Tech vs. Capital: The Inescapable Debate on Scalable Innovation

| Start-up in the Making (or Breaking) |

What happens when innovation, one of human’s greatest gifts, runs into money problems?

Start-up founders have wonderful visions and missions to build a “better future” through their envisaged product or service creation. They would work unwaveringly day-and-night to build their proprietary technologies.

However, for their ideas to take off and scale, oftentimes they need initial (and continual) capital support from investors, especially for seed-stage and pre-revenue companies. Hence, founders must learn and sharpen one important skill that is irrelevant to tech development but essential for start-up operations: fundraising.

While entrepreneurs need to spend time on sourcing capital, dedicating too much effort on fundraising will distract them from building their innovative product, which is ultimately the core value creation of a start-up.

This begs the question:

Should start-ups put their priority on developing tech or fundraising for the company?

It’s a classic conundrum in the start-up world.

During my time at an electric car (EV) start-up (2016-2019) where we decided to engineer our car in Silicon Valley but manufacture in China, “tech vs. capital” was one of the most critical debates between the two co-founders, between the finance and engineering team, and between the board and senior management.

The Correct but Clichéd Answer: You need both, or a balance of both.

For an electric car to be functional, it needs the battery, an electric motor, the drivetrain, and four wheels at the minimum.

Similarly, for a start-up to work, you need both the tech and the financing.

But many entrepreneurs cannot have the cake and eat it. In reality, the process of fundraising is demanding and onerous. At the early stage of a start-up, it may require the core team to divert a significant amount of time and resources from developing its actual product.

When I (as the corporate finance director) was running the Series B financing round of my then two-year-old EV company, the investor community desired to see an actual prototype that people can drive and experience the basic in-car software applications that we claimed to include.

It seemed a sensible request from the investors, but to come up with a workable vehicle prototype with sufficient user friendliness at that embryonic stage was premature and required a meaningful amount of design, engineering and manufacturing work that may not ultimately contribute towards the development of the actual vehicle for mass production.

Adding fuel to the fire was the fact that we needed to budget extra funding to speed up the development of the prototype so that we can secure our financing on time.

We knew that to force out a prototype at that moment would be a distraction from achieving the goal of vehicle mass production, but we had to address investor requests in order to obtain funding to continue pursuing our mission. The conflicting priorities put our co-founders in a very difficult position.

This exemplifies why start-up founders often need to formulate the proper strategy with a strong sense of judgment to help determine when and how to prioritize.

It is where the debate starts.

The Silicon Valley Answer: Is that even a question? Tech, of course!

Without a doubt, the success of a start-up is fundamentally predicated upon the excellence of the innovative product or service.  Product is the key driver of a company’s revenue and operating cash flow.

Think about the life-changing smartphone invented by Apple, the cost-effective rockets built at SpaceX, the residential rental sharing services provided by Airbnb, the popular game Fortnite developed by Epic Games, the payment processing software serviced by Stripe, the civilian drones produced by DJI, the short-video sharing platform created by Bytedance… all of these became incredibly popular because of the massive value they created through their outstanding product and service offerings that are powered by advanced technologies. 

The co-founder at my EV start-up who has an engineering background and many years of experience at BMW Germany was always vocal about prioritizing development of the car as he believed that producing a high-quality product is the definitive way to win customers and investors.

The argument against prioritizing capital goes:

Money is a commodity. It does not help a start-up differentiate. There is plenty of it out there, especially with central banks flooding the market with liquidity and pushing up asset values around the world.

The finance function of a start-up is a cost center. It merely supports the engineering team by performing financial analyses and strategic capital allocations. Money itself does not drive innovation.

When you have a winning product, money will follow.

The amount of capital raised (and consequently, the valuation of the start-up) is merely a manifestation of the company’s status quantified in monetary terms.

Without the product and technology, even if it possesses billions of dollars, the start-up is nothing. It is not an asset management play.

The Asian Perspective: Whoever has a deeper pocket wins. It’s that simple.

While this perspective involves a certain degree of generalization, what I am trying to highlight is that the mindset and value system in Asian societies tend to be more realistic, as I have experienced first-hand over the years, particularly in China.

Before I dive into the counterargument to prioritizing tech, I want to reference an entrepreneurial notion introduced by LinkedIn co-founder and venture capitalist Reid Hoffman called “blitzscaling”.

