Invest Like the Best with Patrick O'Shaughnessy
00:08:04 · Martin Casado
[00:08:04] S1: So I think the root of the confusion is not a definitional problem. I think the root of the confusion is conceptually we conflate the mechanism with the shape of the moat. There's many things that could create a moat, right? Like a brand, scale, a two sided marketplace, network effect. But that moat, to reason about that, is only really useful if it has some properties that makes the company defensible against somebody else. If that moat grows super linearly with scale, like a classic Metcalfe's law network effect would, that's really defensible. If it grows sub linearly with scale, it may not be useful at all. And so I think to you and I have a conversation of defensibility, I think the first thing we need to do is not conflate the shape of the moat with the mechanism that caused it. So first, I think we should say the mode that we have is super linear, it's linear, or it's sublinear with scale. And then the second thing, a lot of things actually contribute to a mode. For example, like we mentioned, network effects will or scale effect. What's a scale effect? A scale effect to me is as the company scale, it can reduce unit economics normally because it has pricing power for example or maybe CAC goes down because of brand. What's a two sided marketplace that's very different to me than a network effect? That's where basically you've got self reinforcing supply and demand. So I think that there are many mechanisms and then there's the shape and then to have a discussion I think you want to make sure that the shape is something that actually provides long term defensibility. Then the last thing I'll say is it's almost impossible to have these conversations in isolation because we're actually talking about competitive equilibria. Because if you have a network effect, then maybe the competitor has a network effect too. And maybe if they have more capital than you and grow faster, that probably impacts the shape of your moat. You may not grow as fast marginally because they're stealing your customers or something like that. And so I just think that we need a very very basic concepts. We need to not conflate the notion of the actual shape with the actual mechanism. And then I think we should enumerate the mechanisms because something like the definition that you had just doesn't really help anybody.
00:10:08 · Patrick O'Shaughnessy, Martin Casado
[00:10:08] S0: Can you give examples of super linear, linear, sub linear just to bring it to life? [00:10:12] S1: Yeah, for sure. A common view of where network effects came from was from the seventies. I forgot the name of the economist that did it but he worked at Bell Labs and he noticed for train networks and communications networks, the interactions of users grows with the square of the number of people that join. As a user joins they can communicate to many other people so the actual number of connections grows more than the number of users. Therefore, the value grows more than just legally within that. The same thing with destinations on a highway or destinations on a train. So that would mean that if you have two competing companies, one takes $5,000,000 of funding and the other takes $5,000,000 of funding but this one is marginally better, marginally larger. This one's a little bit larger. For the same amount of investment, it will grow faster than a challenger. The growth actually increases over time and that's why you get a monopoly. Whereas sublinear means if I'm a leader and I invest the same amount as a challenger, I grow marginally slower than the challenger. That would be sublinear. Clearly this is very important when it comes to modes because if you have two competing companies and there's a sublinear mode, the challenger will always catch up to the leader because the leader has to spend ever more money to grow, all things being equal. [00:11:28] S0: Favorite recent company examples of these different types?
00:11:28 · Patrick O'Shaughnessy, Martin Casado
[00:11:28] S0: Favorite recent company examples of these different types? [00:11:31] S1: How many actual network effects in the Metcalfe's law of super linear do you think there have actually been? [00:11:36] S0: Very few, I don't
00:11:37 · Martin Casado
[00:11:37] S1: know. I feel like this almost never happens. Like I think we can all agree, the telcos, that's why we had to break them up. We could probably all agree LinkedIn, They haven't had to change very much and they seem to have a permanent status. Social networking. But all of these examples, it's like the interconnections of people. I would say GitHub was another one that had a It's effectively interconnection. It's interconnections of users, right? So I think there are not very many examples but when you have them these are these very durable high value companies. So that to me would be like a classic network effect. Other companies probably are more scale effects. For example, people will say Uber. I'm not sure that that would follow the definition of a network effect. Maybe a two sided marketplace because you have the drivers and you have the passengers. Maybe you could use that but even then, you don't have a lock on either of them. Like all drivers drive for everybody and all passengers could use anybody. That was more like of a funding scale effect because they could raise more money and therefore the unit economics went down. My meta observation... So first off, I actually think the network effecting was more of a personal annoyance and me being a pedantic. But I actually think defensibility in most is not really even worth talking about most of the time. Let me explain why. Here's my experience for what it's worth. If a market you're investing in is growing, then companies are not gonna wanna compete. There's like a lot of new white space that gets created and so what they'll try and do is they'll try and just move into other white space. Talking about defensibility is kind of a second or third order thing if the market is growing. And if the market is slowing down or shrinking, normally it consolidates anyways independent of most or not. And so I do think we spend a lot of time as investors hand wringing about defensibility when in practice it doesn't really matter especially in growing markets which we invest in and we've seen this with AI. I remember early discussions on models. I mean, I can't tell you how many investors are like, I will never invest in a model. It'll never accrue value. It's not defensible. That's fine, but as long as the market's growing in a large market, it's gonna accrue a lot of value.
00:13:33 · Martin Casado, Patrick O'Shaughnessy
I remember this about the Neo Clouds. They're never dependable, the quality of revenue is bad. I think that we kind of trick ourselves as investors by thinking in terms of defensibility when if there's a growing market, it's kind of not even worth considering. [00:13:46] S0: Do you think that's a unique privilege of your stage of investor? And then once you get later stage public, someone that's buying the Anthropic S1 needs to probably think about defensibility. [00:13:57] S1: I mean, depends on your thesis on the size of the market. I mean, you believe we're 0.1% penetrated, this has got a long way to go and value will accrue and if you're liquid, can go in and out of the market if values accrues. I think the nature of venture has really changed actually in general. If you read Arthur Rock, it was really frontier like investing and people didn't think about quality of revenue. You know, they didn't think about defensibility so much. It was like people and it was tech and it was new markets. Over the last thirty years, the tech market has grown so large. The amount of money that's available to investors has grown so much and then the size of the private companies has grown. Like a private company today rivals public companies of just ten years ago. And so I say in some level, VCs have actually become public investors and then a lot of the people that have entered VC have come from more business school and traditional finance background. So I think a lot of the mindset comes from that world but I [00:14:56] S0: think it gets applied too early. Financial mindset gets applied
00:14:58 · Martin Casado
[00:14:58] S1: too traditional investing financial mindset gets applied too early and it's very often for example I talk to like a junior investor and they're like, oh the quality of revenue's bad. I'm like, call me, we don't even know how to monetize the internet. Like business models always lag disruptive technologies. If you truly believe you're investing in a disruptive technology, if that's what you truly believe in, a, you should believe it creates TAM, so why would you worry about market size because it's creating market size, And b, it's disruptive. So we don't even know what the pricing model is. Like, remember like how long it took for us to go from like perpetual to like recurring? Years of hand wringing, etcetera. And so my caution is is like most investors should know what kind of investor they are. Maybe you're a financial investor, that's how you view the world, but then you're not actually evaluating tech. You're not evaluating the disruptive power of tech, you're literally looking at the quality of revenue. Which by the way is going to naturally move you towards non disruptive technology because if it's disruptive you probably don't know what the business model is, you probably don't know what the TAM is. On the other hand, if you believe I invest in tech and tech creates value and that's the type of investor you are and you do that early, you should not consider these other things. I think it's less about is there a right way to invest? No, these are all legitimate coherent right ways to invest. It's more about don't be confused in your basic approach because otherwise you become incoherent. You're like, oh, I'm a disruptive tech investor but I'm looking for a good NRR. Like, it doesn't work that way.