Creative Entrepreneurship

Note from the Authors:
“Creative Entrepreneurship” was born out of the desire, want and curiosity of kbs+’s
staff to understand the crazy world of entrepreneurship. “Creative Entrepreneurship”
curates the perspectives of leading entrepreneurs and venture capitalists as a guide for
people interested in learning more. Each writer graciously contributed their work to
create a curated resource for creative entrepreneurs.
This book is the teaching and inspirational aid for our kbs+ Ventures Fellows – a
highly select group of kbs+ staffers from all levels and areas of the agency – who go
through a six-month educational program to immerse themselves in the startup and
venture capital world.
Share this entrepreneurial inspiration with friends using @kbspvc or #kbspvcbook.
If you would like to share any inspiration, thoughts or feedback, please contact us at
@kbspvc anytime – we look forward to hearing from you.
Thank you for downloading our book!
Darren Herman Taylor Davidson
Creative
Entrepreneurship
Darren Herman
Taylor Davidson
a kbs+ partner
We have received explicit permission from all authors of the works found in this
book. Unless otherwise stated, we do not claim to have written or own any of this
work. We are purely aggregating it into a simple book format for the education of
anyone who picks up this book.
The price of this book is free; if anyone tries to sell this book to you, please report
them to us. Hopefully this book inspires you as much as it does us. We do not
guarantee you will start the next successful startup after reading this book but we
do think it will make you at least one IQ point smarter. Enjoy it and after you are
done with it, hand it to someone else to read. Sharing means caring.
The author and publisher have taken care in the preparation of this book, but
make no expressed or implied warranty of any kind and assume no responsibility
for errors or omissions. No liability is assumed for incidental or consequential
damages in connection with or arising out of the use of the information or
programs contained herein.
Contact Info:
kbs+ Ventures
160 Varick Street
New York, NY 10013
Email us:
[email protected]
Follow us on Twitter:
@kbspVC
Visit our Website:
http://www.kbsp.vc
Copyright © 2012 kbs+
All rights reserved. Printed in the United States of America.
A very special thank-you to Lara Fischer-Zernin and Eugenia Koo for their
persistence and curiosity that got this book to where it is today.
To a whole new generation of Mad (Wo)Men. Our industry is changing and we
have the power to shape it. Let’s not fuck it up.
– Darren Herman
President, kbs+ Ventures & Chief Digital Media Officer
kbs+ The Media Kitchen
Table of Contents
FOREWORD
By Darren Herman
CHAPTER ONE
History & Context
Types of Innovation
Blake Masters: Peter Thiel’s CS183: Startup –
Class 1 Notes Essay
The Internet: From Static to Collaborative, What Might Come Next
Tim O’Reilly: What Is Web 2.0: Design Patterns and Business
Models for the Next Generation of Software
Paul Graham: Web 2.0
Theories about Web 3.0
Jay Jamison: Web 3.0: The Mobile Era
Groundbreaking Entrepreneurship
Sarah Lacy: Inside the DNA of the Facebook Mafia
CHAPTER TWO
The Funding Ecosystem
Types of Investors
Paul Graham: How to Fund a Startup
What Every Startup Should Know About Investors
Paul Graham: The Hacker’s Guide to Investors
Mark Suster: Angel Funding Advice
Why Everyone Does Not Need to Raise
Dan Shapiro: Companies That Would Do Best Without
Venture Capital
CHAPTER THREE
Finance 201
What Is Venture Capitalism?
Marc Averitt & Matthew V. Waterman:
Venture Capital Basics
Convertible Debt
Fred Wilson: MBA Mondays: Convertible Debt
Preferred Equity
Fred Wilson: MBA Mondays: Preferred Stock
Intro to the Cap Table
Mark Suster: Want to Know How VCs Calculate
Valuation Differently from Founders?
Critical Terms
Fred Wilson: The Three Terms You Must Have
in a Venture Investment
CHAPTER FOUR
How to be a VC
Maintaining Relationships
Charlie O’Donnell: How to be a VC: Being Open
Chris Dixon: Being Friendly Has Become a
Competitive Advantage in VC
Touting Expertise
Mark Suster: Domain Knowledge
Understanding the Statistics
Blake Masters: Peter Thiel’s CS193:Startup –
Class 7 Notes Essay
CHAPTER FIVE
How to be an Entrepreneur
Picking an Idea
Chris Dixon: Founder/Market Fit
Andrew Chen: When Has a Consumer Startup Hit
Product/Market Fit?
Constructing a Team
Seth Levine: Hiring as a Core Competency
Darren Herman: The Startup as a Band
Culture
Scott Weiss: 20 Rules of Thumb for Building a Great
Startup Culture
CHAPTER SIX
Fundraising
How to Fundraise
Mark Suster: A 6-Step Relationship Guide to VC
Chris Dixon: Pitch Yourself, Not Your Idea
Charlie O’Donnell: A Framework to Think About Pricing Seed,
Angel, and Venture Capital Rounds From Whom to Fundraise
Chris Dixon: How to Select Your Angel Investors
When to Fundraise
Mark Suster: VC Funding Season Ends Next Week
How to Build a Deck
Babak Nivi: What Should I Send to Investors?
CHAPTER SEVEN
Building a Business
Agile vs. Waterfall Software Development
Rutul Dave: Web Development Methodologies:
Agile vs. Waterfall Lean vs. Heavy Startup Methodology
Wikipedia: Learn Startup
Metrics to Consider
Steve Blank: No Accounting for Startups
Dave McClure: Startup Metrics for Pirates
Taylor Davidson: Why Financial Models Are
Easier Than You Think
Focus on User Acquisition/ Marketing
Blake Masters: Peter Thiel’s CS183: Startup –
Class 9 Notes Essay
Don’t Be Afraid to Pivot
Adam L. Penenberg: Enter the Pivot: The Critical
Course Corrections of Flickr, Fab.com, and More
CHAPTER EIGHT
Business Acceleration and Beyond
Business Development and Corporate Collaboration
Chris Dixon: Business Development – The Goldilocks
Principle
Robert Ackerman, Jr.: The Most Unlikely
Place to Find Startup Funding
Exits
Walter G. Kortschak: Strategic Acquisition or IPO?
Chris Dixon: Three Types of Acquisitions
Felix Salmon: For High Tech Companies,
Going Public Sucks All in All – Do Things that Matter
Paul Graham: What You’ll Wish You’d Known
About the Contributors
FOREWORD
kbs+ Ventures was established as the early stage investment arm of the
marketing services agency kirshenbaum bond senecal + partners (kbs+) in
January of 2011. Our goal was (and is) to return two types of outcomes:
financial returns and knowledge returns, through a highly narrow thesis of
investing in advertising and marketing technology. I spun up Ventures, had
kbs+ make us a nifty logo and website and we were off to the races. Over time,
I added a Senior Associate, Taylor Davidson (@tdavidson) and an occasional
Ventures Intern and now, just a year and a half later, we have made eight
individual investments into early-stage marketing and advertising technology
companies innovating, building and disrupting the future of the industry. A
big shout out to MDC Partners for supporting an investment arm at the agency
level, which tends to be very non-traditional.
kbs+ Ventures exists because kbs+’s clients pay handsome sums of monies to help
them drive transformational business growth. Whether this growth is created
through general advertising, media planning and buying, execution of creative
technologies, public relations and crisis management or other “agency-like”
services, what has always been present in kbs+’s DNA is the drive to push the
boundaries around marketing inventions. We have built many “firsts” in this
agency and that comes from thinking well beyond where the market is today.
Early stage innovation pushes and pulls markets forward. Sometimes, the early
stage innovation is too far in the distance and does not connect to the present
day (and fizzles out), but other times innovation is happening on the cutting
edge of the marketplace and drags the entire marketplace forward. Examples
of this are Twitter, Napster, and Instagram, three organizations that have/
are disrupting industries through information, music, and photo distribution,
respectively. These innovations were executed into the sweet spot of the
adoption curve and became, in their own ways, part of the mainstream.
(Source: http://techcrunch.com/2012/04/01/the-market-curve-the-life-cycle/)
kbs+ Ventures tries to understand what is happening on and beyond the edges
to understand patterns and trends so that we can make better investment
decisions and distribute the learnings back to our agency counterparts to make
everyone smarter. In turn, this makes our clients smarter and more proactive in
the marketplace because we know what is and is not coming in the future.
A week does not go by without someone from kbs+ telling Taylor and me about
their entrepreneurial idea, or a new company, or a cousin of theirs who just got
funding from a top tier venture capitalist. We love this. And it made us realize
that even though we’re on Madison Avenue (well, really Varick Street), there is a
lot of passion for entrepreneurship in the agency.
And thus, the kbs+ Ventures Fellows Program was born. This program is a
competitive, application-only program that brings together 15-20 kbs+’ers
from all levels and practice areas of the agency to work with kbs+ Ventures for
six months. To date, we’ve celebrated two Fellows classes that have graduated
over 35 people. It has been instrumental in building kbs+ Ventures’ view into
the future, but at the same time one consistent piece of constructive feedback
was that they all wanted more formal education about venture capital and
entrepreneurship.
Taylor, Lara Fischer-Zernin and I, along with Eugenia Koo, our 2012 Summer
intern, brainstormed ways of bringing more education to the Fellows class. We
realized quickly that we do a lot of educating both actively (we teach a monthly
class) and passively (any Fellows member can take reimbursable classes at
participating entrepreneurial education institutions such as General Assembly or
Skillshare) but we never formally structured it.
Thus, this book, Creative Entrepreneurship, was born. It was born out of
the desire, want, and curiosity of our staff to understand this crazy world of
entrepreneurship. As a teaching and inspiration aid to our new classes for the
Ventures Fellows, Creative Entrepreneurship will help provide a textbook-like
object to structure and teach our lessons through the perspectives of some of the
leading entrepreneurs, angel investors, and venture capitalists who graciously
contributed their writings to this book.
As we worked on this book and got it to the point of hitting the “publish”
button, we realized that it has far greater potential than just being a teaching
aid for kbs+ Ventures Fellows.
The world of advertising is going through a renaissance period. What worked
on Madison Avenue 30, 20, or even 10 years ago might not work today. If we
continue doing today what we did yesterday, then we might as well shut our
doors and file for bankruptcy. But obviously, we do not want that. We need to
evolve and become a modern agency that is servicing the needs of our roster
of Blue Chip clients. Reinventing ourselves is applying the art of Creative
Entrepreneurship to whatever we do: for our agency, our clients, our staff, etc.
We come up with marketing inventions, not just creative solutions. We believe
that the content in this book will help inspire anyone who steps foot into kbs+
and frankly, anyone who steps into the marketing industry.
So read this book with an open mind and an open heart. Dreams start in your
mind and enter your heart when you fulfill them. While this book, Creative
Entrepreneurship, will not execute your dreams for you, it will bring you one
step closer to the world of entrepreneurship which is what this brave new world
demands.
Enjoy.
Darren Herman
President, kbs+ Ventures & Chief Digital Media Officer
kbs+ The Media Kitchen
CHAPTER ONE
HISTORY & CONTEXT
We will begin from the bottom up.
What exactly does innovation look like?
How did the web get to be where it is today, and how might we use it
tomorrow?
We spotlight some of the greatest entrepreneurs from recent history, and how
they’ve led a movement around building solutions for real-world problems.
Types of Innovations
Blake Masters: Peter Thiel’s CS183: Startup – Class 1 Notes Essay
Purpose and Preamble
We might describe our world as having retail sanity, but wholesale madness.
Details are well understood; the big picture remains unclear. A fundamental
challenge—in business as in life—is to integrate the micro and macro such that
all things make sense.
Humanities majors may well learn a great deal about the world. But they don’t
really learn career skills through their studies. Engineering majors, conversely,
learn in great technical detail. But they might not learn why, how, or where
they should apply their skills in the workforce. The best students, workers, and
thinkers will integrate these questions into a cohesive narrative. This course
aims to facilitate that process.
I. The History of Technology
For most of recent human history—from the invention of the steam engine in
the late 17th century through about the late 1960s or so— technological process
has been tremendous, perhaps even relentless. In most prior human societies,
people made money by taking it from others. The industrial revolution wrought
a paradigm shift in which people make money through trade, not plunder.
The importance of this shift is hard to overstate. Perhaps 100 billion people
have ever lived on Earth. Most of them lived in essentially stagnant societies;
success involved claiming value, not creating it. So the massive technological
acceleration of the past few hundred years is truly incredible.
The zenith of optimism about the future of technology might have been the
1960s. People believed in the future. They thought about the future. Many
were supremely confident that the next 50 years would be a half-century of
unprecedented technological progress.
But with the exception of the computer industry, it wasn’t. Per capita incomes
are still rising, but that rate is starkly decelerating. Median wages have
been stagnant since 1973. People find themselves in an alarming Alice-inWonderland-style scenario in which they must run harder and harder—that is,
work longer hours—just to stay in the same place. This deceleration is complex,
and wage data alone don’t explain it. But they do support the general sense that
the rapid progress of the last 200 years is slowing all too quickly.
II. The Case For Computer Science
Computers have been the happy exception to recent tech deceleration. Moore’s/
Kryder’s/Wirth’s laws have largely held up, and forecast continued growth.
Computer tech, with ever-improving hardware and agile development, is
something of a model for other industries. It’s obviously central to the Silicon
Valley ecosystem and a key driver of modern technological change. So CS is the
logical starting place to recapture the reins of progress.
III. The Future For Progress
A. Globalization and Tech: Horizontal vs. Vertical Progress
Progress comes in two flavors: horizontal/extensive and vertical/intensive.
Horizontal or extensive progress basically means copying things that work. In
one word, it means simply “globalization.” Consider what China will be like
in 50 years. The safe bet is it will be a lot like the United States is now. Cities
will be copied, cars will be copied, and rail systems will be copied. Maybe some
steps will be skipped. But it’s copying all the same.
Vertical or intensive progress, by contrast, means doing new things. The single
word for this is “technology.” Intensive progress involves going from 0 to 1 (not
simply the 1 to n of globalization). We see much of our vertical progress come
from places like California, and specifically Silicon Valley. But there is every
reason to question whether we have enough of it. Indeed, most people seem
to focus almost entirely on globalization instead of technology; speaking of
“developed” versus “developing nations” is implicitly bearish about technology
because it implies some convergence to the “developed” status quo. As a society,
we seem to believe in a sort of technological end of history, almost by default.
It’s worth noting that globalization and technology do have some interplay;
we shouldn’t falsely dichotomize them. Consider resource constraints as a 1
to n subproblem. Maybe not everyone can have a car because that would be
environmentally catastrophic. If 1 to n is so blocked, only 0 to 1 solutions can
help. Technological development is thus crucially important, even if all we
really care about is globalization.
B. The Problems of 0 to 1
Maybe we focus so much on going from 1 to n because that’s easier to do.
There’s little doubt that going from 0 to 1 is qualitatively different, and almost
always harder, than copying something n times. And even trying to achieve
vertical, 0 to 1 progress presents the challenge of exceptionalism; any founder or
inventor doing something new must wonder: am I sane? Or am I crazy?
Consider an analogy to politics. The United States is often thought of as an
“exceptional” country. At least many Americans believe that it is. So is the U.S.
sane? Or is it crazy? Everyone owns guns. No one believes in climate change.
And most people weigh 600 pounds. Of course, exceptionalism may cut the
other way. America is the land of opportunity. It is the frontier country. It offers
new starts, meritocratic promises of riches. Regardless of which version you buy,
people must grapple with the problem of exceptionalism. Some 20,000 people,
believing themselves uniquely gifted, move to Los Angeles every year to become
famous actors. Very few of them, of course, actually become famous actors. The
startup world is probably less plagued by the challenge of exceptionalism than
Hollywood is. But it probably isn’t immune to it.
C. The Educational and Narrative Challenge
Teaching vertical progress or innovation is almost a contradiction in terms.
Education is fundamentally about going from 1 to n. We observe, imitate, and
repeat. Infants do not invent new languages; they learn existing ones. From
early on, we learn by copying what has worked before.
That is insufficient for startups. Crossing T’s and dotting I’s will get you maybe
30% of the way there. (It’s certainly necessary to get incorporation right, for
instance. And one can learn how to pitch VCs.) But at some point you have to
go from 0 to 1—you have to do something important and do it right—and that
can’t be taught. Channeling Tolstoy’s intro to Anna Karenina, all successful
companies are different; they figured out the 0 to 1 problem in different ways.
But all failed companies are the same; they botched the 0 to 1 problem. So case
studies about successful businesses are of limited utility. PayPal and Facebook
worked. But it’s hard to know what was necessarily path-dependent. The next
great company may not be an e-payments or social network company. We
mustn’t make too much of any single narrative. Thus the business school case
method is more mythical than helpful.
D. Determinism vs. Indeterminism
Among the toughest questions about progress is the question of how we should
assess a venture’s probability of success. In the 1 to n paradigm, it’s a statistical
question. You can analyze and predict. But in the 0 to 1 paradigm, it’s not a
statistical question; the standard deviation with a sample size of 1 is infinite.
There can be no statistical analysis; statistically, we’re in the dark.
We tend to think very statistically about the future. And statistics tells us that
it’s random. We can’t predict the future; we can only think probabilistically. If
the market follows a random walk, there’s no sense trying to out-calculate it.
But there’s an alternative math metaphor we might use: calculus. The calculus
metaphor asks whether and how we can figure out exactly what’s going to
happen. Take NASA and the Apollo missions, for instance. You have to figure
out where the moon is going to be, exactly. You have to plan whether a rocket
has enough fuel to reach it. And so on. The point is that no one would want to
ride in a statistically, probabilistically-informed spaceship.
Startups are like the space program in this sense. Going from 0 to 1 always
has to favor determinism over indeterminism. But there is a practical problem
with this. We have a word for people who claim to know the future: prophets.
And in our society, all prophets are false prophets. Steve Jobs finessed his way
about the line between determinism and indeterminism; people sensed he was
a visionary, but he didn’t go too far. He probably cut it as close as possible (and
succeeded accordingly).
The luck versus skill question is also important. Distinguishing these factors is
difficult or impossible. Trying to do so invites ample opportunity for fallacious
reasoning. Perhaps the best we can do for now is to flag the question, and
suggest that it’s one that entrepreneurs or would-be entrepreneurs should have
some handle on.
E. The Future of Intensive Growth
There are four theories about the future of intensive progress. First is
convergence; starting with the industrial revolution, we saw a quick rise in
progress, but technology will decelerate and growth will become asymptotic.
Second, there is the cyclical theory. Technological progress moves in cycles;
advances are made, retrenchments ensue. Repeat. This has probably been true
for most of human history. But it’s hard to imagine it remaining true; to think
that we could somehow lose all the information and know-how we’ve amassed
and be doomed to have to re-discover it strains credulity.
Third is collapse/destruction. Some technological advance will do us in.
Fourth is the singularity where technological development yields some AI or
intellectual event horizon.
People tend to overestimate the likelihood or explanatory power of the
convergence and cyclical theories. Accordingly, they probably underestimate the
destruction and singularity theories.
IV. Why Companies?
If we want technological development, why look to companies to do it?
It’s possible, after all, to imagine a society in which everyone works for
the government. Or, conversely, one in which everyone is an independent
contractor. Why have some intermediate version consisting of at least two
people but less than everyone on the planet?
The answer is straightforward application of the Coase Theorem. Companies
exist because they optimally address internal and external coordination costs. In
general, as an entity grows, so do its internal coordination costs. But its external
coordination costs fall. Totalitarian government is entity writ large; external
coordination is easy, since those costs are zero. But internal coordination, as
Hayek and the Austrians showed, is hard and costly; central planning doesn’t
work.
The flipside is that internal coordination costs for independent contractors
are zero, but external coordination costs (uniquely contracting with absolutely
everybody one deals with) are very high, possibly paralyzingly so. Optimality—
firm size—is a matter of finding the right combination.
V. Why Startups?
A. Costs Matter
Size and internal vs. external coordination costs matter a lot. North of 100
people in a company, employees don’t all know each other. Politics become
important. Incentives change. Signaling that work is being done may become
more important than actually doing work. These costs are almost always
underestimated. Yet they are so prevalent that professional investors should
and do seriously reconsider before investing in companies that have more
than one office. Severe coordination problems may stem from something as
seemingly trivial or innocuous as a company having a multi-floor office. Hiring
consultants and trying to outsource key development projects are, for similar
reasons, serious red flags. While there’s surely been some lessening of these
coordination costs in the last 40 years—and that explains the shift to somewhat
smaller companies—the tendency is still to underestimate them. Since they
remain fairly high, they’re worth thinking hard about.
Path’s limiting its users to 150 “friends” is illustrative of this point. And ancient
tribes apparently had a natural size limit that didn’t much exceed that number.
Startups are important because they are small; if the size and complexity of
a business is something like the square of the number of people in it, then
startups are in a unique position to lower interpersonal or internal costs and
thus to get stuff done.
The familiar Austrian critique dovetails here as well. Even if a computer could
model all the narrowly economic problems a company faces (and, to be clear,
none can), it wouldn’t be enough. To model all costs, it would have to model
human irrationalities, emotions, feelings, and interactions. Computers help,
but we still don’t have all the info. And if we did, we wouldn’t know what to do
with it. So, in practice, we end up having companies of a certain size.
B. Why Do a Startup?
The easiest answer to “why startups?” is negative: because you can’t develop
new technology in existing entities. There’s something wrong with big
companies, governments, and non-profits. Perhaps they can’t recognize financial
needs; the federal government, hamstrung by its own bureaucracy, obviously
overcompensates some while grossly undercompensating others in its employ.
Or maybe these entities can’t handle personal needs; you can’t always get
recognition, respect, or fame from a huge bureaucracy. Anyone on a mission
tends to want to go from 0 to 1. You can only do that if you’re surrounded
by others that want to go from 0 to 1. That happens in startups, not huge
companies or government.
Doing startups for the money is not a great idea. Research shows that people
get happier as they make more and more money, but only up to about $70,000
per year. After that, marginal improvements brought by higher income are more
or less offset by other factors (stress, more hours, etc. Plus there is obviously
diminishing marginal utility of money even absent offsetting factors).
Perhaps doing startups to be remembered or become famous is a better motive.
Perhaps not. Whether being famous or infamous should be as important as
most people seem to think it is highly questionable. A better motive still would
be a desire to change the world. The U.S. in 1776-79 was a startup of sorts.
What were the Founders motivations? There is a large cultural component to
the motivation question, too. In Japan, entrepreneurs are seen as reckless risktakers. The respectable thing to do is become a lifelong employee somewhere.
The literary version of this sentiment is “behind every fortune lies a great
crime.” Were the Founding Fathers criminals? Are all founders criminals of one
sort or another?
C. The Costs of Failure
Startups pay less than bigger companies. So founding or joining one involves
some financial loss. These losses are generally thought to be high. In reality,
they aren’t that high.
The nonfinancial costs are actually higher. If you do a failed startup, you
may not have learned anything useful. You may actually have learned how
to fail again. You may become more risk-averse. You aren’t a lottery ticket, so
you shouldn’t think of failure as just 1 of n times that you’re going to start a
company. The stakes are a bit bigger than that.
A 0 to 1 startup involves low financial costs but low non-financial costs too.
You’ll at least learn a lot and probably will be better for the effort. A 1 to n
startup, though, has especially low financial costs, but higher non-financial
costs. If you try to do Groupon for Madagascar and it fails, it’s not clear where
exactly you are. But it’s not good.
VI. Where to Start?
The path from 0 to 1 might start with asking and answering three questions.
First, what is valuable? Second, what can I do? And third, what is nobody else
doing?
The questions themselves are straightforward. Question one illustrates the
difference between business and academia; in academia, the number one sin is
plagiarism, not triviality. So much of the innovation is esoteric and not at all
useful. No one cares about a firm’s eccentric, non-valuable output. The second
question ensures that you can actually execute on a problem; if not, talk is just
that. Finally, and often overlooked, is the importance of being novel. Forget
that and we’re just copying.
The intellectual rephrasing of these questions is: What important truth do very
few people agree with you on?
The business version is: What valuable company is nobody building?
These are tough questions. But you can test your answers; if, as so many people
do, one says something like “our educational system is broken and urgently
requires repair,” you know that that answer is wrong (it may be a truth, but
lots of people agree with it). This may explain why we see so many education
non-profits and startups. But query whether most of those are operating in
technology mode or globalization mode. You know you’re on the right track
when your answer takes the following form:
“Most people believe in X. But the truth is !X.”
Make no mistake, it’s a hard question. Knowing what 0 to 1 endeavor is worth
pursuing is incredibly rare, unique, and tricky. But the process, if not the result,
can also be richly rewarding.
The Internet: From Static to
Collaborative, What Might Come Next
Tim O’Reilly: What Is Web 2.0: Design Patterns and Business Models
for the Next Generation of Software
The bursting of the dot-com bubble in the fall of 2001 marked a turning
point for the web. Many people concluded that the web was overhyped, when
in fact bubbles and consequent shakeouts appear to be a common feature of
all technological revolutions. Shakeouts typically mark the point at which an
ascendant technology is ready to take its place at center stage. The pretenders
are given the bum’s rush, the real success stories show their strength, and there
begins to be an understanding of what separates one from the other.
The concept of “Web 2.0” began with a conference brainstorming session
between O’Reilly and MediaLive International. Dale Dougherty, web pioneer
and O’Reilly VP, noted that far from having “crashed,” the web was more
important than ever, with exciting new applications and sites popping up
with surprising regularity. What’s more, the companies that had survived the
collapse seemed to have some things in common. Could it be that the dot-com
collapse marked some kind of turning point for the web, such that a call to
action such as “Web 2.0” might make sense? We agreed that it did, and so the
Web 2.0 Conference was born.
In the year and a half since, the term “Web 2.0” has clearly taken hold, with
more than 9.5 million citations in Google. But there’s still a huge amount of
disagreement about just what Web 2.0 means, with some people decrying
it as a meaningless marketing buzzword, and others accepting it as the new
conventional wisdom.
This article is an attempt to clarify just what we mean by Web 2.0.
In our initial brainstorming, we formulated our sense of Web 2.0 by example:
Web 1.0
DoubleClick
Ofoto
Akamai
mp3.com
Britannica Online
personal websites
evite
-->
Google AdSense
-->Flickr
-->BitTorrent
-->Napster
-->Wikipedia
-->blogging
-->
upcoming.org and EVDB
search engine
-->
optimization
-->
cost per click
-->
web services
-->participation
-->wikis
-->
tagging (“folksonomy”)
-->syndication
domain name speculation
page views
screen scraping
publishing
content management systems
directories (taxonomy)
stickiness
Web 2.0
The list went on and on. But what was it that made us identify one application
or approach as “Web 1.0” and another as “Web 2.0”? (The question is
particularly urgent because the Web 2.0 meme has become so widespread
that companies are now pasting it on as a marketing buzzword, with no real
understanding of just what it means. The question is particularly difficult
because many of those buzzword-addicted startups are definitely not Web 2.0,
while some of the applications we identified as Web 2.0, like Napster and
BitTorrent, are not even properly web applications!) We began trying to tease
out the principles that are demonstrated in one way or another by the success
stories of Web 1.0 and by the most interesting of the new applications.
I. The Web As Platform
Like many important concepts, Web 2.0 doesn’t have a hard boundary, but
rather, a gravitational core. You can visualize Web 2.0 as a set of principles and
practices that tie together a veritable solar system of sites that demonstrate some
or all of those principles, at a varying distance from that core.
Figure 1 shows a “meme map” of Web 2.0 that was developed at a
brainstorming session during FOO Camp, a conference at O’Reilly Media. It’s
very much a work in progress, but shows the many ideas that radiate out from
the Web 2.0 core.
For example, at the first Web 2.0 conference, in October 2004, John Battelle
and I listed a preliminary set of principles in our opening talk. The first of those
principles was “The web as platform.” Yet that was also a rallying cry of Web 1.0
darling Netscape, which went down in flames after a heated battle with
Microsoft. What’s more, two of our initial Web 1.0 exemplars, DoubleClick
and Akamai, were both pioneers in treating the web as a platform. People don’t
often think of it as “web services,” but in fact, ad serving was the first widely
deployed web service, and the first widely deployed “mashup” (to use another
term that has gained currency of late). Every banner ad is served as a seamless
cooperation between two websites, delivering an integrated page to a reader on
yet another computer. Akamai also treats the network as the platform, and at
a deeper level of the stack, building a transparent caching and content delivery
network that eases bandwidth congestion.
Nonetheless, these pioneers provided useful contrasts because later entrants
have taken their solution to the same problem even further, understanding
something deeper about the nature of the new platform. Both DoubleClick and
Akamai were Web 2.0 pioneers, yet we can also see how it’s possible to realize
more of the possibilities by embracing additional Web 2.0 design patterns.
Let’s drill down for a moment into each of these three cases, teasing out some of
the essential elements of difference.
Netscape vs. Google
If Netscape was the standard bearer for Web 1.0, Google is most certainly the
standard bearer for Web 2.0, if only because their respective IPOs were defining
events for each era. So let’s start with a comparison of these two companies and
their positioning.
Netscape framed “the web as platform” in terms of the old software paradigm:
their flagship product was the web browser, a desktop application, and their
strategy was to use their dominance in the browser market to establish a
market for high-priced server products. Control over standards for displaying
content and applications in the browser would, in theory, give Netscape the
kind of market power enjoyed by Microsoft in the PC market. Much like the
“horseless carriage” framed the automobile as an extension of the familiar,
Netscape promoted a “webtop” to replace the desktop, and planned to populate
that webtop with information updates and applets pushed to the webtop by
information providers who would purchase Netscape servers.
In the end, both web browsers and web servers turned out to be commodities,
and value moved “up the stack” to services delivered over the web platform.
Google, by contrast, began its life as a native web application, never sold
or packaged, but delivered as a service, with customers paying, directly
or indirectly, for the use of that service. None of the trappings of the old
software industry are present. No scheduled software releases, just continuous
improvement. No licensing or sale, just usage. No porting to different platforms
so that customers can run the software on their own equipment, just a massively
scalable collection of commodity PCs running open source operating systems
plus homegrown applications and utilities that no one outside the company ever
gets to see.
At bottom, Google requires a competency that Netscape never needed: database
management. Google isn’t just a collection of software tools, it’s a specialized
database. Without the data, the tools are useless; without the software, the data
is unmanageable. Software licensing and control over APIs—the lever of power
in the previous era—is irrelevant because the software never need be distributed
but only performed, and also because without the ability to collect and manage
the data, the software is of little use. In fact, the value of the software is
proportional to the scale and dynamism of the data it helps to manage.
Google’s service is not a server—though it is delivered by a massive collection
of Internet servers—nor a browser—though it is experienced by the user within
the browser. Nor does its flagship search service even host the content that it
enables users to find. Much like a phone call, which happens not just on the
phones at either end of the call, but on the network in between, Google happens
in the space between browser and search engine and destination content server,
as an enabler or middleman between the user and his or her online experience.
While both Netscape and Google could be described as software companies, it’s
clear that Netscape belonged to the same software world as Lotus, Microsoft,
Oracle, SAP, and other companies that got their start in the 1980’s software
revolution, while Google’s fellows are other internet applications like eBay,
Amazon, Napster, and yes, DoubleClick and Akamai.
DoubleClick vs. Overture and AdSense
Like Google, DoubleClick is a true child of the Internet era. It harnesses
software as a service, has a core competency in data management, and, as noted
above, was a pioneer in web services long before web services even had a name.
However, DoubleClick was ultimately limited by its business model. It bought
into the ‘90’s notion that the web was about publishing, not participation; that
advertisers, not consumers, ought to call the shots; that size mattered, and that
the Internet was increasingly being dominated by the top websites as measured
by MediaMetrix and other web ad scoring companies.
As a result, DoubleClick proudly cites on its website “over 2000 successful
implementations” of its software. Yahoo! Search Marketing (formerly Overture)
and Google AdSense, by contrast, already serve hundreds of thousands of
advertisers apiece.
Overture and Google’s success came from an understanding of what Chris
Anderson refers to as “the long tail,” the collective power of the small sites
that make up the bulk of the web’s content. DoubleClick’s offerings require a
formal sales contract, limiting their market to the few thousand largest websites.
Overture and Google figured out how to enable ad placement on virtually any
web page. What’s more, they eschewed publisher/ad-agency friendly advertising
formats such as banner ads and popups in favor of minimally intrusive, contextsensitive, consumer-friendly text advertising.
The Web 2.0 lesson: leverage customer-self service and algorithmic data
management to reach out to the entire web, to the edges and not just the center,
to the long tail and not just the head.
Not surprisingly, other Web 2.0 success stories demonstrate this same behavior.
eBay enables occasional transactions of only a few dollars between single
individuals, acting as an automated intermediary. Napster (though shut down
for legal reasons) built its network not by building a centralized song database,
but by architecting a system in such a way that every downloader also became a
server, and thus grew the network.
Akamai vs. BiTorrent
Like DoubleClick, Akamai is optimized to do business with the head, not the
tail, with the center, not the edges. While it serves the benefit of the individuals
at the edge of the web by smoothing their access to the high-demand sites at the
center, it collects its revenue from those central sites.
BitTorrent, like other pioneers in the P2P movement, takes a radical approach
to Internet decentralization. Every client is also a server; files are broken up into
fragments that can be served from multiple locations, transparently harnessing
the network of downloaders to provide both bandwidth and data to other users.
The more popular the file, in fact, the faster it can be served, as there are more
users providing bandwidth and fragments of the complete file.
BitTorrent thus demonstrates a key Web 2.0 principle: the service automatically
gets better the more people use it. While Akamai must add servers to
improve service, every BitTorrent consumer brings his own resources to the
party. There’s an implicit “architecture of participation,” a built-in ethic of
cooperation, in which the service acts primarily as an intelligent broker,
connecting the edges to each other and harnessing the power of the users
themselves.
A Platform Beats an Application Every Time
In each of its past confrontations with rivals, Microsoft has successfully played the platform card, trumping
even the most dominant applications. Windows allowed Microsoft to displace Lotus 1-2-3 with Excel,
WordPerfect with Word, and Netscape Navigator with Internet Explorer.
This time, though, the clash isn’t between a platform and an application, but between two platforms, each
with a radically different business model: On the one side, a single software provider, whose massive installed
base and tightly integrated operating system and APIs give control over the programming paradigm; on
the other, a system without an owner, tied together by a set of protocols, open standards and agreements for
cooperation.
Windows represents the pinnacle of proprietary control via software APIs. Netscape tried to wrest control
from Microsoft using the same techniques that Microsoft itself had used against other rivals, and failed.
But Apache, which held to the open standards of the web, has prospered. The battle is no longer unequal, a
platform versus a single application, but platform versus platform, with the question being which platform,
and more profoundly, which architecture, and which business model, is better suited to the opportunity
ahead.
Windows was a brilliant solution to the problems of the early PC era. It leveled the playing field for
application developers, solving a host of problems that had previously bedeviled the industry. But a single
monolithic approach, controlled by a single vendor, is no longer a solution, it’s a problem. Communicationsoriented systems, as the internet-as-platform most certainly is, require interoperability. Unless a vendor can
control both ends of every interaction, the possibilities of user lock-in via software APIs are limited.
Any Web 2.0 vendor that seeks to lock in its application gains by controlling the platform will, by definition,
no longer be playing to the strengths of the platform.
This is not to say that there are not opportunities for lock-in and competitive advantage, but we believe they
are not to be found via control over software APIs and protocols. There is a new game afoot. The companies
that succeed in the Web 2.0 era will be those that understand the rules of that game, rather than trying to go
back to the rules of the PC software era.
II. Harnessing Collective Intelligence
The central principle behind the success of the giants born in the Web 1.0 era
who have survived to lead the Web 2.0 era appears to be this, that they have
embraced the power of the web to harness collective intelligence:
• Hyperlinking is the foundation of the web. As users add new content,
and new sites, it is bound in to the structure of the web by other users
discovering the content and linking to it. Much as synapses form in the
brain, with associations becoming stronger through repetition or intensity,
the web of connections grows organically as an output of the collective
activity of all web users.
• Yahoo!, the first great internet success story, was born as a catalog, or
directory of links, an aggregation of the best work of thousands, then
millions of web users. While Yahoo! has since moved into the business of
creating many types of content, its role as a portal to the collective work of
the net’s users remains the core of its value.
• Google’s breakthrough in search, which quickly made it the undisputed
search market leader, was PageRank, a method of using the link structure
of the web rather than just the characteristics of documents to provide
better search results.
• eBay’s product is the collective activity of all its users; like the web itself,
eBay grows organically in response to user activity, and the company’s role
is as an enabler of a context in which that user activity can happen. What’s
more, eBay’s competitive advantage comes almost entirely from the critical
mass of buyers and sellers, which makes any new entrant offering similar
services significantly less attractive.
• Amazon sells the same products as competitors such as Barnesandnoble.com,
and they receive the same product descriptions, cover images, and
editorial content from their vendors. But Amazon has made a science of
user engagement. They have an order of magnitude more user reviews,
invitations to participate in varied ways on virtually every page—and even
more importantly, they use user activity to produce better search results.
While a Barnesandnoble.com search is likely to lead with the company’s
own products, or sponsored results, Amazon always leads with “most
popular,” a real-time computation based not only on sales but other factors
that Amazon insiders call the “flow” around products. With an order of
magnitude more user participation, it’s no surprise that Amazon’s sales also
outpace competitors.
Now, innovative companies that pick up on this insight and perhaps extend it
even further, are making their mark on the web:
• Wikipedia, an online encyclopedia based on the unlikely notion that an
entry can be added by any web user, and edited by any other, is a radical
experiment in trust, applying Eric Raymond’s dictum (originally coined
in the context of open source software) that “with enough eyeballs, all
bugs are shallow,” to content creation. Wikipedia is already in the top 100
websites, and many think it will be in the top ten before long. This is a
profound change in the dynamics of content creation!
• Sites like del.icio.us and Flickr, two companies that have received a great
deal of attention of late, have pioneered a concept that some people
call “folksonomy” (in contrast to taxonomy), a style of collaborative
categorization of sites using freely chosen keywords, often referred to as
tags. Tagging allows for the kind of multiple, overlapping associations that
the brain itself uses, rather than rigid categories. In the canonical example,
a Flickr photo of a puppy might be tagged both “puppy” and “cute”—
allowing for retrieval along natural axes—generated user activity.
• Collaborative spam filtering products like Cloudmark aggregate the
individual decisions of email users about what is and is not spam,
outperforming systems that rely on analysis of the messages themselves.
• It is a truism that the greatest Internet success stories don’t advertise
their products. Their adoption is driven by “viral marketing”—that is,
recommendations propagating directly from one user to another. You can
almost make the case that if a site or product relies on advertising to get
the word out, it isn’t Web 2.0.
• Even much of the infrastructure of the web—including the Linux,
Apache, MySQL, and Perl, PHP, or Python code involved in most
web servers—relies on the peer-production methods of open source, in
themselves an instance of collective, net-enabled intelligence. There are
more than 100,000 open source software projects listed on SourceForge.
net. Anyone can add a project, anyone can download and use the code,
and new projects migrate from the edges to the center as a result of users
putting them to work, an organic software adoption process relying almost
entirely on viral marketing.
The lesson: Network effects from user contributions are the key to market dominance
in the Web 2.0 era.
Blogging and the Wisdom of Crowds
One of the most highly touted features of the Web 2.0 era is the rise of
blogging. Personal home pages have been around since the early days of the
web, and the personal diary and daily opinion column around much longer
than that, so just what is the fuss all about?
At its most basic, a blog is just a personal home page in diary format. But as
Rich Skrenta notes, the chronological organization of a blog “seems like a trivial
difference, but it drives an entirely different delivery, advertising and value
chain.”
One of the things that has made a difference is a technology called RSS. RSS
is the most significant advance in the fundamental architecture of the web
since early hackers realized that CGI could be used to create database-backed
websites. RSS allows someone to link not just to a page, but to subscribe to
it, with notification every time that page changes. Skrenta calls this “the
incremental web.” Others call it the “live web.”
Now, of course, “dynamic websites” (i.e., database-backed sites with dynamically
generated content) replaced static web pages well over ten years ago. What’s
dynamic about the live web are not just the pages, but the links. A link to a
weblog is expected to point to a perennially changing page, with “permalinks”
for any individual entry, and notification for each change. An RSS feed is thus a
much stronger link than, say, a bookmark or a link to a single page.
RSS also means that the web browser is not the only means of viewing a web
page. While some RSS aggregators, such as Bloglines, are web-based, others are
desktop clients, and still others allow users of portable devices to subscribe to
constantly updated content.
RSS is now being used to push not just notices of new blog entries, but also
all kinds of data updates, including stock quotes, weather data, and photo
availability. This use is actually a return to one of its roots: RSS was born
in 1997 out of the confluence of Dave Winer’s “Really Simple Syndication”
technology, used to push out blog updates, and Netscape’s “Rich Site
Summary,” which allowed users to create custom Netscape home pages with
regularly updated data flows. Netscape lost interest, and the technology was
carried forward by blogging pioneer Userland, Winer’s company. In the current
crop of applications, we see, though, the heritage of both parents.
But RSS is only part of what makes a weblog different from an ordinary web
page. Tom Coates remarks on the significance of the permalink:
It may seem like a trivial piece of functionality now, but it was
effectively the device that turned weblogs from an ease-of-publishing
phenomenon into a conversational mess of overlapping communities.
For the first time it became relatively easy to gesture directly at
a highly specific post on someone else’s site and talk about it.
Discussion emerged. Chat emerged. And—as a result—friendships
emerged or became more entrenched. The permalink was the first—
and most successful—attempt to build bridges between weblogs.
In many ways, the combination of RSS and permalinks adds many of the
features of NNTP, the Network News Protocol of the Usenet, onto HTTP,
the web protocol. The “blogosphere” can be thought of as a new, peer-to-peer
equivalent to Usenet and bulletin-boards, the conversational watering holes of
the early internet. Not only can people subscribe to each others’ sites, and easily
link to individual comments on a page, but also, via a mechanism known as
trackbacks, they can see when anyone else links to their pages, and can respond,
either with reciprocal links, or by adding comments.
Interestingly, two-way links were the goal of early hypertext systems like
Xanadu. Hypertext purists have celebrated trackbacks as a step towards two
way links. But note that trackbacks are not properly two-way—rather, they
are really (potentially) symmetrical one-way links that create the effect of two
way links. The difference may seem subtle, but in practice it is enormous.
Social networking systems like Friendster, Orkut, and LinkedIn, which require
acknowledgment by the recipient in order to establish a connection, lack the
same scalability as the web. As noted by Caterina Fake, co-founder of the
Flickr photo sharing service, attention is only coincidentally reciprocal. (Flickr
thus allows users to set watch lists—any user can subscribe to any other user’s
photostream via RSS. The object of attention is notified, but does not have to
approve the connection.)
If an essential part of Web 2.0 is harnessing collective intelligence, turning the
web into a kind of global brain, the blogosphere is the equivalent of constant
mental chatter in the forebrain, the voice we hear in all of our heads. It may not
reflect the deep structure of the brain, which is often unconscious, but is instead
the equivalent of conscious thought. And as a reflection of conscious thought
and attention, the blogosphere has begun to have a powerful effect.
First, because search engines use link structure to help predict useful pages,
bloggers, as the most prolific and timely linkers, have a disproportionate role in
shaping search engine results. Second, because the blogging community is so
highly self-referential, bloggers paying attention to other bloggers magnifies their
visibility and power. The “echo chamber” that critics decry is also an amplifier.
If it were merely an amplifier, blogging would be uninteresting. But like
Wikipedia, blogging harnesses collective intelligence as a kind of filter. What
James Suriowecki calls “the wisdom of crowds” comes into play, and much as
PageRank produces better results than analysis of any individual document, the
collective attention of the blogosphere selects for value.
While mainstream media may see individual blogs as competitors, what is really
unnerving is that the competition is with the blogosphere as a whole. This
is not just a competition between sites, but a competition between business
models. The world of Web 2.0 is also the world of what Dan Gillmor calls “we,
the media,” a world in which “the former audience,” not a few people in a back
room, decides what’s important.
The Architecture of Participation
Some systems are designed to encourage participation. In his paper, The Cornucopia of the Commons,
Dan Bricklin noted that there are three ways to build a large database. The first, demonstrated by
Yahoo!, is to pay people to do it. The second, inspired by lessons from the open source community,
is to get volunteers to perform the same task. The Open Directory Project, an open source Yahoo!
competitor, is the result. But Napster demonstrated a third way. Because Napster set its defaults to
automatically serve any music that was downloaded, every user automatically helped to build the value
of the shared database. This same approach has been followed by all other P2P file sharing services.
One of the key lessons of the Web 2.0 era is this: Users add value. But only a small percentage of
users will go to the trouble of adding value to your application via explicit means. Therefore, Web 2.0
companies set inclusive defaults for aggregating user data and building value as a side-effect of ordinary
use of the application. As noted above, they build systems that get better the more people use them.
Mitch Kapor once noted that “architecture is politics.” Participation is intrinsic to Napster, part of its
fundamental architecture.
This architectural insight may also be more central to the success of open source software than the more
frequently cited appeal to volunteerism. The architecture of the internet, and the World Wide Web, as
well as of open source software projects like Linux, Apache, and Perl, is such that users pursuing their
own “selfish” interests build collective value as an automatic byproduct.
Each of these projects has a small core, well-defined extension mechanisms, and an approach that lets
any well-behaved component be added by anyone, growing the outer layers of what Larry Wall, the
creator of Perl, refers to as “the onion.” In other words, these technologies demonstrate network effects,
simply through the way that they have been designed.
