One of the biggest causes of death in the 1700s was the lack of washable underwear.

Back then clothes were made of wool. If you ever worn a woolen hand-knitted sweater, you know they are itchy and extremely hard to wash.

So hands were dirty, people scratched to calm the itchiness and didn't wash before eating. This was perfect transmission of microbes from waste to hands to food to digestive tract, causing a gastrointestinal infection which back then led to death.

The answer was found in innovation. The main product of the new technology that we know know as the Industrial Revolution was cheap, washable cotton.

For the first time, the common man could afford washable cotton underwear, putting a stop to the transmission cycle and saving many lives in the process.

As David S. Landes suggests in the introduction to The Wealth of Nations, "commoners of the late nineteenth and early twentieth century often lived cleaner than the kings and queens of a century earlier."

Just like the tech companies of today, the Industrial Revolution and the rise of machinery brought to market a very different value proposition that had been available previously and disrupting how society operated.

The mechanized cotton industry in the late 1700s was the equivalent of today's technology industry and the mechanized cotton-producing mills were the tech companies.

Technological revolutions then and now

Technological breakthroughs like the Industrial Revolution are seen continuously throughout history.

As Carlota Perez proposes in her seminal work Technological Revolutions and Financial Capital, technological revolutions go in cycles: great surges of technological development followed by quieter periods of adaptation. Perez describes two distinct periods that last two or three decades each:

Installation, during which the critical mass of the industries and infrastructures of the revolution are put in place against the resistance of the established paradigm and driven increasingly by the criteria and the turbulent dynamics of financial capital

Deployment, during which "the transformation potential of the revolution spreads across the economy, yielding its full development benefits." Technology becomes ubiquitous and innovation slows down.

Each period in turn goes through two different phases, so that the recurring sequence is made up of four phases lasting around a decade each.

Where are we right now?

The Industrial Revolution ended, then came the Age of Steam and Railways. 200 years and three cycles later, we are now in the Age of the Internet & Telecommunications.

That cycle is right now on its second half, the Deployment age.

One of the effects of the Deployment Age is that innovation becomes ubiquitous.

At some point in time, as all companies started adopting machinery to operate, mechanized cotton companies stopped being mechanized companies and started being just cotton companies.

It's worth considering that the same will happen today.

This essay is an attempt to understand how the definition of a tech company is changing and the impact of said change in capital allocation over the next decade.

But let's start by defining what a tech company is (or has been until now).

Defining a tech company

Ben Thompson defines tech companies as follows:

Software creates ecosystems. Software has zero marginal costs. Software improves over time. Software offers infinite leverage. Software enables zero transaction costs.

The question of whether companies are tech companies, then, depends on how much of their business is governed by software’s unique characteristics, and how much is limited by real world factors.

He proposes a few examples, Netflix being one of them:

Consider Netflix, a company that both competes with traditional television and movie companies yet is also considered a tech company:

There is no real software-created ecosystem.

Netflix shows are delivered at zero marginal costs without the need to pay distributors (although bandwidth bills are significant).

Netflix’s product improves over time.

Netflix is able to serve the entire world because of software, giving them far more leverage than much of their competition.

Netflix can transact with anyone with a self-serve model.

As Thompson said, Netflix checks four of the five boxes so we can consider it a tech company, while someone like WeWork, who  pays a huge percentage of its revenue in rent..

The proposition I'm putting forward is that software and its unique characteristics won't be the decisive part when defining a tech company.

Instead, something else, something bigger, will take precedence. Lets cover two of those five points – software improves over time and marginal costs – and how they are changing.

Improvements over time and the rate of innovation

One of the defining factors of the Deployment period is that technology's improvement trajectory (what we want to do with that technology and how we want to apply it) is very clear.

As a result, we've reached a point in which technology and innovation as we know it is ubiquitous. But a side effect of being everywhere is that there's no room for expansion and therefore the rate of new innovation dramatically slows down.

The Deployment Period is not an age of exploration because there's no more green pastures. It's not the time to arm the rebels but rather expand the technological paradigm to the rest of the population.

Here's where it gets tricky.

Improving over time is a key advantage unique to software. It's what allow technology companies to expand markets, retain customers and fend-off competition.

But when software and innovation is everywhere, that advantage disappears as a function of everyone having it.

If everyone uses the NZT-48 pill from Limitless, then the drug isn't an edge, it is a prerequisite to operate.

Marginal costs and zero-sum games

Another clear advantage of software is zero marginal costs. Tech companies can invest, develop and produce software upfront and then sell infinite copies at no extra cost.

This eliminates the physical barriers to scaling and enables the possibility of uncapped returns at exceptional velocity.

In the chase for said returns, startups compete against incumbents for two resources:

  • Attention from consumers.
  • Budget from other companies.

For the past couple of decades, we've seen a both attention and budgets expand astronomically. Here's John Luttig on When Tailwinds Vanish:

As market tailwinds grew at 20%+ CAGR, the market dynamics shifted so quickly that incumbents couldn’t react, leaving room for startups to emerge. When SaaS spend grew 50% per year, it was hard not to find green pastures as a new software startup. And consumers doubling their Internet spend and smartphone usage simultaneously every couple of years opened a massive window for new mobile applications.

