Equity value

Warren Buffet once said:

Buy into a business that’s doing so well an idiot could run it, because sooner or later, one will.

This is a useful way to understand the meaning of “equity value”. You learn in finance that equity value is the overall value of a the stock (i.e. equity) of a business, which in turn is the present value of all future profits. Of course with startups the future is extremely uncertain, leading to a huge variance in valuations.

In perfectly competitive markets, all profit margins tend toward zero. So equity value is a function of the degree to which you can make your market inefficient by making your business hard to copy (so called “defensibility”). If your defensibility depends solely on having superior people, you have what VCs call a “service business.” In a competitve labor market, service businesses tend to have low margins and therefore low equity value. A popular saying about service businesses is “the equity value walks out of the building every night.”

Different types of tech businesses exhibit different relationships between capital, revenue, profits, and equity value. Enterprise software companies tend to require lots of capital to get to scale but command high equity values once they do, partly because enterprises are risk averse and like to adopt the most popular technology, leading to winner-take-all dynamics. Adtech companies tend to be quick to revenue but slower to equity value, and sometimes risk becoming service businesses. The equity value of consumer internet companies vary widely, depending on their defensibility (usually networks effects and brand) and business models (e.g. transactional vs ad supported). Biotech companies require boatloads of capital for R&D and regulatory approval but then can generate lots of equity value, with the defensibility coming primarily from patents. (Patents introduce market innefficiencies, but, proponents argue, are necessary to create sufficient incentives for entrepreneurs and investors). E-commerce companies generally require a lot of capital as well, since their defensibility comes mostly through brand and economies of scale.

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