These projects can be seen to have a natural architecture of participation. But as Amazon demonstrates,
by consistent effort (as well as economic incentives such as the Associates program), it is possible to
overlay such an architecture on a system that would not normally seem to possess it.
III. Data is the Next Intel Inside
Every significant Internet application to date has been backed by a specialized
database: Google’s web crawl, Yahoo!’s directory (and web crawl), Amazon’s
database of products, eBay’s database of products and sellers, MapQuest’s
map databases, Napster’s distributed song database. As Hal Varian remarked
in a personal conversation last year, “SQL is the new HTML.” Database
management is a core competency of Web 2.0 companies, so much so that we
have sometimes referred to these applications as “infoware” rather than merely
software.
This fact leads to a key question: Who owns the data?
In the Internet era, one can already see a number of cases where control over
the database has led to market control and outsized financial returns. The
monopoly on domain name registry initially granted by government fiat to
Network Solutions (later purchased by Verisign) was one of the first great
moneymakers of the Internet. While we’ve argued that business advantage via
controlling software APIs is much more difficult in the age of the internet,
control of key data sources is not, especially if those data sources are expensive
to create or amenable to increasing returns via network effects.
Look at the copyright notices at the base of every map served by MapQuest,
maps.yahoo.com, maps.msn.com, or maps.google.com, and you’ll see the
line “Maps copyright NavTeq, TeleAtlas,” or with the new satellite imagery
services, “Images copyright Digital Globe.” These companies made substantial
investments in their databases (NavTeq alone reportedly invested $750 million
to build their database of street addresses and directions. Digital Globe spent
$500 million to launch their own satellite to improve on government-supplied
imagery.) NavTeq has gone so far as to imitate Intel’s familiar Intel Inside logo:
Cars with navigation systems bear the imprint, “NavTeq Onboard.” Data is
indeed the Intel Inside of these applications, a sole source component in systems
whose software infrastructure is largely open source or otherwise commodified.
The now hotly contested web mapping arena demonstrates how a failure to
understand the importance of owning an application’s core data will eventually
undercut its competitive position. MapQuest pioneered the web mapping
category in 1995, yet when Yahoo!, and then Microsoft, and most recently
Google, decided to enter the market, they were easily able to offer a competing
application simply by licensing the same data.
Contrast, however, the position of Amazon.com. Like competitors such as
Barnesandnoble.com, its original database came from ISBN registry provider
R.R. Bowker. But unlike MapQuest, Amazon relentlessly enhanced the
data, adding publisher-supplied data such as cover images, table of contents,
index, and sample material. Even more importantly, they harnessed their
users to annotate the data, such that after ten years, Amazon, not Bowker,
is the primary source for bibliographic data on books, a reference source for
scholars and librarians as well as consumers. Amazon also introduced their
own proprietary identifier, the ASIN, which corresponds to the ISBN where
one is present, and creates an equivalent namespace for products without one.
Effectively, Amazon “embraced and extended” their data suppliers.
Imagine if MapQuest had done the same thing, harnessing their users to
annotate maps and directions, adding layers of value. It would have been much
more difficult for competitors to enter the market just by licensing the base data.
The recent introduction of Google Maps provides a living laboratory for the
competition between application vendors and their data suppliers. Google’s
lightweight programming model has led to the creation of numerous valueadded services in the form of mashups that link Google Maps with other
internet-accessible data sources. Paul Rademacher’s housingmaps.com, which
combines Google Maps with Craigslist apartment rental and home purchase
data to create an interactive housing search tool, is the pre-eminent example of
such a mashup.
At present, these mashups are mostly innovative experiments, done by hackers.
But entrepreneurial activity follows close behind. And already, one can see that
for at least one class of developer, Google has taken the role of data source away
from Navteq and inserted themselves as a favored intermediary. We expect
to see battles between data suppliers and application vendors in the next few
years, as both realize just how important certain classes of data will become as
building blocks for Web 2.0 applications.
The race is on to own certain classes of core data: location, identity, calendaring
of public events, product identifiers and namespaces. In many cases, where there
is significant cost to create the data, there may be an opportunity for an Intel
Inside style play, with a single source for the data. In others, the winner will be
the company that first reaches critical mass via user aggregation, and turns that
aggregated data into a system service.
For example, in the area of identity, PayPal, Amazon’s 1-click, and the millions
of users of communications systems, may all be legitimate contenders to build a
network-wide identity database. (In this regard, Google’s recent attempt to use
cell phone numbers as an identifier for Gmail accounts may be a step towards
embracing and extending the phone system.) Meanwhile, startups like Sxip are
exploring the potential of federated identity, in quest of a kind of “distributed
1-click” that will provide a seamless Web 2.0 identity subsystem. In the area of
calendaring, EVDB is an attempt to build the world’s largest shared calendar
via a wiki-style architecture of participation. While the jury’s still out on the
success of any particular startup or approach, it’s clear that standards and
solutions in these areas, effectively turning certain classes of data into reliable
subsystems of the “internet operating system,” will enable the next generation of
applications.
A further point must be noted with regard to data, and that is user concerns
about privacy and their rights to their own data. In many of the early web
applications, copyright is only loosely enforced. For example, Amazon lays
claim to any reviews submitted to the site, but in the absence of enforcement,
people may repost the same review elsewhere. However, as companies begin
to realize that control over data may be their chief source of competitive
advantage, we may see heightened attempts at control.
Much as the rise of proprietary software led to the Free Software movement,
we expect the rise of proprietary databases to result in a Free Data movement
within the next decade. One can see early signs of this countervailing trend in
open data projects such as Wikipedia, the Creative Commons, and in software
projects like Greasemonkey, which allow users to take control of how data is
displayed on their computer.
IV. End of the Software Release Cycle
As noted above in the discussion of Google vs. Netscape, one of the defining
characteristics of Internet era software is that it is delivered as a service, not as
a product. This fact leads to a number of fundamental changes in the business
model of such a company:
1. Operations must become a core competency. Google’s or Yahoo!’s expertise in
product development must be matched by an expertise in daily operations.
So fundamental is the shift from software as artifact to software as service
that the software will cease to perform unless it is maintained on a daily
basis. Google must continuously crawl the web and update its indices,
continuously filter out link spam and other attempts to influence its
results, continuously and dynamically respond to hundreds of millions of
asynchronous user queries, simultaneously matching them with contextappropriate advertisements.
It’s no accident that Google’s system administration, networking, and load
balancing techniques are perhaps even more closely guarded secrets than
their search algorithms. Google’s success at automating these processes is a
key part of their cost advantage over competitors.
It’s also no accident that scripting languages such as Perl, Python, PHP, and
now Ruby, play such a large role at Web 2.0 companies. Perl was famously
described by Hassan Schroeder, Sun’s first webmaster, as “the duct tape of the
internet.” Dynamic languages (often called scripting languages and looked
down on by the software engineers of the era of software artifacts) are the
tool of choice for system and network administrators, as well as application
developers building dynamic systems that require constant change.
2. Users must be treated as co-developers, in a reflection of open source
development practices (even if the software in question is unlikely to be
released under an open source license.) The open source dictum, “release
early and release often” in fact has morphed into an even more radical
position, “the perpetual beta,” in which the product is developed in the
open, with new features slipstreamed in on a monthly, weekly, or even daily
basis. It’s no accident that services such as Gmail, Google Maps, Flickr,
del.icio.us, and the like may be expected to bear a “Beta” logo for years at a
time.
Real time monitoring of user behavior to see just which new features
are used, and how they are used, thus becomes another required core
competency. A web developer at a major online service remarked: “We put
up two or three new features on some part of the site every day, and if users
don’t adopt them, we take them down. If they like them, we roll them out
to the entire site.”
Cal Henderson, the lead developer of Flickr, recently revealed that they
deploy new builds up to every half hour. This is clearly a radically different
development model! While not all web applications are developed in as
extreme a style as Flickr, almost all web applications have a development
cycle that is radically unlike anything from the PC or client-server era. It is
for this reason that a recent ZDnet editorial concluded that Microsoft won’t
be able to beat Google: “Microsoft’s business model depends on everyone
upgrading their computing environment every two to three years. Google’s
depends on everyone exploring what’s new in their computing environment
every day.”
While Microsoft has demonstrated enormous ability to learn from and
ultimately best its competition, there’s no question that this time, the
competition will require Microsoft (and by extension, every other existing
software company) to become a deeply different kind of company. Native
Web 2.0 companies enjoy a natural advantage, as they don’t have old patterns
(and corresponding business models and revenue sources) to shed.
V. Lightweight Programming Models
Once the idea of web services became au courant, large companies jumped into
the fray with a complex web services stack designed to create highly reliable
programming environments for distributed applications.
But much as the web succeeded precisely because it overthrew much of
hypertext theory, substituting a simple pragmatism for ideal design, RSS has
become perhaps the single most widely deployed web service because of its
simplicity, while the complex corporate web services stacks have yet to achieve
wide deployment.
Similarly, Amazon.com’s web services are provided in two forms: one adhering
to the formalisms of the SOAP (Simple Object Access Protocol) web services
stack, the other simply providing XML data over HTTP, in a lightweight
approach sometimes referred to as REST (Representational State Transfer).
While high value B2B connections (like those between Amazon and retail
partners like ToysRUs) use the SOAP stack, Amazon reports that 95% of the
usage is of the lightweight REST service.
This same quest for simplicity can be seen in other “organic” web services.
Google’s recent release of Google Maps is a case in point. Google Maps’ simple
AJAX (Javascript and XML) interface was quickly decrypted by hackers, who
then proceeded to remix the data into new services.
Mapping-related web services had been available for some time from GIS
vendors such as ESRI, as well as from MapQuest and Microsoft MapPoint.
But Google Maps set the world on fire because of its simplicity. While
experimenting with any of the formal vendor-supported web services required
a formal contract between the parties, the way Google Maps was implemented
left the data for the taking, and hackers soon found ways to creatively re-use
that data.
A Web 2.0 Investment Thesis
Venture capitalist Paul Kedrosky writes: “The key is to find the actionable investments where you
disagree with the consensus.” It’s interesting to see how each Web 2.0 facet involves disagreeing with the
consensus: everyone was emphasizing keeping data private, Flickr/Napster/et al. make it public. It’s not
just disagreeing to be disagreeable (pet food! online!), it’s disagreeing where you can build something
out of the differences. Flickr builds communities, Napster built breadth of collection.
Another way to look at it is that the successful companies all give up something expensive but considered critical to get something valuable for free that was once expensive. For example, Wikipedia gives
up central editorial control in return for speed and breadth. Napster gave up on the idea of “the catalog”
(all the songs the vendor was selling) and got breadth. Amazon gave up on the idea of having a physical
storefront but got to serve the entire world. Google gave up on the big customers (initially) and got
the 80% whose needs weren’t being met. There’s something very aikido (using your opponent’s force
against them) in saying “you know, you’re right—absolutely anyone in the whole world CAN update
this article. And guess what, that’s bad news for you.”
—Nat Torkington
There are several significant lessons here:
1. Support lightweight programming models that allow for loosely coupled systems.
The complexity of the corporate-sponsored web services stack is designed
to enable tight coupling. While this is necessary in many cases, many of
the most interesting applications can indeed remain loosely coupled, and
even fragile. The Web 2.0 mindset is very different from the traditional IT
mindset!
2. Think syndication, not coordination. Simple web services, like RSS and
REST-based web services, are about syndicating data outwards, not
controlling what happens when it gets to the other end of the connection.
This idea is fundamental to the Internet itself, a reflection of what is known
as the end-to-end principle.
3. Design for “ hackability” and remixability. Systems like the original
web, RSS, and AJAX all have this in common: the barriers to re-use
are extremely low. Much of the useful software is actually open source,
but even when it isn’t, there is little in the way of intellectual property
protection. The web browser’s “View Source” option made it possible for
any user to copy any other user’s web page; RSS was designed to empower
the user to view the content he or she wants, when it’s wanted, not at the
behest of the information provider; the most successful web services are
those that have been easiest to take in new directions unimagined by their
creators. The phrase “some rights reserved,” which was popularized by the
Creative Commons to contrast with the more typical “all rights reserved,” is
a useful guidepost.
Innovation in Assembly
Lightweight business models are a natural concomitant of lightweight
programming and lightweight connections. The Web 2.0 mindset is good
at re-use. A new service like housingmaps.com was built simply by snapping
together two existing services. Housingmaps.com doesn’t have a business model
(yet)—but for many small-scale services, Google AdSense (or perhaps Amazon
associates fees, or both) provides the snap-in equivalent of a revenue model.
These examples provide an insight into another key Web 2.0 principle, which
we call “innovation in assembly.” When commodity components are abundant,
you can create value simply by assembling them in novel or effective ways.
Much as the PC revolution provided many opportunities for innovation in
assembly of commodity hardware, with companies like Dell making a science
out of such assembly, thereby defeating companies whose business model
required innovation in product development, we believe that Web 2.0 will
provide opportunities for companies to beat the competition by getting better at
harnessing and integrating services provided by others.
VI. Software Above the Level of a Single Device
One other feature of Web 2.0 that deserves mention is the fact that it’s no
longer limited to the PC platform. In his parting advice to Microsoft, long time
Microsoft developer Dave Stutz pointed out that “Useful software written above
the level of the single device will command high margins for a long time to
come.”
Of course, any web application can be seen as software above the level of a
single device. After all, even the simplest web application involves at least two
computers: the one hosting the web server and the one hosting the browser.
And as we’ve discussed, the development of the web as platform extends this
idea to synthetic applications composed of services provided by multiple
computers.
But as with many areas of Web 2.0, where the “2.0-ness” is not something new,
but rather a fuller realization of the true potential of the web platform, this
phrase gives us a key insight into how to design applications and services for the
new platform.
To date, iTunes is the best exemplar of this principle. This application
seamlessly reaches from the handheld device to a massive web back-end, with
the PC acting as a local cache and control station. There have been many
previous attempts to bring web content to portable devices, but the iPod/iTunes
combination is one of the first such applications designed from the ground up
to span multiple devices. TiVo is another good example.
iTunes and TiVo also demonstrate many of the other core principles of Web 2.0.
They are not web applications per se, but they leverage the power of the web
platform, making it a seamless, almost invisible part of their infrastructure.
Data management is most clearly the heart of their offering. They are services,
not packaged applications (although in the case of iTunes, it can be used as a
packaged application, managing only the user’s local data). What’s more, both
TiVo and iTunes show some budding use of collective intelligence, although
in each case, their experiments are at war with the IP lobby’s. There’s only a
limited architecture of participation in iTunes, though the recent addition of
podcasting changes that equation substantially.
This is one of the areas of Web 2.0 where we expect to see some of the greatest
change, as more and more devices are connected to the new platform. What
applications become possible when our phones and our cars are not consuming data
but reporting it? Real time traffic monitoring, flash mobs, and citizen journalism
are only a few of the early warning signs of the capabilities of the new platform.
VII. Rich User Experiences
As early as Pei Wei’s Viola browser in 1992, the web was being used to deliver
“applets” and other kinds of active content within the web browser. Java’s
introduction in 1995 was framed around the delivery of such applets. JavaScript
and then DHTML were introduced as lightweight ways to provide client side
programmability and richer user experiences. Several years ago, Macromedia
coined the term “Rich Internet Applications” (which has also been picked up
by open source Flash competitor Laszlo Systems) to highlight the capabilities
of Flash to deliver not just multimedia content but also GUI-style application
experiences.
However, the potential of the web to deliver full scale applications didn’t hit the
mainstream till Google introduced Gmail, quickly followed by Google Maps,
web based applications with rich user interfaces and PC-equivalent interactivity.
The collection of technologies used by Google was christened AJAX, in a
seminal essay by Jesse James Garrett of web design firm Adaptive Path. He
wrote:
“Ajax isn’t a technology. It’s really several technologies, each flourishing in its
own right, coming together in powerful new ways. Ajax incorporates:
•
•
•
•
•
standards-based presentation using XHTML and CSS;
dynamic display and interaction using the Document Object Model;
data interchange and manipulation using XML and XSLT;
asynchronous data retrieval using XMLHttpRequest;
and JavaScript binding everything together.”
AJAX is also a key component of Web 2.0 applications such as Flickr, now part
of Yahoo!, 37signals’ applications basecamp and backpack, as well as other
Google applications such as Gmail and Orkut. We’re entering an unprecedented
period of user interface innovation, as web developers are finally able to build
web applications as rich as local PC-based applications.
Interestingly, many of the capabilities now being explored have been around for
many years. In the late ‘90s, both Microsoft and Netscape had a vision of the
kind of capabilities that are now finally being realized, but their battle over the
standards to be used made cross-browser applications difficult. It was only when
Microsoft definitively won the browser wars, and there was a single de-facto
browser standard to write to, that this kind of application became possible. And
while Firefox has reintroduced competition to the browser market, at least so far
we haven’t seen the destructive competition over web standards that held back
progress in the ‘90s.
We expect to see many new web applications over the next few years, both truly
novel applications, and rich web reimplementations of PC applications. Every
platform change to date has also created opportunities for a leadership change
in the dominant applications of the previous platform.
Gmail has already provided some interesting innovations in email,
combining the strengths of the web (accessible from anywhere, deep database
competencies, searchability) with user interfaces that approach PC interfaces in
usability. Meanwhile, other mail clients on the PC platform are nibbling away
at the problem from the other end, adding IM and presence capabilities. How
far are we from an integrated communications client combining the best of
email, IM, and the cell phone, using VoIP to add voice capabilities to the rich
capabilities of web applications? The race is on.
It’s easy to see how Web 2.0 will also remake the address book. A Web 2.0-style
address book would treat the local address book on the PC or phone merely
as a cache of the contacts you’ve explicitly asked the system to remember.
Meanwhile, a web-based synchronization agent, Gmail-style, would remember
every message sent or received, every email address and every phone number
used, and build social networking heuristics to decide which ones to offer up as
alternatives when an answer wasn’t found in the local cache. Lacking an answer
there, the system would query the broader social network.
Web 2.0 Design Patterns
In his book, A Pattern Language, Christopher Alexander prescribes a format for the concise description
of the solution to architectural problems. He writes: “Each pattern describes a problem that occurs over
and over again in our environment, and then describes the core of the solution to that problem, in such
a way that you can use this solution a million times over, without ever doing it the same way twice.”
1.
The Long Tail
Small sites make up the bulk of the internet’s content; narrow niches make up the bulk of the
internet’s possible applications. Therefore: Leverage customer-self service and algorithmic data
management to reach out to the entire web, to the edges and not just the center, to the long tail
and not just the head.
2.
Data is the Next Intel Inside
Applications are increasingly data-driven. Therefore: For competitive advantage, seek to own a
unique, hard-to-recreate source of data.
3.
Network Effects by Default
Only a small percentage of users will go to the trouble of adding value to your application.
Therefore: Set inclusive defaults for aggregating user data as a side-effect of their use of the
application.
4.
Some Rights Reserved
Intellectual property protection limits re-use and prevents experimentation. Therefore: When
benefits come from collective adoption, not private restriction, make sure that barriers to
adoption are low. Follow existing standards, and use licenses with as few restrictions as possible.
Design for “hackability” and “remixability.”
5.
The Perpetual Beta
When devices and programs are connected to the internet, applications are no longer software
artifacts, they are ongoing services. Therefore: Don’t package up new features into monolithic
releases, but instead add them on a regular basis as part of the normal user experience. Engage
your users as real-time testers, and instrument the service so that you know how people use the
new features.
6.
Cooperate, Don’t Control
Web 2.0 applications are built of a network of cooperating data services. Therefore: Offer web
services interfaces and content syndication, and re-use the data services of others. Support
lightweight programming models that allow for loosely-coupled systems.
7.
Software Above the Level of a Single Device
The PC is no longer the only access device for internet applications, and applications that are
limited to a single device are less valuable than those that are connected. Therefore: Design
your application from the get-go to integrate services across handheld devices, PCs, and
internet servers.
A Web 2.0 word processor would support wiki-style collaborative editing, not
just standalone documents. But it would also support the rich formatting we’ve
come to expect in PC-based word processors. Writely is a good example of such
an application, although it hasn’t yet gained wide traction.
Nor will the Web 2.0 revolution be limited to PC applications. Salesforce.com
demonstrates how the web can be used to deliver software as a service, in
enterprise scale applications such as CRM.
The competitive opportunity for new entrants is to fully embrace the potential
of Web 2.0. Companies that succeed will create applications that learn from
their users, using an architecture of participation to build a commanding
advantage not just in the software interface, but in the richness of the shared
data.
Core Competencies of Web 2.0 Companies
In exploring the seven principles above, we’ve highlighted some of the principal
features of Web 2.0. Each of the examples we’ve explored demonstrates one
or more of those key principles, but may miss others. Let’s close, therefore,
by summarizing what we believe to be the core competencies of Web 2.0
companies:
• Services, not packaged software, with cost-effective scalability
• Control over unique, hard-to-recreate data sources that get richer as
more people use them
• Trusting users as co-developers
• Harnessing collective intelligence
• Leveraging the long tail through customer self-service
• Software above the level of a single device
• Lightweight user interfaces, development models, AND business models
The next time a company claims that it’s “Web 2.0,” test their features against
the list above. The more points they score, the more they are worthy of the
name. Remember, though, that excellence in one area may be more telling than
some small steps in all seven.
Paul Graham: Web 2.0
Does “Web 2.0” mean anything? Till recently I thought it didn’t, but the truth
turns out to be more complicated. Originally, yes, it was meaningless. Now
it seems to have acquired a meaning. And yet those who dislike the term are
probably right, because if it means what I think it does, we don’t need it.
I first heard the phrase “Web 2.0” in the name of the Web 2.0 conference in
2004. At the time it was supposed to mean using “the web as a platform,”
which I took to refer to web-based applications. [1]
So I was surprised at a conference this summer when Tim O’Reilly led a session
intended to figure out a definition of “Web 2.0.” Didn’t it already mean using
the web as a platform? And if it didn’t already mean something, why did we
need the phrase at all?
Origins
Tim says the phrase “Web 2.0” first arose in “a brainstorming session between
O’Reilly and Medialive International.” What is Medialive International?
“Producers of technology tradeshows and conferences,” according to their
site. So presumably that’s what this brainstorming session was about. O’Reilly
wanted to organize a conference about the web, and they were wondering what
to call it.
I don’t think there was any deliberate plan to suggest there was a new version
of the web. They just wanted to make the point that the web mattered again.
It was a kind of semantic deficit spending: they knew new things were coming,
and the “2.0” referred to whatever those might turn out to be.
And they were right. New things were coming. But the new version number
led to some awkwardness in the short term. In the process of developing the
pitch for the first conference, someone must have decided they’d better take a
stab at explaining what that “2.0” referred to. Whatever it meant, “the web as a
platform” was at least not too constricting.
The story about “Web 2.0” meaning the web as a platform didn’t live much past
the first conference. By the second conference, what “Web 2.0” seemed to mean
was something about democracy. At least, it did when people wrote about it
online. The conference itself didn’t seem very grassroots. It cost $2,800, so the
only people who could afford to go were VCs and people from big companies.
And yet, oddly enough, Ryan Singel’s article about the conference in Wired
News spoke of “throngs of geeks.” When a friend of mine asked Ryan about
this, it was news to him. He said he’d originally written something like
“throngs of VCs and biz dev guys” but had later shortened it just to “throngs,”
and that this must have in turn been expanded by the editors into “throngs
of geeks.” After all, a Web 2.0 conference would presumably be full of geeks,
right?
Well, no. There were about 7. Even Tim O’Reilly was wearing a suit, a sight
so alien I couldn’t parse it at first. I saw him walk by and said to one of the
O’Reilly people “that guy looks just like Tim.”
“Oh, that’s Tim. He bought a suit.” I ran after him, and sure enough, it was. He
explained that he’d just bought it in Thailand.
The 2005 Web 2.0 conference reminded me of Internet trade shows during the
Bubble, full of prowling VCs looking for the next hot startup. There was that
same odd atmosphere created by a large number of people determined not to
miss out. Miss out on what? They didn’t know.
Whatever was going to happen—whatever Web 2.0 turned out to be.
I wouldn’t quite call it “Bubble 2.0” just because VCs are eager to invest again.
The Internet is a genuinely big deal. The bust was as much an overreaction as
the boom. It’s to be expected that once we started to pull out of the bust, there
would be a lot of growth in this area, just as there was in the industries that
spiked the sharpest before the Depression.
The reason this won’t turn into a second Bubble is that the IPO market is gone.
Venture investors are driven by exit strategies. The reason they were funding all
those laughable startups during the late 90s was that they hoped to sell them to
gullible retail investors; they hoped to be laughing all the way to the bank. Now
that route is closed. Now the default exit strategy is to get bought, and acquirers
are less prone to irrational exuberance than IPO investors. The closest you’ll
get to Bubble valuations is Rupert Murdoch paying $580 million for Myspace.
That’s only off by a factor of 10 or so.
1. Ajax
Does “Web 2.0” mean anything more than the name of a conference yet? I
don’t like to admit it, but it’s starting to. When people say “Web 2.0” now, I
have some idea what they mean. And the fact that I both despise the phrase and
understand it is the surest proof that it has started to mean something.
One ingredient of its meaning is certainly Ajax, which I can still only just bear
to use without scare quotes. Basically, what “Ajax” means is “Javascript now
works.” And that in turn means that web-based applications can now be made
to work much more like desktop ones.
As you read this, a whole new generation of software is being written to take
advantage of Ajax. There hasn’t been such a wave of new applications since
microcomputers first appeared. Even Microsoft sees it, but it’s too late for them
to do anything more than leak “internal” documents designed to give the
impression they’re on top of this new trend.
In fact the new generation of software is being written way too fast for
Microsoft even to channel it, let alone write their own in house. Their only
hope now is to buy all the best Ajax startups before Google does. And even
that’s going to be hard, because Google has as big a head start in buying
microstartups as it did in search a few years ago. After all, Google Maps, the
canonical Ajax application, was the result of a startup they bought.
So ironically the original description of the Web 2.0 conference turned out to
be partially right: web-based applications are a big component of Web 2.0. But
I’m convinced they got this right by accident. The Ajax boom didn’t start till
early 2005, when Google Maps appeared and the term “Ajax” was coined.
2. Democracy
The second big element of Web 2.0 is democracy. We now have several
examples to prove that amateurs can surpass professionals, when they have
the right kind of system to channel their efforts. Wikipedia may be the most
famous. Experts have given Wikipedia middling reviews, but they miss the
critical point: it’s good enough. And it’s free, which means people actually read
it. On the web, articles you have to pay for might as well not exist. Even if you
were willing to pay to read them yourself, you can’t link to them. They’re not
part of the conversation.
Another place democracy seems to win is in deciding what counts as news. I
never look at any news site now except Reddit. [2] I know if something major
happens, or someone writes a particularly interesting article, it will show up there.
Why bother checking the front page of any specific paper or magazine? Reddit’s
like an RSS feed for the whole web, with a filter for quality. Similar sites include
Digg, a technology news site that’s rapidly approaching Slashdot in popularity,
and del.icio.us, the collaborative bookmarking network that set off the “tagging”
movement. And whereas Wikipedia’s main appeal is that it’s good enough and
free, these sites suggest that voters do a significantly better job than human editors.
The most dramatic example of Web 2.0 democracy is not in the selection
of ideas, but their production. I’ve noticed for a while that the stuff I read
on individual people’s sites is as good as or better than the stuff I read in
newspapers and magazines. And now I have independent evidence: the top
links on Reddit are generally links to individual people’s sites rather than to
magazine articles or news stories.
My experience of writing for magazines suggests an explanation. Editors. They
control the topics you can write about, and they can generally rewrite whatever
you produce. The result is to damp extremes. Editing yields 95th percentile
writing—95% of articles are improved by it, but 5% are dragged down. 5% of
the time you get “throngs of geeks.”
On the web, people can publish whatever they want. Nearly all of it falls short
of the editor-damped writing in print publications. But the pool of writers
is very, very large. If it’s large enough, the lack of damping means the best
writing online should surpass the best in print. [3] And now that the web has
evolved mechanisms for selecting good stuff, the web wins net. Selection beats
damping, for the same reason market economies beat centrally planned ones.
Even the startups are different this time around. They are to the startups of
the Bubble what bloggers are to the print media. During the Bubble, a startup
meant a company headed by an MBA that was blowing through several million
dollars of VC money to “get big fast” in the most literal sense. Now it means
a smaller, younger, more technical group that just decided to make something
great. They’ll decide later if they want to raise VC-scale funding, and if they
take it, they’ll take it on their terms.
3. Don’t Maltreat Users
I think everyone would agree that democracy and Ajax are elements of “Web
2.0.” I also see a third: not to maltreat users. During the Bubble a lot of popular
sites were quite high-handed with users. And not just in obvious ways, like
making them register, or subjecting them to annoying ads. The very design of
the average site in the late 90s was an abuse. Many of the most popular sites
were loaded with obtrusive branding that made them slow to load and sent the
user the message: this is our site, not yours. (There’s a physical analog in the
Intel and Microsoft stickers that come on some laptops.)
I think the root of the problem was that sites felt they were giving something
away for free, and till recently a company giving anything away for free could
be pretty high-handed about it. Sometimes it reached the point of economic
sadism: site owners assumed that the more pain they caused the user, the more
benefit it must be to them. The most dramatic remnant of this model may be at
salon.com, where you can read the beginning of a story, but to get the rest you
have sit through a movie.
At Y Combinator we advise all the startups we fund never to lord it over users.
Never make users register, unless you need to in order to store something for
them. If you do make users register, never make them wait for a confirmation
link in an email; in fact, don’t even ask for their email address unless you need
it for some reason. Don’t ask them any unnecessary questions. Never send them
email unless they explicitly ask for it. Never frame pages you link to, or open
them in new windows. If you have a free version and a pay version, don’t make
the free version too restricted. And if you find yourself asking “should we allow
users to do x?” just answer “yes” whenever you’re unsure. Err on the side of
generosity.
In How to Start a Startup I advised startups never to let anyone fly under
them, meaning never to let any other company offer a cheaper, easier solution.
Another way to fly low is to give users more power. Let users do what they
want. If you don’t and a competitor does, you’re in trouble.
iTunes is Web 2.0ish in this sense. Finally you can buy individual songs instead
of having to buy whole albums. The recording industry hated the idea and
resisted it as long as possible. But it was obvious what users wanted, so Apple
flew under the labels. [4] Though really it might be better to describe iTunes
as Web 1.5. Web 2.0 applied to music would probably mean individual bands
giving away DRMless songs for free.
The ultimate way to be nice to users is to give them something for free that
competitors charge for. During the 90s a lot of people probably thought we’d
have some working system for micropayments by now. In fact things have gone
in the other direction. The most successful sites are the ones that figure out new
ways to give stuff away for free. Craigslist has largely destroyed the classified
ad sites of the 90s, and OkCupid looks likely to do the same to the previous
generation of dating sites.
Serving web pages is very, very cheap. If you can make even a fraction of a
cent per page view, you can make a profit. And technology for targeting ads
continues to improve. I wouldn’t be surprised if ten years from now eBay had
been supplanted by an ad-supported freeBay (or, more likely, gBay).
Odd as it might sound, we tell startups that they should try to make as little
money as possible. If you can figure out a way to turn a billion dollar industry
into a fifty million dollar industry, so much the better, if all fifty million go to
you. Though indeed, making things cheaper often turns out to generate more
money in the end, just as automating things often turns out to generate more
jobs.
The ultimate target is Microsoft. What a bang that balloon is going to make
when someone pops it by offering a free web-based alternative to MS Office. [5]
Who will? Google? They seem to be taking their time. I suspect the pin will be
wielded by a couple of 20-year-old hackers who are too naive to be intimidated
by the idea. (How hard can it be?)
The Common Thread
Ajax, democracy, and not dissing users. What do they all have in common? I
didn’t realize they had anything in common till recently, which is one of the
reasons I disliked the term “Web 2.0” so much. It seemed that it was being used
as a label for whatever happened to be new—that it didn’t predict anything.
But there is a common thread. Web 2.0 means using the web the way it’s meant
to be used. The “trends” we’re seeing now are simply the inherent nature of the
web emerging from under the broken models that got imposed on it during the
Bubble.
I realized this when I read an interview with Joe Kraus, the co-founder of
Excite. [6]
Excite really never got the business model right at all. We fell into
the classic problem of how when a new medium comes out it adopts
the practices, the content, the business models of the old medium—
which fails, and then the more appropriate models get figured out.
It may have seemed as if not much was happening during the years after the
Bubble burst. But in retrospect, something was happening: the web was finding
its natural angle of repose. The democracy component, for example—that’s not
an innovation, in the sense of something someone made happen. That’s what
the web naturally tends to produce.
Ditto for the idea of delivering desktop-like applications over the web. That idea
is almost as old as the web. But the first time around it was co-opted by Sun,
and we got Java applets. Java has since been remade into a generic replacement
for C++, but in 1996 the story about Java was that it represented a new model
of software. Instead of desktop applications, you’d run Java “applets” delivered
from a server.
This plan collapsed under its own weight. Microsoft helped kill it, but it would
have died anyway. There was no uptake among hackers. When you find PR
firms promoting something as the next development platform, you can be sure
it’s not. If it were, you wouldn’t need PR firms to tell you, because hackers
would already be writing stuff on top of it, the way sites like Busmonster used
Google Maps as a platform before Google even meant it to be one.
The proof that Ajax is the next hot platform is that thousands of hackers have
spontaneously started building things on top of it. Mikey likes it.
There’s another thing all three components of Web 2.0 have in common. Here’s
a clue. Suppose you approached investors with the following idea for a Web 2.0
startup:
Sites like del.icio.us and flickr allow users to “tag” content with
descriptive tokens. But there is also huge source of implicit tags
that they ignore: the text within web links. Moreover, these
links represent a social network connecting the individuals and
organizations who created the pages, and by using graph theory we
can compute from this network an estimate of the reputation of each
member. We plan to mine the web for these implicit tags, and use
them together with the reputation hierarchy they embody to enhance
web searches.
How long do you think it would take them on average to realize that it was a
description of Google?
Google was a pioneer in all three components of Web 2.0: their core business
sounds crushingly hip when described in Web 2.0 terms, “Don’t maltreat users”
is a subset of “Don’t be evil,” and of course Google set off the whole Ajax boom
with Google Maps.
Web 2.0 means using the web as it was meant to be used, and Google does.
That’s their secret.
They’re sailing with the wind, instead of sitting becalmed praying for a business
model, like the print media, or trying to tack upwind by suing their customers,
like Microsoft and the record labels. [7]
Google doesn’t try to force things to happen their way. They try to figure out
what’s going to happen, and arrange to be standing there when it does. That’s
the way to approach technology—and as business includes an ever larger
technological component, the right way to do business.
The fact that Google is a “Web 2.0” company shows that, while meaningful,
the term is also rather bogus. It’s like the word “allopathic.” It just means doing
things right, and it’s a bad sign when you have a special word for that.
Notes
[1] From the conference site, June 2004: “While the first wave of the Web was closely tied to the browser,
the second wave extends applications across the web and enables a new generation of services and business
opportunities.” To the extent this means anything, it seems to be about web-based applications.
[2] Disclosure: Reddit was funded by Y Combinator. But although I started using it out of loyalty to the
home team, I’ve become a genuine addict. While we’re at it, I’m also an investor in !MSFT, having sold all
my shares earlier this year.
[3] I’m not against editing. I spend more time editing than writing, and I have a group of picky friends who
proofread almost everything I write. What I dislike is editing done after the fact by someone else.
[4] Obvious is an understatement. Users had been climbing in through the window for years before Apple
finally moved the door.
[5] Hint: the way to create a web-based alternative to Office may not be to write every component yourself,
but to establish a protocol for web-based apps to share a virtual home directory spread across multiple
servers. Or it may be to write it all yourself.
[6] In Jessica Livingston’s Founders at Work.
[7] Microsoft didn’t sue their customers directly, but they seem to have done all they could to help SCO sue
them.
Theories about Web 3.0
Jay Jamison: Web 3.0: The Mobile Era
The highest flying of Internet high-flyers, Facebook and Zynga, were laid
low last week in public markets on weaker than expected guidance on their
paths forward. What a difference public market scrutiny and forward-looking
forecasts can make. Given the size, scope and importance of these two
companies to the broader technology ecosystem, it’s worth analyzing what these
reports might mean for industry trends.
According to Wall Street analysts, Zynga had a “dreadful” Q2 report. Several
negatives converged to deliver an egg, reported the New York Times:
A critical new game, the Ville, was delayed. Another new game,
Mafia Wars II, just was not very good, executives conceded. The
heavily hyped Draw Something, acquired in March, proved more fad
than enduring classic. Some old standbys also lost some appeal.
Zynga’s problems, however, could be characterized as broader than just a weak
quarter. Financial analyst, Richard Greenfield of BTIG painted Zynga’s issues
as more far-reaching, saying, “Right now, everything is going wrong for Zynga.
In a rapidly changing Internet landscape that is moving to mobile, it’s very hard
to have confidence these issues are temporary.”
Things weren’t much better for Facebook, which was reporting its earnings to
the public for the first time. Given the symbiotic partnership between Zynga
and Facebook, anyone paying attention knew Zynga’s weak results spelled
trouble for Facebook. And as expected, Wall Street found Facebook’s earnings
disappointing. In coverage, three key themes of concern arose out of Facebook’s
report.
First, user growth is slowing. This is undeniably true: the growth of two key
user metrics, Daily Active Users (DAU) and Monthly Active Users (MAU), is
slowing. It’s unclear whether this is a useful concern. If the entire Western world
is using Facebook, then Facebook probably is not going to showcase much
growth in DAU or MAU until it cracks China. The land has been grabbed.
A second growth concern is revenue. Can Facebook convert all its social
engagement into monetization? Facebook clearly has more to prove, but it’s a
strong start. With a topline of $1.2B for Q2, Facebook beat analyst estimates
on revenue. Its 32% Q2 revenue growth was equal to its year-over-year growth
in DAUs. This revenue growth map to its DAU growth is where concern
centers. On the one hand, having revenue growth equal to DAU growth shows
that on a per-user basis, Facebook is monetizing effectively. At the same time,
if DAU growth continues to slow, as it inevitably will, the question will be
how Facebook can continue to grow it’s topline faster than DAU growth. The
answer is not yet clear. Expect much hand-wringing here around the answer to
this question.
These concerns around growth and revenue point to the third and most
significant concern around Facebook (and Zynga): MOBILE. While we’ve
known that mobile is the fastest growing technology wave the world has
ever seen, it’s been a challenge to frame truly how important, impactful, and
disruptive the mobile wave is. Last week’s reports from Zynga and Facebook
make crystal clear the implications of mobile—two leading innovators and
upstarts that basically created and drove the social computing wave are facing
questions about their future earning streams on the basis of their execution on
mobile.
So the broader story of what’s happening in technology is this: Mobile is what’s
happening. Here’s one shorthand framework for the technology waves over the
last roughly 20 years. Web 1.0 was about web connectivity, the giants of that
epoch catalyzed by Netscape were companies like AOL, Yahoo, and Google.
Web 2.0 was social, with Facebook, LinkedIn, Zynga, Twitter, and newcomer
Quora as the foundational creators of the web’s ‘social layer.’ The power and
impact of the social layer is difficult to overstate—existing industries and
corporate giants (to say nothing of several repressive governmental regimes)
have faced huge disruption on the basis of these companies.
Now we’re entering Web 3.0, which is mobile, and we are in the thick of it.
The Mobile Web 3.0 has elements that build upon prior eras, but it also has
several distinct and different elements from what’s come before. Some of these
distinct elements of the Mobile Web 3.0 era include:
•
•
•
•
•
•
Real-time
Ubiquitous (always connected, always with you)
Location aware
Sensors
Tailored, smaller screen
High quality camera and audio: these elements have two key implications for today’s leaders and tomorrow’s disrupters.
Let’s Get Small: Designing for Mobile
First, the tailored, smaller screens of the Mobile Web offer new entrants the
opportunity to deliver value and experience that differentiates from the existing
leaders. Most leading tech companies today, with the exception of Instagram, were
created with a PC web-first approach. Designing and building for the PC-centric
web services packed increasing amounts of information onto ever growing screen
sizes. Take a look at Facebook on your computer’s browser—it’s like a Bloomberg
terminal full of fun—birthdates, events, status updates, advertisements, chatting.
It’s a cornucopia of information laid out all around the screen.
For any company whose heritage is designing for the PC web, mobile is a big
challenge in getting small. Compressing a PC-web experience down onto a
smartphone screen doesn’t work all that well. You may get the users—Facebook
certainly has—but it is easy to overwhelm a user with an experience that packs
in too much information into too small a screen size.
The challenge of mobile offers new entrants focused on a mobile-first strategy
an opportunity to craft and tailor a user experience that is easier to use and
enjoy on mobile. Instagram is the poster child example with its mobile-only,
photo-centric social service. Rather than pack more information onto a mobile
screen, for Instagram a picture was worth a thousand words (and a billion
dollars). Instagram’s mobile-first, photo-sharing service created an alternative
social network, and has since grown to over 80M users and its billion-dollar
acquisition by Facebook. Other mobile-first social services are following—
Foursquare, Path, Foodspotting, Banjo, Pulse, and others—and each has an
opportunity, through an approach that focuses on getting small to build a new
audience and brand that stand out from the PC-web-based incumbents.
Getting Real: Mobile Will Drive MoreReal-World Commerce
Whether they’re a newer mobile-centric startup like a Path or an existing giant
like Facebook, the key will be monetizing n a mobile world. Monetizing in
mobile will likely evolve in new directions relative to what we’ve seen in the
PC-web. Specifically: monetizing in Mobile is about getting even more real and
concrete in the value delivered to customers.
Here’s why. In Web 1.0, Google achieved supernova momentum when it
introduced its Cost-Per-Click ad model. With a dominatingly high quality
search engine for users, Google gained share on search, and in effect knew what
people were interested in. This was a break-through for advertisers in terms of
measurability. Advertisers could escape the Mad Men world of spending on TV,
print, OOH, and banner ads with their fuzzy efficacy and measurability. With
Google, advertisers now could place ads in front of people searching on relevant
terms. A huge step in terms of measurability, Google’s model had the added benefit
of only charging when a user clicked on a specific ad. All combined to deliver a
vastly more measurable and as such valuable approach to spending ad dollars.
Web 2.0 ushered in the social wave. Facebook now is showing ads of stuff we
might like based on the interests we’ve indicated or based on referrals from
friends. This embraces and extends much of the Google model, but provides
potentially even more. Facebook knows what we like day to day (Graf Ice
Skates, Breaking Bad, Crossfit for me), and what our friends like. Add to
this the tremendously detailed demographic data that its users have willingly
provided, and the opportunities for advertisers are pretty profound. While
Facebook will continue to optimize its approach to ads, there should be little
question that its current core business of ads is going to continue to grow.
With Mobile Web 3.0, the user experience opens the door for another level of
innovation in advertising and promotion. Now technology services have the
ability to leverage not just the social graph data from Facebook, but even more
real-time / real-world information. Your current location, weather, traffic, local
merchants other friends nearby, how often you’ve been to this specific store
or location are available (or will be soon). And this in turn provides a whole
new level of commerce opportunities for potential advertisers. Mobile brings
advertisers and users closer to being able to close a transaction. It’s real-world
commerce. Which leads to the question: Why pay for a click when you can
get an actual customer? That’s the promise of mobile for advertisers, brands
and merchants. The opportunity is huge: both in pure dollar size opportunity
and for disruption. The Internet advertising models of selling clicks to
advertisers will need to evolve.
A few companies to watch in this new world are Waze, ShopKick and
Foodspotting, to name just a few. Waze, the social mapping and GPS service,
provides free turn-by-turn directions with real-time traffic information and
routing to over 20m users. With users depending on Waze to help them find
the fastest and least congested routes, Waze now shows offers for the cheapest
gas prices along the way. Real value for users translates to real commerce for
merchants.
ShopKick is a mobile app that gamifies retail shopping. Users who open
ShopKick gain rewards for different tasks or quests they complete on ShopKick.
What ShopKick is starting to show retailers is that ShopKick users tend
to spend more money when they’re in store, because of the interaction and
engagement the ShopKick app can drive while the user is at the point of
purchase. Again, real value for users leads to real commerce for merchants.
Open Foodspotting, a visual guide to what’s interesting to eat near you, and
the app will locate where you are and show you pictures of the best food at
restaurants nearby. Over 2m dishes have been submitted to Foodspotting at
over half a million restaurants in the US alone. Users can express that they love
certain restaurants and dishes. As it has grown its community, Foodspotting
can now approach restaurants with promotional offerings for people who are
nearby right now, who are fans of their type of food. Real value for users, real
commerce for merchants.
So Mobile Web 3.0 is super exciting. But a word of caution: delivering value
and driving monetization in the Mobile Web 3.0 era is hard. The answer
will not be for web-first properties to scrunch their ad platforms onto mobile.
Monetization via mobile advertising will require offerings that do more to close
the loop of commerce. Advertisers increasingly will ask of mobile: why buy a
click when what I want is a paying customer or user? The services with the best
offers here will be big winners in this Mobile Web 3.0.
Groundbreaking Entrepreneurship
Sarah Lacy: Inside the DNA of the Facebook Mafia
A lot of things about Facebook have been impressive, even by the Silicon Valley
standards. Almost no other Valley company has reached so many people around
the world so quickly. Few Valley companies have been considered important
forces in causes as disparate as planning a party or a political uprising. Rarely
has a kid in his early 20s held onto the CEO reins this long. And of course, no
other Valley company has been made into a star-studded, over the top Oscarnominated film.
