Deep Tech Thesis, Potential For Return and Historical Trends
My previous article mainly discussed a high-level view of deep tech, why it is crucial, and where we are going with deep tech investments. I got a ton of fantastic feedback and lots of exciting questions that prompted me to think more about this question: “does deep tech as an investment thesis make sense for VCs and Angels?” I decided to look into why outsized returns can be found in deep tech investments and how has deep tech investments performed historically. I will introduce a technology/market risk quadrant to better define the risk/return dynamic.
Betting on Outsized Returns
As we evaluate startups for investment, two metrics always are discussed; technology and market readiness. In cleantech, for example, most companies have a proven market need but have an unproven technology. One example in cleantech is the need for a smaller, cheaper, and more efficient energy storage system (proven market), and many startups are working to prove their technology (unproven technology).
To simplify the idea of technology/market risk I am using the following matrix. Risk, reward and success are not defined by these two factors only and we are assuming every other variable is the same across startups, clearly, this is an overgeneralization of the innovation ecosystem. Evaluating an investment opportunity is never black and white and it is not possible to compare technology and market risk on the same scale. It is also fair to argue that black swan events causing a rapid increase in demand can lead to rapid value jump for both deep tech (e.g. BionTech) and shallow tech (e.g. Zoom) companies which clearly shows the fact that “Success has many fathers”. However, bear with me as this is a good model for our discussion:
Type I Deep Tech Companies: Proven Market and Unproven Technology
Most deep tech companies have unproven technology and carry higher risk and, as a result, higher rewards compared to shallow tech companies with proven markets (bottom left). Type I deep tech (Top left) companies have no market risk, they disrupt a vertical and can create a niche in existing markets, but they have unproven technology. There is no market risk for a new, reliable, low-cost, and efficient energy storage system. However, from lab to market, the technology scale-up is unproven. Now the question is will you rather be operating in this quadrant to achieve higher rewards or not?
The benefit of Type I Deep Tech companies is that if we can evaluate the technology and understand scale-up risks, we can price the risk in the deal and have a better chance of success.
Most VCs are surprised by the complexity of building a successful deep tech startup and rather operate where they understand the technology risk. The problem is that given the state of the market, accessibility of software and the sheer fact that shallow tech ideas out there are not novel anymore, the potential for outsized return of a shallow tech can be lower (not saying impossible, its not black and white) than ten years ago.
In fact, I argue that these shallow technologies are not startups anymore and should be categorized as small and medium-sized businesses. If, in Canada alone, there are over ten startups focused on reusable containers for delivered food, there is no real winner, there is no real differentiation, and indeed there is no outsized return. While these businesses could be in their own right successful, they are not massively scalable and disruptive innovations anymore.
Type II Deep Tech Companies: Unproven Market and Unproven Technology
I would simply rather not put the focus of my portfolio on the Type II deep tech (top right) quadrant where companies have unproven technology and unproven markets. However, there is a massive untapped opportunity here that can be realized by those who can stomach the investment risk.
Startups with both market risk and technology risk can be very challenging to bring to market, but they can also have significant potential for innovation and disruption. There are technologies that have historically made outsized returns which we have heard of. When Steve Jobs had a vision of a personal computer for everyone, no one knew if Jobs can pull off the tech or if people would buy computers for their homes. But he pulled it off and it was a home run for all investors.
A recent example of such a startup is Joby, the electric air taxi maker that went public in 2021. We can say that early-stage investors had a win after the IPO. But at ~$2.7B market cap this venture is still not generating revenue and we are not taking air taxis to work. They might pull this off and against all odds make it happen. But, it is the investor’s job to evaluate whether this is a risk they are willing to take.
Startups that face both market risk and technology risk typically require significant investments and have long development cycles, as they need to not only develop new and innovative technologies but also educate customers and build demand for their products. These startups also face the challenge of operating in highly competitive markets where established players may have significant resources and advantages.
Investors should carefully evaluate the potential risks and rewards before investing in such startups and should be prepared for a long-term investment horizon.
Innovative Shallow Tech: Unproven Market and Proven Technology
In his recent conversation at Stanford GSB, Airbnb CEO, Brian Chesky, shared how no one could believe that people would rent their apartments to strangers when he was pitching to VCs. A crazy business model innovation powered by software that no one saw could work is killing it. But can this happen again in 2023? how about a marketplace/social media for cheese lovers to buy and sell their favourite cheese and post pictures? I call it Chee-Z
When you review the list of 1000+ unicorns, you see a lot of food delivery apps and eCommerce stores globally that are copies of Uber and Shopify. I argue that in this day and age, there will be few or no new and unique ideas with no industry knowledge based on simple apps or software solutions that can make outsized returns. I have seen ideas that the brightest undergrads out of school come up with, they are not better than my Chee-Z idea.
The unproven market is such an important factor that according to a 2021 CB Insights analysis, the second top reason why 35% of startups fail is that there is no market need for their product. An analysis in 2019 showed the main reason for 42% of startup failures was a lack of market need.
Historical Deep Tech Investment Activity
According to Startup Genome, as of 2021, 77% of all VC funding in the U.S. went to software, e-commerce and cloud companies, while, manufacturing and other industries like energy accounted for just 4%. VC-backed robotic startups raised $17 billion in 2021, nearly triple from a year earlier. In Europe, nearly 25% of VC investments are in deep tech. Hello Tomorrow’s analysis published in 2021 shows 4X growth in deep tech investment from $15B in 2016 to almost $60B in 2020. While investment declined a bit in 2022, the sector has weathered the downturn far better than SaaS or B2B software.
In a recent TechCrunch article Karthee Madasamy, writes about the result of an analysis they have done at FMV partners. The capital and time requirements for deep tech startups to become a unicorn are on par with other startups. 5.2 years and $115M is the median for startups to become a unicorn.
So still less investment goes to deep tech than shallow tech, which should make investors looking for a new thesis more excited as deep tech is the space that is less crowded and is a missed opportunity for shallow tech investors who are afraid of deep tech.
Research published by BDC shows deep tech businesses are disproportionately more impactful than traditional VC-backed firms. Deep tech firms attracted 11% of start-up funding between 2014 and 2019 but were responsible for 17% of unicorns in that period.
If there is no market risk for a deep tech company (green line) and you are mainly betting on the technology risk, you are dealing with an extended R&D phase as compared to shallow tech (black line). But once the technical risk is alleviated a massive jump in value is observed as the adoption is bound to happen very rapidly. For a long time there is no light at the end of the tunnel and money is used for R&D which can be scary for some investors. The shallow techs where an existing tech is being exploited should test to evaluate product-market fit early in their journey. Since there is no IP or protection and the barrier to entry is low, then everyone can jump on the idea and gain market share.
Let me know what you think…
