Challenges in Valuing & Capitalizing Enabling Businesses

This past week, I attended the Space Investment Summit in Boston. Interestingly, a large proportion of the entrepreneurs in this nascent industry depend heavily on a small number of recent innovations. For example, a number of businesses became feasible due to SpaceX’s Falcon 9 rocket, a private sector launch vehicle that reduces the cost of a rocket launch from NASA’s $10,000/lb to roughly $3,500/lb. Businesses that enable innovation can be astronomically profitable, but a toxic combination of risks and uncertainties means that they are generally capitalized in a frenzied investment climate.

Enabling businesses, companies (or institutions) that create new industries by acting as platforms for others’ wealth and value creation, are one of the most effective ways to monetize disruptive innovations. A disruptive innovation, such as the silicon chip or the internet, radically re-defines the market(s) in which it operates. An enabling business, usually with an enabling technology at its core, creates a new platform on which other businesses and technologies can operate. The key is that without the enabler the subsequent developments would not be possible.

The success or failure of an enabling business, as platforms, hinges greatly on their ability to spark an eco-system of businesses dependent on them. Another way of saying this is that enabling businesses are typically very viral. Virulence is a property of a business that describes how the value to a customer varies with the total number of customers a business has. A cookie company exhibits is non-viral because the quality of one customer’s cookie-consuming experience has a negligible effect on the next customer’s experience. Social networks, on the other hand, are highly viral since a network with a large, active community is far more valuable than one with only a handful of subscribers. Note that in the financial markets, the virulence of a product manifests itself in the form of liquidity (a product with few other buyers and sellers will be more difficult to sell without significant loss than one with an active market). Virulence securely ensconces the market leader, but is challenging to establish in the first place. There is no sure-fire way of predicting whether a business will spark a viral following; this adds a thick layer of risk to an investment in a potentially enabling business. This uncertainty makes these businesses, so critical to society’s progress, prohibitively risky investments to most investors.

Economic bubbles and frenzies push capital to the periphery of the investable universe, capitalizing innovative technologies and concepts that would otherwise be too radical to receive funding. To illustrate the point, imagine a landscape where each point represents a potential business and where elevation is how far from the status quo that potential business is, a proxy for its riskiness (and by definition its return before risk). On this landscape is an ocean of the world’s investable capital, with the water’s depth being a function of the local liquidity. As the ocean expands and contracts it covers and uncovers, or funds and disbands, various investment prospects. During a frenzy, the ocean’s waters surge over the landscape, submerging even the riskiest concepts in ample capital. When this bubble burst and the waters recede, it leaves behind isolated pools of capital. Most of these pools will inevitably dry up, but a few will sustain long enough to carve a path to the global capital markets. Until they tap the oceanic markets, these pools are specialty, or exotic, capital markets, providing fledgling industries and their enabling businesses with funding and credibility until they are ready to enter global waters. Without a frenzy to fuel highly irregular concepts, an economy would find itself void of the breakthrough, disruptive businesses characteristic of innovative civilizations.

Enabling businesses are catalysts for economic growth and technological progress. These companies act as gateways to new possibilities, generating historically over-performing profits from their dependents. Yet this dependency is really a co-dependency, given the virulence that characterizes enabling companies. This co-dependency is extremely difficult to model in a predictable way; further compounding the problem is that many enabling businesses hold at their core an innovative and often unproven technology. Together, these risks prove too much for most investors during calm markets. When a market boils over, however, these businesses are able to get the capital they need to grow. Though most still crumble under the weight of their risk profile, a few go on to change the world and make their investors spectacular returns.