So it shouldn’t be surprising that the Facebook mafia—made up of high profile
alumni responsible for building companies like Quora, Cloudera, Jumo, Asana
and Path—has also emerged so early and become so distinct, well before
Facebook has come close to a major liquidity event. Like most of the things that
make Facebook unique, part of this is due to Facebook itself, and part is due to
the time in which the company was formed.
But before we get to the specifics of the Facebook mafia, it bears noting that
not all companies produce bona fide mafias. It’s more than just alums doing
well. A true “mafia” is a collection of co-founders, early hires and top engineers
who’ve been battle-tested together with an enthusiasm and financial resources
to start many different ventures immediately. There’s also a communal sense
of co-investing in and supporting one another, hence the idea of keeping it
“in the family.” While plenty of smart entrepreneurs and angel investors came
from or filtered through Google, Yahoo, eBay, Amazon and Microsoft, those
gargantuan successes didn’t really create a mafia that catalyzed at a certain
moment of time, resulting in an cluster of cool new stuff.
In fact, few big successful, lasting companies spin out mafias, because those
companies grow to such a large size that the unique DNA of the culture gets
watered down. And for financial reasons, insiders used to be tethered to the
company until after its IPO. By then, they’d missed being in the middle of
the next big startup wave. Instead mafias tend to fall out of companies that
didn’t go as far as they could have. It creates a frustrated sense of still having
something to accomplish, or as Peter Thiel said about the PayPal mafia, “You
had a lot of smart, competitive people who all needed something to do.”
Think of the most noted mafias in Valley history: Fairchild Semiconductor
started it all with a high-profile exodus of core talent that encouraged others
to do the same. Netscape was another huge one, post AOL sale. Netscape was
such a world-changing company, it was hard for anyone who was a part of it to
go back to a regular day job, and Netscapers had more cred than anyone in the
dot com heyday. There was Quincy Smith, Ram Shriram and Khosla Ventures’
David Weiden to name a few members of the diaspora. Of course, the biggest
result of the Netscape mafia was the angel portfolio of Marc Andreessen and
Ben Horowitz, who also founded Opsware selling it to HP for $1.6 billion.
That angel portfolio included early bets on companies vital to the early Web
2.0 movement, including Digg, Delicious, Twitter and more. And that angel
portfolio led to the formation of Andreessen Horowitz, which has funded
everyone from Zynga to Foursquare to Skype.
Excite@Home spawned another mafia. For those who don’t remember, Excite@
Home was an ill-thought-out $6.7 billion mash-up of two hot companies that
proved to be one of the highest flying dot-com disasters. But out of Excite@
Home came Joe Kraus who founded JotSpot and is now a partner with
Google Ventures, Brett Bullington an angel investor and board member in
several Valley companies, Craig Donato of Oodle, David Sze who would fund
Facebook, LinkedIn, and help revitalize Greylock’s West Coast brand.
Excite’s mafia may not have founded the next billion dollar company, but
they’ve funded several of them. And, like most mafias, they do things
collectively. Donato was funded by Sze and Bullington is on his board. Find an
industry conference and you’ll find these guys clustered at a back table joking
about the good-old-days. Mafias aren’t just about people who had a certain
company on their resumes starting something new—there’s the cultural aspect
of doing it together that makes them unique.
Of course, the most written about Valley mafia was the PayPal mafia. The three
founders alone had a tremendous impact. Max Levchin started Slide which
sold for $228 million to Google, and incubated Yelp, which has a good shot at
becoming a billion dollar company. Peter Thiel started Clarium Capital and
Founders Fund which backed many PayPal mafia companies and most famously,
backed an early Facebook when no one else would. Thiel was an important
early mentor for Mark Zuckerberg. Elon Musk invested in Solar City, and
founded Tesla and SpaceX. Tesla has already gone public and revolutionized the
automobile world, SpaceX and Solar City are expected to go public sometime
this year. Oh, and the three founders have produced movies too.
And let’s not forget the biggest exit so far of the PayPal mafia: YouTube’s $1.65
billion sale to Google, which cemented the reputation of Sequoia’s then new
partner, Roelof Botha—once PayPal’s CFO. Second biggest was IronPort, built
by Scott Banister and sold to Cisco for $830 million. And soon, we’ll see the
debut of the PayPal mafia’s first IPO, when LinkedIn—founded by former
PayPal executive Reid Hoffman—goes public. Hoffman, too, has funded and
mentored dozens of Web 2.0 companies.
And let’s also not forget some newer, promising companies from the mafia
like David Sacks’ Yammer. Sacks was PayPal’s COO—and the guy who came
up with that early viral marketing scheme of paying users cash to refer their
friends. And PayPal’s Keith Rabois is one of the top executives at Square, a
company leading the next wave of fundamental disruption of the financial
industry. eBay loves to trumpet how fabulous PayPal was as an acquisition. But
the PayPal mafia has created many more billions and changed the world far more.
I once asked Peter Thiel if PayPal made a mistake selling too early—something
we fixate on in the Valley. He answered that he’d wrestled with that a lot,
especially seeing how big PayPal has gotten under eBay, and imagining how
much bigger it could have become as a stand alone company. But ultimately,
he said, looking at all the companies that had been created as a result of those
smart competitive people needing something to do, it was hard to argue selling
PayPal was a mistake in the macro sense.
You could have the same conversation today about the good and the bad
of Facebook’s hundreds of millions of dollars of secondary share cash-outs,
which has largely made this early mafia possible. The secondary sales have
been a challenge for Facebook, because it makes retaining some of those early
employees harder, and I’ve argued before that it contributes to the Valley’s
increasingly short-term, instant-gratification, mercenary culture. But if Quora,
Path, Asana and others can live up to the early hype, the Valley’s ecosystem
will get its cake and get to eat it too: Facebook keeps growing, seemingly
unstoppably, to become the biggest company of this generation and we get a
wide impact of startups spinning out of it too.
So what does the Facebook mafia look like, and other than its surprising early
existence what makes it different? I wanted to examine it, because I was struck by
three things: The continuing Valley love-affair with Quora, Dave Morin of Path’s
almost incomprehensibly ballsy rejection of Google’s $120 million purchase
offer and the many things about Dustin Moskovitz’s Asana that reminded
me philosophically of the early days of Facebook, even though the product is
decidedly not a Facebook for the enterprise. That got me thinking about other
Facebook spinouts we don’t write about as much, like Cloudera and Jumo.
So I decided to spend much of the last two weeks interviewing more than a
dozen people who were early advisers, investors and insiders at Facebook on and
off the record about what it was that was making the companies spinning out
of this young mafia so striking, in so many different ways. Here are some of
the core characteristics, and how they stand out from startups I’m seeing in the
Valley at large.
Not for Sale by Owner
To a person, the early Facebook people I spoke with all mentioned Zuckerberg’s
July 2006 rejection of Yahoo’s $1 billion purchase offer as a seminal moment
that not only changed Facebook, but changed their thinking personally as
entrepreneurs. In hindsight it looks like a no-brainer, but the outside world
deemed Zuckerberg arrogant and delusional at the time. Inside Facebook, his
decision caused a split within the company.
Dustin Moskovitz remembered several people saying to Zuckerberg at the time,
“If you knew you didn’t want to sell, why did you take us so far down this
path? Because that’s what was so painful, getting to the alter and then breaking
up.” After that, Zuckerberg never went down the aisle again. And similarly,
Moskovitz’s company Asana has refused to engage in conversations about a flip,
and sources say Quora has the same philosophy.
And then, there’s Path—a mobile photo sharing site that doesn’t even have a
million users and turned down a purchase of more than $100 million. As Mike
said in his post, Morin is definitely crazy—we just don’t yet know if that’s a
good crazy or a bad crazy. During the weekend Morin was agonizing over the
decision, he holed up with his biggest angel investor—Moskovitz. Moskovitz
was one of the only people who didn’t make Morin feel crazy, and it played a
big role in giving him the confidence to do what he knew he wanted to do, turn
the insanely generous offer down.
Engineers Are Gods and Education Isn’t what Made Them that Way
These companies all revolve around engineers in almost a cultish way. Their
investors and competitors always note how good the team is—which is saying
something in a Valley locked in a full-scale talent war. They are insanely picky
about hiring engineers and when they find a good one they will pay him nearly
anything. Asana gives engineers $10,000 to pimp their desks. Zuckerberg has
described Quora co-founder Adam D’Angelo as one of the best—if not the
best– engineers he has ever met. And Path’s team was reportedly one of the
assets Google was so willing to pay up for.
But unlike companies like Google and Amazon who rigorously hired based
on college degrees, GPAs and standardized test scores, Facebook and the
companies that have spun out of it have hewed toward sheer, raw, hacker-like
genius. That’s created a more entrepreneurial culture inside the company. Justin
Rosenstein—who was at Google and then Facebook before leaving to co-found
Asana with Moskovitz—says that working at Google is often described as
a wonderland for academics, while Facebook’s early days were more of an
extension of a messy dorm room full of engineers hacking away all night, then
collapsing most of the day.
Rejection of the Lean Startup Ideal
One thing that made Facebook so distinct from its early Web 2.0 peers was
how much money it raised and how rapidly it scaled up. In the aftermath of the
dot com bust, there was a paranoid fear of taking too much money or doing in
house what you could outsource. But Zuckerberg had missed the bubble and
the bust, and built the company as he deemed appropriate.
Likewise, some of these companies still have small teams, but it’s not for the
sake of being small. They’ve not been shy about raising money, and because
there’s not an emphasis on selling the company, they have no problem hiring or
raising more when needed. And as the salaries and perks paid to engineers show,
it’s not a culture that wastes time nickeling-and-diming the important things.
Efficiency and Organization at the Expense of a Free-for-all
The hallmarks of each of these products are around efficiency, not sprawling
messy communities. Quora seeks to organize information to benefit the person
answering the question, not the person asking it. As such, some people posing
the questions get annoyed that they don’t get the right to retain more control of
the dialogue.
Similarly, Path is an efficient way to jump in and out of friend’s photo streams.
Like Facebook, the emphasis is on engaging with the app seamlessly throughout
a day, not spending hours in it at a time. And Asana controls work flow and
collaboration through a core news-feed like layout. The emphasis, again, is on
living in the app, engaging with it throughout the day, not spending an hour
doing things inside of it. It’s that difference between being a “utility” and a
“media” property that Zuckerberg talked so much about in the early days.
Controlled Pacing, Not Cheap Viral Hacks
Here’s a core difference between these companies and many I see in the Valley.
Most companies put an implicit value on size for the sake of size, and doing
any cheap viral game in the book to get there, even if it means a low percentage
of users ever engage with your app or return to your site again. In the last five
years the value of a unique user has been almost completely eroded.
Instead, many of these companies take a cue from the way Facebook rolled
out with a deliberate controlled pacing that allowed it to scale as it went from
just Harvard, to include Ivy League schools, high schools, work places, and
eventually the world. Facebook had a confident sense of not being in a hurry,
that helped keep its community from becoming overrun and eroded. Likewise,
Quora’s press, valuation and influence has far outstripped its user base. Path
has a small fraction of Instagram’s users. And Asana has more than 5,000
companies on its waiting list to use its product. These companies may all
become huge one day, but that’s clearly not their priority now.
Solving Big, Messy Social Problems Others Have Failed Trying to Solve
Before
Perhaps it’s because the founders were at Facebook before, and it would take
something big to get them to leave. Or maybe they’re all idealists who want
to change the world. But each of these companies has a big sense of mission.
None of them started from building a cool app or site for the founder and his
friends, they all started to solve a big problem. And what’s more: That problem
isn’t typically a new problem. This is where you get these companies biggest
haters: The people who say Quora is just Yahoo Answers, the people who say
Instagram beat Path before it got the chance to get started, the people who look
at Asana and see yet another collaboration software play.
But here’s the thing: The core problems still exist despite billions invested in
solving them, particularly in the case of Quora, Asana, and Chris Hughes’
Jumo, an ambitious play to organize the messy world of nonprofits. We can all
see the pitfalls these companies will face, because we’ve seen companies fall into
them before. But call it arrogance, confidence, delusion or some insight we just
don’t understand from the outside, these founders all think they have a key to
solving it.
It’s hard not to compare this to Facebook. The biggest reason people wouldn’t
fund it in the early days was because of the great flame out of Friendster. Then,
when MySpace took off, no one thought Facebook had a chance of catching
them. Those naysayers were all wrong.
And like Facebook, companies like Asana, Path and Quora are trying to
solve problems that are inherently social. Not social in the capital-S SOCIAL
MEDIA! sense of the word, rather social in the sense of the messiness that
results from people trying to interact online and bringing all the messy aspects
of human interaction, communication and relationships with them. They are
problems that machines can’t purely solve and people can’t purely solve, and
each of these companies tries to use both to solve them, rather than Google’s
slavish love of the algorithm or Yahoo’s early belief in directories and curation.
They are all likely problems that have no one solution, but a long road of
getting closer.
Moskovitz says it’s less like they’ve all gone their separate ways, and more like
they’re all still working in one bigger, deconstructed company that stretches
through the Valley. He’s still trying to solve problems he was working on within
Facebook, but on a bigger scale and for all companies. He uses Cloudera’s data
processing engine and Quora to handle some of their press and messaging, and
uses all the others on a personal level.
At the end of the day, this is exactly what makes Silicon Valley irrepressible as
an entrepreneur hot spot–more than the money, the universities, and the rest.
You can trace a whole lineage of mafias coming out of mafias. Facebook had its
roots in the PayPal mafia, which had its roots in the early University of Illinois
days along with Netscape and Mosiac. And Netscape grew out of Silicon
Graphics. It’s this lineage that has taken decades to develop in the Valley that
no government programs or well-meaning civic boosters can replicate.
CHAPTER TWO
THE FUNDING ECOSYSTEM
Where there is opportunity, there is cash.
Contributors write about how angel investors, venture capitalists, and bankers
serve distinct purposes and provide distinct services during the startup growth
trajectory.
Types of Investors
Paul Graham: How to Fund a Startup
Venture funding works like gears. A typical startup goes through several rounds
of funding, and at each round you want to take just enough money to reach the
speed where you can shift into the next gear.
Few startups get it quite right. Many are underfunded. A few are overfunded,
which is like trying to start driving in third gear.
I think it would help founders to understand funding better—not just the
mechanics of it, but what investors are thinking. I was surprised recently when
I realized that all the worst problems we faced in our startup were due not to
competitors, but investors. Dealing with competitors was easy by comparison.
I don’t mean to suggest that our investors were nothing but a drag on us. They
were helpful in negotiating deals, for example. I mean more that conflicts with
investors are particularly nasty. Competitors punch you in the jaw, but investors
have you by the balls.
Apparently our situation was not unusual. And if trouble with investors is one
of the biggest threats to a startup, managing them is one of the most important
skills founders need to learn.
Let’s start by talking about the five sources of startup funding. Then we’ll
trace the life of a hypothetical (very fortunate) startup as it shifts gears through
successive rounds.
Friends and Family
A lot of startups get their first funding from friends and family. Excite did, for
example: after the founders graduated from college, they borrowed $15,000
from their parents to start a company. With the help of some part-time jobs
they made it last 18 months.
If your friends or family happen to be rich, the line blurs between them and
angel investors. At Viaweb we got our first $10,000 of seed money from our
friend Julian, but he was sufficiently rich that it’s hard to say whether he should
be classified as a friend or angel. He was also a lawyer, which was great, because
it meant we didn’t have to pay legal bills out of that initial small sum.
The advantage of raising money from friends and family is that they’re easy
to find. You already know them. There are three main disadvantages: you
mix together your business and personal life; they will probably not be as well
connected as angels or venture firms; and they may not be accredited investors,
which could complicate your life later.
The SEC defines an “accredited investor” as someone with over a million dollars
in liquid assets or an income of over $200,000 a year. The regulatory burden is
much lower if a company’s shareholders are all accredited investors. Once you
take money from the general public you’re more restricted in what you can do. [1]
A startup’s life will be more complicated, legally, if any of the investors aren’t
accredited. In an IPO, it might not merely add expense, but change the
outcome. A lawyer I asked about it said:
When the company goes public, the SEC will carefully study all
prior issuances of stock by the company and demand that it take
immediate action to cure any past violations of securities laws. Those
remedial actions can delay, stall or even kill the IPO.
Of course the odds of any given startup doing an IPO are small. But not as
small as they might seem. A lot of startups that end up going public didn’t seem
likely to at first. (Who could have guessed that the company Wozniak and Jobs
started in their spare time selling plans for microcomputers would yield one of
the biggest IPOs of the decade?) Much of the value of a startup consists of that
tiny probability multiplied by the huge outcome.
It wasn’t because they weren’t accredited investors that I didn’t ask my parents
for seed money, though. When we were starting Viaweb, I didn’t know about
the concept of an accredited investor, and didn’t stop to think about the value
of investors’ connections. The reason I didn’t take money from my parents was
that I didn’t want them to lose it.
Consulting
Another way to fund a startup is to get a job. The best sort of job is a
consulting project in which you can build whatever software you wanted to
sell as a startup. Then you can gradually transform yourself from a consulting
company into a product company, and have your clients pay your development
expenses.
This is a good plan for someone with kids, because it takes most of the risk out
of starting a startup. There never has to be a time when you have no revenues.
Risk and reward are usually proportionate; however, you should expect a plan
that cuts the risk of starting a startup also to cut the average return. In this case,
you trade decreased financial risk for increased risk that your company won’t
succeed as a startup.
But isn’t the consulting company itself a startup? No, not generally. A company
has to be more than small and newly founded to be a startup. There are
millions of small businesses in America, but only a few thousand are startups.
To be a startup, a company has to be a product business, not a service business.
By which I mean not that it has to make something physical, but that it has
to have one thing it sells to many people, rather than doing custom work for
individual clients. Custom work doesn’t scale. To be a startup you need to be
the band that sells a million copies of a song, not the band that makes money
by playing at individual weddings and bar mitzvahs.
The trouble with consulting is that clients have an awkward habit of calling
you on the phone. Most startups operate close to the margin of failure, and the
distraction of having to deal with clients could be enough to put you over the
edge. Especially if you have competitors who get to work full time on just being
a startup.
So you have to be very disciplined if you take the consulting route. You have to
work actively to prevent your company growing into a “weed tree,” dependent
on this source of easy but low-margin money. [2]
Indeed, the biggest danger of consulting may be that it gives you an excuse for
failure. In a startup, as in grad school, a lot of what ends up driving you are
the expectations of your family and friends. Once you start a startup and tell
everyone that’s what you’re doing, you’re now on a path labeled “get rich or
bust.” You now have to get rich, or you’ve failed.
Fear of failure is an extraordinarily powerful force. Usually it prevents people
from starting things, but once you publish some definite ambition, it switches
directions and starts working in your favor. I think it’s a pretty clever piece of
jiu-jitsu to set this irresistible force against the slightly less immovable object of
becoming rich. You won’t have it driving you if your stated ambition is merely
to start a consulting company that you will one day morph into a startup.
An advantage of consulting, as a way to develop a product, is that you know
you’re making something at least one customer wants. But if you have what it
takes to start a startup you should have sufficient vision not to need this crutch.
Angel Investors
Angels are individual rich people. The word was first used for backers of
Broadway plays, but now applies to individual investors generally. Angels who’ve
made money in technology are preferable, for two reasons: they understand
your situation, and they’re a source of contacts and advice.
The contacts and advice can be more important than the money. When del.icio.us
took money from investors, they took money from, among others, Tim O’Reilly.
The amount he put in was small compared to the VCs who led the round, but
Tim is a smart and influential guy and it’s good to have him on your side.
You can do whatever you want with money from consulting or friends and
family. With angels we’re now talking about venture funding proper, so it’s time
to introduce the concept of exit strategy. Younger would-be founders are often
surprised that investors expect them either to sell the company or go public.
The reason is that investors need to get their capital back. They’ll only consider
companies that have an exit strategy—meaning companies that could get
bought or go public.
This is not as selfish as it sounds. There are few large, private technology
companies. Those that don’t fail all seem to get bought or go public. The reason
is that employees are investors too—of their time—and they want just as much
to be able to cash out. If your competitors offer employees stock options that
might make them rich, while you make it clear you plan to stay private, your
competitors will get the best people. So the principle of an “exit” is not just
something forced on startups by investors, but part of what it means to be a
startup.
Another concept we need to introduce now is valuation. When someone buys
shares in a company that implicitly establishes a value for it. If someone pays
$20,000 for 10% of a company, the company is in theory worth $200,000.
I say “in theory” because in early stage investing, valuations are voodoo. As a
company gets more established, its valuation gets closer to an actual market
value. But in a newly founded startup, the valuation number is just an artifact
of the respective contributions of everyone involved.
Startups often “pay” investors who will help the company in some way by
letting them invest at low valuations. If I had a startup and Steve Jobs wanted to
invest in it, I’d give him the stock for $10, just to be able to brag that he was an
investor. Unfortunately, it’s impractical (if not illegal) to adjust the valuation of
the company up and down for each investor. Startups’ valuations are supposed
to rise over time. So if you’re going to sell cheap stock to eminent angels, do it
early, when it’s natural for the company to have a low valuation.
Some angel investors join together in syndicates. Any city where people start
startups will have one or more of them. In Boston the biggest is the Common
Angels. In the Bay Area it’s the Band of Angels. You can find groups near you
through the Angel Capital Association. [3] However, most angel investors don’t
belong to these groups. In fact, the more prominent the angel, the less likely
they are to belong to a group.
Some angel groups charge you money to pitch your idea to them. Needless to
say, you should never do this.
One of the dangers of taking investment from individual angels, rather than
through an angel group or investment firm, is that they have less reputation to
protect. A big-name VC firm will not screw you too outrageously, because other
founders would avoid them if word got out. With individual angels you don’t
have this protection, as we found to our dismay in our own startup. In many
startups’ lives there comes a point when you’re at the investors’ mercy—when
you’re out of money and the only place to get more is your existing investors.
When we got into such a scrape, our investors took advantage of it in a way that
a name brand VC probably wouldn’t have.
Angels have a corresponding advantage; however, they’re also not bound by all
the rules that VC firms are. And so they can, for example, allow founders to
cash out partially in a funding round, by selling some of their stock directly to
the investors. I think this will become more common; the average founder is
eager to do it, and selling, say, half a million dollars worth of stock will not, as
VCs fear, cause most founders to be any less committed to the business.
The same angels who tried to screw us also let us do this, and so on balance
I’m grateful rather than angry. (As in families, relations between founders and
investors can be complicated.)
The best way to find angel investors is through personal introductions. You
could try to cold-call angel groups near you, but angels, like VCs, will pay more
attention to deals recommended by someone they respect.
Deal terms with angels vary a lot. There are no generally accepted standards.
Sometimes angels’ deal terms are as fearsome as VCs’. Other angels, particularly
in the earliest stages, will invest based on a two-page agreement.
Angels who only invest occasionally may not themselves know what terms
they want. They just want to invest in this startup. What kind of anti-dilution
protection do they want? Hell if they know. In these situations, the deal terms
tend to be random: the angel asks his lawyer to create a vanilla agreement, and
the terms end up being whatever the lawyer considers vanilla. Which in practice
usually means, whatever existing agreement he finds lying around his firm.
(Few legal documents are created from scratch.)
These heaps o’ boilerplate are a problem for small startups, because they tend
to grow into the union of all preceding documents. I know of one startup that
got from an angel investor what amounted to a five hundred pound handshake:
after deciding to invest, the angel presented them with a 70-page agreement.
The startup didn’t have enough money to pay a lawyer even to read it, let alone
negotiate the terms, so the deal fell through.
One solution to this problem would be to have the startup’s lawyer produce the
agreement, instead of the angel’s. Some angels might balk at this, but others
would probably welcome it.
Inexperienced angels often get cold feet when the time comes to write that big
check. In our startup, one of the two angels in the initial round took months
to pay us, and only did after repeated nagging from our lawyer, who was also,
fortunately, his lawyer.
It’s obvious why investors delay. Investing in startups is risky! When a company
is only two months old, every day you wait gives you 1.7% more data about
their trajectory. But the investor is already being compensated for that risk in
the low price of the stock, so it is unfair to delay.
Fair or not, investors do it if you let them. Even VCs do it. And funding delays
are a big distraction for founders, who ought to be working on their company,
not worrying about investors. What’s a startup to do? With both investors and
acquirers, the only leverage you have is competition. If an investor knows you
have other investors lined up, he’ll be a lot more eager to close­— and not just
because he’ll worry about losing the deal, but because if other investors are
interested, you must be worth investing in. It’s the same with acquisitions. No
one wants to buy you till someone else wants to buy you, and then everyone
wants to buy you.
The key to closing deals is never to stop pursuing alternatives. When an
investor says he wants to invest in you, or an acquirer says they want to buy you,
don’t believe it till you get the check. Your natural tendency when an investor
says yes will be to relax and go back to writing code. Alas, you can’t; you have
to keep looking for more investors, if only to get this one to act. [4]
Seed Funding Firms
Seed firms are like angels in that they invest relatively small amounts at early
stages, but like VCs in that they’re companies that do it as a business, rather
than individuals making occasional investments on the side.
Till now, nearly all seed firms have been so-called “incubators,” so Y
Combinator gets called one too, though the only thing we have in common is
that we invest in the earliest phase.
According to the National Association of Business Incubators, there are about
800 incubators in the US. This is an astounding number, because I know the
founders of a lot of startups, and I can’t think of one that began in an incubator.
What is an incubator? I’m not sure myself. The defining quality seems to be
that you work in their space. That’s where the name “incubator” comes from.
They seem to vary a great deal in other respects. At one extreme is the sort
of pork-barrel project where a town gets money from the state government
to renovate a vacant building as a “high-tech incubator,” as if it were merely
lack of the right sort of office space that had till now prevented the town from
becoming a startup hub. At the other extreme are places like Idealab, which
generates ideas for new startups internally and hires people to work for them.
The classic Bubble incubators, most of which now seem to be dead, were like
VC firms except that they took a much bigger role in the startups they funded.
In addition to working in their space, you were supposed to use their office
staff, lawyers, accountants, and so on.
Whereas incubators tend (or tended) to exert more control than VCs, Y
Combinator exerts less. And we think it’s better if startups operate out of
their own premises, however crappy, than the offices of their investors. So it’s
annoying that we keep getting called an “incubator,” but perhaps inevitable,
because there’s only one of us so far and no word yet for what we are. If we have
to be called something, the obvious name would be “excubator.” (The name is
more excusable if one considers it as meaning that we enable people to escape
cubicles.)
Because seed firms are companies rather than individual people, reaching them is
easier than reaching angels. Just go to their web site and send them an email. The
importance of personal introductions varies, but is less than with angels or VCs.
The fact that seed firms are companies also means the investment process is
more standardized. (This is generally true with angel groups too.) Seed firms
will probably have set deal terms they use for every startup they fund. The fact
that the deal terms are standard doesn’t mean they’re favorable to you, but if
other startups have signed the same agreements and things went well for them,
it’s a sign the terms are reasonable.
Seed firms differ from angels and VCs in that they invest exclusively in the
earliest phases—often when the company is still just an idea. Angels and even
VC firms occasionally do this, but they also invest at later stages.
The problems are different in the early stages. For example, in the first couple
months a startup may completely redefine their idea. So seed investors usually
care less about the idea than the people. This is true of all venture funding, but
especially so in the seed stage.
Like VCs, one of the advantages of seed firms is the advice they offer. But
because seed firms operate in an earlier phase, they need to offer different kinds
of advice. For example, a seed firm should be able to give advice about how to
approach VCs, which VCs obviously don’t need to do; whereas VCs should be
able to give advice about how to hire an “executive team,” which is not an issue
in the seed stage.
In the earliest phases, a lot of the problems are technical, so seed firms should
be able to help with technical as well as business problems.
Seed firms and angel investors generally want to invest in the initial phases of
a startup, then hand them off to VC firms for the next round. Occasionally
startups go from seed funding direct to acquisition, however, and I expect this
to become increasingly common.
Google has been aggressively pursuing this route, and now Yahoo is too. Both
now compete directly with VCs. And this is a smart move. Why wait for further
funding rounds to jack up a startup’s price? When a startup reaches the point
where VCs have enough information to invest in it, the acquirer should have
enough information to buy it. More information, in fact; with their technical
depth, the acquirers should be better at picking winners than VCs.
Venture Capital Funds
VC firms are like seed firms in that they’re actual companies, but they invest
other people’s money, and much larger amounts of it. VC investments average
several million dollars. So they tend to come later in the life of a startup, are
harder to get, and come with tougher terms.
The word “venture capitalist” is sometimes used loosely for any venture
investor, but there is a sharp difference between VCs and other investors: VC
firms are organized as funds, much like hedge funds or mutual funds. The fund
managers, who are called “general partners,” get about 2% of the fund annually
as a management fee, plus about 20% of the fund’s gains.
There is a very sharp drop-off in performance among VC firms, because in the
VC business both success and failure are self-perpetuating. When an investment
scores spectacularly, as Google did for Kleiner and Sequoia, it generates a lot
of good publicity for the VCs. And many founders prefer to take money from
successful VC firms, because of the legitimacy it confers. Hence a vicious (for
the losers) cycle: VC firms that have been doing badly will only get the deals
the bigger fish have rejected, causing them to continue to do badly.
As a result, of the thousand or so VC funds in the US now, only about 50 are
likely to make money, and it is very hard for a new fund to break into this
group.
In a sense, the lower-tier VC firms are a bargain for founders. They may not be
quite as smart or as well connected as the big-name firms, but they are much
hungrier for deals. This means you should be able to get better terms from
them.
Better how? The most obvious is valuation: they’ll take less of your company.
But as well as money, there’s power. I think founders will increasingly be able to
stay on as CEO, and on terms that will make it fairly hard to fire them later.
The most dramatic change, I predict, is that VCs will allow founders to cash
out partially by selling some of their stock direct to the VC firm. VCs have
traditionally resisted letting founders get anything before the ultimate “liquidity
event.” But they’re also desperate for deals. And since I know from my own
experience that the rule against buying stock from founders is a stupid one, this
is a natural place for things to give as venture funding becomes more and more
a seller’s market.
The disadvantage of taking money from less known firms is that people will
assume, correctly or not, that you were turned down by the more exalted ones.
But, like where you went to college, the name of your VC stops mattering once
you have some performance to measure. So the more confident you are, the less
you need a brand-name VC. We funded Viaweb entirely with angel money; it
never occurred to us that the backing of a well-known VC firm would make us
seem more impressive. [5]
Another danger of less known firms is that, like angels, they have less reputation
to protect. I suspect it’s the lower-tier firms that are responsible for most of
the tricks that have given VCs such a bad reputation among hackers. They
are doubly hosed: the general partners themselves are less able, and yet they
have harder problems to solve, because the top VCs skim off all the best deals,
leaving the lower-tier firms exactly the startups that are likely to blow up.
For example, lower-tier firms are much more likely to pretend to want to do a
deal with you just to lock you up while they decide if they really want to. One
experienced CFO said:
The better ones usually will not give a term sheet unless they really
want to do a deal. The second or third tier firms have a much higher
break rate—it could be as high as 50%.
It’s obvious why: the lower-tier firms’ biggest fear, when chance throws them a
bone, is that one of the big dogs will notice and take it away. The big dogs don’t
have worry about that.
Falling victim to this trick could really hurt you. As one VC told me:
If you were talking to four VCs, told three of them that you accepted
a term sheet, and then have to call them back to tell them you were
just kidding, you are absolutely damaged goods.
Here’s a partial solution: when a VC offers you a term sheet, ask how many of
their last 10 term sheets turned into deals. This will at least force them to lie
outright if they want to mislead you.
Not all the people who work at VC firms are partners. Most firms also have a
handful of junior employees called something like associates or analysts. If you
get a call from a VC firm, go to their web site and check whether the person you
talked to is a partner. Odds are it will be a junior person; they scour the web
looking for startups their bosses could invest in. The junior people will tend to
seem very positive about your company. They’re not pretending; they want to
believe you’re a hot prospect, because it would be a huge coup for them if their
firm invested in a company they discovered. Don’t be misled by this optimism.
It’s the partners who decide, and they view things with a colder eye.
Because VCs invest large amounts, the money comes with more restrictions.
Most only come into effect if the company gets into trouble. For example, VCs
generally write it into the deal that in any sale, they get their investment back
first. So if the company gets sold at a low price, the founders could get nothing.
Some VCs now require that in any sale they get 4x their investment back before
the common stock holders (that is, you) get anything, but this is an abuse that
should be resisted.
Another difference with large investments is that the founders are usually
required to accept “vesting”—to surrender their stock and earn it back over the
next 4-5 years. VCs don’t want to invest millions in a company the founders
could just walk away from. Financially, vesting has little effect, but in some
situations it could mean founders will have less power. If VCs got de facto
control of the company and fired one of the founders, he’d lose any unvested
stock unless there was specific protection against this. So vesting would in that
situation force founders to toe the line.
The most noticeable change when a startup takes serious funding is that the
founders will no longer have complete control. Ten years ago VCs used to insist
that founders step down as CEO and hand the job over to a business guy they
supplied. This is less the rule now, partly because the disasters of the Bubble
showed that generic business guys don’t make such great CEOs.
But while founders will increasingly be able to stay on as CEO, they’ll have to
cede some power, because the board of directors will become more powerful.
In the seed stage, the board is generally a formality; if you want to talk to the
other board members, you just yell into the next room. This stops with VCscale money. In a typical VC funding deal, the board of directors might be
composed of two VCs, two founders, and one outside person acceptable to
both. The board will have ultimate power, which means the founders now have
to convince instead of commanding.
This is not as bad as it sounds, however. Bill Gates is in the same position; he
doesn’t have majority control of Microsoft; in principle he also has to convince
instead of commanding. And yet he seems pretty commanding, doesn’t he?
As long as things are going smoothly, boards don’t interfere much. The danger
comes when there’s a bump in the road, as happened to Steve Jobs at Apple.
Like angels, VCs prefer to invest in deals that come to them through people
they know. So while nearly all VC funds have some address you can send your
business plan to, VCs privately admit the chance of getting funding by this
route is near zero. One recently told me that he did not know a single startup
that got funded this way.
I suspect VCs accept business plans “over the transom” more as a way to keep
tabs on industry trends than as a source of deals. In fact, I would strongly advise
against mailing your business plan randomly to VCs, because they treat this as
evidence of laziness. Do the extra work of getting personal introductions. As
one VC put it:
I’m not hard to find. I know a lot of people. If you can’t find some
way to reach me, how are you going to create a successful company?
One of the most difficult problems for startup founders is deciding when to
approach VCs. You really only get one chance, because they rely heavily on first
impressions. And you can’t approach some and save others for later, because
(a) they ask whom else you’ve talked to and when and (b) they talk among
themselves. If you’re talking to one VC and he finds out that you were rejected
by another several months ago, you’ll definitely seem shopworn.
So when do you approach VCs? When you can convince them. If the founders
have impressive resumes and the idea isn’t hard to understand, you could
approach VCs quite early. Whereas if the founders are unknown and the idea
is very novel, you might have to launch the thing and show that users loved it
before VCs would be convinced.
If several VCs are interested in you, they will sometimes be willing to split
the deal between them. They’re more likely to do this if they’re close in the
VC pecking order. Such deals may be a net win for founders, because you get
multiple VCs interested in your success, and you can ask each for advice about
the other. One founder I know wrote:
Two-firm deals are great. It costs you a little more equity, but being
able to play the two firms off each other (as well as ask one if the
other is being out of line) is invaluable.
When you do negotiate with VCs, remember that they’ve done this a lot more
than you have. They’ve invested in dozens of startups, whereas this is probably
the first you’ve founded. But don’t let them or the situation intimidate you. The
average founder is smarter than the average VC. So just do what you’d do in
any complex, unfamiliar situation: proceed deliberately, and question anything
that seems odd.
It is, unfortunately, common for VCs to put terms in an agreement whose
consequences surprise founders later, and also common for VCs to defend
things they do by saying that they’re standard in the industry. Standard,
schmandard; the whole industry is only a few decades old, and rapidly evolving.
The concept of “standard” is a useful one when you’re operating on a small scale
(Y Combinator uses identical terms for every deal because for tiny seed-stage
investments it’s not worth the overhead of negotiating individual deals), but it
doesn’t apply at the VC level. On that scale, every negotiation is unique.
Most successful startups get money from more than one of the preceding five
sources. [6] And, confusingly, the names of funding sources also tend to be
used as the names of different rounds. The best way to explain how it all works
is to follow the case of a hypothetical startup.
Stage 1: Seed Round
Our startup begins when a group of three friends have an idea—either an idea
for something they might build, or simply the idea “let’s start a company.”
Presumably they already have some source of food and shelter. But if you have
food and shelter, you probably also have something you’re supposed to be
working on: either classwork or a job. So if you want to work full-time on a
startup, your money situation will probably change too.
A lot of startup founders say they started the company without any idea of what
they planned to do. This is actually less common than it seems: many have to
claim they thought of the idea after quitting because otherwise their former
employer would own it.
The three friends decide to take the leap. Since most startups are in competitive
businesses, you not only want to work full-time on them, but more than fulltime. So some or all of the friends quit their jobs or leave school. (Some of the
founders in a startup can stay in grad school, but at least one has to make the
company his full-time job.)
They’re going to run the company out of one of their apartments at first, and
since they don’t have any users they don’t have to pay much for infrastructure.
Their main expenses are setting up the company, which costs a couple thousand
dollars in legal work and registration fees, and the living expenses of the
founders.
The phrase “seed investment” covers a broad range. To some VC firms it means
$500,000, but to most startups it means several months’ living expenses. We’ll
suppose our group of friends starts with $15,000 from their friend’s rich uncle,
who they give 5% of the company in return. There’s only common stock at
this stage. They leave 20% as an options pool for later employees (but they set
things up so that they can issue this stock to themselves if they get bought early
and most is still unissued), and the three founders each get 25%.
By living really cheaply they think they can make the remaining money last
five months. When you have five months’ runway left, how soon do you need
to start looking for your next round? Answer: immediately. It takes time to find
investors, and time (always more than you expect) for the deal to close even
after they say yes. So if our group of founders knows what they’re doing they’ll
start sniffing around for angel investors right away. But of course their main job
is to build version 1 of their software.
The friends might have liked to have more money in this first phase, but
being slightly underfunded teaches them an important lesson. For a startup,
cheapness is power. The lower your costs, the more options you have—not just
at this stage, but at every point till you’re profitable. When you have a high
“burn rate,” you’re always under time pressure, which means (a) you don’t have
time for your ideas to evolve, and (b) you’re often forced to take deals you don’t
like.
Every startup’s rule should be: spend little, and work fast.
After ten weeks’ work the three friends have built a prototype that gives one
a taste of what their product will do. It’s not what they originally set out to
do—in the process of writing it, they had some new ideas. And it only does a
fraction of what the finished product will do, but that fraction includes stuff
that no one else has done before.
They’ve also written at least a skeleton business plan, addressing the five
fundamental questions: what they’re going to do, why users need it, how large
the market is, how they’ll make money, and who the competitors are and why
this company is going to beat them. (That last has to be more specific than
“they suck” or “we’ll work really hard.”)
If you have to choose between spending time on the demo or the business plan,
spend most on the demo. Software is not only more convincing, but a better
way to explore ideas.
Stage 2: Angel Round
While writing the prototype, the group has been traversing their network of
friends in search of angel investors. They find some just as the prototype is
demoable. When they demo it, one of the angels is willing to invest. Now the
group is looking for more money: they want enough to last for a year, and
maybe to hire a couple friends. So they’re going to raise $200,000.
The angel agrees to invest at a pre-money valuation of $1 million. The
company issues $200,000 worth of new shares to the angel; if there were 1000
shares before the deal, this means 200 additional shares. The angel now owns
200/1200 shares, or a sixth of the company, and all the previous shareholders’
percentage ownership is diluted by a sixth. After the deal, the capitalization
table looks like this:
To keep things simple, I had the angel do a straight cash for stock deal. In
reality the angel might be more likely to make the investment in the form of a
Shareholder
Shares
Percent
Angel
200
16.7
Uncle
50
4.2
Each Founder
250
20.8
Option Pool
200
16.7
Total
1200
100
convertible loan. A convertible loan is a loan that can be converted into stock
later; it works out the same as a stock purchase in the end, but gives the angel
more protection against being squashed by VCs in future rounds.
Who pays the legal bills for this deal? The startup, remember, only has a couple
thousand left. In practice this turns out to be a sticky problem that usually gets
solved in some improvised way. Maybe the startup can find lawyers who will do
it cheaply in the hope of future work if the startup succeeds. Maybe someone
has a lawyer friend. Maybe the angel pays for his lawyer to represent both sides.
(Make sure if you take the latter route that the lawyer is representing you rather
than merely advising you, or his only duty is to the investor.)
An angel investing $200k would probably expect a seat on the board of
directors. He might also want preferred stock, meaning a special class of stock
that has some additional rights over the common stock everyone else has.
Typically these rights include vetoes over major strategic decisions, protection
against being diluted in future rounds, and the right to get one’s investment
back first if the company is sold.
Some investors might expect the founders to accept vesting for a sum this size,
and others wouldn’t. VCs are more likely to require vesting than angels. At
Viaweb we managed to raise $2.5 million from angels without ever accepting
vesting, largely because we were so inexperienced that we were appalled at the
idea. In practice this turned out to be good, because it made us harder to push
around.
Our experience was unusual; vesting is the norm for amounts that size. Y
Combinator doesn’t require vesting, because (a) we invest such small amounts,
and (b) we think it’s unnecessary, and that the hope of getting rich is enough
motivation to keep founders at work. But maybe if we were investing millions
we would think differently.
I should add that vesting is also a way for founders to protect themselves against
one another. It solves the problem of what to do if one of the founders quits. So
some founders impose it on themselves when they start the company.
The angel deal takes two weeks to close, so we are now three months into the
life of the company.
The point after you get the first big chunk of angel money will usually be
the happiest phase in a startup’s life. It’s a lot like being a postdoc: you have
no immediate financial worries, and few responsibilities. You get to work on
juicy kinds of work, like designing software. You don’t have to spend time on
bureaucratic stuff, because you haven’t hired any bureaucrats yet. Enjoy it while
it lasts, and get as much done as you can, because you will never again be so
productive.
With an apparently inexhaustible sum of money sitting safely in the bank, the
founders happily set to work turning their prototype into something they can
release. They hire one of their friends—at first just as a consultant, so they
can try him out—and then a month later as employee #1. They pay him the
smallest salary he can live on, plus 3% of the company in restricted stock,
vesting over four years. (So after this the option pool is down to 13.7%). [7]
They also spend a little money on a freelance graphic designer.
How much stock do you give early employees? That varies so much that there’s
no conventional number. If you get someone really good, really early, it might
be wise to give him as much stock as the founders. The one universal rule is
that the amount of stock an employee gets decreases polynomially with the age
of the company. In other words, you get rich as a power of how early you were.
So if some friends want you to come work for their startup, don’t wait several
months before deciding.
A month later, at the end of month four, our group of founders has something
they can launch. Gradually through word of mouth they start to get users.
Seeing the system in use by real users—people they don’t know—gives them
lots of new ideas. Also they find they now worry obsessively about the status of
their server. (How relaxing founders’ lives must have been when startups wrote
VisiCalc.)
By the end of month six, the system is starting to have a solid core of features,
and a small but devoted following. People start to write about it, and the
founders are starting to feel like experts in their field.
We’ll assume that their startup is one that could put millions more to use.
Perhaps they need to spend a lot on marketing, or build some kind of expensive
infrastructure, or hire highly paid salesmen. So they decide to start talking to
VCs. They get introductions to VCs from various sources: their angel investor
connects them with a couple; they meet a few at conferences; a couple VCs call
them after reading about them.
Step 3: Series A Round
Armed with their now somewhat fleshed-out business plan and able to demo
a real, working system, the founders visit the VCs they have introductions
to. They find the VCs intimidating and inscrutable. They all ask the same
question: who else have you pitched to? (VCs are like high school girls: they’re
acutely aware of their position in the VC pecking order, and their interest in a
company is a function of the interest other VCs show in it.)
One of the VC firms says they want to invest and offers the founders a term
sheet. A term sheet is a summary of what the deal terms will be when and if
they do a deal; lawyers will fill in the details later. By accepting the term sheet,
the startup agrees to turn away other VCs for some set amount of time while
this firm does the “due diligence” required for the deal. Due diligence is the
corporate equivalent of a background check: the purpose is to uncover any
hidden bombs that might sink the company later, like serious design flaws in
the product, pending lawsuits against the company, intellectual property issues,
and so on. VCs’ legal and financial due diligence is pretty thorough, but the
technical due diligence is generally a joke. [8]
The due diligence discloses no ticking bombs, and six weeks later they go ahead
with the deal. Here are the terms: a $2 million investment at a pre-money
valuation of $4 million, meaning that after the deal closes the VCs will own a
third of the company (2 / (4 + 2)). The VCs also insist that prior to the deal the
option pool be enlarged by an additional hundred shares. So the total number
of new shares issued is 750, and the cap table becomes:
Shareholder
Shares
Percent
VCs
650
33.3
Angel
200
10.3
Uncle
50
2.6
Each Founder
250
12.8
Employee
36*
1.8
Option Pool
264
13.5
Total
1950
100
*unvested
This picture is unrealistic in several respects. For example, while the
percentages might end up looking like this, it’s unlikely that the VCs would
keep the existing numbers of shares. In fact, every bit of the startup’s paperwork
would probably be replaced, as if the company were being founded anew. Also,
the money might come in several tranches, the later ones subject to various
conditions—though this is apparently more common in deals with lower-tier
VCs (whose lot in life is to fund more dubious startups) than with the top
firms.
