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Does Elon Musk Master Productive Uncertainty?
Today: For some startups, the upside is all about the future size of their markets. Case in point: Tesla.
The Agenda 👇
There are increasing returns across the economy
VCs are pursuing uncertainty more than increasing returns
Elon Musk excels at exploiting uncertainty to grow Tesla
What does that tell deep tech founders?
Here’s a recent tweet by Sam Hammond of the Niskanen Center:
I thought I would write a short essay about it because it echoes many thoughts previously shared here.
In particular, I wrote about the fact that increasing returns to scale exist well beyond the realm of ubiquitous computing and networks. Check out An Important Point About Increasing Returns (September 2020—using the same Thompson quote as noted by Matthew Yglesias above):
In a Stratechery update last year, Ben Thompson observed that “silicon-based chips have similar characteristics [as software]; there are massive up-front costs to develop and build a working chip, but once built additional chips can be manufactured for basically nothing”. I found this observation odd at the time, and I still do, because for me building silicon chips is a manufacturing business, and the economics pointed out by Ben are characteristics of manufacturing...in its early stages of development.
Indeed, increasing returns to scale have always been at the core of capitalism-driven value creation, well before semiconductor manufacturing and software development were even a thing. I wrote as much in Think You Understand Capitalism? Think Again.:
Thanks to increasing returns to scale, capitalist enterprises contribute to generating a huge economic surplus, which is a fancy name for all the economic value that corporations create and capture as part of their ongoing business. That surplus is the pie that workers, customers, and capitalists grow together, with its value being realized as it’s transformed into wealth.
Today I’d like to point out the following: there’s no absolute correlation between a line of business generating increasing returns to scale and venture capitalists backing ventures in the corresponding sector:
There are many lines of business, such as aircraft manufacturing (Sam cites Boeing as an example) that have increasing returns to scale, and yet you won’t find many venture capital firms willing to back startups in that particular line of business.
On the other hand, there are many lines of business where VC-backed startups are multiplying despite the fact that they don’t seem to be marked by returns to scale as high as in software: biotech, consumer goods, hardware, deep tech, AI in general (see this write-up about AI economics by a16z’s Martin Casado and Matt Bornstein)—even ride sharing!
Which all leads me to another iteration of discussing Jerry Neumann’s concept of Productive Uncertainty as the distinctive mark of startups worthy of being backed by venture capitalists. Reflecting on it, I’d divide investment opportunities into two categories:
Startups entering a market that is well identified, but on which contenders potentially have very high increasing returns to scale. The uncertainty isn’t related to the existence or potential size of the market, but rather who has a shot at winning it—because, to quote W. Brian Arthur (the founding father of increasing returns economics), “increasing returns generate not equilibrium but instability: If a product or a company or a technology—one of many competing in a market—gets ahead by chance or clever strategy, increasing returns can magnify this advantage, and the product or company or technology can go on to lock in the market.”
Startups that are in line of business where increasing returns to scale are not that impressive, but those returns are in a market which itself could be subject to exponential growth. In other words: the market’s growth will compensate for the somewhat slower growth at the scale of the individual business that eventually becomes the leader.
Case in point: Tesla. Sure, there are many ways in which it’s boosting increasing returns as part of its strategy (embedded cloud-based software, AI-powered autopilot, the grid formed by power chargers and power walls, even the connection to the larger grid formed by SolarCity’s panels on roofs). But in the end, it is what it is: Elon Musk might look and sound like a tech CEO, but Tesla is a car manufacturer. And in such a tangible line of business, returns can increase only up to a certain point.
So why is Tesla exciting for venture capitalists and tech people in general (even though it is well beyond the stage where it could be backed by VC firms)?
The answer has become obvious over the years: today we all feel that the market for electric cars can grow exponentially; Tesla now has what it takes to become a leader on this market, thus putting it in a position to be lifted up by the exponential growth of the market itself; and precisely because it’s a tangible business, once Tesla has established its leadership on the market, it will benefit from a very large moat that will make it hard for anyone else to contend!
Being a tech CEO (he co-founded PayPal, after all), Musk knows that Tesla is not that scalable of a business, which is why he’s betting everything on boosting the market’s growth and becoming the leader on that market! Hence his reliance on promoting his own narrative, notably through social media, and surfing other storytelling trends that can magnify Tesla’s advantage (see: Musk on basic income; Musk on the world being a virtual simulation; Musk on cryptocurrencies, etc.).
Here’s how this all relates to Jerry’s essay: The uncertainty is more about the future size of the market and Tesla’s share of it than it is about Tesla’s line of business per se. Everyone knows that building electric vehicles is hard, but that incumbents will eventually catch up. What nobody knows is how fast the market will grow and who will be in a leadership position when this growth enters an exponential phase. In many respects, Tesla is a deep tech startup; but the key to its success is not the breakthrough technology coming out of its lab, it’s the uncertainty still surrounding what the market will look like in 5-10 years.
I’ve written skeptical pieces about deep tech startups over the years, notably in Sifted last December—actually using Jerry’s concept of “Productive Uncertainty” to make the case that deep tech is not a particularly promising field from a VC perspective because of the lack of uncertainty.
But I’m wondering if precedents such as Tesla can’t constitute a typical playbook for founders in the deep tech world:
When trying to lure venture capitalists, don’t talk about your breakthrough technology—which they know isn’t that defensible. Instead, focus on how uncertain the future size of the market is, and how they could win big if only your company manages to grab a big slice of it.
I’ll iterate on that one, but reflecting on it is quite timely because my firm The Family has several deep tech/hardware startups in the current batch! In the meantime, what do you think?
The Hard Truth About Deep Tech (European Straits, June 2019)
Evaluating Markets, With a European Perspective (European Straits, June 2019)
At What Stage Should You Invest in European Startups? (European Straits, June 2019)
An Important Point About Increasing Returns (European Straits, September 2020)
On Jerry Neumann's “Productive Uncertainty” (Round 1) (European Straits, November 2020)
On Jerry Neumann's “Productive Uncertainty” (Round 2) (European Straits, December 2020)
Is investing in 'deeptech' a good move for Europe's VCs? (Sifted, December 2020)
DeepTech: Many Roads May Lead There, But There's Only One Rome (Bill Janeway, European Straits, January 2021)
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From Munich, Germany 🇩🇪