Covid-19 casts a spotlight on startups in intellectual property businesses

A crisis is a disruptive event. But while it may be scary, it is also a time when fairy tales are born.

Take our current situation: Though we’re trapped inside our homes, our need for social and physical activity has created some unexpected winners.

Enter Animal Crossing. It’s a decades-old Nintendo game franchise, a type of animated social game that has recently taken the world by storm.

On the surface, the game seems to be designed for kids with its cutesy animal characters. But adults are the ones going gaga over it because, at a deeper level, the game is a reflection of real-world politics. Take Tom Nook, for instance. The crooked raccoon makes players do the dirty work and then claims all the credit. Sounds familiar?

Characters from Animal Crossing / Photo credit: Nintendo

Another title that’s benefited from the current climate is Beat Saber, a virtual reality game that was recently acquired by Facebook. Here, ancient sword fighting meets modern dancing, guided by hurling cubes tagged with directional cues. If your quarantine workout has involved doing burpees to the beat of Gangnam Style, you don’t know what you’re missing.

What does all this have to do with venture capital? Well, VCs care more about the micro rather than the macro, about the winners rather than the losers. In fact, some purist VCs would argue that the only startups worth investing in are those in intellectual property (IP) businesses such as software, gaming, and biotech.

This is because the business model of these firms is almost all about fixed cost. To them, unit economics is irrelevant, as there is no physical unit cost to assign to each new customer, and any revenue made after breaking even is almost pure profit.

Think about Zoom. When you connect and chat with someone on the video conferencing app, you don’t have to pay a separate service provider, unlike when you use Uber and have to pay the driver. Zoom doesn’t need to pay a landlord every time its users host a meeting, unlike WeWork. As a result, the company is able to generate gross margins of 80%, which is the norm across successful IP-based businesses such as Oracle, Electronic Arts, and Gilead.

So why aren’t all VCs investing solely in IP-based companies?

The reason is that a majority of startups are incapable of “crossing the chasm” to become must-have products. This idea came from Geoffrey Moore, a Silicon Valley marketing guru who has observed that mass market adoption is the ultimate determinant of a particular technology’s success.

While most products are well-received by a specific group of early adopters, very few brands can cross the chasm that separates them from widespread usage. Ironically, to be able to do this, Moore advises companies to focus on selling rather than customer service, because it is the market share leader – and not the one who has created the best product – that becomes the winner.

An in-game photo of Beat Saber / Photo credit: PlayStation