And of course any VCs reading this are probably rolling on the floor laughing at
how my hypothetical VCs let the angel keep his 10.3 of the company. I admit,
this is the Bambi version; in simplifying the picture, I’ve also made everyone
nicer. In the real world, VCs regard angels the way a jealous husband feels about
his wife’s previous boyfriends. To them the company didn’t exist before they
invested in it. [9]
I don’t want to give the impression you have to do an angel round before going
to VCs. In this example I stretched things out to show multiple sources of
funding in action. Some startups could go directly from seed funding to a VC
round; several of the companies we’ve funded have.
The founders are required to vest their shares over four years, and the board
is now reconstituted to consist of two VCs, two founders, and a fifth person
acceptable to both. The angel investor cheerfully surrenders his board seat.
At this point there is nothing new our startup can teach us about funding—or
at least, nothing good. [10] The startup will almost certainly hire more people
at this point; those millions must be put to work, after all. The company may
do additional funding rounds, presumably at higher valuations. They may if
they are extraordinarily fortunate do an IPO, which we should remember is also
in principle a round of funding, regardless of its de facto purpose. But that, if
not beyond the bounds of possibility, is beyond the scope of this article.
Deals Fall Through
Anyone who’s been through a startup will find the preceding portrait to be
missing something: disasters. If there’s one thing all startups have in common,
it’s that something is always going wrong. And nowhere more than in matters of
funding.
For example, our hypothetical startup never spent more than half of one round
before securing the next. That’s more ideal than typical. Many startups—even
successful ones—come close to running out of money at some point. Terrible
things happen to startups when they run out of money, because they’re designed
for growth, not adversity.
But the most unrealistic thing about the series of deals I’ve described is that
they all closed. In the startup world, closing is not what deals do. What deals do
is fall through. If you’re starting a startup you would do well to remember that.
Birds fly; fish swim; deals fall through.
Why? Partly the reason deals seem to fall through so often is that you lie to
yourself. You want the deal to close, so you start to believe it will. But even
correcting for this, startup deals fall through alarmingly often—far more
often than, say, deals to buy real estate. The reason is that it’s such a risky
environment. People about to fund or acquire a startup are prone to wicked
cases of buyer’s remorse. They don’t really grasp the risk they’re taking till the
deal’s about to close. And then they panic. And not just inexperienced angel
investors, but big companies too.
So if you’re a startup founder wondering why some angel investor isn’t returning
your phone calls, you can at least take comfort in the thought that the same
thing is happening to other deals a hundred times the size.
The example of a startup’s history that I’ve presented is like a skeleton—
accurate so far as it goes, but needing to be fleshed out to be a complete picture.
To get a complete picture, just add in every possible disaster.
A frightening prospect? In a way. And yet also in a way encouraging. The
very uncertainty of startups frightens away almost everyone. People overvalue
stability—especially young people, who ironically need it least. And so in
starting a startup, as in any really bold undertaking, merely deciding to do it
gets you halfway there. On the day of the race, most of the other runners won’t
show up.
Notes
[1] The aim of such regulations is to protect widows and orphans from crooked investment schemes;
people with a million dollars in liquid assets are assumed to be able to protect themselves. The unintended
consequence is that the investments that generate the highest returns, like hedge funds, are available only to
the rich.
[2] Consulting is where product companies go to die. IBM is the most famous example. So starting as a
consulting company is like starting out in the grave and trying to work your way up into the world of the
living.
[3] If “near you” doesn’t mean the Bay Area, Boston, or Seattle, consider moving. It’s not a coincidence you
haven’t heard of many startups from Philadelphia.
[4] Investors are often compared to sheep. And they are like sheep, but that’s a rational response to their
situation. Sheep act the way they do for a reason. If all the other sheep head for a certain field, it’s probably
good grazing. And when a wolf appears, is he going to eat a sheep in the middle of the flock, or one near the
edge?
[5] This was partly confidence, and partly simple ignorance. We didn’t know ourselves which VC firms
were the impressive ones. We thought software was all that mattered. But that turned out to be the right
direction to be naive in: it’s much better to overestimate than underestimate the importance of making a
good product.
[6] I’ve omitted one source: government grants. I don’t think these are even worth thinking about for the
average startup. Governments may mean well when they set up grant programs to encourage startups,
but what they give with one hand they take away with the other: the process of applying is inevitably so
arduous, and the restrictions on what you can do with the money so burdensome, that it would be easier to
take a job to get the money.
You should be especially suspicious of grants whose purpose is some kind of social engineering—e.g. to
encourage more startups to be started in Mississippi. Free money to start a startup in a place where few
succeed is hardly free.
Some government agencies run venture funding groups, which make investments rather than giving grants.
For example, the CIA runs a venture fund called In-Q-Tel that is modeled on private sector funds and
apparently generates good returns. They would probably be worth approaching—if you don’t mind taking
money from the CIA.
[7] Options have largely been replaced with restricted stock, which amounts to the same thing. Instead of
earning the right to buy stock, the employee gets the stock up front, and earns the right not to have to give
it back. The shares set aside for this purpose are still called the “option pool.”
[8] First-rate technical people do not generally hire themselves out to do due diligence for VCs. So the most
difficult part for startup founders is often responding politely to the inane questions of the “expert” they
send to look you over.
[9] VCs regularly wipe out angels by issuing arbitrary amounts of new stock. They seem to have a standard
piece of casuistry for this situation: that the angels are no longer working to help the company, and so don’t
deserve to keep their stock. This of course reflects a willful misunderstanding of what investment means;
like any investor, the angel is being compensated for risks he took earlier. By a similar logic, one could argue
that the VCs should be deprived of their shares when the company goes public.
[10] One new thing the company might encounter is a down round, or a funding round at valuation lower
than the previous round. Down rounds are bad news; it is generally the common stock holders who take
the hit. Some of the most fearsome provisions in VC deal terms have to do with down rounds—like “full
ratchet anti-dilution,” which is as frightening as it sounds.
Founders are tempted to ignore these clauses, because they think the company will either be a big success or
a complete bust. VCs know otherwise: it’s not uncommon for startups to have moments of adversity before
they ultimately succeed. So it’s worth negotiating anti-dilution provisions, even though you don’t think you
need to, and VCs will try to make you feel that you’re being gratuitously troublesome.
What Every Startup Should Know About Investors
Paul Graham: The Hacker’s Guide to Investors
(This essay is derived from a keynote talk at the 2007 ASES Summit at Stanford
University.)
The world of investors is a foreign one to most hackers—partly because
investors are so unlike hackers, and partly because they tend to operate in
secret. I’ve been dealing with this world for many years, both as a founder and
an investor, and I still don’t fully understand it.
In this essay I’m going to list some of the more surprising things I’ve learned
about investors. Some I only learned in the past year.
Teaching hackers how to deal with investors is probably the second most
important thing we do at Y Combinator. The most important thing for a
startup is to make something good. But everyone knows that’s important. The
dangerous thing about investors is that hackers don’t know how little they know
about this strange world.
1. The investors are what make a startup hub.
About a year ago I tried to figure out what you’d need to reproduce Silicon
Valley. I decided the critical ingredients were rich people and nerds—investors
and founders. People are all you need to make technology, and all the other
people will move.
If I had to narrow that down, I’d say investors are the limiting factor. Not
because they contribute more to the startup, but simply because they’re least
willing to move. They’re rich. They’re not going to move to Albuquerque just
because there are some smart hackers there they could invest in. Whereas
hackers will move to the Bay Area to find investors.
2. Angel investors are the most critical.
There are several types of investors. The two main categories are angels and
VCs: VCs invest other people’s money, and angels invest their own.
Though they’re less well known, the angel investors are probably the more
critical ingredient in creating a silicon valley. Most companies that VCs invest
in would never have made it that far if angels hadn’t invested first. VCs say
between half and three quarters of companies that raise series A rounds have
taken some outside investment already. [1]
Angels are willing to fund riskier projects than VCs. They also give valuable
advice, because (unlike VCs) many have been startup founders themselves.
Google’s story shows the key role angels play. A lot of people know Google
raised money from Kleiner and Sequoia. What most don’t realize is how late.
That VC round was a series B round; the premoney valuation was $75 million.
Google was already a successful company at that point. Really, Google was
funded with angel money.
It may seem odd that the canonical Silicon Valley startup was funded by angels,
but this is not so surprising. Risk is always proportionate to reward. So the most
successful startup of all is likely to have seemed an extremely risky bet at first,
and that is exactly the kind VCs won’t touch.
Where do angel investors come from? From other startups. So startup hubs like
Silicon Valley benefit from something like the marketplace effect, but shifted in
time: startups are there because startups were there.
3. Angels don’t like publicity.
If angels are so important, why do we hear more about VCs? Because VCs
like publicity. They need to market themselves to the investors who are their
“customers”—the endowments and pension funds and rich families whose
money they invest—and also to founders who might come to them for funding.
Angels don’t need to market themselves to investors because they invest their
own money. Nor do they want to market themselves to founders: they don’t
want random people pestering them with business plans. Actually, neither
do VCs. Both angels and VCs get deals almost exclusively through personal
introductions. [2]
The reason VCs want a strong brand is not to draw in more business plans
over the transom, but so they win deals when competing against other VCs.
Whereas angels are rarely in direct competition, because (a) they do fewer deals,
(b) they’re happy to split them, and (c) they invest at a point where the stream is
broader.
4. Most investors, especially VCs, are not like founders.
Some angels are, or were, hackers. But most VCs are a different type of people:
they’re dealmakers.
If you’re a hacker, here’s a thought experiment you can run to understand why
there are basically no hacker VCs: How would you like a job where you never
got to make anything, but instead spent all your time listening to other people
pitch (mostly terrible) projects, deciding whether to fund them, and sitting on
their boards if you did? That would not be fun for most hackers. Hackers like
to make things. This would be like being an administrator.
Because most VCs are a different species of people from founders, it’s hard to
know what they’re thinking. If you’re a hacker, the last time you had to deal
with these guys was in high school. Maybe in college you walked past their
fraternity on your way to the lab. But don’t underestimate them. They’re as
expert in their world as you are in yours. What they’re good at is reading
people, and making deals work to their advantage. Think twice before you try
to beat them at that.
5. Most investors are momentum investors.
Because most investors are dealmakers rather than technology people, they
generally don’t understand what you’re doing. I knew as a founder that most
VCs didn’t get technology. I also knew some made a lot of money. And yet it
never occurred to me till recently to put those two ideas together and ask “How
can VCs make money by investing in stuff they don’t understand?”
The answer is that they’re like momentum investors. You can (or could once)
make a lot of money by noticing sudden changes in stock prices. When a stock
jumps upward, you buy, and when it suddenly drops, you sell. In effect you’re
insider trading, without knowing what you know. You just know someone
knows something, and that’s making the stock move.
This is how most venture investors operate. They don’t try to look at something
and predict whether it will take off. They win by noticing that something is
taking off a little sooner than everyone else. That generates almost as good
returns as actually being able to pick winners. They may have to pay a little
more than they would if they got in at the very beginning, but only a little.
Investors always say what they really care about is the team. Actually what
they care most about is your traffic, then what other investors think, then the
team. If you don’t yet have any traffic, they fall back on number 2, what other
investors think. And this, as you can imagine, produces wild oscillations in the
“stock price” of a startup. One week everyone wants you, and they’re begging
not to be cut out of the deal. But all it takes is for one big investor to cool on
you, and the next week no one will return your phone calls. We regularly have
startups go from hot to cold or cold to hot in a matter of days, and literally
nothing has changed.
There are two ways to deal with this phenomenon. If you’re feeling really
confident, you can try to ride it. You can start by asking a comparatively lowly
VC for a small amount of money, and then after generating interest there, ask
more prestigious VCs for larger amounts, stirring up a crescendo of buzz, and
then “sell” at the top. This is extremely risky, and takes months even if you
succeed. I wouldn’t try it myself. My advice is to err on the side of safety: when
someone offers you a decent deal, just take it and get on with building the
company. Startups win or lose based on the quality of their product, not the
quality of their funding deals.
6. Most investors are looking for big hits.
Venture investors like companies that could go public. That’s where the big
returns are. They know the odds of any individual startup going public are
small, but they want to invest in those that at least have a chance of going
public.
Currently the way VCs seem to operate is to invest in a bunch of companies,
most of which fail, and one of which is Google. Those few big wins compensate
for losses on their other investments. What this means is that most VCs will
only invest in you if you’re a potential Google. They don’t care about companies
that are a safe bet to be acquired for $20 million. There needs to be a chance,
however small, of the company becoming really big.
Angels are different in this respect. They’re happy to invest in a company where
the most likely outcome is a $20 million acquisition if they can do it at a low
enough valuation. But of course they like companies that could go public too.
So having an ambitious long-term plan pleases everyone.
If you take VC money, you have to mean it, because the structure of VC deals
prevents early acquisitions. If you take VC money, they won’t let you sell early.
7. VCs want to invest large amounts.
The fact that they’re running investment funds makes VCs want to invest large
amounts. A typical VC fund is now hundreds of millions of dollars. If $400
million has to be invested by 10 partners, they have to invest $40 million each.
VCs usually sit on the boards of companies they fund. If the average deal size
was $1 million, each partner would have to sit on 40 boards, which would not
be fun. So they prefer bigger deals, where they can put a lot of money to work
at once.
VCs don’t regard you as a bargain if you don’t need a lot of money. That may
even make you less attractive, because it means their investment creates less of a
barrier to entry for competitors.
Angels are in a different position because they’re investing their own money.
They’re happy to invest small amounts—sometimes as little as $20,000—as
long as the potential returns look good enough. So if you’re doing something
inexpensive, go to angels.
8. Valuations are fiction.
VCs admit that valuations are an artifact. They decide how much money you
need and how much of the company they want, and those two constraints yield
a valuation.
Valuations increase as the size of the investment does. A company that an angel
is willing to put $50,000 into at a valuation of a million can’t take $6 million
from VCs at that valuation. That would leave the founders less than a seventh
of the company between them (since the option pool would also come out of
that seventh). Most VCs wouldn’t want that, which is why you never hear of
deals where a VC invests $6 million at a premoney valuation of $1 million.
If valuations change depending on the amount invested, that shows how far
they are from reflecting any kind of value of the company.
Since valuations are made up, founders shouldn’t care too much about them.
That’s not the part to focus on. In fact, a high valuation can be a bad thing. If
you take funding at a premoney valuation of $10 million, you won’t be selling
the company for 20. You’ll have to sell for over 50 for the VCs to get even a
5x return, which is low to them. More likely they’ll want you to hold out for
100. But needing to get a high price decreases the chance of getting bought at
all; many companies can buy you for $10 million, but only a handful for 100.
And since a startup is like a pass/fail course for the founders, what you want to
optimize is your chance of a good outcome, not the percentage of the company
you keep.
So why do founders chase high valuations? They’re tricked by misplaced
ambition. They feel they’ve achieved more if they get a higher valuation. They
usually know other founders, and if they get a higher valuation they can say
“mine is bigger than yours.” But funding is not the real test. The real test is the
final outcome for the founder, and getting too high a valuation may just make a
good outcome less likely.
The one advantage of a high valuation is that you get less dilution. But there is
another less sexy way to achieve that: just take less money.
9. Investors look for founders like the current stars.
Ten years ago investors were looking for the next Bill Gates. This was a mistake,
because Microsoft was a very anomalous startup. They started almost as a
contract programming operation, and the reason they became huge was that
IBM happened to drop the PC standard in their lap.
Now all the VCs are looking for the next Larry and Sergey. This is a good
trend, because Larry and Sergey are closer to the ideal startup founders.
Historically investors thought it was important for a founder to be an expert
in business. So they were willing to fund teams of MBAs who planned to
use the money to pay programmers to build their product for them. This is
like funding Steve Ballmer in the hope that the programmer he’ll hire is Bill
Gates—kind of backward, as the events of the Bubble showed. Now most VCs
know they should be funding technical guys. This is more pronounced among
the very top funds; the lamer ones still want to fund MBAs.
If you’re a hacker, it’s good news that investors are looking for Larry and Sergey.
The bad news is, the only investors who can do it right are the ones who knew
them when they were a couple of CS grad students, not the confident media
stars they are today. What investors still don’t get is how clueless and tentative
great founders can seem at the very beginning.
10. The contribution of investors tends to be underestimated.
Investors do more for startups than give them money. They’re helpful in
doing deals and arranging introductions, and some of the smarter ones,
particularly angels, can give good advice about the product.
In fact, I’d say what separates the great investors from the mediocre ones is the
quality of their advice. Most investors give advice, but the top ones give good
advice.
Whatever help investors give a startup tends to be underestimated. It’s to
everyone’s advantage to let the world think the founders thought of everything.
The goal of the investors is for the company to become valuable, and the
company seems more valuable if it seems like all the good ideas came from
within.
This trend is compounded by the obsession that the press has with founders. In
a company founded by two people, 10% of the ideas might come from the first
guy they hire. Arguably they’ve done a bad job of hiring otherwise. And yet this
guy will be almost entirely overlooked by the press.
I say this as a founder: the contribution of founders is always overestimated.
The danger here is that new founders, looking at existing founders, will think
that they’re supermen that one couldn’t possibly equal oneself. Actually they
have a hundred different types of support people just off screen making the
whole show possible. [3]
11. VCs are afraid of looking bad.
I’ve been very surprised to discover how timid most VCs are. They seem to
be afraid of looking bad to their partners, and perhaps also to the limited
partners—the people whose money they invest.
You can measure this fear in how much less risk VCs are willing to take. You
can tell they won’t make investments for their fund that they might be willing
to make themselves as angels. Though it’s not quite accurate to say that VCs are
less willing to take risks. They’re less willing to do things that might look bad.
That’s not the same thing.
For example, most VCs would be very reluctant to invest in a startup founded
by a pair of 18 year old hackers, no matter how brilliant, because if the startup
failed their partners could turn on them and say “What, you invested $x
million of our money in a pair of 18 year olds?” Whereas if a VC invested in a
startup founded by three former banking executives in their 40s who planned
to outsource their product development—which to my mind is actually a lot
riskier than investing in a pair of really smart 18 year olds—he couldn’t be
faulted, if it failed, for making such an apparently prudent investment.
As a friend of mine said, “Most VCs can’t do anything that would sound bad
to the kind of doofuses who run pension funds.” Angels can take greater risks
because they don’t have to answer to anyone.
12. Being turned down by investors doesn’t mean much.
Some founders are quite dejected when they get turned down by investors. They
shouldn’t take it so much to heart. To start with, investors are often wrong. It’s
hard to think of a successful startup that wasn’t turned down by investors at
some point. Lots of VCs rejected Google. So obviously the reaction of investors
is not a very meaningful test.
Investors will often reject you for what seem to be superficial reasons. I read
of one VC who turned down a startup simply because they’d given away so
many little bits of stock that the deal required too many signatures to close. [4]
The reason investors can get away with this is that they see so many deals. It
doesn’t matter if they underestimate you because of some surface imperfection,
because the next best deal will be almost as good. Imagine picking out apples at
a grocery store. You grab one with a little bruise. Maybe it’s just a surface bruise,
but why even bother checking when there are so many other unbruised apples
to choose from?
Investors would be the first to admit they’re often wrong. So when you get
rejected by investors, don’t think “we suck,” but instead ask “do we suck?”
Rejection is a question, not an answer.
13. Investors are emotional.
I’ve been surprised to discover how emotional investors can be. You’d expect
them to be cold and calculating, or at least businesslike, but often they’re not.
I’m not sure if it’s their position of power that makes them this way, or the large
sums of money involved, but investment negotiations can easily turn personal.
If you offend investors, they’ll leave in a huff.
A while ago an eminent VC firm offered a series A round to a startup we’d
seed funded. Then they heard a rival VC firm was also interested. They were
so afraid that they’d be rejected in favor of this other firm that they gave the
startup what’s known as an “exploding term sheet.” They had, I think, 24 hours
to say yes or no, or the deal was off. Exploding term sheets are a somewhat
dubious device, but not uncommon. What surprised me was their reaction
when I called to talk about it. I asked if they’d still be interested in the startup
if the rival VC didn’t end up making an offer, and they said no. What rational
basis could they have had for saying that? If they thought the startup was worth
investing in, what difference should it make what some other VC thought?
Surely it was their duty to their limited partners simply to invest in the best
opportunities they found; they should be delighted if the other VC said no,
because it would mean they’d overlooked a good opportunity. But of course
there was no rational basis for their decision. They just couldn’t stand the idea
of taking this rival firm’s rejects.
In this case the exploding term sheet was not (or not only) a tactic to pressure
the startup. It was more like the high school trick of breaking up with someone
before they can break up with you. In an earlier essay I said that VCs were a lot
like high school girls. A few VCs have joked about that characterization, but
none have disputed it.
14. The negotiation never stops till the closing.
Most deals, for investment or acquisition, happen in two phases. There’s an
initial phase of negotiation about the big questions. If this succeeds you get a
term sheet, so called because it outlines the key terms of a deal. A term sheet
is not legally binding, but it is a definite step. It’s supposed to mean that a deal
is going to happen, once the lawyers work out all the details. In theory these
details are minor ones; by definition all the important points are supposed to be
covered in the term sheet.
Inexperience and wishful thinking combine to make founders feel that when
they have a term sheet, they have a deal. They want there to be a deal; everyone
acts like they have a deal; so there must be a deal. But there isn’t and may
not be for several months. A lot can change for a startup in several months.
It’s not uncommon for investors and acquirers to get buyer’s remorse. So you
have to keep pushing, keep selling, all the way to the close. Otherwise all the
“minor” details left unspecified in the term sheet will be interpreted to your
disadvantage. The other side may even break the deal; if they do that, they’ll
usually seize on some technicality or claim you misled them, rather than
admitting they changed their minds.
It can be hard to keep the pressure on an investor or acquirer all the way to
the closing, because the most effective pressure is competition from other
investors or acquirers, and these tend to drop away when you get a term sheet.
You should try to stay as close friends as you can with these rivals, but the
most important thing is just to keep up the momentum in your startup. The
investors or acquirers chose you because you seemed hot. Keep doing whatever
made you seem hot. Keep releasing new features; keep getting new users; keep
getting mentioned in the press and in blogs.
15. Investors like to co-invest.
I’ve been surprised how willing investors are to split deals. You might think
that if they found a good deal they’d want it all to themselves, but they seem
positively eager to syndicate. This is understandable with angels; they invest on
a smaller scale and don’t like to have too much money tied up in any one deal.
But VCs also share deals a lot. Why?
Partly I think this is an artifact of the rule I quoted earlier: after traffic, VCs
care most what other VCs think. A deal that has multiple VCs interested in it is
more likely to close, so of deals that close, more will have multiple investors.
There is one rational reason to want multiple VCs in a deal: Any investor
who co-invests with you is one less investor who could fund a competitor.
Apparently Kleiner and Sequoia didn’t like splitting the Google deal, but it did
at least have the advantage, from each one’s point of view, that there probably
wouldn’t be a competitor funded by the other. Splitting deals thus has similar
advantages to confusing paternity.
But I think the main reason VCs like splitting deals is the fear of looking bad.
If another firm shares the deal, then in the event of failure it will seem to have
been a prudent choice—a consensus decision, rather than just the whim of an
individual partner.
16. Investors collude.
Investing is not covered by antitrust law. At least, it better not be, because
investors regularly do things that would be illegal otherwise. I know personally
of cases where one investor has talked another out of making a competitive
offer, using the promise of sharing future deals.
In principle investors are all competing for the same deals, but the spirit of
cooperation is stronger than the spirit of competition. The reason, again,
is that there are so many deals. Though a professional investor may have a
closer relationship with a founder he invests in than with other investors, his
relationship with the founder is only going to last a couple years, whereas his
relationship with other firms will last his whole career. There isn’t so much at
stake in his interactions with other investors, but there will be a lot of them.
Professional investors are constantly trading little favors.
Another reason investors stick together is to preserve the power of investors
as a whole. So you will not, as of this writing, be able to get investors into an
auction for your series A round. They’d rather lose the deal than establish
a precedent of VCs competitively bidding against one another. An efficient
startup funding market may be coming in the distant future; things tend to
move in that direction; but it’s certainly not here now.
17. Large-scale investors care about their portfolio, not any individual
company.
The reason startups work so well is that everyone with power also has equity.
The only way any of them can succeed is if they all do. This makes everyone
naturally pull in the same direction, subject to differences of opinion about
tactics.
The problem is, larger scale investors don’t have exactly the same motivation.
Close, but not identical. They don’t need any given startup to succeed, like
founders do, just their portfolio as a whole to. So in borderline cases the rational
thing for them to do is to sacrifice unpromising startups.
Large-scale investors tend to put startups in three categories: successes, failures,
and the “living dead”—companies that are plugging along but don’t seem likely
in the immediate future to get bought or go public. To the founders, “living
dead” sounds harsh. These companies may be far from failures by ordinary
standards. But they might as well be from a venture investor’s point of view,
and they suck up just as much time and attention as the successes. So if such
a company has two possible strategies, a conservative one that’s slightly more
likely to work in the end, or a risky one that within a short time will either yield
a giant success or kill the company, VCs will push for the kill-or-cure option.
To them the company is already a write-off. Better to have resolution, one way
or the other, as soon as possible.
If a startup gets into real trouble, instead of trying to save it VCs may just sell it
at a low price to another of their portfolio companies. Philip Greenspun said in
Founders at Work that Ars Digita’s VCs did this to them.
18. Investors have different risk profiles from founders.
Most people would rather a 100% chance of $1 million than a 20% chance of
$10 million. Investors are rich enough to be rational and prefer the latter. So
they’ll always tend to encourage founders to keep rolling the dice. If a company
is doing well, investors will want founders to turn down most acquisition offers.
And indeed, most startups that turn down acquisition offers ultimately do
better. But it’s still hair-raising for the founders, because they might end up with
nothing. When someone’s offering to buy you for a price at which your stock is
worth $5 million, saying no is equivalent to having $5 million and betting it all
on one spin of the roulette wheel.
Investors will tell you the company is worth more. And they may be right. But
that doesn’t mean it’s wrong to sell. Any financial advisor who put all his client’s
assets in the stock of a single, private company would probably lose his license
for it.
More and more, investors are letting founders cash out partially. That should
correct the problem. Most founders have such low standards that they’ll
feel rich with a sum that doesn’t seem huge to investors. But this custom is
spreading too slowly, because VCs are afraid of seeming irresponsible. No one
wants to be the first VC to give someone fuck-you money and then actually get
told “fuck you.” But until this does start to happen, we know VCs are being too
conservative.
19. Investors vary greatly.
Back when I was a founder I used to think all VCs were the same. And in
fact they do all look the same. They’re all what hackers call “suits.” But since
I’ve been dealing with VCs more I’ve learned that some suits are smarter than
others.
They’re also in a business where winners tend to keep winning and losers
to keep losing. When a VC firm has been successful in the past, everyone
wants funding from them, so they get the pick of all the new deals. The selfreinforcing nature of the venture funding market means that the top ten firms
live in a completely different world from, say, the hundredth. As well as being
smarter, they tend to be calmer and more upstanding; they don’t need to do
iffy things to get an edge, and don’t want to because they have more brand to
protect.
There are only two kinds of VCs you want to take money from, if you have the
luxury of choosing: the “top tier” VCs, meaning about the top 20 or so firms,
plus a few new ones that are not among the top 20 only because they haven’t
been around long enough.
It’s particularly important to raise money from a top firm if you’re a hacker,
because they’re more confident. That means they’re less likely to stick you with
a business guy as CEO, like VCs used to do in the 90s. If you seem smart and
want to do it, they’ll let you run the company.
20. Investors don’t realize how much it costs to raise money from them.
Raising money is a huge time suck at just the point where startups can least
afford it. It’s not unusual for it to take five or six months to close a funding
round. Six weeks is fast. And raising money is not just something you can leave
running as a background process. When you’re raising money, it’s inevitably the
main focus of the company. Which means building the product isn’t.
Suppose a Y Combinator company starts talking to VCs after demo day, and is
successful in raising money from them, closing the deal after a comparatively
short 8 weeks. Since demo day occurs after 10 weeks, the company is now 18
weeks old. Raising money, rather than working on the product, has been the
company’s main focus for 44% of its existence. And mind you, this an example
where things turned out well.
When a startup does return to working on the product after a funding round
finally closes, it’s as if they were returning to work after a months-long illness.
They’ve lost most of their momentum.
Investors have no idea how much they damage the companies they invest in by
taking so long to do it. But companies do. So there is a big opportunity here for
a new kind of venture fund that invests smaller amounts at lower valuations,
but promises to either close or say no very quickly. If there were such a firm, I’d
recommend it to startups in preference to any other, no matter how prestigious.
Startups live on speed and momentum.
21. Investors don’t like to say no.
The reason funding deals take so long to close is mainly that investors can’t
make up their minds. VCs are not big companies; they can do a deal in 24
hours if they need to. But they usually let the initial meetings stretch out over
a couple weeks. The reason is the selection algorithm I mentioned earlier. Most
don’t try to predict whether a startup will win, but to notice quickly that it
already is winning. They care what the market thinks of you and what other
VCs think of you, and they can’t judge those just from meeting you.
Because they’re investing in things that (a) change fast and (b) they don’t
understand, a lot of investors will reject you in a way that can later be claimed
not to have been a rejection. Unless you know this world, you may not even
realize you’ve been rejected. Here’s a VC saying no:
We’re really excited about your project, and we want to keep in close
touch as you develop it further.
Translated into more straightforward language, this means: We’re not investing
in you, but we may change our minds if it looks like you’re taking off.
Sometimes they’re more candid and say explicitly that they need to “see some
traction.” They’ll invest in you if you start to get lots of users. But so would any
VC. So all they’re saying is that you’re still at square 1.
Here’s a test for deciding whether a VCs response was yes or no. Look down at
your hands. Are you holding a term sheet?
22. You need investors.
Some founders say “Who needs investors?” Empirically the answer seems to
be: everyone who wants to succeed. Practically every successful startup takes
outside investment at some point.
Why? What the people who think they don’t need investors forget is that
they will have competitors. The question is not whether you need outside
investment, but whether it could help you at all. If the answer is yes, and you
don’t take investment, then competitors who do will have an advantage over
you. And in the startup world a little advantage can expand into a lot.
Mike Moritz famously said that he invested in Yahoo! because he thought they
had a few weeks’ lead over their competitors. That may not have mattered quite
so much as he thought, because Google came along three years later and kicked
Yahoo!’s ass. But there is something in what he said. Sometimes a small lead
can grow into the yes half of a binary choice.
Maybe as it gets cheaper to start a startup, it will start to be possible to succeed
in a competitive market without outside funding. There are certainly costs to
raising money. But as of this writing the empirical evidence says it’s a net win.
23. Investors like it when you don’t need them.
A lot of founders approach investors as if they needed their permission to start a
company—as if it were like getting into college. But you don’t need investors to
start most companies; they just make it easier.
And in fact, investors greatly prefer it if you don’t need them. What excites
them, both consciously and unconsciously, is the sort of startup that approaches
them saying “the train’s leaving the station; are you in or out?” not the one
saying “please can we have some money to start a company?”
Most investors are “bottoms” in the sense that the startups they like most are
those that are rough with them. When Google stuck Kleiner and Sequoia with
a $75 million premoney valuation, their reaction was probably “Ouch! That
feels so good.” And they were right, weren’t they? That deal probably made
them more than any other they’ve done.
The thing is, VCs are pretty good at reading people. So don’t try to act tough
with them unless you really are the next Google, or they’ll see through you in a
second. Instead of acting tough, what most startups should do is simply always
have a backup plan. Always have some alternative plan for getting started if any
given investor says no. Having one is the best insurance against needing one.
So you shouldn’t start a startup that’s expensive to start, because then you’ll be
at the mercy of investors. If you ultimately want to do something that will cost
a lot, start by doing a cheaper subset of it, and expand your ambitions when and
if you raise more money.
Apparently the most likely animals to be left alive after a nuclear war are
cockroaches, because they’re so hard to kill. That’s what you want to be
as a startup, initially. Instead of a beautiful but fragile flower that needs to
have its stem in a plastic tube to support itself, better to be small, ugly, and
indestructible.
Notes
[1] I may be underestimating VCs. They may play some behind the scenes role in IPOs, which you
ultimately need if you want to create a silicon valley.
[2] A few VCs have an email address you can send your business plan to, but the number of startups that
get funded this way is basically zero. You should always get a personal introduction—and to a partner, not
an associate.
[3] Several people have told us that the most valuable thing about startup school was that they got to see
famous startup founders and realized they were just ordinary guys. Though we’re happy to provide this
service, this is not generally the way we pitch startup school to potential speakers.
[4] Actually this sounds to me like a VC who got buyer’s remorse, then used a technicality to get out of the
deal. But it’s telling that it even seemed a plausible excuse.
Mark Suster: Angel Funding Advice
This post is for those who want to raise angel money. My goal is to describe
how, with whom, how to find them, how much to raise and at what value.
Definitely not a short post (sorry for letting you down, Ari). So if you’re
casually reading and don’t really care about angel financing – abort now! I’ll
make my next posting shorter.
If you really want to know about the topic I hope this will be worth your time.
How:
1. Good idea & plan: You must start with a good idea and a
PowerPoint deck. Jarl Mohn says he hates seeing PowerPoint.
I get that. But some people will want to see it. So you need to
do one and have it in your back pocket ready to whip out your
presentation or your laptop at any moment and go through it in
case you’re asked or in case you’re not building the rapport you
hope to just verbally. It is also the best thing to send in advance.
2. Team: You need a team. Very few people fund individuals. I won’t
say never but having a team validates that you can attract people
to the cause. Better if they’re full time rather than moonlighting
but take what you can get.
3. Product: You should build a product or a prototype. I’m a
software guy so I’m sure there are cases where building isn’t
feasible. But for most businesses it is. In most cases if you can’t get
a prototype done you’re probably not an entrepreneur. That’s OK.
99.8% of people aren’t. But there really are very few excuses in
this day and age for not having a prototype.
I know you’re not a tech guy and haven’t done anything other
than an HTML course you once took, but if you’re inspirational
and a leader you’ll find somebody to moonlight for free to get
your prototype built. If you can’t do wireframes, learn how. If you
don’t know what wireframes are you should.
Go research it. You cannot be just a biz dev type, salesperson,
marketing genius or whatever and divorce yourself from product.
Great companies are built by having great products. And a great
product starts with the founder.
4. Market validation: This one is optional but important. At an
angel round you can get away with no market validation. But if
you CAN find a way to even get your 0.1 release out the door and
get some customers using it, or friendly people piloting it then at
least there is some validation to the product and some people to
speak to about their experiences.
If you can’t get product released and validated then do user
studies. Poll people on the problem you’re solving and get their
feedback on why they’d want your product and their willingness
to pay for it. One great company, AppFolio, filmed all of this user
interaction and made the DVD available to me. Granted, it was
for an A round (not angel) but anyone could easily do that for
angel rounds. Stand out from the crowd. Differentiate. Do more
than you are asked to do. And you’ll actually learn more from the
process than you’d imagine.
With Whom?
This is a much-debated topic. For some reason in last night’s discussion it
descended into a discussion of “hairy” dentists and pig farmers (details below).
Here’s a breakdown. If you can raise your money from higher on the list, the
better. But in the end money is money and better that you raise some and get
going than wait too long and lost momentum. Quick caveats: having fewer
investors (3-5) is better than many investors (10-15) and PLEASE make sure
you hire a great lawyer who has experience in doing startups to avoid pitfalls
that will make VC harder down the line. Also, make sure that your investors are
accredited.
1. Professional angels / former entrepreneurs / seed funds – In Silicon
Valley there are people like Ron Conway, Jeff Clavier, Mike Maples
and many more. In SoCal we have Crosscut Ventures, Matt Coffin,
Mike Jones, Klaus Schauser, etc. They exist in every town. They are
people who built and sold companies and have a bit of money. They
have advice to share. They know that the money they invest may be
lost. Their time is too valuable to call you every day wondering if you
spent their $20-$100k wisely. They know all the VCs for intros. Their
name alone is enough to get meetings set up. They are calling cards.
They are full of wisdom. Find out how to meet them in the next
section. They are your best bet. They might be as hard as raising VC.
They are not for everybody. Don’t be despondent if you can’t get their
money. But if you can, you should.
2. Existing tech or industry executives – Do you have strong
relationships in your industry? Do you work in the comedy industry
and know all the venue owners or comedians? Do you work as a civil
engineer on water projects and have great access to wealthy project
developers? The key to getting money is that the people writing the
check trust you. Trust is best earned close to home where people
already know your work. Make sure these people understand the
nature of early-stage angel investing.
I still prefer angel route 1 (above) but this is the next best option in
my mind. Don’t worry if they can’t help in your daily business. There
are other ways you can get help. Surround yourself with great advisors
or other entrepreneurs. Join local organizations like OCTANe,
TechStars or Launchpad LA. If you’re really an entrepreneur you’ll
find a way to network with the right people.
3. Professional angel associations – This one is the source of much
controversy. Some angel groups have a reputation for slow decision
making processes and not enough value add. I’ve been to panels where
people feel that some angel groups ask for onerous terms that make
the VC round more difficult – this came up at last night’s panel.
I can’t really speak generically to this because the Tech Coast Angels
/ Pasadena in SoCal have produced Green Dot, MyShape and many
other successes. And each town has their own group. I can say that
you should do your homework to find out the reputation. And just
like with VCs – it is as much the partner your working wit as the
group more broadly.
So I don’t think you can say a group like Tech Coast Angels is good or
bad. They have great people and probably some duffers. Scott Sangster
has made a good case for himself at the two events I’ve seen him speak
at recently and I know that people love Bryce Benjamin and say he’s
hands on / helpful.
4. Hairy dentists / Pig farmers – I told the story last night how when
I set up my first company the seed investor was a pig farmer from
Ireland. That is a true story. It helps that my first company was
actually founded in Ireland! But the point is the same. He was a very
nice guy but zero value add. And whenever I needed to round up
signatures for future fund raisings it was difficult to track him down/
get him to care. The pure delays due to admin if I would have had 3-4
pig farmers would have killed me.
I don’t know where the term “hairy dentist” came from last night,
but it was a funny euphemism. I think it stands for those people who
have money but not the sophistication to understand the world of
early-stage tech funding. When I write an angel round check I always
tell me wife, “let’s assume that money is lost.” So goes angel investing.
I don’t think that hairy dentists really expect that. They have an
expectation that the IPO will be in 3 years and they were in at the
ground floor. If all goes well from day 1 they’ll love you. If, like many
businesses, you go through some rough patches, hairy dentists can
make life more difficult. But none more difficult and … option 5.
5. Friends, family & fools – I know everybody likes to start by thinking
of the 3 F’s, but I don’t recommend the first 2 F’s – unless it is your
last option. Keep your friends you friends and your family your
family. If either are sophisticated then I put them in buckets 1-3 but
usually they are not. F&F makes it hard to call it quits when you
should. It makes it hard to do down rounds to survive when necessary.
It is even harder to ask them to re-up if you need more cash quickly.
And it makes weddings and bar mitzvahs a whole lot less fun.
How to find them
The biggest question that I get asked is how to find the angels I outlined in
steps 1-3 above. It is really easier and should be a test of your entrepreneurial
chops to figure this out but I’ll give you a cheat sheet.
1. Find local deals – Look at which deals have been done in town. All deals
– especially (but not only) those that got venture funded. Lists are available
everywhere. In LA we have www.socaltech.com but in every market there’s
some sort of database. There are obviously things like www.crunchbase.com
and Venture Source, Venture Wire and many others.
2. Find out who funded them – Contact the management teams. Take them
for a coffee. Ask them for advice. Not just funding but learn their story.
Take no more than 30 minutes to respect their time. Approach companies
that aren’t yet extremely well know. Example companies to avoid would be
people like Twitter, Mint.com, Boxee, BillShrink. All are great companies
– probably too busy for a lot of random approaches. Make sure some of
the questions you ask are, “Did you raise angel money? From whom? Who
did you talk to that didn’t fund? What were they looking for? How much
do they like to invest? Have they added value? Anyone angels you know
that you didn’t fund?” Most important question – “do you know any other
early-stage startups that you recommend I talk with?”
3. Social Networks / Search / Blogs – Obvious, huh? I’m surprised at the
number of people who aren’t good at tracking down relationships in social
networks. LinkedIn is the obvious starting point not only because it maps
out so many relationships but also because you can tell a lot about work
history, references, etc. Obviously Facebook has much info. Looking
at whom I follow in Twitter can give you some indication of my likely
network (although Twitter is more difficult because some people follow too
many people and some people follow people they’re interesting in rather
than people they know).
But the more powerful and seldom used research in Twitter is that you
can go to a person’s’ entire Twitter history and see what they’ve Tweeted.
Based on the text this is a good indicator of who they really know. Sound
creepy? Maybe a little, actually. But this is all public information that has
been Tweeted by people who KNOW this is public information. I think it
is a legitimate research tool; however, I would never considering bringing
up something you read in a person’s Tweet stream with them when you see
them. It creeps people out.
There are more sales oriented tools like JigSaw that tech savvy people hate
but sales savvy people love. Basic search engine research can give many
clues and if people do keep a blog and you want to meet the person then
many clues are obviously there.
My summary on getting access will be to tell you what most people don’t want
to hear. Most people are lazy. When you want to find out information about
who knows whom it is really not difficult. The information is publicly available.
You need to make it an effort by researching on the web and going and doing
50 coffee meetings with people. Most people are not action oriented. Most
people are not obsessive. Most people don’t love networking. Most people are
not entrepreneurs.
How much to raise?
Impossible to define an actual number. My experience tells me that most
individual angels like to write $25-50k checks for companies they really don’t
know well. More professional angels seem to like to do $75-100k. Somewhat
the amount you raise will depend on your needs, how much you’ve raised in
the past and how much you think you can raise quickly enough. If it’s your first
ever raise, many people try to go for $100-$250k because there are less people
to ask for money. You can use this to get more product out the door, pay some
staff and get your customer traction. Most larger angel rounds are in the $500$750k range. Obviously harder because you either need a large anchor ($250k)
or you’re talking about 10 x $50k people / 5 x $100k. If you’re less experienced
I’d probably set a max of $250k on your first raise – but I want to emphasize
that every situation is unique. I just wanted to provide some guidelines.
At what value?
Again, every situation is different. If you’re three s***-hot kids from Stanford,
Caltech or MIT you might be able to push valuation higher. If you’re like most
people and you’re a hard-working individual but not with the 0.1% credentials
you may need to be more humble. The hyperconnected people in Silicon Valley
or big cities might push for convertible debt.
I am always an advocate of setting a price. Why? Because I believe that getting
the best possible angels around the table is far more important than ultimate
valuation. The majority of really good angels want to see the round priced and
it also makes a decision easier to know what your money buys rather than some
vague notion of a discount to a VC round.
Most Venture Capital “A” rounds (as of 2009) seem to start around $3 million
pre-money and may go as high as $5-6 million pre-money if you’ve made a lot
more progress or for some other reason the deal is “hot.” But A rounds also get
done at $2 million pre-money. Not everybody will want to raise VC money.
If you do plan to raise VC you want to be sure of 2 things in your angel round:
1. Your angels are happy when you do the VC round because it is a “step
up” in valuation if possible
2. You don’t make it harder to raise a VC round because your angel
round was priced too high.
You might feel proud that you talked angels into a $9 million pre-money,
raised $1 million and therefore only gave away 10% of your company. But …
if you then can’t raise your VC round then how clever was it? When VCs see
over-priced angel rounds they often don’t even want to spend the time with the
company. They see it as a hassle because nobody wants to have to go back to
your cousins, brothers or your hairy dentist and tell them that the mean VC is
pricing your company lower since they over paid.
Angel rounds tend to get done in the $750k – $1.5 million range in my
experience. If you raise $500k at $1.5 million pre-money then you’ve given away
25% of your company, which is about the norm. If you raise $250k at a $750k
valuation the same goes.
Why Everyone Does Not Need to Raise
Dan Shapiro: Companies That Would Do Best Without Venture
Capital
I just got the following email.
Subject: Small taxi company looking to expand
Hello,
I run a small taxi company outside of Boston, Massachusetts. My
community has been targeted for casino development and I am
looking to expand my business. Could you possibly provide some
advice on how to find venture capital?
For someone who lives in the startup world, this looks pretty silly. But I’m sure
I’d say a lot of silly things if I were getting in to the taxi business, too. So I
figured I’d point him to a simple explanation of why taxi companies (actually,
services companies in general) aren’t appropriate for VC. I did the Google thing
for a bit to find a good article. And no luck.
Well, you know what they say: when the internet fails you, make more internet.
Here, then, are a very good set of reasons not to take venture capital (or – why
venture capital won’t take you).
1. You want to build a profitable company
First day of Founder’s Institute I ask how many people want to raise venture
capital. Most of the hands go up. I then ask who wants to build a profitable
company. Again, most hands go up.
The funny thing about this is – VCs don’t actually like their companies to be
profitable. Someday, sure, but not on their watch. You see, profitability means
that the company wont grow any faster.
This seems odd, but think about this for a minute. At the early stages, a
company may be making money, but it’s almost certainly investing every penny
it makes back in to the business. If it has access to outside capital (e.g., a VCs),
it’s investing more than it makes. And that’s exactly what VCs like: companies
that can grow at amazing speed, and never slow down their burn rate to amass
cash.
