Although there is a lot of excitement about investing in quantum technology companies these days, one should be aware of the considerable risks this involves. The quantum industry is still at its very infancy and we expect a lot of changes to happen over the next decade. Many companies will come and go, technologies will change, engineering schedules will slip, markets will develop in unanticipated directions and competition will be fierce.
While we are not discouraging an intelligent investment strategy in quantum, we will discuss in this article different types of risk one should consider as well as possible strategies to help reduce the risks for both investors and quantum companies. We classify the risks into four broad categories: Valuation Risk, Technology Risk, Execution Risk and Business Risk.
We don’t pretend to be stock market experts, but we are aware that there is considerable debate within the investment community whether overall stock market valuations are too high and whether a correction is coming. You can read examples of articles where analysts express opinions on this here, here, and here. Our comment is that if a correction does happen in the overall market, don’t assume that quantum technology stocks will be immune from it. Many tech companies went under during the dot-com bubble of 2000-2001 and it could happen again.
One of the reasons we are optimistic about quantum is that there are so many companies pursuing a broad variety of different technical approaches to develop a successful solution that provides commercial advantage. Although we expect that many of these approaches will fail, a few of them will work out and become successful. If you talk to the executive team at each of the organizations developing qubits, they will all swear that their approach is the best. But the reality is that no one really knows for sure. As an example of how technologies can change, look at the technologies used in the semiconductor industry. Initially, the dominant semiconductor technology used was germanium bipolar. This was replaced a few years later by silicon bipolar which was subsequently replaced by silicon PMOS, followed by silicon NMOS, and finally silicon CMOS. Some companies, Texas Instruments for example, were able to follow the transitions and are still operating today. While others did not make the transitions and ultimately dropped out of semiconductors. Who remembers hearing about semiconductor devices from companies that were the early market leaders such as Philco, Transitron, Clevite, RCA, GE or Raytheon?
Although software companies may also have issues if there are technology or other changes, it is easier for them to pivot and go in a new direction if new algorithms are discovered or a new customer application needs to be developed or they need to interface with a new hardware technology. But even in these cases, if a software company needs to pivot to an area where there is already an incumbent, it may not be successful. Or if a larger company enters a software market, they may be able to develop a better product using their larger engineering budgets and beat the smaller startups. How many of us still have WordPerfect installed on our PC’s for word processing, or Lotus 1-2-3 for spreadsheets or Netscape for our web browsers?
Engineering schedules slip all the time. This can be particularly true in quantum because it is such a new technology that engineering manager many not even know all the challenges they will eventually have to solve before they end up completing the development. We have already seen this happen with several projects from major quantum companies over the past few years. Quantum is a hard technology. Sometimes companies will compensate for slipping schedules by reducing the scope of a project or lowering the performance specifications for the product. The risk for an investor is that sometimes a product slips so much that the product is no longer viable in the market. So business plans that are based upon product introductions by certain dates with certain performance specifications may need to be reduced drastically if those dates or specifications are not met.
Once the quantum computing market grows to a substantial size, we expect that the competition will be fierce. Our belief is that the large computing companies today, such as IBM, Google, Microsoft, Amazon, and others will fight tooth and nail for every scrap of business. Even if their technology may not always be the best, they will leverage every possible advantage including long standing customer relationships, large marketing budgets, community building, FUD (Fear, Uncertainty, & Doubt), and bundling of products & services to win business.
Large companies also have an advantage that smaller companies do not. If their technology is deficient, they can always partner or acquire a smaller company that does have a better solution using some of their large cash reserves or their stock. In some respects, Microsoft has already started taking this approach by offering quantum access to machines from IonQ, QCI, and Honeywell on their Azure cloud when they saw that their own program for topological based machines was developing slower than originally anticipated. But this approach carries risk for the smaller companies who are the partners. If Microsoft’s or Amazon’s internal developments ever reach fruition, these large companies could decide to switch to their own technologies and end the partnerships creating a significant revenue shortfall for the smaller company.
On the other hand, smaller companies do generally have an advantage in that they are more flexible and often able to innovate more rapidly. In some cases, they can find an appropriate niche and provide solutions where they don’t have to compete directly against the big guys. If there are large changes in the market and the smaller companies do a better job of anticipating it, they may be able to gain a foothold before the big guys get in. This occurred in classical computing when companies such as Digital Equipment, Data General, and Prime created substantial minicomputer businesses while IBM was still focused on mainframes. Unfortunately for the minicomputer companies, companies like Compaq and Dell came in later and created substantial personal computing businesses and left the minicomputer companies flat-footed.
So our prediction is that there will be significant upheaval in the quantum industry over the next decade. We have been tracking over 200 startup companies in the hardware and communication spaces alone and already can name about a half dozen companies that are no longer around. (And this does not even include startup companies developing components or sensor products because we don’t currently track companies in these segments). Our belief is that very few of the startup companies we show today will still exist as standalone companies ten years from now. Many will go out of business, some will be merged together and some will be acquired by larger companies. So this creates significant risks for a potential investor unless their investment achieves a successful IPO or is acquired at a high valuation .
We have heard that some venture capital firms have taken the strategy to invest in only one quantum company to see how it works out. We think this approach carries a high amount of risk due to the factors mentioned above. For those investors who truly believe in quantum, our recommendation is to place a few different quantum bets. The overall market will definitely be large and some companies will be hugely successful. But predicting which ones will be the winners at this point is a major challenge and investors are better off placing their bets on a few different players in the race.
For a quantum startup, our recommendation is to think hard about how the market is expected to develop and what your own place will be in the quantum ecosystem. (See our presentation on A Tour Through the Quantum Ecosystem for our thoughts on this) For a startup, we do not believe that simply creating a better technology will be enough to get end users to flock to you. One needs to provide a complete solution for the end users. Ecosystems and communities are being formed to do this and it may be too late if your strategy is to start from scratch and create your own. Companies that do have a better technology may be able to sell it to another company that already has an existing customer base and wants to improve their offering. Partnering with others is also good solution as long as you don’t end up in a situation where the partner is developing a competing solution that could replace you. We strongly recommend quantum startups develop as a strong patent portfolio as they can to help protect themselves from these situations. Or alternatively, pursue a specific niche where they won’t initially face directly competition with strong adversaries may also be a winning formula.
Technology industries have always exhibited turmoil and change as they progress with many investments turning out to be disappointments along with a few well publicized winners. And to think that it will be any different this time in quantum is just plain foolish.
April 24, 2021