According to Hoffman and entrepreneur Chris Yeh, “blizscaling” is “the pursuit of growth by prioritizing speed over efficiency in the face of uncertainty. It is a risky strategy, but it is the right strategy for outracing the other players when competing for enduring leadership in a winner-take-most market”.

To put it simply: scale as quickly as possible by burning countless amount of capital in order to dominate a new market. Think Uber, Airbnb, WeWork.

(Google, Amazon, Facebook, Apple, and Microsoft are successful case studies, according to Hoffman and Yeh. But I think these examples are debatable as their time frames and stories are different, and it depends on how you interpret the concept of blitzscaling.)

The concept of “blitzscaling” may seem outlandish, as it suggests undermining financial efficiency in favor of rapid scaling and ascendancy of industry leadership. But the implicit assumption here is that there is a superfluous amount of capital available for start-ups to burn.

If you are a start-up entrepreneur who believes in “blitzscaling”, and assuming that you are in an industry where “blitzscaling” makes sense, the question is, how important would capital be to your business?

The answer is obvious because without enough capital, without the luxury of being financially inefficient, “blitzscaling” is irrelevant.

Should you then prioritize securing substantial financial capital?

The debate is particularly illustrative when we look at the development of the global ride hailing industry, where “blitzscaling” is adopted extensively.

Most people would think that Uber is the current global market leader (by revenue and brand perception), followed by DiDi (which is #1 by number of rides completed).

Both loss-making companies were able to burn through billions of dollars and scale up to where they are today largely because their investors have supplied a big enough cash balance, larger than their smaller competitors that were eventually taken out.

Their sizable cash positions also allow them to lead the industry’s consolidation.

Uber owns Dubai’s Careem and has stakes in DiDi, Grab, and Russia’s Yandex.taxi, while DiDi owns Brazil’s 99 and has stakes in Uber, Grab, US’s Lyft and Estonia’s Bolt (formerly Taxify).

The real mastermind of ride hailing, however, is Masayoshi Son’s Softbank, the major investor across the US’s Uber, China’s DiDi, Singapore’s Grab, and India’s Ola.

With the industry’s intertwined ownership structure, Softbank effectively owns the ride hailing market in China (via DiDi), Southeast Asia (via Grab), India (via Ola), Middle East (via Uber’s Careem), Australia (via Uber and DiDi), Latin America (via Uber and DiDi’s 99), and a significant part of North America (via Uber).

Amidst the Japanese tech giant’s substantive industry exposure, there has been speculation around Softbank’s influence on its portfolio companies, including Uber’s decision to exit China and Southeast Asia (so that Uber, DiDi and Grab can dominate their own markets and turn profitable sooner).

How did Softbank manage to have a de facto monopoly on the ride hailing industry?

Well, they came up with a US$100 billion Vision Fund to transform (or, as some argue, distort) the global technology landscape (of which US$45 billion was raised in 45 minutes!).

Had there not been the tremendous amount of capital provided by the Masa’s tech magnate and other blue-chip financial backers, the global transportation industry might never have been revolutionized in the way that it stands today.

The argument against prioritizing tech goes:

A start-up is a business after all. Nothing is more real and tangible than money, which is the raw fuel in business. Operating without funding is like farming without water.

An entrepreneur’s vision will not be crystallized without sufficient funding. On the other hand, the more funding you secure, the more likely you can achieve your vision.

When you have money, talent and tech will follow.

Does capital drive innovation? Not necessarily.

Is capital necessary to scale innovation? Absolutely.

Room for a More Thought-out Answer: It depends.

Because of powerful network effects, software and internet-based businesses are mostly in the winner-take-most markets, where an effective monopoly or duopoly actually generates more value to consumers than a situation with numerous players. This is especially true when you are building a digital platform or marketplace.

Some prime examples are Google (search engine), Amazon/Alibaba (e-commerce), Facebook/Twitter/Tencent/Bytedance (social media), Microsoft/Apple/Google (PC and smartphone operating systems).

But not all high-impact, disruptive ideas require burning through billions of dollars upfront to succeed. According to Crunchbase:

Google only raised US$36 million before its IPO in 2004, through which it raised another US$1.7 billion. The company was already net income positive for at least two years before its listing.

YouTube only received a total of ~US$11.5 million in funding between 2005 and 2006 before Google acquired it for US$1.7 billion.

TripAdvisor only received US$3.3 million before Expedia acquired it in 2005 and spun it off via an IPO in 2011.