They like this for two reasons. First, VCs want to invest in companies that
can grow explosively. That means huge markets, executives who can scale up a
business fast, and a willingness on the part of management to double down on
a winning bet – over, and over, and over again. Second, because it means the
company keeps coming back to the VC for more money on positive terms. That
means the VC keeps getting to buy more and more of the growing concern.
Of course, this is something of an over-broad generalization. I’m required to
include one per post or I lose my startup blogging license. In fact many venture
backed companies are profitable, it’s very impressive to bootstrap your company
to profitability in a few months before raising outside investment, etc. But if you
are excited about a profitable business that can cut you giant dividend checks
(not that most VCs can even accept divided checks – long story), realize that
VCs will not be pleased with that approach to running the business.
They will want you to plow those earnings back in to the business. And when
the day comes that a VC-backed business generates cash faster than it can
effectively spend it? They sell the company, or IPO (which is technically also
selling the company), or replace the CEO with someone who can spend faster.
A taxi business should be run for profits. That’s not VC style.
2. Your business has reasonable margins
As a general rule, VCs don’t like reasonable margins. They are exclusively
interested in outrageous margins. Ludicrous margins. We’re talking about
sneering at 50%, and hoping for 80%, 90%, crazy astronomy stuff. Venture
capital is all about investing a little bit of money to create a business with
massive scale and huge multiples – investing tens of millions to build software
that then can be duplicated or served up for virtually nothing extra per-person
with a total market size of billions.
In particular, VCs don’t like businesses that are people-powered. Software
businesses are awesome, but their evil twin – software consultancies – are
near-pariah to VCs. If adding revenue means adding bodies, they don’t like
it. In fact, enterprise software companies, which can tread a fine line between
software consulting & software development, sometimes get really creative to
come down on the right side of the line.
So the rule of thumb is that VCs like product companies: software, drugs,
cleantech, and so on. And they don’t like the manufacturing, service industry,
and consulting businesses that often are just a tiny shift of business model away.
Every new taxi requires a… well, a new taxi. And a new taxi driver. Not the
right business for VC.
3. You are going to double your investors’ money
I’ve covered this before, but VCs really don’t want to double their money.
Strange though it sounds, their economics make that look like a failure. They
need to target a 10x return on their investment, and that means – depending
on stage and fund size – that you company has to grow to somewhere in the
hundreds-of-millions to billions range to be interesting.
That means taking your taxi business from $20MM in annual revenue to
$40MM just doesn’t do it for them. Particularly because the valuation multiples
on the aforementioned lower-margin businesses are smaller.
4. VCs probably don’t want to invest in you
Here are the people VCs really love to invest in:
• Entrepreneurs who’ve already made them lots of money
• Their closest buddies
Here are the people who VCs can be convinced to invest in:
• People who have been wildly successful at high-profile past jobs
that are related to their new business (e.g., a former executive VP
at a Fortune 500 company, inventor of thingamajig that everyone
knows)
• New graduates from top-of-the-top tier schools who have built
something amazingly cool already
• Extremely charismatic type-A personalities
Anyone else is possible, but our taxi driver is going to have a devil of a time.
5. You have better things to do with 9 months, and you will probably fail
That’s how long it took me to do my Series A for Ontela. 9 months before the
first check came in. Average is 6-12. That’s because a busy VC will look at a
few companies a day, and will make a few investments a year. The math says
the hit rate is well under 1%. That matches my experience – I pitched over 100
times during our Series A investment. Not only that, but most of the companies
pitching the same events and people that I saw worked just as hard as I did,
and did not get funded. And fundraising is a near full-time job; you won’t have
much time for actually driving your taxi.
6. You will have a new boss
You know the great thing about working for yourself? Well, if you raise VC,
you probably don’t have that thing any more. Raising VC usually means
forming a board that includes your investors, and that board is charged with,
among other things, potentially firing and replacing you. I’ve worked with a
number of boards and have been lucky in that they were all awesome and I
would recommend those folks to anybody. But if you like your freedom, then
bringing on VC may feel somewhat familiar – in an “I have a boss again” way
you probably won’t enjoy.
What are my alternatives?
VC is really only appropriate for a tiny fraction of a fraction of the companies in
the US. But there are numerous alternatives.
• Angel investors are individual investors who can invest larger
amounts, on more flexible terms, and with less onerous
restrictions. Many companies that take VC money actually start
with angel investments – but lots of companies never do VC, and
just grow off of angel investment.
• Traditional bank loans are always an option if you have a
sufficiently traditional company – while they may not be right for
many purposes, they’re definitely the best terms you will find for
bringing in capital.
• A Revenue Loan from a company like Lighter Capital is a way for
companies with revenue to bring in capital with a debt structure –
without giving up control to outside investors.
• And, of course, Bootstrapping is arguably the best way of all –
re-investing your company’s profits in your own growth, and
building a strong company based on the revenues from your
business.
… So does this mean I shouldn’t raise VC?
Look. I’ve raised over $30mm from 7 different firms in the course of my two
startups. I will tell you: if you are the right kind of company, and find the
right kind of investor, then VC is awesome. It’s an instant infusion of cash,
connections, experience, credibility, and confidence at the stroke of a pen. It
accelerates everything. It focuses the mind. I can’t recommend it highly enough.
But most companies are not the right kind of companies. And the only thing
more frustrating and time consuming than raising a VC round is failing to raise
a VC round.
CHAPTER THREE
FINANCE 201
In this chapter, we will present how venture capital works as a whole. Then we
will hone in on the two main forms of financing that occur in VC, convertible
debt and preferred equity, and show how a capitalization table is put together.
Last but not least, we will reveal the terms that venture capitalists most care
about when constructing a deal.
What Is Venture Capitalism?
Marc Aventt & Matthew V. Waterman: Venture Capital Basics
What Venture Capital (“VC”) is and is not
• Venture Capital is a sub-class of private equity.
– Venture capitalists (“VCs”) are professional investors that raise
pools of capital from institutional, corporate, and individual
investors.
– VC funds utilize standard limited partnership structure.
• VC used to finance new and growing companies.
– Typically purchase preferred equity securities.
– VCs take higher risks and therefore expect higher rewards.
– VCs make money when companies are sold and/or taken public.
• VCs add value to company through active participation and
management.
– Typically take board of director positions;
– Help with strategy, sales, hiring, etc.
• Angel investors and passive investors are not VCs
“Ideal” Company for VC
• Strong management
•
•
•
•
– Relevant industry experience & contacts
– Proven ability to execute
– Perspective
Addressing large and growing market
Competitive advantages
– Defensible IP able to be commercialized
– Unique business model and/or relationships
Solid business model
– Clear technical, financial, and operational objectives
– Scalable
Chemistry / strength of relationship with VCs
– VC investment creates long-term “partnership”
– Company and its founders understand and accept that VC imposes
restrictions and limits on them
Positioning a company for VC,
and engaging VCs
• Positioning the company:
•
•
•
•
– See previous slide, “’Ideal Company’ for VC”
– Surround company with strong, trusted advisors (advisory board,
attorneys, auditors)
– Consciously position company to be VC-backed
Discliplined documentation of IP and inventions
Clean and well-maintained corporate and legal record keeping
Accounting books and records kept in accordance with GAAP
– Company to have realistic expectations about VC and its affect
on founders’ short term and long term influence and roles with the
company
Engaging the VCs
– ID the VCs best for the company (research, research, research)
– Well drafted, convincing business plan
– Approach VCs through trusted mutual contacts (attorneys,
accountants, other mutual business associates of the VCs and the
company)
– Don’t over-shop (keep focused on a small number of VCs)
How the VC process works
• Initial contacts with VCs (see previous slide, “Positioning a company
•
•
•
•
•
•
•
•
•
•
•
•
for VC, and engaging VCs”)
Presentations to and meetings with VCs
Due diligence
– Business due diligence (including IP due diligence)
– Legal due diligence (including IP due diligence)
Negotiations and documentation
– Non-binding term sheet
– Typical Legal documents
Preferred Stock Purchase Agreement
Restated Certificate/Articles of Incorporation
Investors Rights Agreement
Management Rights Letter
First Refusal and Co-Sale Agreement
Voting Agreement
Stock Restriction Agreements
Closing
On-going relations (see next slide, “So, you got VC funding now what?”)
So, you got VC funding now what?
• Game time
– Executing against plan & the milestone march
– Board meetings (and change of plans)
Exits
• IPOs
• Mergers and acquisitions
• “How about we just keep it private and we’ll pull out cash when it’s
profitable?”
– VCs are not in the business of investing for cash flow
Convertible Debt
Fred Wilson: MBA Mondays: Convertible Debt
Today we are going to talk about convertible debt. Convertible debt can also be
called convertible loans or convertible notes. For the purposes of this post, these
three terms will be interchangeable.
Convertible debt is when a company borrows money from an investor or a
group of investors and the intention of both the investors and the company is
to convert the debt to equity at some later date. Typically the way the debt will
be converted into equity is specified at the time the loan is made. Sometimes
there is compensation in the form of a discount or a warrant. Other times there
is not. Sometimes there is a cap on the valuation at which the debt will convert.
Other times there is not.
There are a number of reasons why the investors and/or the company would
prefer to issue debt instead of equity and convert the debt to equity at a later
date. For the company, the reasons are clearer. If the company believes its equity
will be worth more at a later date, then it will dilute less by issuing debt and
converting it later. It is also true that the transaction costs, mostly legal fees, are
usually less when issuing debt vs equity.
For investors, the preference for debt vs equity is less clear. Sometimes investors
are so eager to get the opportunity to invest in a company that they will put
their money into a convertible note and let the next round investors set the
price. They believe that if they insisted on setting a price now, the company
would simply not take their money. Sometimes investors believe that the
compensation, in the form of a warrant or a discount, is sufficiently valuable
that it offsets the value of taking debt vs equity. Finally, debt is senior to equity
in a liquidation so there is some additional security in taking a debt position
in a company vs an equity position. For early stage startups, however, this is
not particularly valuable. If a startup fails, there is often little or no liquidation
value.
Friends and family rounds are often done via convertible debt. It makes sense
that friends and family would not want to enter into a hardball negotiation with
a founder and would prefer to let the price discussion happen when professional
investors enter the equation.
The typical forms of compensation for making a convertible loan are warrants
or a discount.
Warrants are another form of an option. They are very similar to options. In
the typical convertible note, the Warrant will be an option for whatever security
is sold in the next round. The Warrant is most often expressed in terms of
“warrant coverage percentage.” For example “20% warrant coverage” means you
take the size of the convertible note, say $1mm, multiply it by 20%, which gets
you to $200,000, and the Warrant will be for $200,000 of additional securities
in the next round. Just to complete this example, let’s say the next round is for
$4mm. Then the total size of the next round will be $5.2mm ($4mm of new
money plus $1mm of the convertible note plus a Warrant for another $200k).
The total cost of the convertible loan is $1.2mm of dilution at the next round
price for $1mm of cash.
A discount is simpler to understand but often more complicated to execute. A
discount will also be expressed in terms of a percentage. The most common
discounts are 20% and 25%. The discount is the amount of reduction in price
the convertible loan holders will get when they convert in the next round. Let’s
use the same example as before and use a 20% discount. The company raised
$4mm of new cash and the convertible loan holders will get $1.25mm of equity
in the round for converting their $1mm loan ($1mm divided by .8 equals
$1.25mm). Said another way $1mm is a 20% discount to $1.25mm.
Convertible notes also typically have some cap on the valuation they can
convert at. That cap is anywhere from the current valuation (not very common)
to a multiple of the current valuation. Recently we are starting to see uncapped
convertible notes. These notes have no cap on the valuation they can convert at.
Startups typically think about raising capital via convertible debt early on in
the life of a startup. They want to move fast, keep transaction costs low, and
they are often dealing with a syndicate of angel investors and it is easier to get
the round done with a convertible note than a seed or series A round. While
these are all good reasons to consider convertible debt, I am not a big fan of it
at this stage in a company’s life. I believe it is good practice to set the value of
the equity early on and start the process of increasing it round after round after
round. I also do not like to purchase or own convertible debt myself. I want to
know how much of a company I’ve purchased and I do not like taking equity
risk and getting debt returns.
However, later on in a company’s life convertible debt can make a lot of sense.
A few years ago, we had a portfolio company that was planning on an exit in
a year to two years and needed one last round of financing to get there. They
went out and talked to VCs and figured out how much dilution they would take
for a $7mm to $10mm raise. Then they went to Silicon Valley Bank and talked
to the venture debt group. In the end, they raised something like $7.5mm of
venture debt, issued SVB some Warrants as compensation for making the loan,
and built the company for another year, sold it and did much better in the end
because they avoided the dilution of the last round. This is an example of where
convertible debt is really useful in the financing plan of a startup.
My guess is we will see the use of convertible debt, particularly with no
compensation and no cap on valuation, wane as the current financing gold rush
fizzles out. It will remain an important but less common form of early stage
startup financing and will be particularly valuable in things like friends and
family rounds where all parties want to defer the price negotiation. But I expect
that we will see it used more commonly as companies grow and develop more
sophisticated financing needs. It is a good structure when the compensation for
making the loan is fair and balanced and when the debt vs equity tradeoff is
useful for both the borrower and lender.
Preferred Equity
Fred Wilson: MBA Mondays: Preferred Stock
Today on MBA Mondays Startup Financing Options series, we are going to talk
about the financing option that I specialize in - preferred stock.
Almost all venture capital firms and many angel and seed investors will require
the company they are investing in to issue them preferred stock. The vast
majority of equity dollars invested in startups are securitized with preferred
stock. So if you are an entrepreneur, it makes sense to understand preferred
stock and what it means for you and your company.
Preferred stock is a class of stock that provides certain rights, privileges, and
preferences to investors. Compared to common stock, which is normally held
by the founders, it is a superior security.
Preferred stock takes its name from a critical feature of preferred stock
called liquidation preference. Liquidation preference means that in a sale (or
liquidation) of the company, the preferred stock holders will have the option of
taking their cost out or sharing in the proceeds with the founders as common
stock holders. What this means is that if the value of the sale of the company is
below the valuation the preferred investors paid, then they will get their money
back. If the sale is for more than the valuation the preferred investors paid, then
they will get the percentage of the company they own. Suffice it to say that this
is an important term for investors, including me.
There are variations of the liquidation preference that give the feature a bad
name. Investors will sometimes ask for a multiple of their investment as a
preference. Or investors will ask for their preference plus the common interest
(called a participating preferred). Our firm is not a fan of these “enhanced
preferred” but we do sometimes get them, particularly the participating
preferred, when we join a syndicate where that security already exists. One
thing to know about terms around liquidation preference is whatever you agree
to with one set of investors, that will be what all the future investors will want
because they will not want other investors in the cap table with a preferred
position to them.
There are a number of important rights and privileges that investors secure via
a preferred stock purchase, including a right to a board seat, information rights,
a right to participate in future rounds to protect their ownership percentage
(called a pro-rata right), a right to purchase any common stock that might
come onto the market (called a right of first refusal), a right to participate
alongside any common stock that might get sold (called a co-sale right), and an
adjustment in the purchase price to reflect sales of stock at lower prices (called
an anti-dilution right).
Like many things in life, there are many variations of preferred stock
transactions, from the relatively benign to the ridiculously painful. I’ve
come to the conclusion that VCs should specialize in the relatively benign
because entrepreneurs have long memories and the VCs who specialize in the
ridiculously painful will not get to work with the best entrepreneurs and the
best deals over time.
There have been a number of attempts to specify what a “standard preferred
stock deal” should look like. There is the NVCA standard set of terms and
docs. Fenwick and Gunderson each have a set of standard terms and docs. I
believe Cooley has a set as well. I just reviewed a set from Lowenstein that looks
quite good. If the preferred stock your investors want to purchase resembles
these “standard preferred stock” sets, then you are probably working with an
investor who is trying to be reasonable and fair.
As the AVC wise man JLM likes to say, “in life you don’t get what you deserve,
you get what you negotiate.” When you are preparing to sell preferred stock to
investors, make it a point to familiarize yourself with all the important terms,
what they mean (both to you and your company), and what an “entrepreneur
friendly” deal looks like. And then go get one of them for you and your
company. It helps to have some leverage and leverage in financings means
multiple investors at the table. So when you are dealing with sophisticated
investors, make sure you have options and make sure you understand the key
issues and don’t settle for a bad deal.
Preferred stock doesn’t have to be a bad deal for entrepreneurs. It can be a win/
win for both sides. But you have to work at this part of your business just like
you do at the other parts.
Intro to the Cap Table
Mark Suster: Want to Know How VCs Calculate Valuation Differently
from Founders?
Back in 1999 when I first raised venture capital I had zero knowledge of what
a fair term sheet looked like or how to value my company. Due to competitive
markets we ended up with a pretty good term sheet until we needed to raise
money in April 2001 and then we got completely screwed. It was accept the
terms or go into bankruptcy so we took the money. Those were the dog days of
entrepreneurship.
But the truth is that I didn’t really understand just how screwed I was until
years later when I finally understood every term in a term sheet and more
importantly I understood how each term could actually be used to screw me.
Things like “participating preferred stock” in legalese unsurprisingly never
actually call out, “hey, this is the participating preferred language.” We got a 3x
participating liquidation preference with interest (not participating with a 3x
cap, but 3x participating. Ugh. I explain the difference later in the post or you
can click through on this link above for an explanation).
Back then VentureHacks didn’t exist. Brad Feld hadn’t written his seminal
“term sheet series” and The Funded hadn’t yet been created. And for some
strange reason entrepreneurs didn’t share this information. Other founders, “as
a privately held company we don’t disclose our valuation.” Me, “dude, I’m not
a journalist. I just want to figure out what a fair valuation is.” I figured all the
VCs talked so we should. Duh.
Critical Terms
Fred Wilson: The Three Terms You Must Have in a Venture
Investment
Many years ago, when I was still in my 20s, the managing partner of my first
venture firm, Milt Pappas, told me that he felt there were three terms that really
mattered in a venture deal (other than price of course). They are:
1. The liquidation preference
2. The right to participate pro-rata in future rounds
3. The right to a board seat
I listened intently and have been practicing what Milt preached ever since. In
recent years, I’ve gotten comfortable doing a few deals without the board seat in
very specific circumstances. But I’ve mostly followed Milt’s advice to me and I
have been well served by it.
There are many other provisions in venture term sheets that can, at times, come
in handy. There are the protective provisions, the blocking rights, the rights of
first refusal and co-sale, the anti-dilution protections, redemption rights, etc, etc
I’ve seen some of these provisions invoked and they have been useful to have.
But there are several typical venture terms that I have never seen invoked in
almost 23 years in this business. That doesn’t mean they aren’t useful or even
best practices to have them. But it does mean that some things matter more
than others.
And in a negotiation, it is critical to know what you must have, what you
should have, and what you can live without.
When it comes to venture terms, I believe Milt was spot on. The three things
that have saved my investment and kept people honest more than any others are
the three I listed up front.
The liquidation preference matters because without it, if you invest $1mm for
10pcnt of a business and the next day the entrepreneur gets an offer to sell the
business for $5mm, he or she might choose to take it and get $4.5mm while
you only get $500k. Sure you could negotiate for a blocking right on a sale, but
getting in between an entrepreneur and an exit they want to do is not a recipe
for success in the venture business It’s much better to say, “give me the option to
get my investment back or my negotiated ownership, whichever is more.” And
that’s what a liquidation preference is, plain and simple.
The right to purchase your pro-rata share of future rounds is possibly the most
important term of all. In early stage VC, a few investments generally deliver
the vast majority of the returns in a fund. When you are in one of those deals,
you need to be able to invest in the subsequent rounds (to go “all in” in poker
parlance). The pro-rata right is equally critical in down rounds to protect you
from getting wiped out in a highly dilutive financing.
The board seat is not something all VCs care about. But you cannot have
real impact on an investment without one. It’s the best way to make sure the
investment is going well and when it is not, the board seat gives you the right to
have a say in what is needed to fix the investment.
CHAPTER FOUR
HOW TO BE A VC
What makes up the DNA of a VC? How do certain VCs stand out from others?
In this chapter, we demonstrate how investors consistently need to bring
more to the table than just a checkbook, and how this often leads to them
outperforming their peers.
Maintaining Relationships
Charlie O’Donnell: How to Be a VC: Being Open
I always get asked how to get into VC and so I think a lot about what it takes
to do the job well. I’m way early in my career, so I won’t say I’ve perfected
anything yet, but after 8 years on the investing side and 3 in startups, I’ve come
up at least one thing:
Be open.
In venture capital, you say “no” a lot. When you say no a lot, you get good at it. It
comes off the tongue fast and in lots of different ways. It is your default response.
Practicing the word no as many times as a VC does means you have to fight not
to have your mind close on you. I fight it...and fight it hard. I want your pitch
to be the one I say yes to—and I want you to solve the inherent problems in
your business model. I want to figure out if I can help you get there.
I don’t think that every VC takes the approach that anyone can be successful—
or that every problem is fixable, which is weird to me because their job is to
make people successful and fund things that solve problems. Yet, time and time
again, I see well-practiced dismissiveness.
You see it a lot in the language people use. “We only fund top entrepreneurs.”
“We only hire A level people.” Very rarely do you hear “We can take
hardworking, passionate people and make them really awesome at being CEOs.”
For some, VC is about the picking rather than the fostering and growing.
Just take how most people approach networking events and talks. I give a lot
of talks. In fact, I’ll talk just about anywhere if I’m free. I don’t mind talking
to crowds, but most of all, I like listening to crowds—because I always learn
something new or meet someone interesting.
What’s weird to me is that a few times I’ve spoke, people were surprised that
I hung around after to hear what the entrepreneurs in the crowd had to say.
One event organizer had even asked me if I wanted to give my talk before the
company demos, enabling me to duck out before the crowds could rush me.
Isn’t that what I get paid to do? Take pitches? Listen? Learn?
In today’s world, the democratization of technology means that the next big
thing could literally come from anywhere. It won’t necessarily be built by a
former Paypal Mafia member, or a YC alum. Pedigree does not equal future
success.
Plus, it’s really susceptible to groupthink. True creativity comes from dissent
and a diverse set of opinions.
This article on Groupthink reasons that:
..”.dissent stimulates new ideas because it encourages us to engage
more fully with the work of others and to reassess our viewpoints.
“There’s this Pollyannaish notion that the most important thing to
do when working together is stay positive and get along, to not hurt
anyone’s feelings,” she says. “Well, that’s just wrong. Maybe debate is
going to be less pleasant, but it will always be more productive. True
creativity requires some trade-offs.””
If you’re really going to find the next big thing, then you can’t only spend your
time with people who built the last big thing. You need to find ways of being
open and accessible.
Unfortunately, there’s a lot of the “velvet rope” mentality going on in venture.
The first question out of investor mouths is too often, “Who else are you
talking to?” rather than “How does it work?” or even better “How can I help
you succeed?”
For a VC, I think the process of raising money humbles you. Perhaps this is
why I see this behavior more in the junior folks who never have to pitch to
LPs or who’ve never started a company. It makes you relate to the plight of the
entrepreneur hitting the pavement a little more. You know how hard it is. You
know what it’s like to sit alone in a room after the only person who ever would
have bet on you says no, and you’re all out of money leads. You feel like you’ve
been kicked in the stomach—and that’s before you have to go face your team.
I’m concerned that some of the newer folks in venture capital haven’t been
kicked in the stomach enough. They’ve been through a half of one investment
cycle and they think it will always been this good. I’m not sure if they’re in
venture because they truly want to help someone change the world or because
venture is simply the best exclusive club to get into post grad school.
They’re not in the trenches with the unwashed Twitter masses, attending
Meetups, and putting themselves out there. They want introductions through
their trusted network—pre-screened, pre-vetted pitches that already have
product, traction, other investors with brand names. They spend more time
networking with other VCs than helping entrepreneurs they haven’t even funded
yet.
Some would argue that venture capital is more accessible than it has ever
been—but I actually think it’s as further away from where it needs to be then
ever. Thirty years ago, the only great tech being developed was being done in
labs by scientists and engineers. There were literally only a handful of people
and teams that had the capability and resources to get something off the
ground—and so you only had to be accessible to a few people in a few specific
places.
In a world where literally anyone can build anything on the cheap, is just being
a Techstars mentor or a blogger enough? Sometimes, I think that’s a bit like
false accessibility—where I’m open to you only if you’ve made it through this
very selective program, or I’ll comment back to you but I won’t actually meet
you. I’ll show up at a pitch event where someone has screened companies for me
to see but I’m on the stage behind a protective barrier, readying the thumbs up
or thumbs down like Chuck Norris at a dodgeball tourney. It still seems like too
many hurdles.
People thought I was crazy to put my calendar on my website. I thought it was
crazy that every VC doesn’t do that. It’s not like I have to take all the requests—
so why wouldn’t I just try to be as open as possible, especially in a world where
you can very easily vet anyone through Rapportive and a quick Google search.
People thought I was crazier for having the chat widget on my blog.
Honestly, few people use it. Most of the time, they ask reasonable questions. If
I’m busy, I can’t answer. Simple as that. I’m in a service business, so if you can’t
get to me, I can’t provide my service. Seems pretty cut and dry to me.
Plus, I really just like meeting new people with different ideas than the ones I
have in my head. If this doesn’t sound like you, maybe you shouldn’t be trying
to get into VC. Don’t try to get in because you like the power dynamic of being
a decision maker. Get in because you like people and like being challenged.
And get in, most importantly, because you like to serve. I went to Jesuit schools
and their mantra is “Men and Women for Others.” If you don’t like helping
people, venture capital isn’t for you.
Both Josh Kopelman and Fred Wilson have talked about the entrepreneurs
being their customer. Maybe it’s just because I worked for both of them that I
have this mindset. Josh Breinlinger has this mindset, too. He wrote a great post
about what you tell entrepreneurs when they’re the problem in their pitch...and
I really liked how hard he has tried to treat entrepreneurs well:
I read a lot of entrepreneur’s blogs and reviews on TheFunded. There
was a pretty major theme I saw from a founder’s perspective:
VCs are jerks because they don’t follow up.
So, I thought I would change that. I’m not a jerk (according to at least
a few people I know). I know how much time and energy went into
preparing a pitch deck and trying to describe the vision for the company.
I know that a startup at the early stages is the founder’s baby. I know
that it sucks to try hard to get something only to receive... no response, no
clear indication of what the investors were thinking and why.
I decided I would change the norm. I would reply to everyone who
pitched me. I would give clear and concise reasons for passing if I decided
to pass. I would offer to help out in other ways and I would actually
mean it.
Ultimately, it’s really hard to do this. It’s tough to respond to every e-mail.
There just isn’t enough time for all the e-mails—and the more you answer, the
more you get back. It’s tough to show up to every event and still have a life. It’s
tough to have to say no so many times but still be open to say yes. It’s tough to
figure out what advice to give.
But it’s still not as tough as being an entrepreneur.
Chris Dixon: Being Friendly Has Become a Competitive Advantage
in VC
Over the last decade or two, the supply of venture capital dollars has increased
dramatically at the same time as the cost of building tech startups has sharply
decreased. As a result, the balance of power between capital and startups has
shifted dramatically.
Some VCs understand this. The ones that do try to stand out by, among other
things, 1) going out and finding companies instead of expecting them to come
to them, 2) working hard on behalf of existing investments to establish a good
reputation, and 3) just being friendly, decent people. Believe it or not, until
recently, #3 was pretty rare.
As a seed investor in about 30 companies, I’ve been part of many discussions
with entrepreneurs about which VCs they want to pitch for their next financing
round. More and more, I’ve heard entrepreneurs say something like “I don’t
want to talk to that firm because they are such jerks.” In almost all cases these
are well-known, older firms who come from the era when capital was scarce.
Every experienced entrepreneur I know has a list of “toxic” VCs they won’t
deal with. There are so many VCs out there that you can do this and still have
plenty of VCs to pitch to get a fair price for your company and only deal with
decent, helpful investors. It sounds kind of crazy, but being a reasonably nice
person has become a competitive advantage in venture capital.
Touting Expertise
Mark Suster: Domain Knowledge
This is the second article in a series on what it takes to be a great angel investor
(and why this should matter to entrepreneurs).
I have talked extensively about “social proof” in fund raising in the past. But
the problem is that most deals – even really promising ones – fail. Just ask
the people who poured money into once “hot” companies like RazorGator or
Friendster. And we all know that Ron Conway is considered the savviest of
angel investors and yet by definition not all of his investments succeed.
So being buddies with “all the right people” clearly isn’t enough to be
successful. AngelList – as great and innovative as it is – does not guarantee
success for investors. Obviously. In fact, sometimes seeing social proof (e.g., lots
of brand names piling on) can lead to group think and price creep. I personally
try to avoid many of these club deals. I like to invest where I have a personally
strong connection with the entrepreneur and/or a strong intuition on the market
from prior experience. I like to be early – usually first or near enough to it.
Basically, I’m talking about being an angel leader and not follower. Lead
investors and follow investors can both win equally but in each case you know
why you personally are writing the check. I have been at cocktail parties where
I have heard prolific angels upon hearing that a buddy was backing a deal say,
“count me in for 25” even without knowing the details of the deal. I think that’s
sloppy.
It requires domain knowledge to know what you’re talking about and success
long term as an angel. We are all thrown some good cards from time-to-time.
That’s called luck. Consistently winning like Keith Rabois takes skill.
2. Domain knowledge – Unfortunately many individuals overrate their own
abilities in the “domain knowledge” area. They have a very good sense for what
is going on in a market but not a well-honed knowledge of an industry and
what will define success or failure.
I see this all of the time in financial services. So many deals seem like obvious
money makers. But then I talk with my partner Brian McLoughlin who has
worked in the field for 20 years and he’ll run through the 10 reasons why
similar companies haven’t succeeded. Not in a cynical way – he just has the
domain knowledge to know what has been tried before. It’s sort of like having
an Encyclopedic history book before just launching your product and seeing
whether anybody uses it.
Just because you use all of the products, read all the tech journals, backchannel at all of the right cocktail parties and know a couple of guys at Twitter
or Facebook does not mean that you necessarily have well refined domain
knowledge.
Remember that you’ll be investing against people who have worked on the
Google algorithm and REALLY know what drives SEO. MySpace may not
have been as successful as Facebook in the end but the executives there learned
how to deal with user growth at scale. They have real stories about what drives
user engagement and viral adoption.
Here’s the thing – as Michael Lewis talks about in his book, the adage of investing
is that “if you’re reading about something in the papers it’s already too late.”
Think you know a thing or two about location-based services? You’re going up
against Dennis Crowley who built Dodgeball before ever founding FourSquare.
Oh, and he was acquired by and worked at Google.
Connections. Domain knowledge.
Who ultimately invested in FourSquare? Fred Wilson who had learned much
as an early investor in Twitter. And before that Bryce Roberts who working
alongside Tim O’Reilly (famed publisher and originator of Web 2.0 Expo) gets
advanced access to and domain knowledge of the who’s who of the tech world.
Want to do a Q&A website? The founders of Quora were respected
technologists at Facebook and knew a thing or two about bacn and toast before
setting up their highly sought after venture. And when they wanted money
they turned to none other than Matt Cohler, ex VP of Product Management at
Facebook. Access to Deal Flow. Domain Knowledge.
I know you have good knowledge of how the Internet is developing and have
good intuition of what drives viral adoption, what local services are needed,
what API’s need to be developed, etc. But before you get out your checkbook at
least have a gut check on whether your instincts are likely as refined as the other
players sitting at the table. It’s not good enough to win at the weekend warrior
table – you need to win at the WSOP table.
The most interesting thing I’ve learned by being an investor and sitting on
boards & seeing so many company pitches is how different reality of what is
going on at companies is from what you’re reading about them in the press. So
it’s not good enough to only mine Techmeme every day.
In the Tony Hsieh analogy – it’s the difference between a weekend player and a
professional. In the former you place a couple of casual bets knowing you may
lose. Some early wins can be deceiving and give you a sense of invulnerability.
The same happens in poker before you lose big. Professionals play day-in, dayout for years at a time. They spot the tells. They count the cards. They control
outcomes.
Yet the truth is that I see angels with great deal flow & great instincts whom
I believe will only perform well in times that favor angel investors (like 2010)
where there are early exits. I don’t believe these times will last. And the best
investors over the long-haul will need three more skills.
Understanding the Statistics
Blake Masters: Peter Thiel’s CS183: Startup - Class 7 Notes Essay
Roelof Botha, partner at Sequoia Capital and former CFO of PayPal, and
Paul Graham, partner and co-founder of Y Combinator, joined this class as
guest speakers. Credit for good stuff goes to them and Peter. I have tried to be
accurate. But note that this is not a transcript of the conversation.
I. Venture Capital and You
Many people who start businesses never deal with venture capitalists. Founders
who do interact with VCs don’t necessarily do that early on. First you get your
founders together and get working. Then maybe you get friends, family, or
angels to invest. If you do end up needing to raise a larger amount of capital,
you need to know how VC works. Understanding how VCs think about
money—or, in some cases, how they don’t think about it and thus lose it—is
important.
VC started in late 1940s. Before that, wealthy individuals and families were
investing in new ventures quite frequently. But the idea of pooling funds that
professionals would invest in early stage companies was a product of the ‘40s.
The Sand Hill Road, Silicon Valley version, came in the late 1960s, with
Sequoia, Kleiner Perkins, and Mayfield leading the field.
Venture basically works like this: you pool a bunch of money that you get
from people called limited partners. Then you take money from that pool and
invest it in portfolio companies that you think are promising. Hopefully those
companies become more valuable over time and everybody makes money.
So VCs have the dual role of encouraging LPs to give them money and then
finding (hopefully) successful companies to back.
Most of the profits go back to LPs as returns on their investment. VCs, of
course, take a cut. The typical model is called 2-and-20, which means that
the VC firm charges an annual management fee of 2% of the fund and then
gets 20% of the gains beyond the original investment. The 2% management
fee is theoretically just enough to allow the VC firm to continue to operate. In
practice, it can end up being a lot more than that; a $200m fund would earn
$4m in management fees under a 2-and-20 structure. But it’s certainly true that
the real payout that VCs look for come with the 20% cut of the gains, which is
called the carry.
VC funds last for several years, because it usually takes years for the companies
you invest in to grow in value. Many of the investments in a given fund either
don’t make money or go to zero. But the idea is that the companies that do well
get you all your money back and then some; you end up with more money in
the fund at the end than LPs put in to begin with.
There are many dimensions to being a good VC. You have to be skilled at
coming up with reasonable valuations, identifying great entrepreneurs, etc. But
there’s one dimension that is particularly important, yet surprisingly poorly
understood. It is far and away the most important structural element of venture
capital: exponential power. This may seem odd because it’s just basic math. But
just as 3rd grade arithmetic—knowing not just how many shares you get, but
dividing that by the shares outstanding—was crucial to understand equity, 7th
grade math—understanding exponents—is necessary to understand VC.
The standard Einstein line on this is that the most powerful force in the
universe is compound interest. We see the power of compounding when
companies grow virally. Successful businesses tend to have an exponential arc to
them. Maybe they grow at 50% a year and it compounds for a number of years.
It could be more or less dramatic than that. But that model—some substantial
period of exponential growth—is the core of any successful tech company.
And during that exponential period, valuations tend to go up exponentially.
So consider a prototypical successful venture fund. A number of investments
go to zero over a period of time. Those tend to happen earlier rather than later.
The investments that succeed do so on some sort of exponential curve. Sum it
over the life of a portfolio and you get a J curve. Early investments fail.
You have to pay management fees. But then the exponential growth takes place,
at least in theory. Since you start out underwater, the big question is when you
make it above the water line. A lot of funds never get there.
To answer that big question you have to ask another: what does the distribution
of returns in a venture fund look like? The naïve response is just to rank
companies from best to worst according to their return in multiples of dollars
invested. People tend to group investments into three buckets. The bad
companies go to zero. The mediocre ones do maybe 1x, so you don’t lose much
or gain much. And then the great companies do maybe 3-10x.
But that model misses the key insight that actual returns are incredibly skewed.
The more a VC understands this skew pattern, the better the VC. Bad VCs tend
to think the dashed line is flat, i.e., that all companies are created equal, and
some just fail, spin wheels, or grow. In reality you get a power law distribution.
An example will help clarify. If you look at Founders Fund’s 2005 fund, the
best investment ended up being worth about as much as all the rest combined.
And the investment in the second best company was about as valuable as
number three through the rest. This same dynamic generally held true
throughout the fund. This is the power law distribution in practice. To a first
approximation, a VC portfolio will only make money if your best company
investment ends up being worth more than your whole fund. In practice, it’s
quite hard to be profitable as a VC if you don’t get to those numbers.
PayPal sold to eBay for $1.5bn. PayPal’s early stage investors had a large enough
stake such that their investment was ultimately worth about the size of their
fund. The rest of the fund’s portfolio didn’t do so well, so they more or less
broke even riding on PayPal. But PayPal’s series B investors, despite doing quite
well with the PayPal investment, didn’t break even on their fund. Like many
other VC funds in the early 2000s, theirs lost money.
That investment returns take a power law distribution leads to a few important
conclusions. First, you need to remember that, management fees aside, you only
get paid if you return all the money invested plus more. You have to at least hit
the 100% of fund size mark. So given power law distribution, you have to ask
the question: “Is there a reasonable scenario where our stake in this company
will be worth more than the whole fund?”
Second is that, given a big power law distribution, you want to be fairly
concentrated. If you invest in 100 companies to try and cover your bases
through volume, there’s probably sloppy thinking somewhere. There just aren’t
that many businesses that you can have the requisite high degree of conviction
about. A better model is to invest in maybe 7 or 8 promising companies from
which you think you can get a 10x return. It’s true that in theory, the math
works out the same if you try investing in 100 different companies that you
think will bring 100x returns. But in practice that starts looking less like
investing and more like buying lottery tickets.
Despite being rooted in middle school math, exponential thinking is hard. We
live in a world where we normally don’t experience anything exponentially.
Our general life experience is pretty linear. We vastly underestimate exponential
things. If you backtest Founders Fund’s portfolios, one heuristic that’s worked
shockingly well is that you should always exercise your pro rata participation
rights whenever a smart VC was leading a portfolio company’s up round.
Conversely, the test showed that you should never increase your investment on a
flat or down round.
Why might there be such a pricing inefficiency? One intuition is that people
do not believe in a power law distribution. They intuitively don’t believe
that returns could be that uneven. So when you have an up round with a big
increase in valuation, many or even most VCs tend to believe that the step up
is too big and they will thus underprice it. The practical analogue would be
to picture yourself working in a startup. You have an office. You haven’t hit
the exponential growth phase yet. Then the exponential growth comes. But
you might discount that change and underestimate the massive shift that has
occurred simply because you’re still in the same office, and many things look
the same.
Flat rounds, by contrast, should be avoided because they mean that the
VCs involved believe things can’t have gotten that much worse. Flat rounds
are driven by people who think they might get, say, a 2x return from an
investment. But in reality, often something has gone very badly wrong—hence
the flat round’s not being an up round. One shouldn’t be mechanical about
this heuristic, or treat it as some immutable investment strategy. But it actually
checks out pretty well, so at the very least it compels you to think about power
law distribution.
Understanding exponents and power law distributions isn’t just about
understanding VC. There are important personal applications too. Many
things, such as key life decisions or starting businesses, also result in similar
distributions. We tend to think about these things too moderately. There is a
perception that some things are sort of better than other things, sometimes.
But the reality is probably more extreme than that.
Not always, of course. Sometimes the straighter, perceived curve actually
reflects reality quite closely. If you were to think about going to work for the
Postal Service, for example, the perceived curve is probably right. What you see
is what you get. And there are plenty of things like that. But it’s also true that
we are, for some reason or other, basically trained to think like that. So we tend
to miscalculate in places where the perceived curve does not, in fact, accurately
reflect reality. The tech startup context is one of those places. The skew of
distributions for tech startups is really vast.
This means that when you focus on the percentage of equity you get in a
company, you need to need to add a modifier: given something like a power law
distribution, where your company is on that curve can matter just as much or
more than your individual equity stake.
All else equal, having 1% of a company is better than having 0.5%. But the
100th employee at Google did much better than the average venture-backed
CEO did in the last decade. The distribution is worth thinking hard about. You
could spin this into argument against joining startups. But it needn’t go that
far. The power law distribution simply means you have to think hard about a
given company is going to fall on the curve.
The pushback to this is that the standard perception is reasonable—or at least
is not unreasonable—because the actual distribution curve turns out to be
random. The thesis is that you are just a lottery ticket. That is wrong. We will
talk about why that is wrong later. For now, it’s enough to point out that the
actual curve is a power law distribution. You don’t have to understand every
detail and implication of what that means. But it’s important to get some
handle on it. Even a tiny bit of understanding of this dimension is incredibly
valuable.
II. The View from Sand Hill Road
Peter Thiel: One thing we should talk about is what secrets VCs use to make
money. Well, actually most don’t make money. So let’s talk about that.
Roelof Botha: The unprofitability of venture capital is pretty well documented.
Average returns have been pretty low for a number of years now. One theory
is that when venture was doing very well in the 1990s, it became a big deal
to more or less blindly follow advice to put more money in venture. So the
industry may be overinvested, and it’s hard for most firms to make money.
Peter Thiel: Paul, what can entrepreneurs do to avoid getting taken
advantage of by VCs?
Paul Graham: There’s nothing inherently predatory about VC. Y-Combinator
is a minor league farm club. We send people on up to VCs. VCs aren’t evil or
corrupt or anything. But in terms of getting a good deal and not a bad one, it’s
the same with any deal; the best way to get a good price is to have competition.
VCs have to be competing to invest in you.
Peter Thiel: We’ve discussed in this class how competition can be a scary
thing. Maybe it’s less bad when you make VCs compete against each other. In
practice, you never really land just one investor. Chances are you have at least
two people who are interested or you have zero. The cynical explanation of this
is that most VCs have little or no confidence in their ability to make decisions.
They just wait to ape others’ decisions.
Paul Graham: But investors also have an interest to wait, if they can. Waiting
means that you’re able to get more data about a given company. So waiting is
only bad for you if founders raise the price while you wait. VCs are looking for
startups that are the next Google, or not. They are cool with 2x returns. But
more than that they don’t want to lose a Google.
Peter Thiel: How do you avoid being a VC that loses money?
Roelof Botha: Since the distribution of startup investment outcomes follows a
power law, you cannot simply expect to make money by simply cutting checks.
That is, you cannot simply offer a commodity. You have to be able to help
portfolio companies in a differentiated way, such as leveraging your network on
their behalf or advising them well. Sequoia has been around for more than 40
years. You cannot get the returns that we have if you are just providing capital.
Paul Graham: The top VC funds have to be able to make up their own minds.
They cannot follow everybody else because it’s everyone that follows them!
Look at Sequoia. Sequoia is very disciplined. This is not a bunch of B-school
frat boys who are screening founders for guys who look like Larry and Sergey.
Sequoia prepares careful research documents on prospective investments…
Roelof Botha: But succinct research. If you make or believe you need a 100page document, you miss the forest for trees. You must be able to condense it
into 3-5 pages. If there can be no succinct description, there’s probably nothing
there.
Peter Thiel: Even within an individual business, there is probably a sort of
power law as to what’s going to drive it. It’s troubling if a startup insists that it’s
going to make money in many different ways. The power law distribution on
revenues says that one source of revenue will dominate everything else. Maybe
you don’t know what that particular source is yet. But it’s certainly worth
thinking about. Making money with A is key. Making money with A through
E is terrifying, from an investor’s perspective.
Roelof Botha: LinkedIn is exception that proves the rule there. It had 3
revenue streams that are pretty equal. No one else really has that. At least it’s
very unusual.
Peter Thiel: Do Y-Combinator companies follow a power law distribution?
Paul Graham: Yes. They’re very power law.
Peter Thiel: Incubators can be tricky. Max Levchin started one. It had a
really long cycle—maybe even a year-long cycle. That made for some crazy
intercompany dynamics. All these people start in similar boats but, because
of the power law dynamic, end up in very different ships. The perceptions are
quite jarring. What happens with different people as they reach these different
stages can be very complicated.
Roelof Botha: People don’t always appreciate or understand rapid increases in
value when businesses take off. They underestimate the massive asymmetry of
returns. They hear that a company has joined the billion-dollar club and are
perplexed because only 6 months ago, it was worth $200m. The alternative to
understanding the exponential growth is believing that Silicon Valley VCs have
gone crazy.
Peter Thiel: PayPal’s most successful up round resulted in a 5x increase in
valuation. But it was pitched in a forward-looking context. It wasn’t about
taking x and multiplying by 5. The narrative was that the valuation made sense
because of the promising future ahead. The real value is always in the future.
Absent a very specific future you can point to, people anchor to a very specific
past. And that is where you get the pushback of: “How can it possibly be worth
5x what it was 3 months ago?”
Paul Graham: You could even say that the whole world is increasingly taking
power law shape. People are broken into so many different camps now. If
everyone were forced to work for 1 of 10 GM-like companies—maybe like
Japan—it would straighten the power law curve and make it taut. Distributions
would be clustered together because everyone is bound together. But when you
have lots of slack and people break apart, extremes form. And you can bet on
this trend continuing in the future.
Roelof Botha: One thing that people struggle with is the notion that these
massive companies can be built very quickly, often seemingly overnight. In the
early PayPal days, there were perhaps 300 million internet users. Now there are
2 billion. We have more mobile phones. We have cloud computing. There are
so many ways to grow. Consequently there is a qualitative difference in one’s
ability to have such a huge impact as an entrepreneur.
