Then younger businesses will be less afraid of going public sooner, and that’ll start to turn the capital markets’ momentum in favor of long-term growth, and that has huge ramifications, because then hedge funds will tell companies to invest more in R&D
- Chamath Palihapitiya

I won't hide my admiration for Chamath Palihapitiya. His is a classic rags to riches story; born into poverty in Sri Lanka, Chamath emigrated to Canada at the age of six. His brilliance set him apart from his peers and after studying at the University of Waterloo, he become AOL's youngest ever executive.

After that, as one of Facebook's earliest employees, Chamath was key to the social media network's success in his role as VP for Growth. Chamath left Facebook with his new-found wealth in 2011 to start Social Capital, which quickly became one of the best known funds in Silicon Valley.

It's only at this stage of his life that he started to receive widespread attention for perhaps his most defining trait: contrarianism. Whether it's bitcoin, ESG, Tesla, social media or most recently the fate of billionaires during the pandemic, the qualities that have helped his elevation in Silicon Valley - articulacy, coherence, mastery of the subject at hand - are vigorously on display in each case - so much so, that it's hard not to be persuaded by his views.

In the last few years, Palihapitiya has honed in on a problem that has profound implications for technology, innovation and society. Let's dive in.

SPACs and innovation

In 2017, Palihapitiya raised $700m in the IPO of Social Capital Hedosophia, a Special Purpose Acquisition Company ('SPAC'). SPACs are shell companies which IPO with the express mandate of finding attractive private companies to acquire and take public within a defined time horizon. With Social Capital Hedosophia, public market investors had essentially backed Chamath and the rest of the SPAC's management team to find a highly attractive private company and acquire it, thereby converting their ownership of the SPAC into ownership of the target company, which is now publicly listed. I won't go in to the minutiae, but the charts below illustrates some of the high-level mechanics and steps.

Source: Matt Collins, 'Special Purpose Acquisition Companies', Fordham University
Source: Ramey Layne and Brenda Lenahan, Vinson & Elkins LLP, Special Purpose Acquisition Companies: An Introduction

From the investors point of view, SPACs are a bet on the sponsors' (in this case Palihapitiya's) abilities to find those companies. Of far more importance is the target company's perspective. For them, SPACs represent an alternative to the traditional IPO model for going public. Why does this matter? Well, let's look at one of the most successful recent examples: Virgin Galactic

Virgin Galactic's mission is to make space travel a reality for everyone. From an investor's standpoint, there are a lot of inherent technological challenges that stand in the way of that mission being realised, not to mention concerns over the economics. Then there are the operational challenges, time horizons and a million other reasons not to fund it.

With that being said, the mission is one that has the potential to ignite a whole generation's fascination for space and spark the world's imagination unlike any moment since the Apollo missions. The huge outlay in R&D to make commercial space tourism viable on a large scale could be compared to SpaceX's reusable rockets, which have fundamentally altered the economics of commercial spaceflight. Indeed, UBS estimated that the wider space tourism and aviation industry could be worth $20bn already, with huge potential for more use cases of the technology once it's proven and costs fall.

So, I think it's clear 35 minutes might not be enough to convey these nuances, which is the average length of time a CEO has to sell his business to prospective investors during an IPO roadshow. The IPO process has received a lot of criticism in recent years, most noticeably by proponents of direct listing like Bill Gurley relating to pricing and the incentives of investment bankers. With the SPAC model, Chamath has focused his attention on a larger problem: the public markets are undervaluing R&D and long-term value creation and overvaluing current cash flow. The corollaries of this trend are fewer listed companies and smaller R&D budgets.

As Palihapitiya pointed out in an interview to Laura Shin:

There were 8 thousand or 9 thousand public companies in 2000. There are about 4 thousand now. Two-thirds of the S&P 500 have no R&D budgets. Now, you can say, well, this is a stock market problem, but I actually think that this is a US economic problem, which is that we don’t have capital markets that can support young, high-growing, fast companies in a way that really builds for the future of America the resiliency of America.

The profundity of this is hard to appreciate without context of the twentieth century's most significant technological advancements. In an exceptional paper published last year, researchers from Duke University reviewed the origins of seminal technological innovations and their effect on productivity and economic growth. Noting a decline in productivity since 1970, the authors pointed out that much of the productivity growth in the preceding 50 years was a result of technological processes conducted by researchers working in corporate labs. Robert J. Gordon wrote of corporate R&D labs in his book "The Rise and Fall of American Growth: The U.S. Standard of Living Since the Civil War":

Much of the early development of the automobile culminating in the powerful Chevrolets and Buicks of 1940-41 was achieved at the GM corporate research labs. Similarly, much of the development of the electronic computer was carried out in the corporate laboratories of IBM, Bell Labs, and other large firms. The transistor, the fundamental building block of modern electronics and digital innovation, was invented by a team led by William Shockley at Bell Labs in late 1947. The corporate R&D division of IBM pioneered most of the advances of the mainframe computer era from 1950 to 1980. Improvements in consumer electric appliances occurred at large firms such as General Electric, General Motors and Whirlpool, while RCA led the early development of television.

The authors go on to note some of the key features of corporate R&D labs which make them fertile sources of science-based innovation:

Large corporations have access to significant resources, can more easily integrate multiple knowledge streams, and direct their research toward solving specific practical problems, which makes it more likely for them to produce commercial applications.