My favorite example (and that is not a marketplace) is Khan Academy, a non-profit educational organization that produces online tools and short lessons in the form of videos. They received US$10.2 million of funding in grants, but their positive impact on underprivileged students around the world was simply invaluable.

While not every entrepreneur is inspired to create a software empire or develop an online marketplace, some start-up companies operate in industries where large amount of financial support is not only required, but vital.

Tesla and SpaceX are two well-known, vivid examples.

I have encountered the same situation at my EV endeavor.

The value proposition of my previous EV company was to develop a premium, smart electric vehicle that is designed to embrace the forthcoming era of shared mobility and autonomous driving. While the vehicle does require the internet network to be intelligent, the fundamental prerequisite is to build a physical car.

Although the EV market has immense potential to grow, the business of making a car does not allow the company to take advantage of the network effects. The speed of distributing physical cars to customers is also structurally slow compared with that of internet companies.

Most importantly, to develop and manufacture a car (not a mobile phone), incurring considerable fixed investments is inevitable.

It is a difficult case where the company must burn through hundreds of millions merely to meet the bar of mass manufacturing a car, which means that it will not be able to scale up fast enough to take out competition (not possible in the auto maker space – even Toyota only accounts for ~11% global market share of vehicle production). Tesla went through the same challenge.

The other co-founder who has a sales and marketing background from BMW China understood the importance of our product development, but unlike software businesses which have vertically zero or negligible marginal cost, to electrify and produce a high-quality vehicle at scale requires significant upfront and recurring cash burn. Therefore, he was more supportive on prioritizing fundraising.

Putting aside the notion of scalability, it is worth highlighting that there is a new wave of internet-powered entrepreneurship where individuals can leverage digital platforms entirely with manageable upfront cost to promote goods (physical and digital) and build their own communities by utilizing their creativity, knowledge and witty ideas.

They are the key beneficiaries of the Covid-19 pandemic – the Youtubers, Instagrammers or Tiktokers that you watch, the yoga instructor that you follow, the personal finance advisor that you listen to, the online coding course that you signed up for, and the foreign language teacher that you hired to educate your kids.

Although they are not building world-changing companies (i.e. they are not building their own tech), these newly empowered individual entrepreneurs represent an emerging group of start-up businesses. Because of the low setup cost, the individual entrepreneurs possess minuscule need to fundraise.

The point here is that whether you should prioritize tech development or capital raising depends considerably on the industry landscape, sub-category, specific region, your vision and your particular entrepreneurial idea.

My view on the examples above:

In the case of building a marketplace or Software-as-a-Service (SaaS) company, assuming the circumstance allows, I would prioritize tech. Earn your way to scale first, then take fundraising more seriously.

In the case of vehicle electrification, I would prioritize funding security over product development, because the nature of auto manufacturing requires high capital expenditure that you simply cannot participate without the financing.

In the case of individual, internet-enabled entrepreneurship, I would prioritize digital content and product development, because you are rewarded online by productizing your creativity and knowledge, which does not require high R&D and distribution cost.

My Answer to the Tech vs. Capital Debate

Although I am fascinated with the debate and eager to seek the winner between the two subjects, the debate itself actually distracts us from thinking about the bigger fundamental problem. 

From my perspective, the ultimate key is the people involved in the start-up.

By design, a start-up entrepreneur would prioritize developing an amazing product, not raising money or financial return. An investor is always in the capital camp with the key focus on ROI and less on the vision of the start-up.

As such, they do not naturally fit well together. A mismanaged founder-investor relationship can cause unnecessary politics, potentially detrimental to the survival of the company.

What we need is forging a trust-based, vigorous “team” formed by a partnership between perseverant, mission-driven entrepreneurs who understand the significance of raising capital and smart, entrepreneurial investors who respect and support the mission of the start-up founders.

Good technologies attract capital, which leads to great technologies that yield more capital. If the team can genuinely collaborate on commencing this virtuous cycle, then they are one major step closer towards scalable and sustainable innovations.

Finding the “team” is easier said than done. What is probably more useful is to work towards becoming part of the team yourself.

Whether you are an engineer or accountant, an entrepreneur or investor, if you are interested in participating in the world of start-ups, I recommend that you strive for a more sophisticated understanding of both categories.

A start-up starts with people, not capital or technology.

It starts with you.


Sherman
Time to Mobilize.

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