Question from audience: Do up, flat, and down rounds reflect power law
distributions, or specifically where a company will fall on the distribution?
Peter Thiel: First, it’s important to note that when you join or start a startup,
you’re investing in it. All your eggs are in that basket. But because of the power
law distribution, your investors aren’t in a radically different place than you are.
In a sense, VCs’ eggs are in your basket too. They have a few more baskets than
you do, but again, because of the power law, not many. VC isn’t private equity
where you shoot for consistent 2x or 3x returns.
One way to rephrase the question would be: is there a market inefficiency here?
My backtesting claim is that one should do a full pro rata investment whenever
one of your companies does an up round led by a smart VC.
Roelof Botha: I don’t have the data you’re looking at, but my intuition is that’s
true. But only for the best VCs. Where the VC leading the round isn’t as smart
or as trusted, the reverse can happen. Companies can end up with too much
cash. They might have a 15-month runway. They get complacent and there’s
not enough critical thinking. Things go bump at 9 months and it turns into a
crisis. And then no one wants to invest more.
Peter Thiel: Even factoring in dilution, you tend to do quite well if every round
is an up round. But even a single down round tends to be disastrous, mainly
because it destroys relationships among all the relevant players. If you’re going
to go with a not-so-intelligent investor who gives you a really huge valuation,
you should take it only if it’s the last money you’re going to take.
Question from audience: Does the shape of the distribution curve change or
depend on the time or stage of the investment?
Peter Thiel: The curve is fairly fractal-esque all the way up. Founders Fund
tries to invest in 7 to 10 companies per fund. The goal is to get to 10x return.
How hard is it to get to 10x? It’s about as hard to get from $10m to $100m as it
is from $100m to $1bn or $1bn to 10bn. Taking $100bn to a trillion is harder
because the world isn’t that big. Apple’s market cap is $500bn. Microsoft’s is
$250bn. There’s a pretty incredible power law all the way up.
The same is probably true on angel level. The angel investment landscape is sort
of saturated for angel piece, especially now with the JOBS Act. But some would
say that angel investors are less aware of power law dynamics than other people
are, and so they tend to overestimate a given company as a result.
Roelof Botha: There is a 50% mortality rate for venture-funded businesses.
Think about that curve. Half of it goes to zero. There are some growth
investments—later stage investments—which makes things less drastic. Some
people try for 3-5x returns with a very low mortality rate. But even that VC
model is still subject to power law. The curve is just not as steep.
Question from audience: What if your business is just worth $50m and you
can’t grow it any more?
Paul Graham: That assumption is nonsense. Grow it, if you want to. There’s
no such thing as an immutable company size. Companies are not intrinsically
or inherently limited like that. Look at Microsoft or Apple. They started
out making some small thing. Then they scaled and branched out as they
succeeded.
To be clear, it’s totally cool to have low aspirations. If you just want to make a
$50m company, that’s great. Just don’t take venture capital, or at least don’t tell
VCs about your plans!
Peter Thiel: It would raise a big red flag if you were to put a slide at the end of
your deck that says you’re looking to sell the company for $20m in 18 months.
Question from audience: What happens when you take out a bunch of rounds
and things don’t go well and your current investors don’t want to put in more?
Paul Graham: In that scenario you are essentially wasting one of your
investors’ board seats. Their opportunity cost of having you going sideways is
very high. People can only stand being on a dozen or so boards. Any more than
that and they go crazy. So they’ll try to get you sold.
Peter Thiel: Such unequal outcomes produces another cost of ending up on
multiple boards. There are big reputational costs to just switching boards. So
there is a big disconnect between public branding—narratives about how VCs
pay loving attention to all their companies and treat them all equally—and the
reality of the power law.
Roelof Botha: And it can be even worse than that; the problem companies can
actually take up more of your time than the successful ones.
Peter Thiel: That is a perverse misallocation. There are differing perspectives
on what to do in these situations. At one extreme, you just write checks and
check out. At the other, you help whoever needs it as much as they need it.
The unspoken truth is that the best way to make money might be to promise
everyone help but then actually help the ones who are going to provide the best
returns.
Question from audience: Bill Gates took no funding and he ended up with
a large piece of Microsoft. If a startup can bootstrap instead of taking venture
capital, what should it do?
Paul Graham: VC lets you borrow against future growth. You could wait until
your revenues are high enough to fund x. But, if you’re good enough, someone
will give you money to do x now. If there’s competition, you may need to do x
quickly. So if you don’t screw things up, VC can often help you a great deal.
Roelof Botha: We would not be in the business if it were just writing checks.
The entrepreneurs make it happen; they are the ones building the companies.
But the board and VCs can roll up their sleeves, offer counsel, and assist as
needed. They can be there for the entrepreneurs. We shouldn’t overstate the
importance of that, but neither should we dismiss it.
Paul Graham: Just being backed by a big VC firm will help you open lots of
doors. It will help considerably with your hiring.
Peter Thiel: If you’re doing something where you don’t need to move as quickly
as possible, you might want to rethink taking venture funding. But if there’s
any sort of winner-take-all dynamic—if there is a power law distribution at
play, then you want VC. Giving up 25% of your business is worth it if it enables
you to take over your industry.
Question from audience: Do Sequoia or other top-tier VC firms offer tougher
term sheets to account for the extra value they provide? Is all the stuff about
non-monetary value-add just overplayed?
Roelof Botha: It’s not overplayed. It really is personal. Who are you getting
in business with? Can you trust them? I wouldn’t send my brother to most VC
firms. But some are great. You really have to get to know the people you might
be working with. You’re essentially entering a long-term relationship.
Just look at you. There’s information contained in your Stanford degree. The
signaling helps you quite a bit. The same is true if you’re backed by certain VCs.
There’s a lot of value in the name, independent of things like making important
introductions. And strategic direction is hard to pinpoint, but it can accumulate
in many interesting and beneficial ways. Even if we don’t have the answers, we
have probably seen similar problems before and we can help entrepreneurs think
through the questions.
Question from audience: Right now, entrepreneurs are trying to flip
companies for $40m in 2 years or less. The incentive is to flip easy stuff
instead of creating hard technical stuff. What’s the cause and what’s the effect?
Entrepreneur greed? VCs who don’t value technical innovation?
Paul Graham: I disagree with the premise that there’s a lack of innovation.
$50m companies innovate. Mine did. We basically invented the web app. We
were doing complex stuff in LISP when everyone else was doing CGI scripts.
And, quite frankly, $50m is no small thing. We can’t all get bought for $1.5bn,
after all… [looks at Peter].
Peter Thiel: Let me rephrase the question: are VCs looking for quicker profits?
Are we getting thinner companies than we should be?
Paul Graham: I don’t think investors have too much effect on what companies
actually do. They don’t push back and say no, do this cool thing x instead of
that dumb thing y. Of course, tons of people just try and imitate what they see
and think is easy. Y-Combinator is probably going to be filtering out thousands
of Instagram-like applications next cycle.
Roelof Botha: If someone came to me and I got the sense that he was trying to
just flip a company quickly, I’d run. But most founders aren’t B-school finance
mechanics who calculate exactly what space would be most profitable to enter.
Most good founders are people solving problems that frustrate them. Google
grew out of a research project stemming from frustration with AltaVista.
Peter Thiel: One strange corollary to the power curve dynamic is that the
people who build the really great companies are usually hesitant to sell them.
Almost necessarily that’s the case. And it’s not for lack of offers. Paradoxically,
people who are heavily motivated by money are never the ones who make the
most money in the power law world.
Question from audience: If the most money comes from people who aren’t
trying to make the most money, how do you handle that paradox as a VC?
Roelof Botha: Consider a simple 2 x 2 matrix: on one axis you have easy to get
along with founder, and not. On the other, you have exceptional founder, and
not. It’s easy to figure out which quadrant VCs make money backing.
Question from audience: If the power law distribution is so extreme, how can
Y-Combinator succeed?
Paul Graham: There is a very steep drop-off. Y Combinator essentially gets the
first pick of a very good national and even international applicant pool.
Peter Thiel: I won’t come out as pro- or anti-Y Combinator. They do some
things well and maybe some other things less well. But I will do something
anti-not-Y Combinator. If you go to incubator that’s not Y Combinator, that is
perceived as negative credential. It’s like getting a degree at Berkeley. Okay. It’s
not Stanford. You can a complicated story about how you had to do it because
your parents had a big mortgage or something. But it’s a hard negative signal to
get past.
Question from audience: Do you back founders or ideas?
Paul Graham: Founders. Ideas are just indicative of how the founders can
think. We look for relentlessly resourceful people. That combination is
key. Relentlessness alone is useful. You can relentlessly just bang your head
against the wall. It’s better to be relentless in your search for a door, and then
resourcefully walk through it.
Roelof Botha: It is so rare to find people who can clearly and concisely identify
a problem and formulate a coherent approach to solve it.
Peter Thiel: Which is why it’s very important to drill down on the founding
team.
Roelof Botha: You can discover a lot about founders by asking them about
their choices. What are the key decisions you faced in your life and what did
you decide? What were the alternatives? Why did you go to this school? Why
did you move to this city?
Paul Graham: Another corollary to the power law is that it’s OK to be lame
in a lot of ways, so long as you’re not lame in some really important ways. The
Apple guys were crazy and really bad dressers. But they got importance of
microprocessors. Larry and Sergey got that search was important.
Peter Thiel: Isaiah Berlin wrote an essay called “The Hedgehog and the Fox.”
It revolved around a line from an ancient Greek poet: foxes know many little
things, but hedgehogs know one big thing. People tend to think that foxes are
best because they are nimble and have broad knowledge. But in business, it’s
better to be a hedgehog if you have to choose between the two. But you should
still try and know lots of little things too.
Question from audience: You mentioned “smart VCs” in your backtesting
example. Who are the smart VCs?
Peter Thiel: The usual suspects. Next question.
Question from audience: What keeps you guys up at night? What do you fear
most?
Paul Graham: I fear that something will come along that causes me personally
to have to do a lot more work. What’s your greatest fear, Roelof? Andreessen
Horowitz?
Roelof Botha: Suffice it to say that you’re only as good as your next investment.
Question from audience: Can entrepreneurs raise venture capital if they’ve
raised and failed before?
Paul Graham: Yes.
Roelof Botha: Max fell twice before PayPal, right? Here, it’s a myth that failure
is stigmatized. In some places, such as France, that is true. Failure is looked
down upon. But much less so in the U.S. and in Silicon Valley in particular.
Peter Thiel: One still shouldn’t take failure lightly, though. There is still a
reasonably high cost of failure.
Paul Graham: It largely depends on why one failed, though. Dalton Caldwell
got killed by the music business. Everyone knows that wasn’t his fault. It’s like
getting shot by the mafia. You can’t be blamed for it.
Roelof Botha: Sometimes having experience with failed startups can make an
entrepreneur even better. If they learn from it, maybe they get inspiration or
insight for their next company. There are plenty of examples. But you should
not fail for the sake of failure, of course.
Question from audience: Do you fund teams of 1?
Paul Graham: Yes. Drew Houston was a team of one. We suggested that he
find a co-founder. He did. It worked well.
Peter Thiel: A core founding team of two people with equal shares tends to
work very well. Or sometimes it makes sense to have one brilliant founder that’s
far and away above anyone else.
Paul Graham: Four is too many.
Peter Thiel: Think about co-founders from a power law perspective. Having
one means giving up half the company. Having two means giving up 2/3. But
if you pick the right people, it’s likely that the outcome will be more than 2x or
3x what it would’ve been without them. So co-founders work pretty well in the
power law world.
CHAPTER FIVE
HOW TO BE AN ENTREPRENEUR
Entrepreneurship is about ideas, people, and solving problems. Contributors
share best practices for deciding on a business idea and finding the right team
to help bring it to life.
Picking an Idea
Chris Dixon: Founder/Market Fit
An extremely useful concept that has grown popular among startup founders
is what eminent entrepreneur and investor Marc Andreessen calls “product/
market fit,” which he defines as “being in a good market with a product that can
satisfy that market.” Andreessen argues persuasively that product/market fit is
“the only thing that matters for a new startup” and that ”the life of any startup
can be divided into two parts: before product/market fit and after product/market
fit.”
But it takes time to reach product/market fit. Founders have to choose a market
long before they have any idea whether they will reach product/market fit. In
my opinion, the best predictor of whether a startup will achieve product/market
fit is whether there is what David Lee calls “founder/market fit.” Founder/
market fit means the founders have a deep understanding of the market they are
entering, and are people who “personify their product, business and ultimately
their company.”
A few points about founder/market fit:
Founder/market fit can be developed through experience: No one is born with
knowledge of the education market, online advertising, or clean energy
technologies. You can learn about these markets by building test projects,
working at relevant companies, or simply doing extensive research. I have a
friend who decided to work in the magazine industry. He discovered some
massive inefficiencies and built a very successful technology company that
addressed them. My Founder Collective partners Eric Paley and Micah
Rosenbloom spent many months/years becoming experts in the dental industry
in order to create a breakthrough dental technology company.
Founder/market fit is frequently overestimated: One way to have a deep
understanding of your market is to develop product ideas that solve problems
you personally have. This is why Paul Graham says that “the best way to come
up with startup ideas is to ask yourself the question: what do you wish someone
would make for you?” This is generally an excellent heuristic, but can also lead
you astray. It is easy to think that because you like food you can create a better
restaurant. It is an entirely different matter to rent and build a space, market
your restaurant, manage inventory, inspire your staff, and do all the other
difficult things it takes to create a successful restaurant.
Similarly, just because you can imagine a website you’d like to use, doesn’t
mean you have founder/market fit with the consumer Internet market.
Founders need to be brutally honest with themselves. Good entrepreneurs are
willing to make long lists of things at which they have no ability. I have never
built a sales team. I don’t manage people well. I have no particular knowledge
of what college students today want to do on the Internet. I could go on and on
about my deficiencies. But hopefully being aware of these things helps me focus
on areas where I can make a real contribution and also allows me to recruit
people that complement those deficiencies.
Most importantly, founders should realize that a startup is an endeavor that
generally lasts many years. You should fit your market not only because you
understand it, but because you love it — and will continue to love it as your
product and market change over time.
Andrew Chen: When Has a Consumer Startup Hit Product/Market Fit?
This post is part of my recent 2011 blogging roadmap post, where I created an
outline of going from zero to product/market fit. Getting to this endpoint is
obviously a good goal in theory, but the question is, what does it even mean to
hit this goal?
The original definition
In Marc Andreessen’s original post on the topic, he writes:
Product/market fit means being in a good market with a product that can
satisfy that market.
You can always feel when product/market fit isn’t happening. The customers
aren’t quite getting value out of the product, word of mouth isn’t spreading,
usage isn’t growing that fast, press reviews are kind of “blah,” the sales cycle
takes too long, and lots of deals never close.
And you can always feel product/market fit when it’s happening. The customers
are buying the product just as fast as you can make it—or usage is growing just
as fast as you can add more servers. Money from customers is piling up in your
company checking account. You’re hiring sales and customer support staff as
fast as you can. Reporters are calling because they’ve heard about your hot new
thing and they want to talk to you about it. You start getting entrepreneur of
the year awards from Harvard Business School. Investment bankers are staking
out your house. You could eat free for a year at Buck’s.
His partner, Ben Horowitz, follows it up with a bunch of other observations
about the fact the event isn’t a “big bang” kind of event—instead, there’s lots of
gray area as your product starts working for the market.
So the short answer is, there’s no easy test.
Now given that caveat, I’m going look at this through the lens of consumer
internet to add some additional thoughts.
What is a market anyway? And how do you validate it’s real?
How do you even define a market for consumer internet? Ultimately, I
concluded that the most useful definition of “market” is 100% consumercentric. Here’s an attempt at a simple definition, focused on consumer internet:
A market consists of all the consumers who can search for and compare
products for a use case they already have in mind.
This definition is very focused on the notion of pre-existing demand for
products in your market, and is scoped narrowly to avoid confusion.
The most concrete test of pre-existing demand is using the Google Keyword
Tool, which tells you how many people are searching on Google for a particular
keyword. To try this out, you’d execute the following steps:
1. What keyword do people search to get to your site?
2. Put those keywords into Google Keyword Tool
3. How many people are searching for this keyword?
If the answer to #3 is large (millions or more), then you have a large market.
This test is very concrete, and also very finicky. By design, terms like “vacation
package” score high on this test, whereas “travel experiences” do not, even
though an educated entrepreneur or investor might abstractly group them
together. Similarly, by design, a person who’s building a “social network for
musicians” might be inclined to list the # of musicians in the US as part of their
market sizing, but under this test, you’d quickly see that there’s not too many
people are specifically looking for that. Also interestingly enough, you’d never
say there was a “Photoshop market” but a quick search will show that in fact
almost 40 million searches per month on “photoshop,” and it might be a great
strategy to position yourself relative to that keyword.
Validating that you are part of a pre-existing market comes with all sorts of
benefits, which I’ll address in later posts. But for now, the most important
benefit is that you know the # of potential customers is large.
(In general, I’ve been constantly confused about how to even define a market
in consumer internet, given that there’s so much similar featureset between
otherwise very different products. For example, early on, people talked about
“social” as if it were a type of site, whereas now it’s seen as an aspect for all new
products coming to the web. Similarly, people sometimes talk about “Facebook
apps” as if it’s a market when, again, it’ll probably just end up an aspect of every
new online service.)
What’s a great market?
What are other attributes that make a market attractive? For consumer internet,
a great market is commonly defined by:
• A large number of potential users
• High growth in # of potential users
• Ease of user acquisition
Not competition, in my opinion, because for consumer internet there is
often literally billions of potential users, and you’re mostly competing against
obscurity. So even if there’s a ton of competition, if it’s easy to acquire
consumers to your product, that’s great! Then get a good enough product, and
you’re ready to go.
Not monetization, in my opinion, because making money is pretty
straightforward. You can throw on some ads and get $0.1-$1 CPMs, or you
can charge subscription rates and get 1% to convert, or you can do the virtual
goods thing. The biggest risk in all of these monetization models is really about
whether or not you can get millions of users or not.
Picking a great market leads to better products
Leading with a great market helps you execute your product design in a simpler
and cleaner way. The reason is that once you’ve picked a big market, you can
take the time to figure out some user-centric attributes upon which to compete.
This leads to a strong intention for your product design, which drives a clean
and cohesive UX. In a market of all black Model Ts, you can sell otherwise
identical cars of different colors and that’ll work. Picking the right attribute is
its own topic though!
The important part here is that you can usually pick some key things in which
your product is different, but then default the rest of the product decisions. This
means that your product’s design can be more cohesive because you’re trying to
do less, but better.
Once you’ve executed your product, then there are various ways to validate that
it’s “good enough” and your product fits the market:
• When user testing, do people group your product in with the
“right” competitive products?
• Do they understand the differentiation of your product versus
your competitors?
• Will some segment of users in the overall market switch to your
product?
• Are some users who’ve “rejected” the products in the market
willing to try your product?
• How do your underlying metrics (DAU/MAU, +1 week retention,
etc.) compare to your competitors?
All of the above are signals towards product/market fit. The above tests are
interesting in that they’re fundamentally anchored on pre-existing competitive
products in the category. In a new market, you don’t have the luxury of
comparing yourself to other things.
In future posts, I’ll try to give some more concrete metrics based on my research
for what are good numbers in each of these cases, but for now, the important
idea is just that in a large existing market you have more datapoints to at least
say, “my product is at least as good as the other guy’s.”
New markets are a danger to good product design
In fact, one of the scariest things to me about new markets is that doing great
product design for them is extremely hard. It’s so unconstrained that it’s hard
to do anything other than add features, see what sticks, and iterate. This is fun
except that keeping a cohesive product experience is quite hard, and removing
features is usually harder than adding them. So at the end, you incur tons of
product design debt that never gets paid off. (It’s not a surprise to me that Apple
has a history of simplifying already successful product categories, rather than
inventing brand new ones from scratch)
Conclusion
To summarize my main points in this essay, I’ve come to some simplifying
definitions on how to validate product/market fit in consumer internet. For
market, if you constrain the definition to people who know how to search for
products in your category, you can develop a pretty concrete test evaluating
pre-existing demand. And by leading with a market, you can develop a central
design intention that leads to better product design. This in turn can then be
validated by comparing your product metrics to competitor numbers, as well as
user tests that focus on grouping and differentiation.
Constructing a Team
Seth Levine: Hiring as a Core Competency
Most startups spend plenty of time working on things like their product
plans, requirements docs, market studies and the like. They are important
aspects of running their companies and the kind of things that improve with
collaboration and varied input, as well as from the iterative and inclusive process
they typically require. You’d expect to find documents related to these sorts
of activities on an intranet or company wiki and you’d expect that they’d be
included in the occasional board package and discussed with advisors.
I’d suggest companies add something else to this list: a detailed overview of
how they conduct hiring.
Most startups will tell you that hiring great people is one of the most important
determinants of a company’s success. Why then is the process of hiring
generally treated as a completely ad hoc exercise? In my view this leaves to
chance and happenstance something that is much too critical to the successful
operation of a business. Here are some ideas I was recently kicking around
with one of the companies I work with that takes the hiring process extremely
seriously (and as a result has been extraordinarily picky about who they’ve
brought on board).
• Have a job description. I get it. You’re an early stage company and
“people wear a lot of hats” around your shop. Whatever. Get over
that and write up a description of what you’re looking for.
• There’s more to the job than the “to do” list. A good job
description should include more than the daily task list for the job
at hand. What kind of individual are you looking for? What kind
of company culture are you trying to create? What personality
traits are necessary for people to be successful at your business?
• It’s not just the hiring manager’s job. I’m a big believer in having
potential job candidates meet with people from across a company.
This holds whether you’re in a 5 person startup or a 10,000 person
organization. I strongly believe the companies make better hiring
decisions when more people are involved.
• Try before you buy. While not everyone is open to a 30 day
consulting gig before they come on full time, your interview
process should include some kind of working session so you can
get a good sense for how your job candidate works. This could
be a product requirements meeting, a UI/UX discussion or
building a sample financial model. It’s a great way to involve other
people from the company even if they are not a part of the direct
interview process and a well-designed session should give you a
good sense for how your candidate can contribute to the business.
• Aim high. In the fast paced world of startups there’s a natural
tendency to need to get everything done yesterday – including
that latest hire. As a result, it’s pretty easy to convince yourself
that someone is “good enough” or “better than not having
anyone.” Not true. Don’t settle in your hiring. It’s better to delay a
product/release/market launch to find the right person for the job
than to hire low and suffer the consequences. A bad team member
brings the productivity of the entire team down.
• Trust your gut. Isn’t this true of most things in life? It’s definitely
true of hiring. If you have a bad feeling about someone, move on.
• If it’s not working, call it. This is such a cliché, I almost didn’t
include it. But it’s too important not to mention. It’s part of the
old adage “Hire slow and fire fast” but if it’s not working out, it’s
time to move on (see “Aim High”).
Much of this post stemmed from a conversation that I had with one of the
companies that I work with. At this company we had a long discussion with
the entire company (at the time only 7 people but we’ve repeated this company
wide conversation as we’ve grown) about how to avoid hiring mistakes and the
stake that everyone around the table has in making sure that we bring only
great people on board.
So talk openly at your company about your hiring practices and work as a group
to come up with your own plan for how you’ll make hiring a core competency –
and then put all that on your wiki so you don’t forget it.
Darren Herman: The Startup as a Band
I’m always looking to draw parallels between things and one I’d like to share
is my analogy of the music world and the startup world, both of which I feel
extremely passionate about.
Dave Matthews Band is my favorite band, and though I’ve blogged about them
before, I’m going to use them in an analogy. Feel free to replace this band with
one of your choosing and I’m sure the band members will still work.
In the startup world, different people bring various skills to the company. Many
times, people have overlapping skill sets, but if staffed correctly, a solid startup
will have specialists in various areas. Since I’m a digital media guy, I’m going to
lay out a digital media startup:
•
•
•
•
•
CEO/President
Sales Guru (EVP, Sales)
Technology Guru (CTO)
Marketing Guru (CMO)
Financial Wizard (CFO)
These five positions are generally found in most [if not all] digital media
startups and are staffed ideally by the highest caliber members possible. The
members of these positions have exemplified significant amplitude to their
positions and lead their respective charge with a team reporting to them.
Drawing the parallels with DMB, you will find:
•
•
•
•
•
CEO/President: Dave Matthews
Sales Guru (EVP, Sales): Carter Beauford
Technology Guru (CTO): Stefan Lessard
Marketing Guru (CMO): Boyd Tinsley
Financial Wizard (CFO): Leroi Moore
CEO/President: More often than not, the public face of the company and
the most vocal. Dave, being the front man (arguably with drummer, Carter
Beauford) and setting the tone for the band. Rallies the team through ups and
downs and has significant pressure applied by fans (the board) to produce good
music.
Sales Guru: Without this rock star of sales, the company isn’t going anywhere.
At the end of the day, the company must generate revenue and if the co. hasn’t
taken any funding, the days will be short lived. The drummer, Carter Beauford,
keeps the band moving. He calls the shots and decides where the music will go
(should they jam out #41, or end it quickly).
Technology Guru: Yes, Stefan Lessard (bassist) would be the technology guru…
why? Because technology is an enabler. The technology must be present to
successfully run the digital media company, but generally, it holds everything
together and provides the beat/baseline that everything else follows. Take
the bass out of the song and it’ll sound empty; too much base and it’ll sound
terrible. During the song Anyone Seen the Bridge, the technology would shine,
as there is a minor solo by Lessard.
Marketing Guru: The marketing guru is generally responsible for how the
company looks and reacts to the market. This also includes public relations
and the conversation the band has indirectly with the fans. Boyd Tinsley,
violinist of the Dave Matthews Band fills this role extremely well. Solos, solos,
and more solos, but other times, blends in well with the band and plays in the
background. Whether it’s a full solo (think product announcement) in Too
Much, or blending into the background [everyday marketing] in Two Step,
Boyd is a significant part of the band.
Financial Wizard: The financial wizard of the company makes sure everything
is moving forward and the expenses and revenues check. Leroi Moore, DMB’s
saxophonist watches the band from the sideline and fills in any gaps – and has
the ability to blow a horn should the band be off beat. Generally very quiet and
sometimes reclusive, these wizards understand numbers and know them cold.
A major touring act such as the Dave Matthews Band could not survive
without it’s techs (drum & guitar techs), food crew, staff, roadies, drivers, road
managers, personal managers, and business managers (as well as label staff). In
the business world, this equals investors, mentors, board members, advisors, and
consultants.
It’s fascinating to draw the parallels between the music industry and the startup
world, but as you dig deeper into it, you’ll see it for yourself.
“Everybody wake up, if you’re living with your eyes closed.” – Dave Matthews
Band
Culture
Scott Weiss: 20 Rules of Thumb for Building a Great Startup Culture
Developing a good, healthy culture is extremely important at a startup. Culture
reflects the essence of a startup’s operation because it directly affects the success
of a company’s hiring practices and overall strategy. It is, at its core, essentially
a set of shared norms and a key source of strength and guidance when a startup
goes through those virtually inevitable trying times.
Some fundamental practices are obvious “must-dos” in building a strong
culture.
You must, for example, work to engender trust. As a decision maker, you rely on
information being passed to you by the people who report to you. As the CEO,
however, you cannot rely solely on this information. You also need to “dip”
down into your organization and learn directly from employees at all levels and
virtually all skill sets. As a leader, this is how you develop an intuitive sense of
your business, one that can only be formed by hearing directly from staff in
every corner of the company.
While these points create the core foundation for a good culture, it’s just the
beginning. Here are 20 additional rules of thumb I’ve discovered over the
course of my career to build and enhance culture at a more granular level.
1. Personally interview every new employee until the startup has 50
employees. Then interview everyone that will manage others.
2. Spend 30 minutes a week on Mondays talking to new employees
as part of their first day. Close the loop within a month by
dropping by their desk to see how things are progressing.
3. Make a point of having lunch with every employee and learning
not only names but some details about each one. When the
startup reaches 50 employees, take out two at a time.
4. Personally roll out the value, strategy and history of the company
during a comprehensive employee orientation session within the
first 90 days of the hiring of multiple employees.
5. Hold at least one all-hands meeting every quarter and, to
underscore the startup’s team concept, make sure at least one
additional executive joins you in leading the meeting.
6. At every meeting with all employees, set aside 30 minutes for
questions and press for no fewer than five.
7. Review PowerPoint slides after every meeting of the board and report
as much as possible about what was discussed to all employees.
8. Get in the habit of creating employee “notes from the road.” Send
an e-mail or blog to all employees after every trip to customers
and every trip to a conference, detailing key insights, and do the
same whenever a key competitor makes major news.
9. Ask your executive team to review what you write before you send it.
10. Set annual and quarterly goals (two to five is about right) for the
company, as well as for each employee.
11. Personally roll out the performance review process to everyone.
You need to be the leader speaker, not somebody from human
resources.
12. Give your direct reports a performance review at least twice a
year. Spend at least five hours preparing each person’s review and
take at least an hour to present it. Listen closely to feedback.
13. Emphasize the value of “speaking up” every time you get the
chance – during employee orientations, lunches, evaluations and
all-hands meetings.
14. Continually demonstrate that no task or chore is beneath you. For
example, fill the Coke machine, help clean up after a group lunch,
and make a point of helping in moving activities.
15. When a team has to work over a weekend, make a high priority of
being there as well, even if it’s just to stop by and buy them a meal
to show your appreciation.
16. Attend every company function, event and party and act as
though you are the host.
17. Promote mainly from within whenever possible, and always base
the decision solely on performance.
18. Follow the rules of being relatively Spartan and take and maintain
a modest office, park your car in the back lot and fly coach, not
first class.
19. When something significant goes wrong, take all the blame.
20. When something goes unusually well, give all the credit to others.
I’ve been fortunate to have the opportunity to work with many successful
executives and have found these tips to be very effective. Practice makes
perfect too, so embrace as many of these ways as you can as they truly make an
organization’s culture sounder.
CHAPTER SIX
FUNDRAISING
During every young startup’s life, entrepreneurs are faced with questions about
raising capital. Tried-and-true tips can be found in this section on the “how’s,”
“who’s,” and “when’s” of fundraising.
How to Fundraise
Mark Suster: A 6-Step Relationship Guide to VC
You’ve pitched several angels and VCs. Everybody seems to like you but nobody
seems to be getting out their checkbooks. Most of them are telling you that
they just need to see a bit of traction before they’d be prepared to invest.
Your friends and advisers tell you that this means you need revenue because in
this economy VCs will only fund businesses with revenue. Unfortunately your
advisers are wrong.
The “more traction” feedback is a very typical scenario in a down market
economy like the one we’re in. Investors are giving you a version of the “soft
no,” which basically means that they’re not prepared to invest now.
So if it’s not necessarily revenue that’s preventing an investment, then WTF
is traction? Unfortunately there is no real objective measure. Traction can
simply mean showing that you’re making progress with customers, product
development, channel partners, initial revenue as a proof point, attracting wellknown angel investors, winning industry awards / recognition. It is code word
for “I’m not ready to invest for whatever reason … I need more proof.”
Now there are some firms that have strict rules about not funding pre-revenue
companies – that’s different. But many Series A firms tell people they have a
“revenue rule” and then you look at their portfolio and see many exceptions.
6 Steps to Building a Relationship with VCs and Solving the Traction
Problem:
1. Always be pitching (line stolen from my favorite scene in one of my all-time
favorite movies).
Go see a few select VCs before you’re even ready for institutional money. Tell
them about what you’re up to in your business, show them your product or
prototype, tell them your strategy, talk about the deals you’re working on and
seek feedback.
Traction really is about building a relationship with a VC over time and
showing them that you can move the ball forward. Many entrepreneurs make
the mistake of thinking that funding is something you do in “funding season,”
some mythical 2-month period when you’re ready with a great PowerPoint deck
and you hit up all of the VCs at the same time so that you can quickly raise
money and get back to the job of building a business.
Fund raising is an ongoing process and not an event on a work plan. You need
to build a relationship with investors over a long period of time. That is how
you convince VCs that you’re gaining “traction.”
If you wait until you’re “ready” to fund you’re too late. Funding is about
developing a relationship over time. Most of us wouldn’t get married on the first
weekend we met someone in Vegas. And most VCs wouldn’t fund the first time
we meet you. Given that many VCs base their decision on the team, the longer
they have to get to know you the better.
2. Overdeliver
The people who get funded are the people who actually get things done. They
tell you that they’re working on biz dev deals with distribution partners and
they get the deals signed. They tell you they’re going to ship product and they
do. They get their widgets embedded or their products piloted. They hire key
staff.
They get positive product reviews on TechCrunch, GigaOm or Paidcontent.org.
They make progress. You need to over deliver and communicate back with VCs
showing the progress you’ve made.
3. Keep on the radar screen
I know the VCs seemed to love you when they met you. The problem is that
they see hundreds of pitches and they often don’t proactively step back and
think about the companies that seemed promising but they weren’t ready to
pull the trigger.
You should send “update emails” that are very short but highlight some of the
achievements you made with the intro saying, “since you showed interest in
my company I just wanted to provide you a brief update on our progress.” This
is important because it keeps you at the top of the stack in their memory. It’s
marketing 101 for tech companies in terms of how you market to customers.
You have buyers who are ready now and those that aren’t. Sales owns the
former, the latter get marketing emails so you’ll be top of your prospects’ minds.
VCs are the same.
4. Find ways of helping the VC
If as an entrepreneur you get to know other interesting entrepreneurs /
companies it is a good technique to send intro’s the VC and ask if they’re
interested in meeting the company. I usually recommend that you send
the companies PowerPoint deck and ask the VC if they’re interested but
don’t necessarily copy the company on the email until the VC says he/she is
interested. If they’re not at a minimum you’ve shown that you’re thinking of
them and you’ve stayed on their radar screen. It’s not required but I have seen
this technique be used effectively by entrepreneurs.
5. Schedule a follow up meeting.
Contact the VC again when you’ve signed a few more big deals. In your email
to the VC tell them about the additional progress you’ve made and ask for a
short, 30-minute session to update them on the business. Don’t take no for an
answer. Show some chutzpah. But be polite.
You might find that you get a “we’re really not interested” response. That’s OK
– at least you’ll know to cross them off the list. When you do get a follow up
meeting tell them about your new revenue model, ask to show your new demo,
talk about the progress you’ve made and what has turned out differently then
expected. Update them on your fund raising progress. Seek more input from
them.
Stick to your 30 minutes so you build the trust that every time you come back
you don’t abuse your time commitment. Leave them wanting more. Don’t come
back with fake progress. If the business isn’t getting “traction” then probably
best not to come back with a bad impression. Your time is better spent actually
making progress.
6. Rinse and repeat
When you do raise a round, start immediately building the relationship with
VCs who do B rounds. Some of the masters at this VC relationship business
are Jason Nazar (DocStoc), Jon Bischke (EduFire) and Ophir Tanz / Ari Mir
(GumGum). In the latter case, every time I saw them they had moved the ball
forward and evolved their strategy. After more than a year of updates I pulled
the trigger and invested.
We all build relationships over time. Doing an investment is more permanent
then marriage – there are no divorces for irreconcilable differences. I know
that in a booming market people fund quickly. And I know many stories of
Benchmark or similar investors writing term sheets after the first meeting. But I
also read stories about people winning the lottery. Neither is the norm.
Chris Dixon: Pitch Yourself, Not Your Idea
There is a widespread myth that the most important part of building a great
company is coming up with a great idea. This myth is reflected in popular
movies and books: someone invents the Post-it note or cocktail umbrellas and
becomes an overnight millionaire. It is also perpetuated by experienced business
people who, for the most part, don’t believe it. Venture capitalists often talk
about “the best way to pitch your idea” and “honing your elevator pitch.” Most
business schools have business plan contests that are essentially beauty pageants
for startup ideas. All of this reinforces the myth that the idea is primary.
The reality is ideas don’t matter that much. First of all, in almost all startups,
the idea changes – often dramatically – over time. Secondly, ideas are relatively
abundant. For every decent idea there are very likely other people who’ve also
thought of it, and, surprisingly often, are also actively pitching investors. At an
early stage, ideas matter less for their own sake and more insofar as they reflect
the creativity and thoughtfulness of the team.
What you should really be focused on when pitching your early stage startup is
pitching yourself and your team. When you do this, remember that a startup
is primarily about building something. Hence the most important aspect of
your backgrounds is not the names of the schools you attended or companies
you worked at – it’s what you’ve built. This could mean coding a video game,
creating a non-profit organization, designing a website, writing a book,
bootstrapping a company – whatever. The story you should tell is the story of
someone who has been building stuff her whole life and now just needs some
capital to take it to the next level.
Of course a great way to show you can build stuff is to build a prototype of the
product you are raising money for. This is why so many VCs tell entrepreneurs
to “come back when you have a demo.” They aren’t wondering whether your
product can be built – they are wondering whether you can build it.
Charlie O’Donnell: A Framework to Think About Pricing Seed, Angel,
and Venture Capital Rounds
How do you price a round?
It’s one of the most often asked questions and yet I’ve never seen a great answer
given. It seems to me that the most important factor in pricing your round isn’t
your progress or your idea. It seems to come down to two things:
1. How much do you want to raise?
2. Supply and demand of capital willing to invest in your company.
The second is pretty obvious, but what about the first? So the more you want
to raise, the more your company is worth? Kind of, actually...but how much
money a team gets has to do with a number of factors that reflect things like
trust in the team, risk, etc. So instead of pricing that into how much a company
is worth, they tend to price it into round size.
More simply, the better the team, the lower the risk, and the higher the
expected outcome, the more you’re going to be willing to give a team and the
longer you’ll let them go until their next fundraising.
Sometimes, this also relates to capital requirements of what the team needs.
For web development, usually it’s pretty much the same across the board, but if
you’re making jewelry in China, it’s going to be hard to get much done with a
500k seed round. Usually, teams are asking for enough money, plus a cushion,
to get to some milestone roughly 12-18 months out.
So, ask for more and you’ll get a higher price IF the investors think you can
handle it and you need it.
Generally, each round is going to set you back between 15-30%. That means
investors are going to buy that much of your company at a time. It’s a function
of a few things. That means that founders as a group will be right around 50%
ownership after two rounds. It means lead investors can get to 10, 15 or 20%
ownership depending on whatever math they have that makes their own success
model work. That’s just roughly the equilibrium we’ve come to in this world.
Let’s say the default, for simplicity’s sake, is to take 20% of every round. More
often, its probably closer to 25%, but since this is a blog post, I’ll try to look
more entrepreneur friendly. The question then becomes whether or not there’s
any significant reason to move off of that default.
Note that, to even get venture in the first place, you are special. Your team must
be awesome and your idea must have huge potential. Getting less dilution than
standard means that you have to have made fantastic progress, have a worldclass team, etc. way above and beyond what normally gets funded at this stage.
The other way to move that number is much more simple—generate more
demand for the round than there is supply of allocation. If two million of
money wants in to this deal and they’re raising one million, it’s unlikely that me
and my fellow investors are going to get the chunk of the company we normally
get. If you’re not fully subscribed, though, then I’m probably going to stick with
a more normalized price since I’d rather not negotiate against myself.
Just so you see what the results of dilution and raise size come out to be, here’s
the 2nd grade math in a chart:
One note is that I’m talking about equity here—but no matter what kind of
deal you strike, there’s usually an equivalent equity. Some people think that by
raising a convertible note, they’re not pricing a round. Bullshit. Whatever cap
you put on the round, that’s essentially the price, because no one would bet
on you unless they thought you could beat the cap—so its essentially equity.
Uncapped notes, on the other hand, leave the investors and the entrepreneur
misaligned. I’m not exactly hoping for near term success because my price isn’t
locked in. Investors should be able to lock in a price that reflects the risks at the
moment they pulled the trigger. Call me old fashioned.
So, there it is. It’s not that complicated, really.
From Whom to Fundraise
Chris Dixon: How to Select Your Angel Investors
I’ve seen a number of situations recently that are something like the following.
A VC firm signs a term sheet with an early stage company. Let’s say it’s a $2M
round. The VC and entrepreneurs decide to set aside $500K for small investors
(individual investors or micro-VCs). Because it’s a “hot” deal, there is way more
small investor interest than there is capacity (the round is “oversubscribed”),
and the entrepreneur needs to decide which investors are in and which are out.
The most common mistake entrepreneurs make is to base their choice solely
on the investors’ “celebrity” value (by “celebrity” I generally mean in the
TechCrunch sense, not the People magazine sense). Picking celebrity angels
might help you get a little more buzz when you announce the financing and a
few SUL tweets, but that’s about it. A startup is a long trip — what you should
care about is whether, through the ups and downs and after the buzz dies down,
the investors will actually roll up their sleeves and help you.
That isn’t to say that being a celebrity and being helpful are mutually exclusive.
Ron Conway is a celebrity (in the startup world) and is one of the hardest
working investors I know. But there are other celebrity investors who I’m a
co-investor with in a few companies who literally don’t respond to the founder’s
emails. And these are successful companies where the founder sends them only
occasional emails about really important issues.
The second biggest mistake is picking angels that benefit the lead VC. A lot of
times when VCs guide entrepreneurs to certain investors what they are really
doing is “horse trading” – they want you to let in so and so, because so and so
got them into another deal, or will help them get into future deals.
It’s also smart to pick a varied group of people. If you want a few celebrities to
create some buzz, fine. You should also pick some people who are connectors
– who can introduce you to key people when you need it (varying connectors
by geography and industry can also be helpful). Also very important are
active entrepreneurs who can (and will) give you practical advice about hiring,
product development, financing etc.
Finally, don’t spend too much time agonizing over this. One particularly silly
situation I was involved with was where the CTO had invited me to invest but
then the CEO decided he wanted to put me through multiple interviews before
he’d let me in. He probably spent a day of his time deciding whether to give
me some tiny fraction of the round. Eventually he dinged me because I wasn’t
famous, but at that point I was frankly kind of relieved since the CEO seemed
to have such a bad sense of how to prioritize his time.
Disclosure: This post is entirely self-serving, as I consider myself a non-celebrity but a
hard working small investor.
When to Fundraise
Mark Suster: VC Funding Season Ends Next Week
I’m sure I’ll spark the ire of some VCs for saying so, but there is certainly such
a thing as black-out days in venture capital. It’s worth you knowing this so you
don’t waste your time. It’s also very important to understand so that you can
properly plan when you raise money.
Let me first tell you the black-out periods and then I’ll explain why. It is very
difficult to raising venture capital between November 15 – January 7th. It is
also very hard to raise VC from July 15 – September 7th. (you need to have had
your first meeting even earlier.) If you’re thinking about raising VC and have
not yet started the process, you’ve probably already missed the boat for 2009.
If you’ve had your first partner meeting but haven’t had the full partner meeting
then you had better schedule it for Monday, November 23rd. Full partner
meetings are almost always on Mondays and if it isn’t already booked yet for
Monday, November 16th (e.g. this coming Monday) obviously that’s not going
to happen. If your VC is reluctant to schedule the partner meeting by the
23rd it’s a clear signal that they want to wait until the new year (or they aren’t
committed to your deal).
So why is Funding Season over for the rest of the year? The VC process is
almost universal in how it works across firms. You meet an initial person from
a firm – an associate, a principal or a partner. If it’s one of the first two you’ll
probably meet a single partner before coming into a full partner meeting where
(by definition) all of the partners will be in attendance.
It’s true that some VCs will work a few days of Thanksgiving week and many
will work the first 2 weeks of December. But the problem is that trying to get
enough of the partners to be at a full partners meeting during Thanksgiving
week or in December is very difficult. Because almost all VCs know this, many
are reluctant to even start the process with you.
The same thing happens beginning in the middle of July. Many VC partners
take 2-3 (4?) weeks off in August. I know that many VCs also work in August
so I’m not making any commentary about work ethics. But enough take
vacation that organizing full partner meetings proves difficult.
Maybe it’s partially because many entrepreneurs are pre-kids and many VCs are
post kids that VCs take off large blocks of time in the summer? Who knows –
but trust me (regardless of what anyone tells you) it’s a true phenomenon.
Note that Jeff Bussgang says that VCs work in August and he’s right. VCs are
never really “off.” Just like entrepreneurs they take calls from vacations, do
board calls, handle company emergencies and urgent financings. Jeff argues that
his firm has done the most deals in August in the 7 years since he’s been a VC.
I’m betting these processes started much earlier and his firm was just finalizing
what had been previously agreed during Funding Season. Maybe I’m wrong but
if I am I’m telling you in my experience his firm is the exception.
One carve out to the “Funding Season” rule – if you’re raising money from
angels or small VCs (2-3 partners) maybe you can get something done as you
don’t have the same scheduling conflicts.
But by and large I encourage entrepreneurs who are raising money to focus on
the following time periods to START your process:
•
•
•
•
•
•
January 6 – May 15th (green zone)
May 16th – June 30th (yellow zone)
July 1st – September 7th (red zone)
September 8th – October 15th (green zone)
October 16th – October 31st (yellow zone)
November 1st – January 7th (red zone)
Please don’t shoot the messenger in the comments, I’m just tellin’ it how it is.
And if VCs are telling you otherwise, when they’re done with your funding
documents I’m sure they’ll also tell you, “the check is in the mail.”
UPDATE: As accurately pointed out in the comments, I advocate building
relationships with VCs year round. It is always best to know your VC well
before you really need money (in the same way you’d historically want to know
your local banker).