It's clear that corporate R&D has both commercial and societal value. As companies retreat from R&D activities, particularly research, society is losing out on countless revolutionary innovations. Various proxies indicate a clear retreat: fewer Fortune 500 recipients of R&D awards, number of publications by R&D performing listed firms. Perhaps most worrying is the marked fall in the proportion of R&D budgets going towards research, which is by definition an exercise of discovery with long time horizons.

Source: Arora et al. (2018), "The changing structure of American innovation: Some cautionary remarks for economic growth"

Shortly after Virgin Galactic listed, Richard Branson said of the SPAC model:

One of the nice things about SPACs is that we know today as we officially float Virgin Galactic already has the money to see it right through to profitability and beyond.

Rightly or wrongly, had Virgin Galactic pursued the traditional IPO route, the prevailing orthodoxy in the public markets may have led to a cold reception. There's the rub. As Chamath later elaborated in his interview with Laura Shin:

So, by building this platform, this IPO 2.0 platform, what I would really like to do with my partners is sort of pioneer a way for young, high-growth companies who can invest lots of money over the next 5 to 10 years to go public, and the way that I do it is we pre-wire the IPO. We go and we curate investors, and we explain what we’re trying to do. We explain the dynamics of the market, and we go and find the target company, and then we break the business model down for these folks. We price it in a way that’s fair, and we eliminate a lot of the overhang in the stock, things like lockups and whatnot.The longer term goal is to raise further SPACs and validate the merits of funding companies that invest in R&D and foster long-term value creation:I raised two more SPACs, and so we’ll see what happens. I’d like to raise, you know, some more after that, but by doing this incrementally, I think that I’ll help educate the smartest hedge funds and mutual funds to want more of these younger businesses. Then younger businesses will be less afraid of going public sooner, and that’ll start to turn the capital markets’ momentum in favor of long-term growth, and that has huge ramifications, because then hedge funds will tell companies invest more in R&D.

In an interview with Fortune last week, Palihapitiya made clear the timelines we're talking about when we discuss more companies turning to SPACs as a route to going public:

I think SPACS are the way tech companies will go public in 50 years.

It's important to note that SPACs come in various forms. Not all of them set out to invest in companies that invest heavily in R&D like Chamath. Nor will most deeply innovative companies seek out the SPAC route, when the IPO model offers better marketing. Academic research into the performance of companies listing through SPACs is scarce. What's clear, however, is that the number of SPACs is on an upward trajectory.

The coronavirus is likely to ripen the market as valuations drop and bargains are there to be found. The quality of sponsors is improving, as is the blue-chip investor base backing them. These are all important tailwinds for the return profile of SPACs. What most excites me most, however, is the types of company that will pursue this model and therefore access the public markets when they may not have been able to do so before.

The most recent example of a reverse merger with a SPAC is Nikola, a company developing electric and hydrogen fuel cell-powered trucks. Nikola says that preorders for commercial fleet vehicles have topped $10 billion. However, as it went public in early June, the company forecast revenues of $0 for 2020. Like Virgin Galactic, the company has the potential for significant value creation in the long-term, both for investors and society at large.

But, as public markets are today, would an IPO have been realistic? If not, are SPACs a genuinely viable strategy or are they simply another fad? We won't know for a while.

What I'm reading

Top 10 Learnings from the Redpoint 2020 GTM Survey - A gold mine of benchmarks and data on go to market for SaaS companies from Redpoint Ventures. Some surprising learnings are the redundancy of NPS as a customer success metric and long payback periods of 10-13 months.

A former Google exec has started a new search engine that neither shows ads nor profits from user data. The tech behind it will be mostly off-the-shelf and the company will have a subscription model premised on the notion that customers will pay to have an ad-free search experience. This promise has secured funding of $37.5m from Greylock and Sequoia Capital.

US regulators have rolled back elements of the Volcker rule, allowing banks to invest in venture capital funds. This new LP base could have important implications for the ecosystem, depending on the direction they want to go in (new fund managers, geographies).

TikTok has lifted the curtain on how it's algorithms work, and it makes for fascinating reading. One key takeaway is that follower count and past engagement are not variables in the model that decides what is recommended to viewers.

The Head of Uber Money quits. I didn't even know Uber Money existed, but there you go. Uber Money was set up to grow the company's suite of financial products, the most notable being Uber Cash. The pandemic has clearly shifted priorities, but even that hasn't gone well with a failed attempt to buy Grubhub cementing a troubled period for Dara Khasrowshahi.

Deals of the week

A few months ago Alex Danco wrote about the looming prospect of venture debt, particularly for SaaS businesses with recurring revenue models. Danco quoted Jonathan Hsu of Tribe Capital, who emphasised that the security of recurring revenue models means that they're not too different to fixed-income securities. This idea was the genesis of Los Angeles-based Pipe, which offers SaaS businesses access to the full value of their contract by connecting them with investors who purchase the future subscription payments for a discounted value. Formed in September 2019, the company just raised $60m from Fin VC, Tribe Capital and Uncorrelated Ventures. The second-order consequences are well worth considering, chiefly: will fewer SaaS companies need to raise VC to grow?

Jumbo Privacy (France) is the app you haven't heard about that you need to be using. The tool scans the websites and apps you use and empowers you to control how much data those companies hold on you. Privacy is likely to remain a hot-button issue in tech for many years as the disparity between consumer beliefs around data usage and the facts narrow. The company is using a pay-what-you-want model to earn the trust of it's user. Balderton led an $8m Series A round.

Quote

"I remember Babe Ruth said, he swings big and he misses big. Same thing with me. I have no fear whatsoever. If I take the last-second shot and I miss, so what? Take it and I make it? Good, let's all go home and get ready for the next game." - Kobe Bryant

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