated from the wider tech ecosystem. With technology woven into everything now, the tech v/s non-tech question cannot be answered only in binary terms.
Positioning oneself as a tech company—exaggeration, outright lie or the truth—is all shades of grey now.
Semantics matter. Definitions matter even as they mislead. Real issues matter more.
Views are personal.
The author is executive-in-residence at ISB and at UCLA, is a global CEO coach, and a C-Suite and startup advisor.