UPDATE 2: Yes, this is US centric. In Europe funding season is longer into
November but much, much shorter in the Summer! (I know, I lived there for 11
years). Any views on funding season in Asia?
How to Build a Deck
Babak Nivi: What Should I Send to Investors?
“PowerPoint plans greatly increase your chance of getting a term
sheet, or at least the dignity of a quick no.”
— David Cowan, Bessemer Venture Partners
A PowerPoint plan (“deck”) is less important than an elevator pitch, and an
elevator pitch is less important than an introduction. Read “What should I send
investors? Part 1: Elevator Pitch” for tips on crafting an elevator pitch.
Many investors will just skim a deck and take a meeting if the introduction and
elevator pitch are good.
But you can still send a deck. A deck lets investors learn more about your
company. It demonstrates that you’ve thought about the company in detail. It’s
an industry norm. And you need one for presentations anyway.
Include a “ten-slide” deck with your elevator pitch.
The best deck template in the universe is David Cowan‘s “How To Not Write A
Business Plan”—use it. There are other templates from excellent sources on the
Web, but this is the best.
Read David Cowan’s article and apply these headings and minor changes:
1. Cover.
2. Mission.
3. Summary. Summarize the key, compelling facts of the company.
You can steal the content from your elevator pitch.
4. Team. Highlight the past accomplishments of the team; if your
team has been successful before, investors may believe it will be
successful again. Don’t include positions you intend to fill—save
that for the Milestones slide. Put yourself last: it seems humble
and lets you tell a story about how your career has led to the
discovery of the…
5. Problem.
6. Solution. Include a demo such as a screencast, a link to working
software, or pictures. God help you if you have nothing to show.
7. Technology.
8. Marketing. Include market size estimates here or in the Problem.
If you haven’t launched, discuss your plan to acquire users or
customers.
9. Sales. If you don’t have sales, discuss your business model and
prospective customers. Ignore the cost of customer acquisition
unless you have some insight into the issue.
10. Competition. Describe why users or customers use your product
instead of the competition’s product. Describe any competitive
advantages that remain after the competition decides to copy you
exactly.
11. Milestones. Don’t build a detailed financial model if you don’t
have past earnings, a significant financial history, or insight into
the issue. Instead, include your current status and milestones for
the next 1-3 quarters for product, team, marketing, sales, and
quarterly and cumulative burn.
12. Conclusion. This slide can be inspirational, a larger vision of
what the company could do if these current plans are realized, or
a rehash of the Summary slide.
13. Financing. Dates, amounts, and sources of money raised. How
much money are you raising in this round?
These slides tell a story.
This sequence of slides tells a story:
We have a mission and a team that is taking us there. Why? We
discovered a large problem and solved it with a product that has this
amazing technology inside. We’re going to market and sell it to these
customers, with these advantages over our competitors. In particular,
we’re working towards these milestones over the next few quarters. In
conclusion, this financing is a great investment opportunity.
The product isn’t revealed until the fifth slide of this methodical sequence—
that’s annoying. Fortunately, the elevator pitch and Summary slide kill the
suspense by summarizing your company and product before an investor jumps
into the deck.
Put pictures in the slides and text in the notes.
Keep the slides simple, visual, and minimal, with 30 point or larger font. The
slides will look great when you present; see “Gates, Jobs, & the Zen Aesthetic.”
(We’ll cover presentations in a future article, this article is about the deck you
send investors.)
Put talking points, reasoning, and prose in the notes that accompany each slide.
Don’t try to cram cogent arguments into bullet points on the slides; see “The
Cognitive Style of PowerPoint.”
Email a PDF that combines each slide and its notes on a single page; slide on
top, notes on bottom. Please don’t email a PowerPoint file unless your deck
contains critical animations or movies.
You now have a single file for emails and live presentations. An investor can
read the slides and notes together and imagine a presentation. And you can
present the slides while you refer to the notes.
Finally, try Keynote if you’re on a Mac. It makes beautiful decks and it’s fun to
use.
CHAPTER SEVEN
BUILDING A BUSINESS
Startups are like snowflakes – every one is unique in their construction.
Although approaches do vary on building a company, a few popular
frameworks have emerged on molding successful businesses. Thought leaders
share core metrics, particularly in the area of user acquisition, and point out
that many times entrepreneurs will end up in a very different and sometimes
better place from where they began.
Agile vs. Waterfall Software Development
Rutul Dave: Web Development Methodologies: Agile vs. Waterfall
Agile development is known for being cheaper, faster, and quicker to respond
to changing market demands, as compared to the slower but steady, sequential
process of the Waterfall method. And while Agile may be more suitable for
projects that are amenable to its speed and quick reaction time, traditional
Waterfall industries are starting to see the value of using this methodology.
Agile vs. Waterfall
Agile development centers around short “sprints” where developers race to
fix bugs and write working software within a span of anywhere between 4
to 6 weeks. Agile is most often talked about in terms of modern Web 2.0
applications where we see frequent updates and changes to code as feature sets
are enhanced and new functionality is added at a rapid pace. This methodology
is typically seen as the opposite of the Waterfall process where development
and management follows a sequential process. In Waterfall projects, progress is
seen as cascading steadily through the phases of conception, initiation, analysis,
design, development and testing.
Agile Making Inroads
But Agile isn’t just for modern languages or web-only applications. While the
financial services and mobile markets were obvious early adopters, we could
argue that there isn’t any industry where Agile wouldn’t be a good fit. Agile is
cheaper, faster, has more flexible processes, responds better to changes in market
demands and, while not perfect, Agile environments can bring a certain honesty
to team dynamics by exposing who’s behind contributions and progress.
Although Agile methods are definitely more suited to projects where you need
to deliver small yet frequent pieces of functionality, and where time to market is
a key concern, we have seen Agile adoption increasing in traditionally Waterfall
industries, like medical device manufacturing and even military/aerospace.
These companies are seeing the value in iterative development in terms of
increased software integrity, developer efficiency and in reducing technical debt.
Considerations When Adopting Agile
The nature of Agile development, however, can introduce risk, as testing cycles
become condensed and serious bugs can be overlooked. This usually requires
an additional level of developer testing upstream to help identify defects early
in the cycle. Most industries, let’s take consumer electronics for instance, make
calculated tradeoffs when it comes to development. A mobile device company
wants to be first to introduce a phone with the latest features, so time to market
might take precedence over quality. However, quality concerns are a primary
drawback in safety-critical industries or industries where projects require
heavy documentation and modeling before coding begins. Because Waterfall
development stresses the end product over process, it has remained prominent
in these industries where quality (and safety) over speed reigns supreme.
It is important to understand that Agile, as defined in the Agile Manifesto, is
a set of values and principles, not a pre-defined process with obvious areas of
limitations. Hence, adoption of the methodology is context-sensitive to the
individual project team practicing it. This means that whatever limitations
experienced need to be addressed via “inspection and adaptation,” and that
the teams detect the problems and seek solutions. However, one area where
most teams are looking for answers is in the area of risk management. This is
a weakness for most software development methodologies. Risk management
in terms of software quality and technical debt needs to be integrated into the
development process.
Lean vs. Heavy Startup Methodology
Wikipedia: Learn Startup
The Lean Startup is a business approach coined by Eric Ries that aims to
change the way that companies are built and new products are launched.[1][2]
[3] The Lean Startup relies on validated learning, scientific experimentation,
and iterative product releases to shorten product development cycles, measure
progress, and gain valuable customer feedback.[1][2][4] In this way, companies,
especially startups, can design their products or services to meet the demands
of their customer base without requiring large amounts of initial funding or
expensive product launches.[2][5]
Originally developed with high-tech companies in mind, the lean startup
philosophy has since been expanded to apply to any individual, team, or
company looking to introduce new products or services into the market.[2]
Today, the lean startup’s popularity has grown outside of its Silicon Valley
birthplace and has spread throughout the world, in large part due to the success
of Ries’ bestselling book, The Lean Startup: How Today’s Entrepreneurs Use
Continuous Innovation to Create Radically Successful Businesses.[6]
Background
Main article: Eric Ries
Ries developed the idea for the Lean Startup from his experiences as a startup
advisor, employee, and founder.[7][8][9] His first startup, Catalyst Recruiting,
failed because they did not understand the wants of their target customers, and
because they focused too much time and energy on the initial product launch.
[10][11] After Catalyst, Ries was a senior software engineer with There, Inc.
[10][11] Ries describes There Inc. as a classic example of a Silicon Valley startup
with five years of stealth R&D, $40 million in financing, and nearly 200
employees at the time of product launch.[11] In 2003, There, Inc. launched
its product, There.com, but they were unable to garner popularity beyond the
initial early adopters.[11] Ries claims that despite the many proximate causes for
failure, the most important mistake was that the company’s “vision was almost
too concrete,” making it impossible to see that their product did not accurately
represent consumer demand.[11]
Although the lost money differed by orders of magnitude, the failures of There,
Inc. and Catalyst Recruiting share similar origins, with Ries stating that “it
was working forward from the technology instead of working backward from
the business results you’re trying to achieve.”[2] Ries began to develop the
lean startup philosophy from these experiences, and from others observed by
working in the high-tech entrepreneurial world.[11][12]
Description
Origins
The lean startup philosophy is based on lean manufacturing, the streamlined
production philosophy developed in the 1980s by Japanese auto manufacturers.
[13] The lean manufacturing system considers the expenditure of resources
for any goal other than the creation of value for the end customer to be
wasteful, and thus a target for elimination. In particular, the system focuses on
strategically placing small stockpiles of inventory, known as kanban, throughout
the assembly line as opposed to storing a full stock in a centralized warehouse.
[13] These kanban provide production workers with the necessary inputs to
production as they need them, and in so doing, reduce waste while increasing
productivity.[13] Additionally, immediate quality control checkpoints can
identify mistakes or imperfections during assembly as early as possible to ensure
that the least amount of time is expended developing a faulty product.[13]
Another primary focus of the lean management system is to maintain close
connections with suppliers in order to understand their customers’ desires.
In 2008, Ries took the advice of his mentors and developed the idea for the lean
startup, using his personal experiences adapting lean management principles
to the high-tech startup world.[10][14] In September 2008, Ries first coined
the term on his blog, Startup Lessons Learned, in a post called “The lean
startup.”[15]
Lean startup
Similar to the precepts of lean management, Ries’ lean startup philosophy seeks
to eliminate wasteful practices and increase value producing practices during
the product development phase so that startups can have better chances of
success without requiring large amounts of outside funding, elaborate business
plans, or the perfect product.[14] Ries believes that customer feedback during
product development is integral to the lean startup process, and ensures that
the producer does not invest time designing features or services that consumers
do not want.[16] This is done primarily through two processes, using key
performance indicators and a continuous deployment process.[17][5][18]
Because startups typically cannot afford to have their entire investment depend
upon the success of one single product launch, Ries maintains that by releasing
a minimum viable product that is not yet finalized, the company can then make
use of customer feedback to help further tailor their product to the specific
needs of its customers.[5][14][19]
The lean startup philosophy pushes web based or tech related startups away
from the ideology of their dot-com era predecessors in order to achieve costeffective production by building a minimal product and gauging customer
feedback.[2] Ries asserts that the “lean has nothing to do with how much
money a company raises,” rather it has everything to do with assessing the
specific demands of consumers and how to meet that demand using the least
amount of resources possible.[10]
Definitions
In his blog and book, Ries uses specific terminology relating to the core lean
startup principles.
Minimum viable product
A minimum viable product (MVP) is the “version of a new product which
allows a team to collect the maximum amount of validated learning about
customers with the least effort.”[1][20] The goal of an MVP is to test
fundamental business hypotheses (or leap-of-faith assumptions) and to help
entrepreneurs begin the learning process as quickly as possible.[1] As an
example, Ries notes that Zappos founder, Nick Swinmurn, wanted to test
the hypothesis that customers were ready and willing to buy shoes online.
[1] Instead of building a website and a large database of footwear, Swinmurn
approached local shoe stores, took pictures of their inventory, posted the
pictures online, bought the shoes from the stores at full price, and sold them
directly to customers if they purchased the shoe through his website.[1]
Swinmurn deduced that customer demand was present, and Zappos would
eventually grow into a billion dollar business based on the model of selling
shoes online.[1]
Continuous deployment
Continuous deployment is a process “whereby all code that is written for
an application is immediately deployed into production,” which results in
a reduction of cycle times.[21] Ries states that some of the companies he’s
worked with deploy new code into production as often as 50 times a day.[21]
The phrase was coined by Timothy Fitz, one of Ries’s colleagues and an early
engineer at IMVU.[1][22]
Split testing
A split test or A/B test is an experiment in which “different versions of a
product are offered to customers at the same time.”[1] The goal of a split test
is to observe changes in behavior between the two groups and to measure the
impact of each version on an actionable metric.
A/B testing can also be performed in serial fashion where a group of users one
week may see one version of the product while the next week users see another.
This can be criticized in circumstances where external events may influence
user behavior one time period but not the other. For example a split test of two
ice cream flavors performed in serial during the summer and winter would see
a marked decrease in demand during the winter where that decrease is mostly
related to the weather and not to the flavor offer.
Vanity metrics
Vanity metrics are measurements which give “the rosiest picture possible” but
do not accurately reflect the key drivers of a business. This is in contrast to
actionable metrics, the measurement of which can lead to a business decision
and subsequent action.[23][1]
Typical examples of a vanity metric are the number of new users gained per day.
While a high number of users gained per day seems beneficial to any company,
if the cost of acquiring each user through expensive advertising campaigns is
significantly higher than the revenue gained per user, then gaining more users
could quickly lead to bankruptcy.
Vanity metrics for one company may be actionable metrics for another. For
example, a company specializing in creating web based dashboards for financial
markets might view the number of web page views[18] per person as a vanity
metric as their revenue is not based on number of page views. However, an
online magazine with advertising would view web page views as a key metric as
page views as directly correlated to revenue.
Pivot
A pivot is a “structured course correction designed to test a new fundamental
hypothesis about the product, strategy, and engine of growth.”[1] A notable
example of a company employing the pivot is Groupon; when the company first
started, it was an online activism platform called The Point.[4] After receiving
almost no traction, the founders opened a Wordpress blog and launched
their first coupon promotion for a pizzeria located in their building lobby.[4]
Although they only received 20 redemptions, the founders realized that their
idea was significant, and had successfully empowered people to coordinate
group action.[4] Three years later, Groupon would grow into a billion dollar
business.
The Lean Startup book
Ries’ book, The Lean Startup: How Today’s Entrepreneurs Use Continuous
Innovation to Create Radically Successful Businesses, was published in September,
2011 by Crown Business Publishing, which is a subsidiary of Random House.
[24] Due to the popularity of the lean startup philosophy prior to the release
of his book, The Lean Startup was highly anticipated, and quickly became a #2
New York Times bestseller.[6][25] The book’s popularity has helped to further
promote the lean startup philosophy, which is used by both startups and more
mature companies.[26][27][28] Amazon listed the book as one of their Best
Business Books of 2011, and as of June 2012, the book has sold 90,000 copies.
[29][30]
The Movement
After introducing the concept on his blog, Startup Lessons Learned, Ries’
lean startup philosophy became widely popular within Silicon Valley tech
startups.[2][6] Ries now sits on many advisory boards for tech companies and
investment funds, frequently gives interviews and presentations on the lean
startup, and has also created his own annual technology conference called
Startup Lessons Learned which has subsequently changed it’s name to the Lean
Startup Conference.[31][2][32][10][24][9][11]
Ries travels constantly to promote the Lean Startup philosophy at conferences,
and estimates that Lean Startup meetups in cities around the world garner
20,000 regular participants.[2] The first Lean Startup meetup named Lean
Startup Circle was created by Rich Collins on June 26th, 2009[33] hosting
speaking events, workshops, and roundtable discussions. As of 2012, there are
lean startup meetups in over 100 cities and 17 countries[34] as well as an online
discussion forum with over 5500 members.[35] Third-party organizers have
led Lean Startup meetups in San Francisco, Chicago, Boston, Austin, Beijing,
China, Dublin, Ireland, and Rio de Janeiro, Brazil, among others—many of
which are personally attended by Ries—with the New York City Lean Startup
Meetup attracting over 2,500 members.[36] [37][38][39][40][41] Ries hosted
the Lean Startup Track at SXSW 2012 with Dave McClure, Steve Blank,
Robert Scoble, and dozens of other entrepreneurs and investors.[42][43]
The Lean Startup Machine created a new spin on the Lean Startup meetups
by having attendees start a new company in three days. As of 2012, the Lean
Startup Machine has created over 600 new startups this way.[44]
Several prominent high-tech companies have begun to publicly employ the
Lean Startup philosophy, including Intuit, DropBox, Wealthfront, Votizen,
Aardvark, and Grockit.[7][16][45] The Lean Startup principles are also taught
in classes at Harvard Business School and are implemented in municipal
governments through Code for America.[29]
In addition, the United States Government has recently begun to employ many
of the lean startup ideas pioneered by Ries. The Federal Chief Information
Officer of the United States, Steven VanRoekel noted that he is taking a “leanstartup approach to government.”[46] Ries has also worked with the former and
current Chief Technology Officers of the United States—Aneesh Chopra and
Todd Park respectively—to implement aspects of the lean startup model into
the United States Government.[47][48][49] In particular, Park noted that in
order to understand customer demand, the Department of Health and Human
Services, recognized “the need to rapidly prototype solutions, engage customers
in those solutions as soon as possible, and then quickly and repeatedly iterate
those solutions based on working with customers.”[50][51] [52] In May 2012,
Ries and The White House announced the Presidential Innovation Fellows
program, which brings together top citizen innovators and government officials
to work on high-level projects and deliver measurable results in six months.[53]
Portfolio.com called 2011 “the year of the lean startup,” and Fast Company
noted that the movement is “less about how to make web startups more
successful and entrepreneurs richer than it is a fundamental reexamination of
how to work in our complicated, faster-moving world.”[4][54] Additionally,
The New York Times noted that the Lean Startup is a “fresh approach to
creating companies that has attracted much attention in the last year or so
among Silicon Valley entrepreneurs, technologists and investors.”[27]
Notes
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25.
26.
27.
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36.
37.
38.
39.
Ries, Eric (2011). The Lean Startup: How Today’s Entrepreneurs Use Continuous
Innovation to Create Radically Successful Businesses. Crown Publishing. p. 103. ISBN 978-0307-88791-7.
^abcdefghi
Roush, Wade. Eric Ries, the Face of the Lean Startup Movement, on How a OnceInsane Idea Went Mainstream. Xconomy. July 6, 2011.
^
The Lean Startup TESS Search. United States Patent and Trademark Office. September 6,
2011.
^abcde
Penenberg, Adam. Eric Ries Is A Lean Startup Machine. Fast Company. September 8,
2011.
^
a b c Adler, Carlye. Ideas Are Overrated: Startup Guru Eric Ries’ Radical New Theory.
Wired. August 30, 2011.
^abc
Bury, Erin. How Eric Ries Changed the Framework for Startup Success. Sprouter.
December 7, 2011.
^ab
Lohr, Steve. The Rise of the Fleet-Footed Startup. The New York Times. April 24, 2010.
^
Solon, Olivia. Interview: Eric Ries, Author Of The Lean Startup. Wired. January 17, 2012.
^ ab
Eric Ries. Business Week.
^abcde
Loizos, Connie. “Lean Startup” evangelist Eric Ries is just getting started. Reuters. May
26, 2011.
^abcdefg
Venture Capital: Eric Ries, author of “The Lean Startup.” YouTube. November 21,
2009.
^
Wealth Front. Advisors to Weathfront. Wealthfront Inc.. 2012.
^abcd
What is Lean Manufacturing?. wiseGEEK.
^abc
Creating the Lean Startup. Inc. Magazine. October 2011.
^
The lean startup. Startup Lessons Learned. September 8, 2008.
^ab
Tam, Pui-Wing. Philosophy Helps Startups Move Faster. The Wall Street Journal. May 20,
2010.
^
Ries, Eric. Are You Building The Right Product? “ TechCrunch. September 11, 2011.
^ab
Schonfeld, Erick. Don’t Be Fooled By Vanity Metrics. Tech Crunch. July 30, 2011.
^
Butcher, Mike. Interview with Eric Ries, author, The Lean Startup. January 17, 2012.
^
Ries, Eric. Minimum Viable Product: a guide. Startup Lessons Learned. August 3, 2009.
^ab
Ries, Eric. Continuous deployment in 5 easy steps. O’Reilly Radar. March 30, 2009.
^
Continuous Deployment at IMVU: Doing the impossible fifty times a day. Timothy Fitz.
February 10, 2009.
^
Ferriss, Tim. Vanity Metrics vs. Actionable Metrics – Guest Post by Eric Ries. May 19, 2009.
^ab
Wellons, Mary Catherine. Startup Lessons From a Pro: Eric Ries on ‘The Lean Startup’.
TechCrunch. September 19, 2011.
^
NYTimes. October 2, 2011 Best Sellers. The New York Times. October 2, 2011.
^
Kopytoff, Verne. Trendspotting at TechCrunch Disrupt. The New York Times. September 14,
2011.
^ab
Lohr, Steve. The Rise of the Fleet-Footed Startup. The New York Times. April 24, 2010.
^
Parsons, Sabrina. Pitching Your Business vs. PLanning Your Business. Forbes. February 29,
2012.
^ab
Greenwald, Ted. Upstart Eric Ries Has the Stage and the Crowd Is Going Wild. Wired.
May 18, 2012.
^
Best Books of 2011: Business & Investing. Amazon.
^
Ries, Eric. Announcing 2012 Lean Startup Conference StartupLessonsLearned.com. June 27,
2012
^
Glenn, Devon. Eric Ries on What Every Startup Should Ask Their Customers. Media Bistro.
August 9, 2010
^
Lean Startup Circle San Francisco
^
Ewel, Jim. Why Marketing Must Also be Lean. Agile Marketing. March 3, 2012.
^
Collins, Rich. New Leadership Lean Startup Circle. April 28, 2012.
^
Faircloth, Kelly. Startup News: Let’s Launch the Summer with a New York Tech Meetup and
Loads of New Features. BetaBeat. May 30, 2012.
^
Eric Ries - Lean Startup Dublin. Eventbrite.
^
Wilson, Fred. Lean. Business Insider. September 16, 2011.
^
Goodison, Donna. ‘Lean Startup’ Guru Shares His Secrets. Hispanic Business. September 27,
2011.
^abcdefghijk
40.
41.
42.
43.
44.
45.
46.
47.
48.
49.
50.
51.
52.
53.
54.
Lean Startup Rio. Meetup.
Lean Startup Meetup Beijing. Meetup.
^
The Lean Startup SxSW Track. SxSW.
^
Lean Startup Author Eric Ries Added to 2012 Programming. SxSW.
^
Mashable. Why Startup Founders Need to Talk to Their Customers.
^
Case Studies. The Lean Startup.
^
Stacy, Michael. U.S. CIO VanRoekel talks startups, savings, new tech in Iowa visit. Silicon
Prairie News. April 5, 2012.
^
Lean Government. Startup Lessons Learned. May 30, 2012.
^
Government as a Startup with ‘The Lean Startup’ Author Eric Ries. Fed Scoop Radio. March
19, 2012.
^
McKendrick, Joe. In search of the US government’s inner ’startup:’ federal CIO. Smartplanet.
October 28, 2011.
^
Making a Difference: Innovation Pathway and Entrepreneurs in Residence U.S. Food and
Drug Administration. April 10, 2012.
^
Foley, John. Busting Through The Federal IT Budget Ceiling. InformationWeek. April 30,
2012.
^
Wilson, Paul. The top five Lean Startup myths. Net Magazine. April 2, 2012.
^
Park, Todd. Wanted: A Few Good Women and Men to Serve as Presidential Innovation
Fellows. The White House Blog. May 23, 2012.
^
Bernhard, Jr., Kent. The Biggest Idea of 2011: Think Lean. Portfolio.com. December 30,
2011.
^
^
Metrics to Consider
Steve Blank: No Accounting for Startups
Startups that are searching for a business model need to keep score differently
than large companies that are executing a known business model.
Yet most entrepreneurs and their VCs make startups use financial models and
spreadsheets that actually hinder their success.
Here’s why.
Managing the Business
When I ran my startups our venture investors scheduled board meetings each
month for the first year or two, going to every six weeks a bit later, and then
moving to quarterly after we found a profitable business model.
One of the ways our VCs kept track of our progress was by taking a monthly
look at three financial documents: Income Statement, Balance Sheet and Cash
Flow Statement.
If I knew what I knew now, I never would have let that happen. These financial
documents were worse than useless for helping us understand how well we were
(or weren’t) doing. They were an indicator of “I went to business school but
don’t really know what to tell you to measure so I’ll have you do these.”
To be clear – Income Statements, Balance Sheets and Cash Flow Statements are
really important at two points in your startup. First, when you pitch your idea
to VCs, you need a financial model showing VCs what your company will look
like after you are no longer a startup and you’re executing the profitable model
you’ve found. If this sounds like you’re guessing – you’re right – you are. But
don’t dismiss the exercise. Putting together a financial model and having the
founders understand the interrelationships of the variables that can make or
break a business is a worthwhile exercise.
The second time you’ll need to know about Income Statements, Balance Sheets
and Cash Flow Statements is after you’ve found your repeatable and profitable
business model. You’ll then use these documents to run your business and
monitor your company’s financial health as you execute your business model.
The problem is that using Income Statement, Balance Sheets and Cash Flow
Statements any other time, particularly in a startup board meeting, has the
founding team focused on the wrong numbers. I had been confused for years
why I had to update an income statement each board meeting that said zero for
18 months before we had any revenue.
But What Does a Business Model Have to Do With Accounting in My
Startup?
A startup is a search for a repeatable and scalable business model. As a founder
you are testing a series of hypotheses about all the pieces of the business model:
Who are the customers/users? What’s the distribution channel? How do we
price and position the product? How do we create end user demand? Who are
our partners? Where/how do we build the product? How do we finance the
company, etc.
An early indication that you’ve found the right business model is when you
believe the cost of getting customers will be less than the revenues the
customers will generate. For web startups, this is when the cost of customer
acquisition is less than the lifetime value of that customer. For biotech
startups, it’s when the cost of the R&D required finding and clinically test a
drug is less than the market demand for that drug. These measures are vastly
different from those captured in balance sheets and income statements
especially in the near term.
What should you be talking about in your board meeting? If you are following
Customer Development, the answer is easy. Board meetings are about
measuring progress measured against the hypotheses in Customer Discovery
and Validation. Do the metrics show that the business model you’re creating
will support the company you’re trying to become?
Startup Metrics
Startups need different metrics than large companies. They need metrics to
tell how well the search for the business model is going, and whether at the
end of that search is the business model you picked worth scaling into a
company. Or is it time to pivot and look for a different business model?
Essentially startups need to “instrument” all parts of their business model to
measure how well their hypotheses in Customer Discovery and Validation are
faring in the real world.
For example, at a minimum, a web based startup needs to understand the
Customer Lifecycle, Customer Acquisition Cost, Marketing Cost, Viral
Coefficient, Customer Lifetime Value, etc. Dave McClure’s AARRR Model is
one illustration of the web sales pipeline.
At a web startup, our board meetings were discussions of the real world
results of testing our hypotheses from Customer Discovery.
We had made some guesses about the customer pipeline and now we had a
live web site. So we put together a spreadsheet that tracked these actual
customer numbers every month. Every month we reported to our board
progress on registrations, activations, retained users, etc. They looked like
this:
User Base
• Registrations (Customers who completed the registration process
during the month)
•
•
•
•
•
•
•
•
Activations (Customers who had activity 3 to 10 days after they
registered. Measures only customers that registered during that
month)
Activation/Registrations %
Retained 30+ Days
Retained 30+/ Total Actives %
Retained 90+ Days
Retained 90+/Total Actives %
Paying Customers (How many customers made $ purchases that
month)
Paying/(Activations + Retained 30+)
Financials
• Revenue
• Contribution Margin
Cash
• Burn Rate
• Months of cash left
Customer Acquisition
• Cost Per Acquisition Paid
• Cost Per Acquisition Net
• Advertising Expenses
• Viral Acquisition Ratio
Web Metrics
• Total Unique Visitors
• Total Page Views
• Total Visits
• PV/visit
A startup selling via a direct sales force will want to understand: average
order size, Customer Lifetime Value, average time to first order, average time
to follow-on orders, revenue per sales person, time to salesperson becomes
effective.
Regardless of your type of business model you should be tracking cash burn
rate, months of cash left, time to cash flow breakeven.
Tell Them No
If you have venture investors, work with them to agree what metrics matter.
What numbers are life and death for the success of your startup? (These
numbers ought to be the hypotheses you’re testing in Customer Discovery and
Validation.) Agree that these will be the numbers that you’ll talk about in your
board meeting. Agree that there will come times that the numbers show that
the business model you picked is not worth scaling into a company. Then you’ll
all agree it’s time to pivot and look for a different business model.
You’ll all feel like you’re focused on what’s important.
Lessons Learned
• Large companies need financial tools to monitor how well they are
executing a known business model.
• Income Statements, Balance Sheets and Cash Flow Statements are
good large company financial monitoring tools.
• Startups need metrics to monitor how well their search for a
business model is going.
• Startups need metrics to evaluate wither the business model you
picked is worth scaling into a company.
• Using large company financial tools to measure startup progress is
like giving the SAT to a first grader. It may measure something in
the future but can only result in frustration and confusion now.
Dave McClure: Startup Metrics for Pirates
Taylor Davidson: Why Financial Models Are Easier Than You Think
Ask any entrepreneur about what they’re building and the problems they are
solving, and their eyes light up. But ask any entrepreneur about their financial
model, and the energy disappears.
Trust me, I talk to entrepreneurs every day as a venture capitalist, and I’ve been
helping entrepreneurs build financial models for over 10 years, and I’ve seen the
reaction thousands of times. But building financial models can still be valuable,
if you remember one thing: the model doesn’t matter, the thought process
does. Overly complex financial models are a waste of time without a solid
understanding of the basic inputs and outputs of your business. That’s why I’ve
worked to help entrepreneurs think about finance and build financial models
the right way.
In March 2012, I ran a survey to understand what entrepreneurs thought about
financial models, and found 4 key insights.
1. Financial models are largely BS
The recurring response I heard from entrepreneurs was that financial models
are useless at best, and potentially even worse:
“A financial model is just a fancy equation with a bunch of input variables. If
the input variables are mistaken, it doesn’t matter how good the equation is, the
whole thing is useless – or even worse than useless, as it breeds false confidence.”
True, to a degree. If your inputs are mistaken or a poor approximation of
reality, then the results (revenue, net income) will be highly inaccurate. But
the results aren’t the important parts to a financial model. Nobody cares about
your hockey-stick growth projections, but people do care about how you think
you’re going to create that hockey-stick growth. The results don’t matter, but
the thought process is critically important. Instead of worrying about building
accurate financial projections, spend your energy building a model that helps
you tell the story behind your business:
“In the end, the most important thing isn’t a really detailed financial model
– it’s having a grasp of what the major influencing factors are on your model
(hint: sales and growth) and then getting some kind of data that helps you
accurately predict these variables.”
2. How do I get good data for my assumptions?
Over half of respondents noted the difficulty in finding good data to ground
their assumptions, and this is something that comes up with every entrepreneur
I talk to. How much should I charge? How many people will buy it? How long
will someone remain a customer? What will my conversion rate be? How many
times will they use it? What will my viral coefficient be?
And answering these questions isn’t easy, especially in light of the prevailing
view that financial models are useless without good inputs.
There’s a couple keys to getting good data for one’s assumptions:
• Research. Ask potential customers. Ask other entrepreneurs for
their experiences. Research comparable companies. And test
assumptions by putting the product in market and learning from
actual users and customers.
• Create scenarios. Acknowledge the fact that there are a variety of
potential outcomes for each one of your key inputs and use range
estimates to create scenarios. Instead of making point estimates
(e.g., the conversion rate will be 5%), use range estimates (the
conversion rate should be between 2% and 10%) to create best,
worst, and expected scenarios using single- and multi-variate
analysis.
Accept that good data for your assumptions is hard. Instead of focusing on
getting the best possible data about your assumptions, get a solid understanding
of the potential ranges and create a financial model that allows you to
understand how your business model flexes.
3. There aren’t enough resources, templates, and guidance on how to get
started
Many entrepreneurs had no idea where to start, and struggled to create financial
models themselves. Templates and best practices are hard to find on the web,
so entrepreneurs typically end up figuring it out for themselves, asking other
entrepreneurs for examples, or asking investment bankers or MBAs to help
them build their financial models.
But there are problems with each route. Many first-time financial modelers
build manual, hard-coded models that are difficult to change and alter, and
often difficult for others to understand. Experienced entrepreneurs can be great
resources, but their models will likely differ from your own business idea, and
thus you will need to do extensive customization anyway. And while investment
bankers and MBAs typically have extensive experience in building financial
models, it’s usually not the right type of experience for building financial
projections for startups, as they tend to be overly complicated, top-down models
that tell little about the real business model of the startup. The best route? Look
at examples, ask other entrepreneurs, and build a model yourself until you reach
a point where you need more help. Where is that point?
4. Don’t build the best financial model possible. Only build what you
need for that point in time, and iterate your model in parallel with your
business
Not only do entrepreneurs have difficulty in starting to build financial models,
they often have problems figuring how much of a model to build. Do I need to
build five-year projections? Do I need detailed cost structure? Do I need full
financial statements? Do I need a complete capitalization table and valuation
estimates?
Taking an insight from the Lean Startup movement, the key is to build a
“minimum viable model.” Focus on building a model that will help you make
the key decisions you have to make at that point in time, and communicate the
current story behind your business. For some, that “minimum viable model”
may be a simple cost budget, and a basic understanding that there is a large
customer base with a willingness to pay for your product. For some, it may be
a robust projections of costs and revenues. For some, it may require complete
financial statements and projections with a detailed capitalization table.
But the important thing is to spend one’s energy appropriately. Yes, financial
models are always wrong. Yes, build products and demos before spreadsheets.
But spreadsheets can still play an important role in understanding and building
your business if you approach them correctly.
Focus on User Acquisition/Marketing
Blake Masters: Peter Thiel’s CS183: Startup - Class 9 Notes Essay
I. Definitions
Distribution is something of a catchall term. It essentially refers to how you
get a product out to consumers. More generally, it can refer to how you spread
the message about your company. Compared to other components that people
generally recognize are important, distribution gets the short shrift. People
understand that team, structure, and culture are important. Much energy is
spent thinking about how to improve these pieces. Even things that are less
widely understood—such as the idea that avoiding competition is usually better
than competing—are discoverable and are often implemented in practice.
But for whatever reason, people do not get distribution. They tend to overlook
it. It is the single topic whose importance people understand least. Even if you
have an incredibly fantastic product, you still have to get it out to people. The
engineering bias blinds people to this simple fact. The conventional thinking is
that great products sell themselves; if you have great product, it will inevitably
reach consumers. But nothing is further from the truth.
There are two closely related questions that are worth drilling down on. First
is the simple question: how does one actually distribute a product? Second is
the meta-level question: why is distribution so poorly understood? When you
unpack these, you’ll find that the first question is underestimated or overlooked
for the same reason that people fail to understand distribution itself.
The first thing to do is to dispel the belief that the best product always wins.
There is a rich history of instances where the best product did not, in fact, win.
Nikola Tesla invented the alternating current electrical supply system. It was,
for a variety of reasons, technologically better than the direct current system
that Thomas Edison developed. Tesla was the better scientist. But Edison was
the better businessman, and he went on to start GE. Interestingly, Tesla later
developed the idea of radio transmission. But Marconi took it from him and
then won the Nobel Prize. Inspiration isn’t all that counts. The best product
may not win.
II. The Mathematics of Distribution
Before getting more abstract, it’s important to get a quantitative handle on
distribution. The straightforward math uses the following metrics:
•
•
•
•
•
Customer lifetime value, or CLV
Average revenue per user (per month), or ARPU
Retention rate (monthly, decay function), or r
Average customer lifetime, which is 1 / (1-r)
Cost per customer acquisition, or CPA
CLV equals the product of ARPU, gross margin, and average customer lifetime.
The basic question is: is CLV greater or less than CPA? In a frictionless world,
you build a great business if CLV > 0. In a world with some friction and
uncertainty, you build a great business if CLV > CPA.
Imagine that your company sells second-tier cell phone plans. Each customer is
worth $40/month. Your average customer lifetime is 24 months. A customer’s
lifetime revenue is thus $960. If you have a 40% gross margin, the customer’s
lifetime value is $384. You’re in good shape if it costs less than $384 to acquire
that customer.
One helpful way to think about distribution is to realize that different kinds
of customers have very different acquisition costs. You build and scale your
operation based on what kinds of things you’re selling.
On one extreme, you have very thin, inexpensive products, such as cheap steak
knives. You target individual consumers. Your sales are a couple of dollars each.
Your approach to distribution is some combination of advertising and viral
marketing—hoping that the knives “catch on.”
Things are fundamentally different if you’re selling a larger package of goods or
services that costs, say, $10,000. You’re probably targeting small businesses. You
try to market your product accordingly.
At the other extreme, you’re selling to big businesses or governments. Maybe
your sales are $1m or $50m each. As the unit value of each sale goes up, there
is necessarily a shift towards more people-intensive processes. Your approach
to these kinds of sales must be to utilize salespeople and business development
people, who are basically just fancy salespeople who do three martini lunches
and work on complex deals.
III. The Strangeness of Distribution
A. Fact versus Sales Pitch
People say it all the time: this product is so good that it sells itself. This is
almost never true. These people are lying, either to themselves, to others, or
both. But why do they lie? The straightforward answer is that they are trying
to convince other people that their product is, in fact, good. They do not want
to say “our product is so bad that it takes the best salespeople in the world to
convince people to buy it.” So one should always evaluate such claims carefully.
Is it an empirical fact that product x sells itself? Or is that a sales pitch?
The truth is that selling things—whether we’re talking about advertising,
mass marketing, cookie-cutter sales, or complex sales—is not a purely rational
enterprise. It is not just about perfect information sharing, where you simply
provide prospective customers with all the relevant information that they then
use to make dispassionate, rational decisions. There is much stranger stuff at
work here.
Consider advertising for a moment. About 610,000 people work in the U.S.
ad industry. It’s a $95bn market. Advertising matters because it works. There
are competing products on the market. You have preferences about many of
them. Those preferences are probably shaped by advertising. If you deny this it’s
because you already know the “right” answer: your preferences are authentic,
and ads don’t work on you. Advertising only works on other people. But exactly
how that’s true for everybody in the world is a strange question indeed. And
there’s a self-referential problem too, since the ad industry has had to—and
did—convince the people who buy ads that advertising actually works.
The U.S. sales industry is even bigger than advertising. Some 3.2 million people
are in sales. It’s a $450bn industry. And people can get paid pretty well. A
software engineer at Oracle with 4-6 years experiences gets a $105k salary and
an $8k bonus. But a sales manager with 4-6 years experiences gets $112k and
a $103k bonus. The situation is very much the same at Google, which claims
to be extremely engineering driven; at a $96k base, $86k in commissions, and
a $40k bonus, Google salespeople earn quite a bit more than their engineering
counterparts. This doesn’t mean everyone should go into sales. But people who
are good at it do quite well.
B. Salesman as Actor
The big question about sales is whether all salesmen are really just actors of one
sort or another. We are culturally biased to think of salespeople as classically
untrustworthy, and unreliable. The used car dealer is the archetypical example.
Marc Andreessen has noted that most engineers underestimate the sales side of
things because they are very truth-oriented people. In engineering, something
either works or it doesn’t. The surface appearance is irrelevant. So engineers
tend to view attempts to change surface appearance of things—that is, sales—
as fundamentally dishonest.
What is tricky about sales is that, while we know that it exists all around us, it’s
not always obvious who the real salesperson is. Tom Sawyer convinced all the
kids on the block to whitewash the fence for him. None of those neighborhood
kids recognized the sale. The game hasn’t changed. And that’s why that story
rings true today.
Look at the images above. Which of these people is a salesman? President
Eisenhower? He doesn’t look like a salesman. The car dealer in the middle does
look like a salesman. So what about the guy on the right?
The guy on the right is Bill Gross, who founded IdeaLab, which was more or
less the Y-Combinator of the late 1990s. IdeaLabs’ venture arm invested in
PayPal. In late 2001, it hosted a fancy investor lunch in Southern California.
During the lunch, Gross turned to Peter Thiel and said something like:
“I must congratulate you on doing a fantastic job building PayPal.
My 14-year-old son is a very apathetic high school student and very
much dislikes writing homework assignments. But he just wrote a
beautiful e-mail to his friends about how PayPal was growing quickly,
why they should sign up for it, and how they could take advantage of
the referral structure that you put in place.”
On some level, this was a literary masterpiece. If nothing else, it was impressive
for the many nested levels of conversation that were woven in. Other people
were talking to other people about PayPal, possibly at infinite levels on down.
The son was talking to other people about those people. Bill Gross was talking
to his son. Then Gross was talking to Peter Thiel. And at the most opaque and
important level, Gross was talking to the other investors at the table, tacitly
playing up how smart he was for having invested in PayPal. The message is that
sales is hidden. Advertising is hidden. It works best that way.
There’s always the question of how far one should push this. People push it
pretty far. Pretty much anyone involved in any distribution role, be it sales,
marketing, or advertising, should have job titles that have nothing to do
with those things. The weak version of this is that sales people are account
executives. A somewhat stronger version is that people trying to raise money are
not I-bankers, but rather are in corporate development. Having a job title that’s
different from what you actually do is an important move in the game. It goes
to the question of how we don’t want to admit that we’re being sold to. There’s
something about the process that’s not strictly rational.
To think through how to come to an organizing principle for a company’s
distribution, consider a 2 x 2 matrix. One axis is product: it either sells itself,
or it needs selling. The other axis is team: you either have no sales effort, or a
strong one.
Consider the quadrants:
• Product sells itself, no sales effort. Does not exist.
• Product needs selling, no sales effort. You have no revenue.
• Product needs selling, strong sales piece. This is a sales-driven
company.
• Product sells itself, strong sales piece. This is ideal.
C. Engineering versus Sales
Engineering is transparent. It’s hard. You could say it’s transparent in its
hardness. It is fairly easy evaluate how good someone is. Are they a good coder?
An ubercoder? Things are different with sales. Sales isn’t very transparent at
all. We are tempted to lump all salespeople in with vacuum cleaner salesmen,
but really there is a whole set of gradations. There are amateurs, mediocrities,
experts, masters, and even grandmasters. There is a wide range that exists, but
can be hard to pin down.
A good analogy to the engineer vs. sales dynamic is experts vs. politicians. If
you work at a big company, you have two choices. You can become expert in
something, like, say, international tax accounting. It’s specialized and really hard.
It’s also transparent in that it’s clear whether you’re actually an expert or not.
The other choice is to be a politician. These people get ahead by being nice to
others and getting everyone to like them. Both expert and politician can be
successful trajectories. But what tends to happen is that people choose to become
politicians rather than experts because it seems easier. Politicians seem like average
people, so average people simply assume that they can do the same thing.
So too in engineering vs. sales. Top salespeople get paid extremely well. But
average salespeople don’t, really. And there are lots of below average salesmen.
The failed salesman has even become something of a literary motif in American
fiction. One can’t help but wonder about the prehistory to all these books. It
may not have been all that different from what we see today. People probably
thought sales was easy and undifferentiated. So they tried it and learned their
error the hard way. The really good politicians are much better than you think.
Great salespeople are much better than you think. But it’s always deeply hidden.
In a sense, probably every President of the United States was first and foremost a
salesman in disguise.
IV. Methods of distribution
To succeed, every business has to have a powerful, effective way to distribute
its product. Great distribution can give you a terminal monopoly, even if your
product is undifferentiated. The converse is that product differentiation itself
doesn’t get you anywhere. Nikola Tesla went nowhere because he didn’t nail
distribution. But understanding the critical importance of distribution is only
half the battle; a company’s ideal distribution effort depends on many specific
things that are unique to its business. Just like every great tech company has
a good, unique product, they’ve all found unique and extremely effective
distribution angles too.
A. Complex Sales
One example is SpaceX, which is the rocket company started by Elon Musk
from PayPal. The SpaceX team has been working on their rocketry systems in
Southern California for about 8 years now. Their basic vision is to be the first to
send a manned mission to Mars. They went about doing this in a phenomenal
way. Time constraints make it impossible to relate all of Elon’s many great sales
victories. But if you don’t believe that sales grandmasters exist, you haven’t met
Elon. He managed to get $500m in government grants for building rockets,
which is SpaceX, and also for building electric cars, which is done by his other
company, Tesla.
That was an even bigger deal than it may initially seem. SpaceX has been busy
knocking out dramatically inferior rocket technologies for the past 10 years,
but it’s been a very tricky, complicated process. The company has about 2,000
people. But the U.S. Space Industry has close to 500,000 people, all distributed
about evenly over the 50 states. It’s hard to overstate the extent of the massive
congressional lobbying that goes to keeping the other space companies—almost
the entire industry—alive. Things are designed to be expensive, and SpaceX’s
mission is to cut launch costs by 90%. To get where it is now—and to get to
Mars later—SpaceX basically took on the entire U.S. House of Representatives
and Senate. And so far, it seems to be winning. It’s going to launch a rocket
next week. If all doesn’t go well, you’ll certainly here about it. But when things
go well, you can predict the general response: move along, nothing to see here,
these aren’t the rockets we’re looking for.
Palantir also has a unique distribution setup. They do government sales and
sales to large financial institutions. Deals tend to range from $1m to $100m.
