How to ascertain if your technology development roadmap is sustainable.
A common yet unnoticed pitfall in both startups and mature companies is the low efficiency in their technology spend. While we have progressed beyond the Industrial Revolution and currently over-endowed with high speed connectivity between humans, societies and geographies, many organisations still fail to harness their technology investments for reasonable economic yields.
In recent years, early stage investments become increasingly expensive as a result of post financial crisis quantitative easing and the global capital liquidity. Furthermore, there is no paucity of information on the dangers of over leverage in the unicorn building journey. As a result, many businesses over-curate their technology investments and under-perform over time.
The perception on technology investments has typically been founded on a cost perspective. For example, how much does it cost for us to build this capability, provide that feature or functionality etc. We believe it is more meaningful to understand the performance of technology from a Return-on-Investment (RoI) angle apart from what technology can do for people and the business itself. However, the performance of a technology investment itself may be seen as compounded into operation costs which furthers clouds proper attribution. Moreover, this may be exacerbated by how businesses design their operation systems, adding further complexity to the equation.
So how could we then circumvent these challenges to help founders and businesses understand the efficiency of their technology investment in a more granular and actionable manner?
The Concept
In the investment domain, the Sharpe ratio is a well-known measure for the financial performance of an asset compared to its risk-free counterpart. What if we can adopt the same thinking for assessing the performance of both planned and invested capital for technology in businesses? To the C-suite, it would be an immensely useful tool to understand the contribution of technology to business growth and hence craft strategies around long term sustainability.
The Technology Efficiency Ratio (TE Ratio)
For discussion purpose, we describe this modified version of the Sharpe ratio as the TE Ratio (Technology Efficiency Ratio). In the same light as the Sharpe ratio, we defined fundamental parameters for the TE ratio as follows.
The TE ratio of a technology asset, a, is defined as the following.
Similar to investment fund’s Sharpe ratio the higher the value of TE ratio the better is the expected returns of the technology investment relative to the risk it takes on from an investment perspective.
Illustration
Suppose a founder or a business intends to invest in developing a technology platform and this is going to cost $100,000. With this platform, the revenue is expected to increase by $25,000. Therefore the expected return of this asset (investment) is 25,000/100,000=25%.
Using another commercial or open-source solution will cost $50,000 and will bring the revenue up by $5,000. The risk-free investment return is 5,000/50,000=10%.
Therefore, Rₐ is 0.25–0.1=0.15 and Rᵦ is 0.1.
Suppose this asset to be developed has a standard deviation of 10% for its excess return (improvement in revenue) compared to the risk-free investment in various adoption scenarios. Therefore, the TE Ratio would be computed as follows.
TE Ratio = (0.15 — 0.1)/0.1 = 0.5 (or 50).
Application
Early stage founders over-invest in technology without truly understanding the market. One solution to mitigate this risk is to challenge the founders to work out the TE Ratio for their businesses.
A data-driven approach forces the founder to confront the business’s economics and provide the investors a fair platform to understand its cost structures and capital efficiency. Furthermore, the TE Ratio would allow entrepreneurs appreciate their performance of their technology not just introspectively but across industries as shown in Table 2. The TE Ratio is not only useful to startups but to businesses in more mature stages as well because the metric is growth-stage agnostic. For Reapra, the TE Ratio can help the both Investment team and founder ascertain if the deal has over leverage on technology investment so that both can work on a purposeful and efficient plan to build a sustainable business. Furthermore, the TE Ratio can be used on a continual basis for tracking efficiency of technology investments as the company grows.
Table 1 and 2 show more examples on the usage of the TE Ratios both within an industry and across industries for bench-marking purposes.
| Farm-to-Table Industry | TE Ratio | Comments |
|---|---|---|
| ABC company | 23.1 | City vertical farming |
| CDE company | 11.5 | Farm Produce marketplace |
| EFG company | 38.9 | Cold-chain management |
Table1: Intra-industry comparison of TE rations.
| TE TRatio | Comments | |
| Healthcare: ABC company | 16.3 | Tele-medical consultation |
| Transport: CDE company | 9.49 | P2P vehicle sharing |
| Recycling: EFG company | 51.88 | Advanced Plastic recycling |
Table2: Cross-industry comparison of TE rations.
Conclusion
Given the fast-pace and multi-faceted nature of technology, it is often a non-trivial task to evaluate the capital efficiency involved in any development lifecycle. We believe the novel TE ratio concept described in this article can help founders and businesses manage the complexity in this subject so that they can create sustainable industries in the long run.