Market-Makers, Surfers and 10x’ers: A Model for Investing in Enterprise IT

Warren
Buffet’s right-hand man and Vice Chairman of Berkshire Hathaway, Charlie
Munger, credits much of his and the Oracle of Omaha’s success to an adherence
to mental models, particularly in their power to guide investment decisions. Munger,
in his 1994 commencement address at USC Marshall School of Business, elaborated:

…the first rule is that you
can’t really know anything if you just remember isolated facts and try and bang
‘em back. If the facts don’t hang together on a latticework of theory, you
don’t have them in a usable form.

You’ve got to have models in
your head. And you’ve got to array your experience—both vicarious and direct—on
this latticework of models…

Mental models
help investors make heads or tails of fact patterns to problem-solve quickly;
something that’s become increasingly important as the velocity of companies
formed and funded has accelerated to breakneck speed.

Most models tend to be deductive,

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together premises believed to be true to arrive at a logical
conclusion. For example, given a startup with little or no historical
performance, VCs will default to evaluating the company across its market,
management team and product and gauge alignment among those variables. If each
variable and alignment among them is strong then they likely proceed with the
investment.

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Figure
1: Market-Management-Product Prism

Another approach
is inductive. This involves starting from a specific observation and moving towards
broader generalizations that can be reapplied to the specifics of a given
opportunity. It goes something like this: company X and Y exited for over $1
billion each and had green logos (specific observation). Therefore companies
with green logos yield better outcomes (generalization). Company Z has a red
logo. Pass.

Clearly the previous
example is an oversimplification, but it points to the fact that inductive
reasoning can be dangerous when generalizations become dogma. After all, there
are exceptions to every rule and often it’s those very exceptions that become breakout successes.

However, when
used appropriately inductive models can be powerful short-hands. In particular,
I’ve found that enterprise IT lends itself nicely to this approach. Why?
Because by its nature the enterprise IT stack is a dynamic organism where
interactions between stakeholders (customers, suppliers, partners, etc.) are
tightly coupled and tend to repeat in cycles. Consequently, patterns emerge
which can be mapped on new opportunities.

With that, I’d like
introduce a model that I’ve found helpful in sorting through enterprise
opportunities efficiently. This model holds that there are three types of
winners in enterprise IT: the Market Maker, the Surfer and the 10x’er. Generally,
if a startup doesn’t fall in one of these buckets, it earns a pass from me. Let’s
unpack this by exploring the characteristics of each type of winner in more
detail:

The
Market Maker

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Market Makers bring
a discontinuous innovation to market and thereby become synonymous with the
technology they spawn. Think Cisco with LAN switching and Oracle with relational databases.

Note that
these companies do not have to be responsible for the original technical
innovation, but most often are the ones who commercialize it successfully. SaaS
was previously called ASP (application service provider) before Salesforce starting banging the “No Software” drum. Virtualization was invented at IBM
in the late 1960s before VMware brought ESX to market in 2002. Similarly the earliest
iteration of containers have lived in open source Linux code for decades before
Dotcloud became Docker.

The defining
characteristic of these companies is that they catalyze a platform shift and, often,
an accompanying outbreak of commoditization that makes its way down the tech stack.

The
Surfer

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Surfers
leverage a market dislocation catalyzed by a more general secular trend or by a
Market Maker, and take advantage of unique conditions to bring innovations to
market that serve an emerging customer need.

Cloudera developed a distribution of and tooling for Apache Hadoop at
a time when unstructured data growth began to outstrip the capacities and
capabilities of existing data warehouses and as commodity hardware invaded datacenters.
Pure
Storage
was founded when
the price/GB of consumer-grade flash had declined sufficiently to become acceptable
for deployment in high-performance enterprise workloads. New Relic correctly identified a gap in the
application performance monitoring market as Ruby on Rails usage exploded and more
and more workloads moved from on-prem to AWS.

Surfers most
often win by taking advantage of an industry-wide technical leap forward in
their own product or by resolving bottlenecks that preclude customers from capitalizing
on an overarching secular trend. In doing so, the innovators in question
position themselves to ride the cresting tsunami that washes over the industry.

The
10x’er

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The10x’er may
not have the benefit of a unique market opportunity, and, in fact, is often
operating in a decelerating market dominated by one or a handful of
incumbents.  However, these companies
have a core innovation that enables them to bring to market a product that is
an order of magnitude superior to incumbent vendors’ solutions along one or multiple
key customer dimensions (performance, cost, time-to-value, etc.).

Tableau spun out VizQL technology out of Stanford which enables data
visualizations with simple drag and drop functions, empowering line-of-business
to benefit from sophisticated BI. MongoDB became the fourth most widely adopted database in the world in only seven years by
simplifying database provisioning and management for developers. More recently,
Slack has up-ended enterprise collaboration by creating a seamless,
light-weight messaging experience where IRC and e-mail fell short.  

The
bottom-line with 10x’ers is they represent a tangible and significant ROI benefit
for customers relative to incumbent solutions.

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The
delineations between these classes of winners are far from absolute – a 10x’er
could very well be riding a wave that can ultimately help crown them a Market Maker
– and, in fact, the most successful companies will have several forces working
in their favor.

Mongo flattened
the learning curve for developers to get up and running with a database, but
also benefited from the broader NoSQL boom. In doing so, Mongo has become the
poster-child for non-relational databases. Docker’s adoption has been buoyed by
a shift to distributed application architectures and the DevOps, and accompanying
continuous deployment, wave. Similarly, VMware benefited from the general trend
around IT consolidation.

The takeaway is that that
great companies are not built in a vacuum. The tech stack is an ever-evolving,
dynamic system where a small change in one part of the stack can send
shockwaves through the entire ecosystem. Correspondingly, at a given moment in
time there exists a set of conditions which creates opportunity. Having a set
of mental models you can lean on as an investor allows you to spot and
capitalize on those opportunities faster.