In the world of venture capital, the space is typically viewed in several verticals which are divided up by the development stage of a startup. This article focuses on a specific niche, a hybrid of an accelerator and an incubator, that is fundamentally different from other strategies: “Moonshot Incubators.”
Before getting into the strategy behind moonshot incubators, below is a quick overview of the differences between an accelerator and an incubator. The investment strategy this blog post focuses on is a modified corporate hybrid model:
The biggest difference between moonshot incubators and other forms of pre-seed capital is that moonshot incubators develop an idea from conceptualization to completion, often building the company over a significantly longer time horizon than that of accelerators or traditional incubators. While moonshot incubators hypothetically can be standalone, in practice they are run by corporates.
The Moonshot Strategy
Often times corporate R&D labs restrict thinking to a certain vertical, which makes sense as R&D expenditures are usually aimed at improving or reinventing certain products that a company sells. Similarly, traditional VC firms will focus on several industries or trends that they are deeply knowledgeable about, as it allows them to deploy capital in areas where they believe they can outperform. By contrast, a moonshot strategy typically succeeds by being as broad as possible.
Minimal focus seems like a recipe for disaster, however, it is this distinctive feature that allows the strategy to succeed. Bringing hundreds of engineers and scientists together to focus on issues they are passionate and knowledgeable about allows for thinking beyond the next logical step in a technology’s development tree.
As per Oliver Franklin-Wallis’ interview with Astro Teller, Captain of Moonshots at Alphabet’s moonshot incubator, X:
“X is not so much a company as a radical way of thinking, a method of pursuing technological breakthroughs by taking crazy ideas seriously. X’s job is not to invent new Google products, but to produce the inventions that might form the next Google.”
The concept is to start with a massive issue in mind, then brainstorm radical solutions which could solve it, irrespective of whether they are currently possible or not. Then, methodically, teams try to pick apart ideas as fast as they can. The goal here is to rapidly fail. The outliers which don’t fail are then passed on to the next development stage where they are first tested at the extremes. Ideas that stubbornly refuse to fail turn into bigger and bigger projects.
Note that there is a key difference here to conventional venture capital thinking. The default status for a typical startup is death, and the entrepreneur must consistently work to prove that an idea can survive. This is because outcomes for users / customers are typically only marginally better (let's call it 10 - 30% better) than what currently exists, so adoption is more difficult. At a moonshot incubator, the default status for an idea is survival. Adoption is almost a guarantee as moonshot ideas aim for user / customer outcomes to be at least 10x better than the status quo. Only until proven impossible can an idea truly be eliminated.
As follows then, moonshot ideas have the three following attributes:
- Addresses a problem that is global on scale
- A radical solution with a breakthrough technology
- 10x better outcomes than existing solutions
If these attributes are met, the idea has potential for an astronomical return.
This overall thesis can be easily observed when looking at the targeted return profile of moonshot incubators versus other forms of private capital (all depictions are illustrative and likely vary from actual asset class returns). Below is the expected distribution of returns that a fund investing in each space may observe from its portfolio (displayed as multiple of money received on initial investments):
The First Moon Landing
The concept of incubating moonshot ideas is not a new one. Their beginnings can be traced back to 1925 with Bell Labs, a joint venture between AT&T and Western Electric. The initial idea was to spin out 4000 engineers and scientists into a new “industrial lab” which would research anything remotely related to human communications, whether it be wires, radio, recorded sound, visual images… or even radio astronomy. It was a mandate to radically innovate and invent.
Funded by a monopoly, Bell Labs initially received ~$12mm per year to fund research, the equivalent to ~$180mm in today’s dollars. The significant budget, combined with a fairly broad mandate allowed the joint venture to slowly morph into the most prominent moonshot incubator in history. More importantly, as AT&T had a very dominant market position, they were able to research and fund ideas that didn’t have an immediately clear path to monetization. That could always be figured out later.
As per The Linux Information Project:
“The artificially high phone rates enabled AT&T to spend lavishly for Bell Labs. For example, researchers could obtain approval within a matter of days to purchase costly equipment, and numerous librarians were available to order any book or periodical subscription that staff scientists requested.
