The founders of a technology company and its investors have the common goal of building a valuable company. The founders desire to solve a customer need in a meaningful way. The investors seek a significant return on their investment.
A technology company generally has two key components: (1) a product or service, and (2) barriers to entry by competitors.
It is essential that a company provide a product or service that is demanded by customers. The founders’ focus is to build this product or service and to do so in a way that creates demand. This is sometimes referred to as achieving product-market fit.
Generally, the value of the company is driven by the extent of profits that are generated by the demand, and the stream of these cash flows that extend into the future. An investor determines the current value of the company by discounting these cash flows to the present day using a cost of capital that corresponds to the risk of the company’s business.
Competitors seeing the success of the product may attempt to sell the same product. Thus, barriers to entry are essential to prevent entry into the market by these competitors. It is these barriers that sustain significant profits over many years, and that are the basis for a high company valuation. A simple example of a barrier is a patent owned by a pharmaceutical company that creates an exclusive market for selling a prescription drug. When the patent expires, other companies who make a generic version of the drug may enter the market, and the pharma company’s profits may fall dramatically.
There are many types of barriers to entry. The building and management of these barriers determines the ultimate value of the company. Examples include patents and other intellectual property rights acquired as a company grows. One prominent barrier is branding.
Branding is the reputation that a company builds as its products become known. The branding is typically supported by one or more trademarks. The building of a brand starts with an innovative product that provides a positive experience for a customer, especially if it offers a surprising improvement like the ChatGPT language model. The customer associates the brand with the new positive experience. Over time, customers will pay a premium for a product associated with the brand. This premium can provide a boost to profits that extends for years or even decades.
Another barrier is technical knowledge developed by a company that is kept secret. This technical knowledge is typically protected by trade secret rights. An example is chemical or other manufacturing processes used to create a product that are kept confidential (e.g., using non-disclosure agreements). These secret processes typically arise from research and development by a company as its engineers learn, for example, how to build a physical product (e.g., manufacturing and robotics) or generate the code for a software product (e.g., SaaS and other cloud services). The inability of others to duplicate the secret processes or software can provide market exclusivity to the company for as long as competitors are not able to reverse engineer or replicate the product.
The market exclusivity provided by patents and trade secrets may be a significant source of value to a company. Profits for a company that is the sole provider in a product market are often increased by 20-80%. If the company continues to research and innovate, this profit advantage may be extended for years. The company greatly influences this value by its patent application filings and efforts to maintain trade secrets.
Another barrier to competitors is data collected by a company but not available to others. For example, real-world data used to make or operate products can be used to train artificial intelligence (AI) systems. In one case, data collected with customer consent from sensors on autonomous vehicles can train ever-improving AI systems for deployment to the vehicles. In another case, data from sensors on robots used in a manufacturing line can train AI systems to increase production quality or efficiency.
How a company manages barriers to entry may be one factor in determining the company’s value, especially as viewed by investors (e.g., venture capitalists and potential acquirers). The investment in building these barriers is guided by understanding how the barriers create value. This helps leaders balance investment in the building of new products with investment in building the barriers that protect the value generated by customer demand for the products.