Investing in Technology vs. Investing in Business Models — Part 1

One of the most enjoyable aspects of investing is developing mental frameworks. There is an art to it, and it is best done grounded in data, experience, domain expertise, principles, and collectively. This is why having partners and colleagues who are intellectual, curious, and honest are paramount to success. A mental framework is an explanation and representation of a person’s thought process (cognition) for how something works in the real world (external reality) — or in other words, the how and why behind evaluating or thinking about something.

A mental framework I find myself discussing a lot lately is the difference between investing in technology vs. investing in business models, and then developing mental frameworks around said categories. There are many ways to segment businesses, and none are perfect, but consistently one finds themselves evaluating a business that can be segmented as an investment into a technology more so than a business model, and vice versa. Sometimes, this concept finds itself related to investing in atoms vs. bits, but many times this is not the case, as many software (bit-based) businesses can themselves be more so a business model investment, or more so a technology investment, and sometimes businesses can be both!

When investing in a technology, you are investing in to some breakthrough that creates tremendous value for other technologies, and captures some of that value for itself. When investing in a business model, you are investing in some business model innovation that creates tremendous value for their customers to capture margin for themselves, or steals margin from other businesses to create margin for themselves and their customers. In my opinion, one of the best ways to properly evaluate segmenting these type of investments is to decipher what are the sustainable competitive advantages and growth engines, and using the 7 Powers is quite useful. I want to spend the next few posts writing about different companies that exhibit characteristics of both segments because I found it difficult to solely classify the best businesses as one or the other.

Fairchild Semiconductor

To begin, let’s look at investing an example of a business I would segment as an investment in to technology, with elements of an investment into a business model (we can argue . Our industry owes a tremendous debt to many people, but none more than to the Traitorous Eight who founded Fairchild semiconductor (founded a subsidiary to be exact but that is a conversation for another time). Continuing on the work the eight did under William Shockley, Fairchild pioneered the development of silicon based transistors and created the integrated circuit, finding tremendous success selling to the government during the Cold War. The company grew from twelve to twelve thousand employees, and was soon raking in some $130 million a year (over $1B in todays dollars) within a few years. Here we see an example of a company building and developing new technology products to be sold via a hardware or products based business model. You have your Bill of Materials, your Cost of Sales, your MSRP, and your margin. The investment then was not into an innovative new way of selling something that already exists, but it was creating something entirely new that would enable other entirely new things to be done, all more efficiently.

Or so I thought…

Fairchild is actually a great example of a cornered resource based technology investment adopting a counter-positioning strategy — when you look at their main customer channel and their pricing. To summarize, they are 100% a technology investment, but they innovated on the existing business model as well.

Fairchild was born at a pivotal time in our nations history, The Cold War, and the government was the largest customer for the growing semiconductor and technology industry. The beginnings of Silicon Valley were rooted in, and were funded by, the government and the defense industry and Fairchild was the beneficiary of the US government’s aggressive commitment to rapid technological progress. Concurrently, Fairchild priced all of its major integrated circuit products at $1. This was not only a fraction of the standard industry price for these chips, but it was also less than it cost Fairchild to make them. The reason this was possible is that the true cost of integrated circuits came from the R&D costs to design them, and capital costs to manufacture them; the actual materials cost was practically zero. This meant that the best route to profitability was to make it up in volume, which the government provided.

Now, pure technology investments are not without risk, and arguably have more risk than pure business model investments. They tend to be binary outcome investments driven by capital needs for R&D vs. S&M. They also can be servicing a small market, or one that does not exist yet, and invoke the skill set to understand the market making dynamics such a technology could have. The best way to gain conviction in such investments has historically been investing in a company with some preferential access to a resource whether it be human capital talent, IP, trade secrets, resources, or more — or a Cornered Resource. Secondarily, one way to gain conviction is an understanding that this company is an “N-of-1” company that also may be going after the problem, or building the business, in a different matter — or Counter-Positioning.

In conclusion, investing in Fairchild would have been an investment into a company that was at its core a technology investment that created tremendous value for other technologies, and captures some of that value for itself, but displayed elements of business model innovation afforded by the technological breakthrough. I would probably classify this as a technology investment with elements of a business model investment.