The freedom to spend created a culture of independence and unhampered scientific inquiry. The brightest and most imaginative researchers from around the world were attracted by the opportunity to pursue their work unrestricted by short-term business considerations. Only a huge monopoly such as AT&T could afford the luxury of thousands of top researchers working on projects of their own choosing and without concern for profits or patents.”
This unique set of characteristics helped the industrial lab create the transistor, the laser, the solar cell, communications satellites, 26,000 other patents and 11 Nobel Prize winners. However, as part of an antitrust lawsuit settled in 1956, AT&T (and consequently Bell Labs) was obligated to license all its patents royalty-free and barred from entering any industry other than telecommunications. Thus, many of Bell Labs’ innovations failed to be fully monetized by AT&T.
Another massive blow to the industrial lab came in 1984 when courts found that AT&T was a monopoly and mandated that the company divest itself of its local telephone operations - leading to the seven regional "Baby Bells”. But history had already been written, and the initial economics of a moonshot strategy had been proven. Bell Labs still remains today but is far heights it once reached.
Moonshots as Part of a Holistic Business Strategy
While radical creativity seems like a great idea, it is very difficult to run as a standalone investment strategy. I’d argue it must be tied into a greater ecosystem and culture which reinforces unrestricted creativity. Thus, only several companies can properly pursue such a strategy and achieve outsized returns.
Below are a few key points of Alphabet’s business strategy which allow it to benefit significantly from its moonshot incubator, X:
- Dominant Market Position. As an aggregator, Alphabet enjoys outsized profits from several of its core business lines (search, ads, YouTube, etc.). Due to this unique market structure, its core businesses are well insulated from competition, which means the excess cash it produces does not need to be fully reinvested to maintain its competitive position. As a result, Alphabet continuously produces excess capital which can be used to pursue reinvestment opportunities.
- High Growth. As many still view Alphabet as a high-growth business (even as it matures), there is significantly less pressure for Alphabet to return all excess capital to shareholders. A meaningful portion of this capital can then be reinvested in the business without scrutiny, meaning a greater level of capital is available to experiment. Further, the market has shown persistent patience for profitability when a high-growth idea shows promise. This means Alphabet can chase projects with a longer-term revenue ramp. Which leads into the next point…
- High Visibility. Alphabet as a platform can bring high visibility to new projects in a very short manner once a project is unveiled due to its significant media presence. Excitement for a new project can lead to rapid adoption once the product launches, solidifying the startup as an immediate market leader. This can help enormously in catapulting the project into becoming a viable standalone business. Further, highly-visible, ground-breaking projects attract the best upcoming talent as Alphabet stays top of mind for graduating students.
- Creativity Cultivation (Signaling). Throughout Alphabet’s history, the business has been structured to be agile and facilitate innovation/invention. The brightest talent has been attracted to Alphabet for these key features. However, as core business lines mature, it's important for Alphabet to continuously signal its willingness to take on risk and invent, otherwise the business will stagnate like many others before it. This is where X becomes massively important. A moonshot incubator sends a very strong signal to future talent that Alphabet is committed to reinventing the way humanity operates. In turn, future talent wants the opportunity to be part of that exciting reinvention process. The best talents then provide new moonshot solutions (and consequently the opportunity to invest in them), and the cycle continues. As some moonshot ideas become successful and integrated into Alphabet’s core business, Alphabet is refreshed and retains its image as a thought leader.
These key points all reinforce each other. For example, creativity cultivation leads to opportunities with a higher rate of return as smarter people chase better ideas (funded by Alphabet’s dominant market positions). This in turn results in higher growth for Alphabet as a handful of these bets succeed. High growth and exciting projects increase the media coverage for Alphabet, and thus visibility and so on.
Over time, companies with a moonshot incubator should become highly diversified. This is a feature, not a bug, of a moonshot incubator. A key point of this strategy is to keep the innovation mandate as broad as possible. Bell Labs benefited from this concept, enabling them to take massive leaps forward in adjacent industries. X’s mandate is to pick an issue the world faces today and solve it - almost as broad as you can get. This means thinking is unrestricted, and imagination begins to take over. Put several hundred brilliant dreamers under a roof together and the rest is history...