But the party is over and we are coming to a stop.

Internet penetration in the West is at all time high and attention is physically limited as "people can’t spend more than 100% of their time or money on the Internet".

On the other hands, company budgets are being shrunk by a mature  industry and accelerated by the COVID-19 pandemic.

Luttig summarizes the result better than I ever could:

We are building an exponential number of Internet companies that compete over ever-shrinking slices of consumer attention and enterprise spend, increasingly locked down by incumbents.

The problem with startups competing for a static pie and entering a zero-sum game is they have embedded growth obligations – they either grow to maintain their position or die trying.

With a mandate for growth, a shrinking market and furious competition for the same ad inventory and enterprise budget, startups will need to "invest more heavily into sales, marketing and operations" to maintain growth.

Companies can make infinite copies of their software at zero costs but can't sell said copies at zero cost.

In reality it's the complete opposite: startups will grow linearly, directly following their investment in sales, marketing & ops.

"As an enterprise software company, on the other hand, your growth would slow as you fire AEs, and churn would increase as you shrink your customer success team."

Suddenly, what look like zero marginal costs in theory become real costs in practice. Ben Thompson raised similar concerns when looking at Uber:

"A major question about Uber concerns transaction costs: bringing and keeping drivers on the platform is very expensive. This doesn’t mean that Uber isn’t a tech company, but it does underscore the degree to which its model is dependent on factors that don’t have zero costs attached to them."

What happens when building an Internet company becomes like Uber getting drivers - expensive and zero-sum?

Zero marginal costs stops being a unique characteristic of technology companies because in practice the cost isn't zero.

Disruption and defining a Tech Company

My proposition is that we should raise the bar for what a technology company means and therefore, how we think about capital allocation.

First, why is a label even important?

Because how you call things matters. You might be surprised by this, but our mother tongue has a deep influence on how we think about the world.

Here's an example.

If you are from the West, you are used to think about left, right, front and back. You are the center of your world, so you the two axes (left-right, front-back) depend on the position of your body.

In short, our axis always shifts together with our vision so we always know where "in front of us' mean, regardless of the location you are describing.

These are called egocentric coordinates: "Turn left, then right, then keep going'. On the other hand, you have 'geographical coordinates'. "Go north, turn south", or "The UK is north of France".

You'd imagine everyone does the same thing. You are wrong.

The tribe Guugu Yimithirr, an Australian Aboriginal Tribe from the Queensland area doesn't use egocentric coordinates at all. They don't have words for left or right, and don't use words like "in front of" to describe the position of objects, because they rely exclusively on geographic coordinates.

Here's Guy Deutscher in Through the Language Glass:

If Guugu Yimithirr speakers want someone to move over in a car to make room, they will say naga-naga manaayi, which means 'move a bit to the east'... Instead of saying that John is in front of the tree, they would say 'John is just north of the tree

They maintain this even when telling stories, reading or explaining hypothethical situations.

You might not think about it, but as Stephen Levinson and his colleagues from the Max Planck Institue of Psycholinguistis proved in this study, this completely changes our perspective of the world.

Second, why should we consider adjusting the label?

Because labels are identifiers and the characteristics that originated said label aren't in place anymore. If everything becomes a tech company, then the 'tech company' label loses meaning.

This is crucial because zero marginal costs and improvements over time is what made venture capital possible. They enable 1000x multiples.

That dynamic is over.

Connecting a thermostat to the Internet wirelessly is awesome, but calling it an Internet-enabled thermostat will start to be like calling a vacuum cleaner an electricity-enabled broom. And if your thermostat does not connect to the Internet, it will be bought only by retro-chic hipsters

So what should we do instead?

Narrow our definition of what a tech company is by assessing whether it's a disruptive technology or a sustaining technology.

"Disruptive technologies bring to a market a very different value proposition than had been available previously. Generally, disruptive technologies underperform established products in mainstream markets. But they have other features that a few fringe (and generally new) customers value. Products based on disruptive technologies are typically cheaper, simpler, smaller, and, frequently, more convenient to use."

The distinction made by Clayton Christensen in The Innovator's Dilemma has become more important than ever: in the Deployment period, sustaining technologies are everywhere and the disappearance of zero marginal costs means that the scale and exit landscape for said companies has changed.

The age of Instagram-esque acquisitions where 13-person companies with millions of users and zero ad spend go for billions of dollars is over. Not even in the consumer space.

So who will get acquired?

Companies with truly disruptive technology. Building software is not enough since all this software has already been built, making it harder to find a true edge. What we used to call tech companies can't provide the return that a typical venture fund expects.

Smaller funds who can thrive with $100 million acquisitions can still play the old game, but bigger funds with world-changing ambitions will need to adjust and focus on the new unit economics that only disruptive technology companies can provide them.

Fortunately for us, Europe has just the right skillset to build, fund and scale disruptive deep technology companies.