What Is a Tech Company?

At first glance, WeWork and Peloton, which both released their S-1s in recent weeks, don’t have much in common: one company rents empty buildings and converts them into office space, and the other sells home fitness equipment and streaming classes. Both, though, have prompted the same question: is this a tech company?

Of course, it is fair to ask, “What isn’t a tech company?” Surely that is the endpoint of software eating the world; I think, though, to classify a company as a tech company because it utilizes software is just as unhelpful today as it would have been decades ago.

IBM and Tech-Centered Ecosystems

Fifty years ago, what is a tech company was an easy question to answer: IBM was the tech company, and everybody else was IBM’s customers. That may be a slight exaggeration, but not by much: IBM built the hardware (at that time the System/360), wrote the software, including the operating system and applications, and provided services, including training, ongoing maintenance, and custom line-of-business software.

All kinds of industries benefited from IBM’s technology, including financial services, large manufacturers, retailers, etc., and, of course, the military. Functions like accounting, resource management, and record-keeping automated and centralized activities that used to be done by hand, dramatically increasing the efficiency of existing activities and making new kinds of activities possible.

Increased efficiency and new business opportunities, though, didn’t make J.P. Morgan or General Electric or Sears tech companies. Technology simply became one piece of a greater whole. Yes, it was essential, but that essentialness exposed technology’s banality: companies were only differentiated to the extent they did not use computers, and then to the downside.

IBM, though, was different: every part of the company was about technology — indeed, IBM was an entire ecosystem onto itself: hardware, software, and services, all tied together with a subscription payment model strikingly similar to today’s dominant software-as-a-service approach. In short, being a tech company meant being IBM, which meant creating and participating in an ecosystem built around technology.

Venture Capital and Zero Marginal Costs

The story of IBM handing Microsoft the contract for the PC operating system and, by extension, the dominant position in computing for the next fifteen years, is a well-known one. The context for that decision, though, is best seen by the very different business model Microsoft pursued for its software.

What made subscriptions work for IBM was that the mainframe maker was offering the entire technological stack, and thus had reason to be in direct ongoing contact with its customers. In 1968, though, in an effort to escape an antitrust lawsuit from the federal government, IBM unbundled their hardware, software, and services. This created a new market for software, which was sold on a somewhat ad hoc basis; at the time software didn’t even have copyright protection.

Then, in 1980, Congress added “computer program” to the definition list of U.S. copyright law, and software licensing was born: now companies could maintain legal ownership of software and grant an effectively infinite number of licenses to individuals or corporations to use that software. Thus it was that Microsoft could charge for every copy of Windows or Visual Basic without needing to sell or service the underlying hardware it ran on.

This highlighted another critical factor that makes tech companies unique: the zero marginal cost nature of software. To be sure, this wasn’t a new concept: Silicon Valley received its name because silicon-based chips have similar characteristics; there are massive up-front costs to develop and build a working chip, but once built additional chips can be manufactured for basically nothing. It was this economic reality that gave rise to venture capital, which is about providing money ahead of a viable product for the chance at effectively infinite returns should the product and associated company be successful.

Indeed, this is why software companies have traditionally been so concentrated in Silicon Valley, and not, say, upstate New York, where IBM was located. William Shockley, one of the inventors of the transistor at Bell Labs, was originally from Palo Alto and wanted to take care of his ailing mother even as he was starting his own semiconductor company; eight of his researchers, known as the “traitorous eight”, would flee his tyrannical management to form Fairchild Semiconductor, the employees of which would go on to start over 65 new companies, including Intel.

It was Intel that set the model for venture capital in Silicon Valley, as Arthur Rock put in $10,000 of his own money and convinced his contacts to add an additional $2.5 million to get Intel off the ground; the company would IPO three years later for $8.225 million. Today the timelines are certainly longer but the idea is the same: raise money to start a company predicated on zero marginal costs, and, if you are successful, exit with an excellent return for shareholders. In other words, it is the venture capitalists that ensured software followed silicon, not the inherent nature of silicon itself.

To summarize: venture capitalist fund tech companies, which are characterized by a zero marginal cost component that allows for uncapped returns on investment.

Microsoft and Subscription Pricing

Probably the most overlooked and underrated era of tech history was the on-premises era dominated by software companies like Microsoft, Oracle, and SAP, and hardware from not only IBM but also Sun, HP, and later Dell. This era was characterized by a mix of up-front revenue for the original installation of hardware or software, plus ongoing services revenue. This model is hardly unique to software: lots of large machinery is sold on a similar basis.

The zero marginal cost nature of software, however, made it possible to cut out the up-front cost completely; Microsoft started pushing this model heavily to large enterprise in 2001 with version 6 of its Enterprise Agreement. Instead of paying for perpetual licenses for software that inevitably needed to be upgraded in a few years, enterprises could pay a monthly fee; this had the advantage of not only operationalizing former capital costs but also increasing flexibility. No longer would enterprises have to negotiate expensive “true-up” agreements if they grew; they were also protected on the downside if their workforce shrunk.

