February 10, 2014

This post discusses two intriguing strategic trends in the technology, media and telecommunications marketplace. Both emerged from Silicon Valley. The first, affecting cloud computing, is a potentially subversive assault on AWS by Google. The second is the counter-intuitive way in which some Silicon Valley VCs now choose and guide management teams through to exits.

Let’s consider the cloud computing market first.

Amazon’s AWS has become the undisputed leader in so-called public cloud computing. Rivals find it hard to compete with AWS on price because – leveraging Amazon’s vast online infrastructure and size – it is able to deploy massive economies of (technology) scale whilst affording required investments by virtue of its parent’s low cost of capital. The public cloud – where one buys apparently unlimited computing capacity on demand and pays for it by the unit and by the hour – is a business model highly tuned to a firm with the heft and cost of capital attributes of AWS. Amazon’s AWS business likely passed the $1.5 billion in revenue mark in 2012 and effectively doubled to $3.2 billion in revenue in 2013. In Q4 2013 AWS seems to have hit $1 billion in revenues, or $4 billion annually. That would be more than two and a half times the revenue of Rackspace (NYSE:RAX), the largest publicly-traded, pure-play cloud competitor.

Rivals such as Rackspace and IBM (buyer of Softlayer) recognise this disparity and are instead focusing on value-added services and differentiated product. They are not inclined to compete against AWS in commodity public cloud.

Is the field of battle then left to AWS? Google would be inclined to disagree. The cash-pumping, search-and-advertising behemoth certainly has the advantages of scale and cost of capital to rival AWS. Indeed unlike Amazon, which perpetually is poised on the cusp of making money but somehow always seems to produce losses or infinitesimally small profits, Google is lavishly profitable. (Amazon produced a net margin of 0.4% in 2013, though analysts surveyed by CapitalIQ expect this to jump to 1% in 2014; by way of comparison Google’s net margin was 11.4%, with analysts expecting a leap to 20.6% in 2014.)

In this context’s Google’s launch of the “Google Cloud Platform” with the explicit aim of assuming a leadership position in cloud computing is highly interesting.

Google certainly has the scale. The firm spent $7.3 billion on data centre capital expenditures in 2013, $2.3 billion of that in Q4 alone. This is almost two and half times higher than the amount spent by Google on data centres in 2012 ($3.27 billion). Google’s strategy is to build several facilities on one data centre “campus” in order to leverage existing power, connectivity and other infrastructure. For example the campuses in Dalles (Oregon), Lenoir (North Carolina) and Berkely (South Carolina) facility each saw $600 million expansion programmes. The scale matches, indeed exceeds, that of Amazon (where total capital expenditure in 2013 was slightly under $3.5 billion).

Yet this does not mean that Google is poised to engage in a crude war of attrition with AWS. Google instead seems to have concluded that fibre is a war-winning weapon.

Google has steadily inked partnerships with municipalities in the United States to build out high capacity fibre optic networks (Austin, Texas as well as Kansas City, Missouri and Provo, Utah are three of the best known deployments). Google is now, in fact, probably one of the top five internet service providers in the US. Google’s fibre to the home (FTTH) networks were initially viewed by many as driving Google’s core search and advertising business (faster speed = more use of the Internet), but there may be important collateral benefits for the cloud platform. It can be theorised that lower cost connectivity (from the FTTH network) can be paired with low cost public cloud services (drawing on the scale and low cost of capital underpinning the Google data centres) in order to win clients. This would make for a differentiated offering, and one that does not play to AWS’ natural strengths.

Should users come to favour bundling – by one service provider – of low cost cloud computing and low cost connectivity, then the strategic ramifications could be significant.

The second counter-intuitive trend to discuss is more diffuse, but affects an even broader array of companies. Baldly put, some venture capitalists are so enamoured of disruptive technology that the traditional model for the “typical” startup (find a crisp management team marrying Harvard Business School-style commercial skills with deep engineering excellence, fund the business and then sell or launch a well-marketed, full disclosure initial public offering) is being challenged. Or rather it is being challenged in public in a manner designed to elicit controversy.

This past weekend, at a conference at Harvard’s Business School, the founder of a venture fund called Social+Capital Partnership stated that “It’s really unfair… but I think you are discriminated against now …”. Mr Chamath Palihapitiya (one of Facebook’s first employees) then carried on to tell students, alumni and others, “…. I would bet a large amount of money that the overwhelming majority of [VCs] would not look favourably on a company started by [a Harvard Business School graduate].” He continued by suggesting that, when evaluating entrepreneurs, naivete was an attribute he particularly valued.

Financial skills and management insights were belittled by another speaker, Mr Alex Benik of Battery Ventures. “Here are the things I don’t care about” he was quoted as saying by the New York Times: “EBITDA, capital structure, leveraged multiples.” What was important, he held, was a passion for technology.

These statements and others of their kind must be taken with several grains of salt, but they seem to be a reflection of the reality that ambitious, technologically interesting and massively money-losing businesses have been bought, or have IPO’d, at significant dollar values. As such worrying about the financial side may prove to be counter-productive.

Aiding this has been a 2012 law designed to assist a rebound in the market for new share issues by growth companies. The “JOBS Act” (JOBS being an acronym for “Jumpstart Our Business Startups”) allows companies to file for an IPO in considerable secrecy, revealing financial details a mere three weeks before the roadshow is to start. They are further able to meet with key institutional investors to gauge how interested the market might be in the prospective issue during this period of secrecy. This is important given that, in many market contexts, half or even three quarters of companies filing for an IPO do not make it through to a successful issue and the commencement of trading. The potential benefit of an IPO is, under the old rules, hedged in by the risk of significant public disclosure (to, amongst others, competitors) before it is clear if an IPO will in fact succeed. The old rules acted, in some ways, as a gating factor and a form of quality check.

The companies that take the route offered by the JOBS Act – cloud-based storage provider Box being a case in point – can therefore test the IPO waters before revealing anything meaningful in terms of financial information.

Taken together this points to an environment wherein VCs will fund a business primarily on the basis of how disruptive the technology is and the firms can approach an IPO without the historic levels of disclosure. As was seen with Twitter, and as will no doubt be seen with Box, disruptive technology is attracting capital and attention. As an investing model this works, until (of course) it doesn’t. At that point EBITDA and financial forecasts may actually regain some lustre in the world of venture capital.