Microsoft, meanwhile, was able to convert its up-front software investment from a one-time payment to regular payments over time that were not only perpetual in nature (because to stop payment was to stop using the software, which wasn’t a viable option for most of Microsoft’s customers) but also more closely matched Microsoft’s own development schedule.

This wasn’t a new idea, as IBM had shown several decades earlier; moreover, it is worth pointing out that the entire function of depreciation when it comes to accounting is to properly attribute capital expenditures across the time periods those expenditures are leveraged. What made Microsoft’s approach unique, though, is that over time the product enterprises were paying for was improving. This is in direct contrast to a physical asset that deteriorates, or a traditional software support contract that is limited to a specific version.

Today this is the expectation for software generally: whatever you pay for today will be better in the future, not worse, and tech companies are increasingly organized around this idea of both constant improvements and constant revenue streams.

Salesforce and Cloud Computing

Still, Microsoft products had to actually be installed in the first place: much of the benefit of Enterprise Agreements accrued to companies that had already gone through that pain.

Salesforce, founded in 1999, sought to extend that same convenience to all companies: instead of having to go through long and painful installation processes that were inevitably buggy and over-budget, customers could simply access Salesforce on Salesforce’s own servers. The company branded it “No Software”, because software installations had such negative connotations, but in fact this was the ultimate expression of software. Now, instead of one copy of software replicated endlessly and distributed anywhere, Salesforce would simply run one piece of software and give anyone anywhere access to it. This did increase fixed costs — running servers and paying for bandwidth is expensive — but the increase was more than made up for by the decrease in upfront costs for customers.

This also increased the importance of scale for tech companies: now not only did the cost of software development need to be spread out over the greatest number of customers, so did the ongoing costs of building and running large centralized servers (of course Amazon operationalized these costs as well with AWS). That, though, became another characteristic of tech companies: scale not only pays the bills, it actually improves the service as large expenditures are leveraged across that many more customers.

Atlassian and Zero Transaction Costs

Still, Salesforce was still selling to large corporations. What has changed over the last ten years in particular is the rise of freemium and self-serve, but the origins of this model go back a decade earlier.

The early 2000s were a dire time in tech: the bubble had burst, and it was nearly impossible to raise money in Silicon Valley, much less anywhere else in the world — including Sydney, Australia. So, in 2001, when Scott Farquhar and Mike Cannon-Brookes, whose only goals was to make $35,000 a year and not have to wear a suit, couldn’t afford a sales force for the collaboration software they had developed called Jira they simply put it on the web for anyone to trial, with a payment form to unlock the full program.

This wasn’t necessarily new: “shareware” and “trialware” had existed since the 1980s, and were particularly popular for games, but Atlassian, thanks to being in the right place (selling Agile project management software) at the right time (the explosion of Agile as a development methodology) was using essentially the same model to sell into enterprise.

What made this possible was the combination of zero marginal costs (which meant that distributing software didn’t cost anything) and zero transaction costs: thanks to the web and rudimentary payment processors it was possible for Atlassian to sell to companies without ever talking to them. Indeed, for many years the only sales people Atlassian had were those tasked with reducing churn: all in-bound sales were self-serve.

This model, when combined with Salesforce’s cloud-based model (which Atlassian eventually moved to), is the foundation of today’s SaaS companies: customers can try out software with nothing more than an email address, and pay for it with nothing more than a credit card. This too is a characteristic of tech companies: free-to-try, and easy-to-buy, by anyone, from anywhere.

The Question of the Real World

So what about companies like WeWork and Peloton that interact with the real world? Note the centrality of software in all of these characteristics:

  • Software creates ecosystems.
  • Software has zero marginal costs.
  • Software improves over time.
  • Software offers infinite leverage.
  • Software enables zero transaction costs.

The question of whether companies are tech companies, then, depends on how much of their business is governed by software’s unique characteristics, and how much is limited by real world factors. Consider Netflix, a company that both competes with traditional television and movie companies yet is also considered a tech company:

  • There is no real software-created ecosystem.
  • Netflix shows are delivered at zero marginal costs without the need to pay distributors (although bandwidth bills are significant).
  • Netflix’s product improves over time.
  • Netflix is able to serve the entire world because of software, giving them far more leverage than much of their competition.
  • Netflix can transact with anyone with a self-serve model.

Netflix checks four of the five boxes.

Airbnb, which has yet to go public, is also often thought of as a tech company, even though they deal with lodging:

  • There is a software-created ecosystem of hosts and renters.
  • While Airbnb’s accounting suggests that its revenue has minimal marginal costs, a holistic view of Airbnb’s market shows that the company effectively pays hosts 86 percent of total revenue: the price of an “asset-lite” model is that real world costs dominate in terms of the overall transaction.
  • Airbnb’s platform improves over time.
  • Airbnb is able to serve the entire world, giving it maximum leverage.
  • Airbnb can transact with anyone with a self-serve model.

Uber, meanwhile, has long been mentioned in the same breath as Airbnb, and for good reason: it checks most of the same boxes:

  • There is a software-created ecosystem of drivers and riders.
  • Like Airbnb, Uber reports its revenue as if it has low marginal costs, but a holistic view of rides shows that the company pays drivers around 80 percent of total revenue; this isn’t a world of zero marginal costs.
  • Uber’s platform improves over time.
  • Uber is able to serve the entire world, giving it maximum leverage.
  • Uber can transact with anyone with a self-serve model.

A major question about Uber concerns transaction costs: bringing and keeping drivers on the platform is very expensive. This doesn’t mean that Uber isn’t a tech company, but it does underscore the degree to which its model is dependent on factors that don’t have zero costs attached to them.

Now for the two companies with which I opened the article. First, WeWork (which I wrote about here and here):

  • WeWork claims it has a software-created ecosystem that connect companies and employees across locations, but it is difficult to find evidence that this is a driving factor for WeWork’s business.
  • WeWork pays a huge percentage of its revenue in rent.
  • WeWork’s offering certainly has the potential to improve over time.
  • WeWork is limited by the number of locations it builds out.
  • WeWork requires a consultation for even a one-person rental, and relies heavily on brokers for larger businesses.

Frankly, it is hard to see how WeWork is a tech company in any way.

Finally Peloton (which I wrote about here):

  • Peloton does have social network-type qualities, as well as strong gamification.
  • While Peloton is available as just an app, the full experience requires a four-figure investment in a bike or treadmill; that, needless to say, is not a zero marginal cost offering. The service itself, though, is zero marginal cost.
  • Peloton’s product improves over time.
  • The size, weight, and installation requirements for Peloton’s hardware mean the company is limited to the United States and the just-added United Kingdom and Germany.
  • Peloton has a high-touch installation process

Peloton is also iffy as far these five factors go, but then again, so is Apple: software-differentiated hardware is in many respects its own category. And, there is one more definition that is worth highlighting.

Peloton and Disruption

The term “technology” is an old one, far older than Silicon Valley. It means anything that helps us produce things more efficiently, and it is what drives human progress. In that respect, all successful companies, at least in a free market, are tech companies: they do something more efficiently than anyone else, on whatever product vector matters to their customers.

To that end, technology is best understood with qualifiers, and one of the most useful sets comes from Clayton Christensen and The Innovator’s Dilemma:

Most new technologies foster improved product performance. I call these sustaining technologies. Some sustaining technologies can be discontinuous or radical in character, while others are of an incremental nature. What all sustaining technologies have in common is that they improve the performance of established products, along the dimensions of performance that mainstream customers in major markets have historically valued. Most technological advances in a given industry are sustaining in character…

Disruptive technologies bring to a market a very different value proposition than had been available previously. Generally, disruptive technologies underperform established products in mainstream markets. But they have other features that a few fringe (and generally new) customers value. Products based on disruptive technologies are typically cheaper, simpler, smaller, and, frequently, more convenient to use.

Sustaining technologies make existing firms better, but it doesn’t change the competitive landscape. By extension, if adopting technology simply strengthens your current business, as opposed to making it uniquely possible, you are not a tech company. That, for example, is why IBM’s customers were no more tech companies than are users of the most modern SaaS applications.

Disruptive technologies, though, make something possible that wasn’t previously, or at a price point that wasn’t viable. This is where Peloton earns the “tech company” label from me: compared to spin classes at a dedicated gym, Peloton is cheap, and it scales far better. Sure, looking at a screen isn’t as good as being in the same room with an instructor and other cyclists, but it is massively more convenient and opens the market to a completely new customer base. Moreover, it scales in a way a gym never could: classes are held once and available forever on-demand; the company has not only digitized space but also time, thanks to technology. This is a tech company.

This definition also applies to Netflix, Airbnb, and Uber; all digitized something essential to their competitors, whether it be time or trust. I’m not sure, though, that it applies to WeWork: to the extent the company is unique it seems to rely primarily on unprecedented access to capital. That may be enough, but it does not mean WeWork is a tech company.

And, on the flipside, being a tech company does not guarantee success: the curse of tech companies is that while they generate massive value, capturing that value is extremely difficult. Here Peloton’s hardware is, like Apple’s, a significant advantage.

On the other hand, asset-lite models, like ride-sharing, are very attractive, but can Uber capture sufficient value to make a profit? What will Airbnb’s numbers look like when it finally IPOs? Indeed, the primary reason Peloton’s numbers look good is because they are selling physical products, differentiated by software, at a massive profit!

Still, definitions are helpful, even if they are not predictive. Software is used by all companies, but it completely transforms tech companies and should reshape consideration of their long-term upside — and downside.

I wrote a follow-up to this article in this Daily Update.