But they don’t have any salespeople—that is, they don’t employ “salespeople.”
Instead they have “forward deployed engineers” and a globetrotting CEO who
spends 25 or 26 days each month traveling to build relationships and sell the
product firsthand. Some argue that the traveling CEO-salesman model isn’t
scalable. It’s a fair point, but the counterpoint is that, at that level, people really
only want to talk to the CEO. You certainly can’t just hire army of salespeople,
because that sounds bad. So you have forward deployed engineers double up in
a sales capacity. Just don’t call them salespeople.
Knewton is a Founders Fund portfolio company that develops adaptive
learning technology. Its distribution challenge was to figure out a way to sell
to big educational institutions. There seemed to be no direct way to knock out
existing players in the industry. You would have to take the disruptive sales
route where you just try to come in and outsell the existing companies. But
much easier is to find a non-disruptive model. So Newton teamed up with
Pearson, the big textbook company. Without that partnership, Knewton figured
it would just be fighting the competition in the same way at every school it
approached, and ultimately it’d just lose.
B. Somewhat Smaller Sales
As we move from big, complex sales to smaller sales, the basic difference is that
the sales process involves a ticket cost of $10k-100k per deal. Things are more
cookie cutter. You have to figure out how to build a scalable process and build
out a sales team to get a large number of people to buy the product.
David Sacks was a product guy at PayPal and went on to found Yammer.
At PayPal, he was vehemently anti-sales and anti-BD. His classic lines were:
“Networking is not working!” and “People doing networking are not working!”
But at Yammer, Sacks found that he had to embrace sales and build out a
scalable distribution system. Things are different, he says, because now the sales
people report to him. Because of its focus on distribution, Yammer was able to
hire away one of the top people from SalesForce to run its sales team.
ZocDoc is a doctor referral service. It’s kind of a classic Internet business; they
are trying to get doctors’ offices to sign up for the service at a cost of $250/
month. Growth is intensively sales-driven, and ZocDoc does market-by-market
launches. There is even a whole internal team of recruiters who do nothing else
but try to recruit new salespeople. Toward the lower end of things—and $250
per month per customer is getting there—things get more transactional and
marginal.
C. The Missing Middle
There is a fairly serious structural market problem that’s worth addressing. On
the right side of the distribution spectrum you have larger ticket items where
you can have an actual person driving the sale. This is Palantir and SpaceX.
On the extreme left-hand side of the spectrum you have mass marketing,
advertising, and the like. There is quite possibly a large zone in the middle in
which there’s actually no good distribution channel to reach customers. This is
true for most small businesses. You can’t really advertise. It wouldn’t make sense
for ZocDoc to take out a TV commercial; since there’s no channel that only
doctors watch, they’d be overpaying. On the other hand, they can’t exactly hire
a sales team that can go knock on every doctor’s door. And most doctors aren’t
that technologically advanced, so internet marketing isn’t a perfect solution. If
you can’t solve the distribution problem, your product doesn’t get sold—even if
it’s a really great product.
The opposite side of this is that if you do figure out distribution—if you can
get small businesses to buy your product—you may have a terminal monopoly
business. Where distribution is a hard nut to crack, getting it right may be
most of what you need. The classic example is Intuit. Small businesses needed
accounting and tax software. Intuit managed to get it to them.
Because it nailed distribution, it’s probably impossible for anyone to displace
Intuit today. Microsoft understood the great value of Intuit’s distribution
success when it tried to acquire Intuit. The Department of Justice struck down
the deal, but the point is that the distribution piece largely explains Intuit’s
durability and value.
D. Marketing
Further to the left on the distribution spectrum is marketing. The key question
here is how can one advertise in a differentiated way. Marketing and advertising
are very creative industries. But they’re also quite competitive. In order to really
succeed, you have to be doing something that others haven’t done? To gain a
significant advantage, your marketing strategy must be very hard to replicate.
Advertising used to be a much more iconic and valued industry. In the 1950s
and ‘60s it was iconic and cutting edge. Think Mad Men. Or think Cary
Grant, who, in the classic movie North by Northwest, played the classic
advertising executive who is cool enough to be mistaken for a spy. Advertising
and espionage were debonair enterprises, roughly equal in glamorousness.
But it didn’t last. As the advertising industry developed in 70s and 80s, more
people figured out ways to do it. Things became much more competitive. The
market grew, but the entrants grew faster. Advertising no longer made as much
money as they had been before. And ever since there has been a relentless,
competitive push to figure out what works and then dial up the levers.
Advertising is tricky in the same way that sales is. The main problem is that,
historically at least, you never quite know if your ads are working. John
Wanamaker, who is billed as the father of advertising, had a line about this:
“Half the money I spend on advertising is wasted: the trouble is I don’t
know which half.” You may think your ad campaign is good. But is it? Or
are the people who made your ad campaign just telling you that it’s good?
Distinguishing between fact and sales pitch is hard.
In most ways, Priceline.com represents certain depressing decline of our society.
It points to a very general failure. But one specific thing Priceline does well is
its powerfully differentiated marketing, which makes it very hard to replicate or
compete against. PayPal once staged a PR event where James Doohan—Scotty
from Star Trek—would beam money using a Palm Pilot. It turned out to be
a total flop. It turns out that Captain Kirk—that is, William Shatner—is in a
league of his own.
Advertising’s historical opaqueness is probably the core of why Google is so
valuable; Google was the first company that enabled people to figure out
whether advertising actually worked. You can look at all sort of metrics—CPM,
CTR, CPC, RPC—and do straightforward calculations to determine your
ROI. This knowledge is important because people are willing to pay a lot for
advertising if it actually works. But in the pre-internet magazine age before
Google, ad people never really had a clue about how they were doing.
Zynga has excelled at building on top of Google’s ad work. Everyone knows
that Zynga experienced great viral growth as its games caught on. Less known
is that they spent a lot of money on targeted advertising. That allowed them to
monetize users much more aggressively than people thought possible. And then
Zynga used that revenue to buy more targeted ads. Other gaming companies
tried to do just viral growth—build games that had some social element at their
core. But Zynga went beyond that distribution strategy and got a leg up by
driving rapid growth with aggressive marketing.
The standard bias on the Internet is that advertising does not work. But that’s
an interesting double standard. There are an awful lot of websites whose
businesses model is ad sales. And then they turn around and say that they don’t
actually believe ads are good way of getting customers. The Zynga experience
shows that creatively rethinking the standard narrative can be quite lucrative.
There is a lot of room for creativity in distribution strategy.
E. Viral Marketing
Viral marketing is, of course, the classic distribution channel that people tend
to think of as characteristic of Internet businesses. There are certainly ways to
get it to work. But it’s easy to underestimate how hard it is to do that. William
Shatner and James Doohan seemed similar. In fact they were a world apart.
Salesmen may seem similar. But some get Cadillac’s, while others get steak
knives. Still others get fired and end up as characters in novels.
[Section on viral marketing math excluded. The gist is twofold: first, viral
cycle time is important. Shorter is better. Second, there is a metric called viral
coefficient, and you need it to be > 1 to have viral growth.]
PayPal’s initial user base was 24 people. Each of those people worked at PayPal.
They all knew that getting to viral growth was critical. Building in cash
incentives for people to join and refer others did the trick. They hit viral growth
of 7% daily—the user base essentially doubled every 10 days. If you can achieve
that kind of growth and keep it up for 4-5 months, you have a user base of
hundreds of thousands of people.
Certain segments grow fasters than others. The goal is to identify the most
important segment first, so that anybody who enters the market after you has
a hard time catching up. Consider Hotmail, for instance. It achieved viral
growth by putting sign-up advertising at the bottom of each e-mail in their
system. Once they did that successfully, it was really hard to copy with the same
success. Even if other providers did it and had similar growth curves, they were
a whole segment behind. If you’re the first mover who is able to get a product to
grow virally, no one else can catch up. Depending on how the exponential math
shakes out in a particular case, the mover can often be the last mover as well.
PayPal is a classic example. The first high-growth segment was power buyers
and power sellers on eBay. These people bought and sold a ton of stuff. The
high velocity of money going through the system was linked to the virality of
customer growth. By the time people understood how and why PayPal took
off on eBay, it was too late for them to catch up. The eBay segment was locked
in. And the virality in every other market segment—e.g., sending money to
family overseas—was much lower. Money simply didn’t move as fast in those
segments. Capturing segment one and making your would-be competitors
scramble to think about second and third-best segments is key.
Dropbox is another good example of a very successful company that
depended on viral growth. Pinterest may be as well. It’s sort of hard to tell at
this point. Is Pinterest actually good? Or is it a fad? Will it become a ghost
town that no one uses? It’s not entirely clear. But it has certainly enjoyed
exponential growth.
Marketing people can’t do viral marketing. You don’t just build a product and
then choose viral marketing. There is no viral marketing add-on. Anyone who
advocates viral marketing in this way is wrong and lazy. People romanticize it
because, if you do it right, you don’t have to spend money on ads or salespeople.
But viral marketing requires that the product’s core use case must be inherently
viral. Dropbox, for example, let’s people share files.
Implicit is that there’s someone—a potential new user—to share with. Spotify
does this with its social music angle. As people use the product, they encourage
other people to use it as well. But it’s not just a “tell your friends” button that
you can add-on post-product.
F. The Power Law Strikes Again
We have seen how startup outcomes and VC performance follow a power law.
Some turn out to be a lot better than others. People tend to underestimate how
extreme the differences are because our generally egalitarian society is always
telling us that people are essentially the same.
We’ve also heard Roelof Botha explain that LinkedIn was the exception that
proves the rule that companies do not have multiple revenue streams of equal
magnitude. The same is true for distribution, and exceptions are rare.
Just as it’s a mistake to think that you’ll have multiple equal revenue streams,
you probably won’t have a bunch of equally good distribution strategies.
Engineers frequently fall victim to this because they do not understand
distribution. Since they don’t know what works, and haven’t thought about it,
they try some sales, BD, advertising, and viral marketing—everything but the
kitchen sink.
That is a really bad idea. It is very likely that one channel is optimal. Most
businesses actually get zero distribution channels to work. Poor distribution—
not product—is the number one cause of failure. If you can get even a single
distribution channel to work, you have great business. If you try for several but
don’t nail one, you’re finished. So it’s worth thinking really hard about finding
the single best distribution channel. If you are an enterprise software company
with a sales team, your key strategic question is: who are the people who are
most likely to buy the product? That will help you close in on a good channel.
What you want to avoid is not thinking hard about which customers are going
to buy it and just sending your sales team out to talk to everybody.
Distribution isn’t just about getting your product to users. It’s also about selling
your company to employees and investors. The familiar anti-distribution theory
is: the product is so good it sells itself. That, again, is simply wrong. But it’s also
important to avoid the employee version: this company is so good, people will be
clamoring to join it. The investor version—this investment is so great, they’ll be
banging down our door to invest—is equally dangerous. When these things seem
to happen, it’s worth remembering that they almost never happen in a vacuum.
There is something else going on that may not be apparent on the surface.
G. PR and Media
PR and Media add yet another layer to the distribution problem. How the
message of your company gets distributed is worth thinking hard about. PR and
media are very linked to this. It is a sketchy and very problematic world. But it’s
also very important because we live in a society where people don’t usually have
a rational idea of what they want.
Consider an example from the VC world. It’s almost never the case that a
company finds just one interested investor. There are always zero or several.
But if the world were economically rational, this wouldn’t be true at all. In
a perfectly rational world, you’d see single investor deals all the time. Shares
would be priced at the marginal price where you get a single highest bidder—
your most bullish prospective investor. If you get more than one person
interested in investing, you’ve done it wrong and have underpriced yourself. But
investors obviously aren’t rational and can’t all think for themselves. So you get
either zero investors or many.
It’s easy and intuitive for smart people to be suspicious of the media. For many
years, Palantir had a very anti-media bias. But even if media exposure wasn’t
critical for customers or business partners, it turned out to be very important
for investors and employees. Prospective employees Google the companies
they’re looking at. What they find or don’t matters, even if it’s just at the level
of people’s parents saying “Palantir? Never heard of it. You should go work at
Microsoft.” And you can’t just plug yourself on your own website; PR is the art
of getting trusted, objective third parties to give you press.
H. On Uncertainty
It’s fairly difficult to overestimate how uncertain people are and how much
they don’t know what they actually want. Of course, people usually insist that
they are certain. People trick themselves into believing that they do know what
they want. At the obvious level, “Everyone wants what everyone wants” is just
a meaningless tautology. But on another level, it describes the dynamic process
in which people who have poorly formed demand functions just copy what they
believe everyone else wants. That’s how the fashion world works, for instance.
V. Distribution is Inescapable
Engineers underestimate the problem of distribution. Since they wish it
didn’t exist, sometimes they ignore it entirely. There’s a plot line from “The
Hitchhiker’s Guide to the Galaxy” in which some imminent catastrophe
required everybody to evacuate the planet. Three ships were to be sent into
space. All the brilliant thinkers and leaders would take the A ship. All the
salespeople, consultants, and executives would take the B ship. All the workers
would take the C ship. The B ship gets launched first, and all the B passengers
think that’s great because they’re self-important. What they don’t realize, of
course, is that the imminent destruction story was just a trick. The A and C
people just thought the B people were useless and shipped them off. And, as the
story goes, the B ship landed on Earth.
So maybe distribution shouldn’t matter in an idealized, fictional world. But it
matters in this one. It can’t be ignored. The questions you must ask are: how
big is the distribution problem? And can this business solve it?
We live in a society that’s big on authenticity. People insist that they make up
their own minds. Ads don’t work on them. Everything they want, they want
authentically. But when you drill down on all these people who claim to be
authentic, you get a very weird sense that it’s all undifferentiated. Fashionable
people all wear the same clothes.
Understanding this is key. You must appreciate that people can only show
the tip of the iceberg. Distribution works best when it’s hidden. Question is
how big the iceberg is, and how you can leverage it. Every tech company has
salespeople. If it doesn’t, there is no company. This is true even if it’s just you
and a computer. Look around you. If you don’t see any salespeople, you are the
salesperson.
Corporate development is important for the same reasons that distribution is
important. Startups tend to focus—quite reasonably—on the initial scramble
of getting their first angel or seed round. But once it scales beyond that—once
a company is worth, say, $30m or more—you should have a full-time person
whose job it is to do nothing but travel around the world and find prospective
investors for your business. Engineers, by default, won’t do this.
It’s probably true that if your company is good, investors will continue show up
and you’ll have decent up rounds. But how much money are you leaving on the
table?
Say your company could reasonably be valued at $300m. Valuation is as much
art as it is science. At that range it can fluctuate by a ratio of 2:1. If you raise
$50m at $300m, you give away 16% of the company. But if you raise that
$50m at $500m, you give away 10%. A 6% delta is huge. So why not hire
the best person you can and give them 1% of the company to make sure you
capture that value?
A similar thing exists with employee hiring. It’s trickier to know what to do
there. But traditional recruiters do not take the distribution problem seriously
enough. They assume that people are always rational, and that by giving them
information, people will make good decisions. That’s not true at all. And since
the best people tend to make the best companies, the founders or one or two
key senior people at any multimillion-dollar company should probably spend
between 25% and 33% of their time identifying and attracting talent.
Don’t Be Afraid to Pivot
Adam L. Penenberg: Enter the Pivot: The Critical Course Corrections
of Flickr, Fab.com, and More
Before Twitter became a microblogging sensation it was a podcasting business.
YouTube’s founders were convinced they’d hit the jackpot with a video-dating
site. PayPal’s original mission was to beam IOUs from Palm Pilot to Palm Pilot.
Flickr grew out of a massive multiplayer online game as a way for players to
drop photos into text messages. Groupon emerged from a community
promoting political action while online flash retailer Fab.com came out of a
failed gay social network called Fabulis. Instagram’s founders created a check-in
technology called Blurbn before settling on photos. Pandora was a B2B music
recommendation service. Yelp* transitioned from email recommendations from
friends to a local search and user review website.
These companies, like many others, are examples of startups that “pivoted”
from their original visions. First articulated by Eric Ries, a Silicon Valley
entrepreneur and author of “The Lean Startup,” “pivoting” has become part of
the business and technology lexicon, the Moore’s Law of startupology. Only a
soothsayer can know what will happen before it happens, and only the savviest
(or luckiest) entrepreneur can take an idea from the initial inspiration to market
and beyond without a few hiccups along the way. So perhaps it shouldn’t be
surprising that pivoting isn’t just common, it’s become the rule more than the
exception. History shows that it’s more likely a tech company will undergo a
steep course correction at one point or another than stay true to their founders’
original vision. Pivots are rooted in learning what works and what doesn’t,
keeping “one foot in in the past” and “one foot in a new possible future,” Ries
says. Boiled down to its essence: It’s all about survival.
Throughout business history companies have pivoted—we just didn’t think
of it that way. Nokia once manufactured paper and rubber boots, Nintendo
sold playing cards, and the Gap was a Bay-Area record store that peddled Levis
jeans. Forty years ago Richard Branson published an indie music magazine
and Virgin Records was a modest record store with one London location. The
Marriot began as a root beer stand in Washington, DC. And startups aren’t
the only enterprises to amend strategy to avoid their own creative destruction.
There was a time not long ago that Apple Inc. earned most of its revenues
from computers and not music players and phones, while no one would accuse
Microsoft of whimsy until it created Xbox. IBM used to be a billion-dollar
computer maker and now it is a billion-dollar seller of business services.
Ries has neatly categorized types of pivots. To name a few, there’s the “zoomin pivot” when a single feature becomes the whole product; the “zoom-out
pivot” when the product becomes a single feature in a different product; the
“value capture pivot,” which deals with how revenue is generated; the “engine
of growth” pivot that identifies how a business attracts users, and many more. It
reminds me of the way one journalism textbook teaches leads, listing everything
from “descriptive leads” to “impact leads” to “narrative leads,” “teaser leads,”
“mystery leads,” “build-on-a-quote leads,” and scads of others. Of course, most
journalists never use these terms and, I assume, most entrepreneurs don’t stay
up at night pondering what classification of pivot their startup should stress test.
Not that everyone agrees on what exactly constitutes a pivot. A couple of
months ago I interviewed Ries for my Entrepreneurial Journalism class at NYU
and he said that Facebook has pivoted several times: Initially Mark Zuckerberg
was content with his social man child remain solely on college campuses before
eventually spanning the globe, then it introduced the news feed, advertising,
Facebook credits, etc. Zuckerberg, however, would likely refer to this as an
“iterative” process. When I contacted James Hong, cofounder of HotorNot, to
schedule an interview, he said his company never pivoted. Sure it did, I replied.
It went from a model based on advertising to a dating service and community.
Recently TechCrunch referred to an incremental change in the way that Bump,
a mobile sharing app, would let users upload a photo as a “mini pivot” (whatever
that means).
“Pivoting” has become part of the business and technology lexicon, the Moore’s
Law of startupology.
Despite its slippery definition, the term has gone through the usual cycle of
acceptance. First it was absorbed into the entrepreneur-startup world with
gimlet-eyed embrace, which quickly swelled into widespread acceptance.
Now there’s the predictable backlash. It’s “the most overused word” in the
startup community and it really means “your startup plan sucks, but we’ll
figure out a better plan later.” It’s “prototyping without vision.” Or it’s “exactly
the wrong approach to launching a new company.”
On one hand it’s so hyped it’s become a cliché, worthy of being lampooned in
the video “Sh*t Entrepreneurs Say.” The main character says things like “AB
test, then pivot, and if you still don’t know, pivot again!” along with other
gems like, “Dude, you’re saying it’s a social network for toddlers?” “My team is
powered by Red Bull and pizzas” and “Health Insurance? That’s for wimps.”
It also became fodder for a New Yorker cartoon: A man and woman are sitting
at a café when the woman says, “I’m not leaving you. I’m pivoting to another
man.” It’s gotten to the point that Sarah Lacy once suggested that TechCrunch
“implement an online ‘swear jar’ for press releases, pitches and Tweets
containing the word ‘pivot.’” On the other hand, there’s no Wikipedia entry for
“pivot” as it relates to startups, and it’s an immutable fact that lean and agile
companies will continue to pivot or face the consequences.
We at Fast Company will be exploring the concept of pivots in the coming
months through a series of blog posts and videos produced by two-time
Sundance award-winning director Ondi Timoner. Hyped or not, we believe
exploring the point when a startup realizes it has to change course or die will
reveal a great deal about entrepreneurs, startups, and the world we live in.
CHAPTER EIGHT
BUSINESS ACCELERATION AND
BEYOND
Powerful businesses are regularly made through influential partnerships. Our
final chapter touches on how startups can go above and beyond and earn
phenomenal value from their accomplishments. Ultimately innovators share one
mentality: do things that matter.
Business Development and Corporate
Collaboration
Chris Dixon: Business Development – The Goldilocks Principle
Somewhat counter intuitively, the biggest problem we encountered when
pitching Hunch technology to potential partners wasn’t that it wasn’t interesting
or useful to them, but that it was so interesting and useful that they considered
it “strategic” or “core” and thus felt they needed to own and not rent it. The
situation reminded me of the “Goldilocks principle” sometimes referred to in
scientific contexts:
The Goldilocks principle states that something must fall within certain
margins, as opposed to reaching extremes. It is used, for example, in the Rare
Earth hypothesis to state that a planet must neither be too far away from, nor
too close to the sun to support life.
Basically, if your technology is “too hot” – or, in business-speak, “strategic” or
“core” – then there are three likely outcomes:
1. The potential partner turns you down because they decide to
build a similar product themselves. This happened to us a number
of times. I think part of the reason was that there was a lot of
market buzz around “big data” and machine learning which lead
to the perception – rightly or wrongly – that those capabilities
needed to be owned and not rented.
2. The potential partner says yes because your assets are so defensible
they can’t replicate them. I’m sure Zynga considers the social
graph strategic but at least for now they have no choice but to
partner with Facebook to access it. It is very rare for startups to
have this kind of leverage, but ones that do are extremely valuable.
3. The potential partner wants to own what you do, but thinks you
have a sufficiently superior team and technology that acquiring
you instead of replicating you makes more sense. This is only
possible if the partner is large enough to acquire you and has a
philosophy consistent with acquiring versus building everything
in-house. (A common tech business term is “NIH” which
stands for “Not Invented Here.” It refers to a set of companies
that consider anything developed outside of their offices
technologically inferior).
4. At the other extreme, if your technology is “too cold” – perceived
as not useful by potential partners – you’re going to have a lot of
frustrating meetings. In this case, it is probably wise to reconsider
whether there is actually demand for your product.
5. To build a long-term sustainable business, the best place to be
is “just right” – useful to lots of partners but not so strategic
that they are unwilling to rent it. This is where I wanted Hunch
to be but we never got there. Most companies I know use
externally developed products (commercial or open source) for
databases, web servers, web analytics, email delivery, payment
processors, etc. These are often highly competitive markets but
the companies that win in these markets tend to become large
and independently sustainable. These “just right” companies – to
extend the astronomy analogy – are the planets that support life.
Robert R. Ackerman Jr.: The Most Unlikely Place to Find Startup
Funding
It’s no secret it’s been a daunting period for entrepreneurs seeking venture
capital. While the market is easing a bit, it will remain tough for the rest of the
year and probably well beyond that. So what’s an entrepreneur to do?
Look for money inside corporations.
Odd as it might sound, the case for a startup/corporate collaboration is actually
quite compelling. Startups are renowned for their creativity and efficient
innovation models, but they often find it difficult to introduce their product or
service to the market because they lack an established brand identity (and, thus,
have minimal distribution and customer support infrastructures). On the other
hand, corporations have recognized brands, established distribution channels
and strong customer relationships. What they lack is a culture of innovation
that can keep pace with chronically changing markets.
A partnership between a startup and a corporate partner offers the potential
for some seductive synergies. As a startup moves from pure research to product
and sales execution, a corporate investor can provide more than just cash. It can
help explain market dynamics to a startup, how best to introduce the product
to the market and how to scale. Commonly, it also provides manufacturing or
distribution channels.
For startups seeking a corporate partnership, it’s critical to realize the goals of
the two organizations are different, naturally. The corporation wants to leverage
the startup’s innovation to respond to market opportunities. The startup
wants high velocity access to new customers for its products and/or services –
usually the corporation’s customers. Finding common ground and developing
a relationship that promotes a healthy partnership requires significant effort on
both sides.
The corporation typically has more leverage, so startups often have to make
a disproportionate effort to foster, develop and support a mutually acceptable
strategic vision. Eventually, this transitions into a more reciprocal relationship,
once the cultural conflicts between the two companies are mitigated.
When a startup is able to demonstrate strong demand for a good product,
execution becomes paramount – and could be the catalyst for a discussion about
the corporation buying the startup outright. An advantage here is if a startup
is acquired before it spends millions scaling up manufacturing and building a
sales team, it can avoid unnecessary duplication – thus, saving both companies
money.
IronPort Systems, one of our former portfolio companies at Allegis Capital, is a
good example of this unusual type of collaboration.
In 2007, Cisco Systems acquired this electronic messaging gateway company.
While Cisco could have bought the company a couple of years earlier, it decided
to wait and first become a customer. After IronPort proved its worth and began
to scale, it became a less risky investment. When Cisco bought the company, it
gave IronPort a huge boost by selling its product through its corporate channel,
causing revenues to more than triple. When Cisco bought the company, it
retained almost 100 percent of the team.
Needless to say, the scenario doesn’t always play out this smoothly. In fact,
major mistakes, cultural and otherwise, commonly kill the marriage and inflict
irreparable harm. If you’re giving this sort of partnership consideration, here are
four crucial tips to keep in mind:
• Share experiences and goals. Like any good relationship, the
more similarities between the two parties, the better. Both
companies should have experience in the same areas and be good
communicators. Both should also have good give-and-take skills,
as well as mutual tolerance, because periodic disagreements
are inevitable – and they need to be resolved amicably and
successfully.
• Seek a synergistic culture. Large corporations tend to resist
change. Entrepreneurs are precisely the opposite, priding
themselves on being untethered, fast and efficient. Predictably,
partnerships between the two can create huge frustrations.
Successfully combining the two cultures requires acknowledgment
from both parties of what each type of company does well and
what it does not. To promote collaboration, the startup should
have an inside “champion.” Clearly, the startup won’t always win
debates. If you don’t think you can have fruitful conversations
with a corporate partner, however, don’t bother with this sort of
partnership opportunity.
• Develop strong negotiation skills. A corporation engages with a
startup for one of two reasons – to fill a technology product void
or to secure an option on a potentially useful innovation. In other
words, the corporation is looking out for its own interests. Startup
entrepreneurs need to do the same. A large corporation can easily
overwhelm the resources of a much smaller strategic partner. And
a large corporation can walk away from a strategic partnership
with no more than a bruise. The consequences can be far more
dire for the startup. So a startup must maximize its exit options to
protect itself against the possibility of a dysfunctional partnership.
• Ensure alignment of interests. Strive to develop a partnership of
equals, one in which both parties share commitments, milestones
and benchmarks. If a corporate partner asks for a startup’s
financial records more than once or twice, don’t do it, since this
undermines the notion of a partnership of equals. Negotiations
are impossible when a corporation holds all the cards.
Exits
Walter G. Kortschak: Strategic Acquisition or IPO?
While the primary consideration in choosing between a strategic acquisition or
going public is often price, there are other critical factors to evaluate as well.
Successful entrepreneurs frequently reach a point where they want to monetize
a portion of their company’s value by selling to a strategic buyer or by offering
shares to the public markets in an IPO. While the primary consideration
is often price—the greatest amount of money that can be obtained for the
company—there are other critical factors to consider. The decision also depends
on a company’s strategy, its growth prospects, and the goals and preferences of
the CEO and management team.
Partnering with a growth equity firm can help entrepreneurs bring their
business up to public company standards, increasing its value to both public
market investors and potential acquirers. For instance, a financial partner may
help better understand and comply with Sarbanes-Oxley requirements, arrange
for an independent audit or improve financial systems and reporting. When
entrepreneurs are ready to explore liquidity options such as an IPO or a merger,
growth equity investors can advise on market conditions and how to position
the company for maximum value.
If you are currently in this situation and deciding between an IPO and a
strategic acquisition, consider which one is your best choice. An IPO is a
financing event, not a liquidity event. Because CEOs and other early investors
may not be able to sell immediately, much can happen—both good and bad—
before you are allowed to sell shares because the underwriters may demand a
lock-up period on your shares. An IPO can be an attractive option, however, if
you and your management team value your independence and wish to continue
in your current roles. You can, in fact, sell a minority versus majority stake, or
in some instances have dual share classes to cement control.
In a strategic acquisition, by contrast, one of two outcomes will generally occur.
In the first case, you will be required to stay on well after the transaction, with
your compensation closely tied to the ongoing performance of the firm; in the
second instance, you will immediately receive cash or unrestricted stock for the
full value of the ownership interest, but will not have a continuing role or direct
financial interest in your company’s future growth.
Entrepreneurs who seek immediate liquidity—or who face succession
planning—may want to sell to a strategic buyer to realize their company’s value
and exit the business. Others who are concerned about the costs and burdens
of Sarbanes-Oxley compliance may see acquisition as a more attractive and less
complicated solution. Furthermore, since the IPO market is cyclical, it may
not be open to companies with less-than-stellar growth records; and when
a company is finally ready, the market may not be open to any companies.
Acquirers, on the other hand, may see the unique value in these companies
because of their expected synergies. As a result, they may be willing to pay
more than the public markets for a specific company because they anticipate
synergies—ways in which the acquired company can enhance the value of the
overall organization.
Bottom line: IPOs are not inherently better than acquisitions, or vice versa.
The right choice depends on your personal goals, your company’s objectives,
your management team, your investors, your employees, and the market
environment. When you are in the process of evaluating these alternatives,
having a top-flight board of directors is vital to making the right choice. Only
by carefully considering all your objectives and priorities can you come to the
best decision.
Chris Dixon: Three Types of Acquisitions
There are three types of technology acquisitions:
• Talent. When the acquirer just wants the team (generally just
engineers and sometimes designers). As a rule of thumb, these
acquisitions are priced at approximately $1M/engineer.
• Tech: When the acquirer wants the technology along with the
team. Generally the prices for these acquisitions are significantly
higher than talent acquisitions. Sometimes they are even in
the hundreds of millions of dollars for fairly small teams (e.g.
Siri). The calculation the acquirer uses to price tech acquisitions
is usually “buy vs build.” An important component in this
calculation is not just the actual cost to build the technology but
the opportunity cost of the time it would take them to do so.
• Business: When the company is either bought on a financial basis
(the acquisition is “accretive”) or bought based on non-financial
but highly defensible assets (Google buying YouTube which had
minimal revenue at the time but a huge network of producers and
consumers of video).
As large companies mature they move from doing just talent acquisitions
to doing talent and tech acquisitions to eventually doing all three types
of acquisitions. Usually it takes a startup beating the large company in an
important area for the large company to realize the necessity of business
acquisitions. For example, Google seemed to dramatically change its attitude
when YouTube crushed Google Video. Eventually every large company has a
moment like this.
Felix Salmon: For High Tech Companies, Going Public Sucks
When Facebook goes public this year, it will raise at least $5 billion, making
it the biggest Internet IPO the world has ever seen. The day it debuts on the
stock exchange, Facebook will be worth more than General Motors, the New
York Times Company, and Sprint Nextel combined. The next morning, Mark
Zuckerberg’s smiling face will appear on the front page of newspapers around
the world.
But don’t be surprised if that smile looks like the forced grin of someone
dragged to the altar. Truth be told, Zuckerberg is going public not because he
wants to but because SEC rules have forced his hand. Once a company takes on
more than 500 shareholders—a number that Facebook easily surpasses if you
include all the investors and employees who have bought or received shares over
the years—it must register its stock. That means shareholders can trade it in the
OTC (over the counter) markets, out of the company’s control and without its
consent or cooperation. No high-profile business wants its shares to be traded in
that opaque purgatory of low valuations.
And so, like a hapless groom, Zuckerberg is about to become just one part of an
institution much bigger than himself—a publicly listed limited-liability jointstock company. The visionary who turned down a billion-dollar offer to cash
out at the age of 22, the imperial CEO with complete control over the company
he built from scratch, will now run a company owned by hordes of shareholders
from all over the world.
Zuckerberg clearly does not relish this prospect, and he has taken great pains to
preserve his iron grip on Facebook. When the company goes public, Zuckerberg
will still control 56.9 percent of the votes, will be free to single-handedly
appoint directors, and will even be able to name his successor. Technically,
Facebook may be going public, but Zuckerberg will continue to run it like his
own privately held concern.
5,000,000,000,000
There’s another option: Skip the VC cash. That may sound like suicide, but
a recent study showed that most fast-growing US companies take no venture
funding at all.
Thanks to those safeguards, Facebook will probably weather its IPO just fine.
But when the world’s most successful young tech entrepreneur does everything
in his power to minimize the impact of public ownership, it makes one thing
clear: The IPO model is broken.
Going public might be good for a company’s investors and employees, but it is
usually bad for the company itself. It forces CEOs to focus on short-term stock
fluctuations at the expense of long-term growth. It wrests control from the
founders and gives it to thousands of faceless shareholders.
For hugely successful mega-businesses—Apple, Facebook, Google—going
public has its benefits. Public companies enjoy cachet, tax advantages, and
access to more and better financing options. But for many young companies,
the drive to go public results in a death spiral of unsustainable growth.
It doesn’t have to be this way. There are better options for financing technology
companies. But first we have to kill the tech industry’s senseless addiction to
the IPO.
For roughly 65 years—say, from 1933 to 1998—the initial public offering
was the engine of American capitalism. Entrepreneurs sold shares to investors
and used the proceeds to build their young companies or invest in the future.
After their IPOs, for instance, Apple and Microsoft had the necessary funds
to develop the Macintosh and Windows. The stock market has been the most
efficient and effective method of allocating capital that the world has ever seen.
That was a useful function, but it’s one that IPOs no longer serve. Going public
is more difficult than it used to be—Sarbanes-Oxley regulations have made
filing much more difficult, and today’s investors tend to shy away from Internet
companies that don’t have a proven track record of steady profitability. That has
created a catch-22: By the time a company can go public, it no longer needs the
cash. Take Google. It had already been profitable for three years before raising
$1.2 billion in its 2004 public offering. And Google never spent the money it
raised that year. Instead, it put the cash straight into the bank, where the funds
have been sitting ever since. Today, Google’s cash pile has grown to more than
$44 billion.
Of course, tech industry startups don’t have to wait for an IPO to raise capital.
Hordes of venture capital firms and angel investors are clamoring to offer them
money. (And there are more all the time; VCs invested $18.2 billion in 2011,
up 32 percent from 2010.) And many entrepreneurs don’t need as much capital
anyway—cloud technology has made it vastly cheaper to start a web company.
That’s one reason why startups haven’t been in any rush to go public. In 1985
most VC-backed companies were less than four years old at the time of their
IPOs. By 2009 most of them were more than 10 years old.
If the primary goal of the IPO is no longer to provide funds for promising
young companies, what purpose does it serve? For the most part, it has become
a reward for the founders, employees, and early investors—a jackpot for
those who placed their bets correctly. That’s not as bad as it sounds. Without
the promise of going public, companies couldn’t use stock options to attract
talented employees—a crucial tool for startups, which usually can’t offer
competitive salaries. And it’s the possibility of a future IPO that makes a
company attractive to venture capitalists and angel investors in the first place.
On the surface, there’s nothing wrong with this arrangement. It simply allows
young companies to raise cash while deferring their IPO until they’re more
established. But it has created a series of perverse incentives, in which investors’
interests conflict with—and usually trump—those of the companies they fund.
SUPERSIZING THE IPO
When the web was new, all you needed to launch a public company like
Netscape was an idea, a couple hundred employees, and a multimillion-dollar
loss in the previous year. After the dotcom bubble burst, the bar to going
public got much higher. When Google held its IPO in 2004, it had already
been profitable for three years. And when Facebook hits the public market, it
will be truly huge—with a profit of $1 billion in 2011. So if you want to go
public today, here’s the secret: Build a company that’s so big you don’t need the
money.—Joanna Pearlstein
VCs and angels may talk about changing the world, but their business
model rests on a more prosaic calculation: Buy low, sell high. They invest in
companies they think will become more valuable, so they can sell their stake
for a sizable profit. From the time that VCs invest in a company, they have
five years—10 at the most—to sell their entire position, hopefully for many
times more than their original investment. After that, it doesn’t matter to them
whether the company survives a year or a century.
To put it another way, the VC model is based on creating wealth for investors,
not on building successful businesses. You buy into a company early on and sell
out a few years later; if you pick well, you can make lots of money. But your
profits don’t accrue to the company itself, which could implode after your exit
for all you care. Silicon Valley is full of venture capitalists who have become
dynastically wealthy off the backs of companies that no longer exist.
Of course, once VCs make their investments, they don’t just sit back and
hope for the best; they push the companies to grow as fast as possible. That
may work for the likes of Apple, Facebook, and Google—all-or-nothing
bets on legitimately world-changing technologies. But it creates problems for
more modest startups, which might have the potential to grow into perfectly
sustainable medium-size firms.
Netscape
Google
Facebook
Year of IPO
Dollars Raised
# of
employees at
time of IPO
filling
1995
$207 million
257
2004
$1/5 billion
2,292
2012*
$5 billion*
3,200
Revenue in
Fiscal Year
before IPO
$8 million
$1.8 billion
$3.7 billion
Profit (loss) in
year before
IPO
Quote from
Prospectus
($16.5 million)
128.9 million
$1 billion
“There can be no
assurance that the
market for the
Company’s
products and
services will
develop … or that
individual PC
users
will use the
Internet for
commerce and
communication.”
“Don’t be evil.
We believe
strongly that in
the long term,
we will be better
served by a
company that
does good
things for the
world even if we
forgo some
short-term
gains.””
“Simply put: we
don’t build
services to make
money; we
make money to
build better
services.”
*projected
Because venture capitalists require such massive returns, they invariably
force the companies they invest in to take outsize risks. Look, for instance, at
Groupon. In the first quarter of 2010, it made a profit of $8 million on revenue
of $44 million. That’s a healthy profit margin for a young company, and it’s
easy to see how it could have grown steadily from that point onward.
But in the first quarter of 2011, Groupon’s revenue skyrocketed to $645
million—an increase of 1,357 percent in one year. Meanwhile, the once-
profitable company was suddenly faced with a loss of $146 million. In one
quarter. The reason for the reversal? Groupon, with the full support of its VC
backers, juiced revenue by spending gobs of money on marketing, sacrificing
profits for growth. That’s an enormous bet: If the company grows fast enough,
everyone gets extremely wealthy—but if it stumbles, it can quickly wither.
In this case, the gamble paid off. When Groupon went public in November
2011, just three years after it first launched, it was valued at almost $13 billion,
making billionaires of founders Eric Lefkofsky, Brad Keywell, and CEO
Andrew Mason. But now the company must keep up its torrid pace of growth
or risk alienating its many investors. Indeed, Groupon’s very first quarterly
earnings report sparked hand-wringing news stories about the company’s
performance.
And for every Groupon success story, there are scores of VC-backed companies
that never go public. Sometimes the flameouts are truly spectacular: The phone
service Amp’d Mobile, for example, was so eager to grow that it signed up
customers regardless of their ability to pay. When too many of them turned
out to be deadbeats, the company went bankrupt in 2007, taking $360 million
in venture capital down with it. Amp’d didn’t need to fail. It might well have
achieved sustainable and modest profitability had it not expanded at such a
breakneck pace.
Or take Zappos. CEO Tony Hsieh had hoped to maintain control of his
company, but his investors, led by Sequoia Capital’s Mike Moritz, had other
ideas. In 2009, worried about Zappos’ cash flow, they started pressuring Hsieh.
“If the economy didn’t improve,” Hsieh recalled in Inc. magazine, “the board
would fire me and hire a new CEO who was concerned only with maximizing
profits.” As a result, Hsieh decided to sell Zappos to Amazon, which he thought
would be a better steward than the investor-packed board of directors. Hsieh
may have kept the board from seizing control of his company, but he had to
give up his independence to do so.
Once a company goes public, the demand for constant growth only increases.
Conventional public companies enter into a devil’s bargain: “Give us capital
now and we’ll attempt to grow in perpetuity,” says Silicon Valley-based IPO
consultant Lise Buyer. “The problem comes when companies try to do heroic
things to meet expectations every quarter, even when that’s an unnatural act.”
It’s like British cyclist Tom Simpson, who took a combination of cognac and
amphetamines before a brutally hot stage of the 1967 Tour de France. It enabled
him to push past his limits—until he collapsed and died on the slopes of
Mount Ventoux. Sometimes it’s best to conserve energy, to play the long game,
and not to risk everything for the sake of a short-term win. But once you’re
public, the markets start pushing you to hit those numbers every quarter. And
the results can be fatal. Look, for example, at Hewlett-Packard—arguably the
most venerable and respected company in Silicon Valley, stifled by cost-cutting
managers and board members who were always trying to do what was right for
the share price rather than what was right for the company and its legacy. Today
HP is struggling to define itself.
Of course, plenty of venture-backed companies fail before they have a chance
to go public. VCs tend to shrug that off as a cost of doing business; their model
depends on funding a whole lot of losers in order to discover a few big winners.
And if they can’t take their portfolio companies public, they’ll simply sell them.
Indeed, selling out to an established player has become a popular alternative
exit strategy for young companies. (Last year 429 VC-backed companies were
acquired, while 52 went public.)
The problem is that, despite every assurance, acquired companies almost always
give up their identity and mission when they get folded into a larger behemoth.
It’s a story you hear again and again: Flickr was a flagship of the Web 2.0
era until Yahoo! bought it and turned it into a photo-sharing afterthought;
TechCrunch dominated the tech blogosphere until AOL’s meddling alienated
founder Michael Arrington and many of his top staffers.
Something has to change. It’s time to stop forcing young companies into a
broken process. We need to find a way to invest in new businesses without
jeopardizing their future.
So, what do you do if you’re a young company that doesn’t want to go public
or get acquired? First you have to find another way of offering equity. After all,
without the ability to give away shares, startups would have a much harder time
competing for top-notch talent. And as it grows, a company can use that stock
on all manner of tactical or strategic priorities. When Apple, say, wants to hire a
couple of great engineers, it can throw lots of stock options and restricted stock
units at them instead of just paying enormous salaries. It’s the Silicon Valley
way, and it helps Apple save cash—not that it really needs to, given the rate at
which its $98 billion trove of cash and marketable securities is growing.
Look at it this way: When Apple went public in 1980, it had 54.2 million shares
outstanding. It has since split three times, so those original 54.2 million shares
have now become 434 million shares. But in fact, Apple currently has 929
million shares outstanding. Many of the extra 495 million shares—worth well
over $200 billion, at current valuations—were issued over the years to pay for
companies or people. And Apple isn’t even particularly acquisitive.
All that equity has no value if there isn’t some way to convert it into cash
eventually. If there’s no IPO, how can any shareholders, be they employees or
investors, hope to sell their shares?
In fact, there are some clear—and increasingly popular—alternatives. One is
to enter the private markets. These are online platforms, like SecondMarket
and SharesPost, that let companies trade their stock without inviting public
scrutiny. In recent years, these markets have become a crucial step on the way
to an IPO. Since 2008, more than $1 billion of stock has changed hands on
SecondMarket, the largest of the private markets.
Here’s how SecondMarket works: Companies set periodic auction dates, at
which point buyers and sellers can post the prices at which they’re willing
to transact. The company usually retains a right of first refusal, giving it the
option to buy back its stock at whatever the winning bid price might be. Unlike
public markets, private markets let companies control who buys their stock and
who gets access to confidential financial information. From a company’s point
of view, the great advantage of these markets is that they give outsiders less
power and influence.
For investors, buying shares through the private markets is very different
from trading public stocks. You can’t just sell your shares whenever you want
but must wait for an arranged auction—by which point their value may have
plummeted.
In other words, these are risky bets, and they are treated as such. To buy shares
on these private exchanges, you need to be a rich, accredited investor; they’re
not accessible to most of us. And it’s certainly true that many people are going
to lose substantial sums of money in these markets. But that’s the whole point
of early-stage equity-market investing: It offers massive returns and also very
big risks. (Still, it’s worth noting that SecondMarket is a broker-dealer and so is
regulated by the Securities and Exchange Commission.)
Private markets are important for other reasons too. In the 1980s, when
companies normally went public at four or five years of age, it was reasonable to
ask employees to wait until the IPO before they tried to sell stock. Today, when
it can easily take a decade to go public, companies are more willing to let their
early employees trade shares on secondary markets.
But if private markets currently serve as a way station on the road to an IPO,
in theory they could end up replacing the IPO altogether. That would be a
boon for most companies. Because these markets restrict the number of times a
company’s stock can be traded, they avoid the problem of overtrading. In public
markets, high-frequency algorithms can trade in and out of a stock hundreds
or thousands of times a day, making tiny profits and losses on each transaction.
They neither know nor care what the company does; they just trade the flows.
At the same time, billions of dollars flow in and out of passive instruments
like index funds, which buy and sell a set group of stocks. The result is that
we’ve recently seen record highs in market correlation—stock prices driven by
broad market movements rather than by any unique qualities of the companies
themselves. The private markets remove those factors, meaning that share prices
rise and fall based on a company’s unique prospects, not just on global trends
over which it has no control.
And there’s another option for startups that don’t want to go public: Forgo VC
and angel investments entirely and fund the company with the profits from
your business. That organic-growth option may sound quaint, but it can still
be quite successful. Indeed, VC funding is by no means necessary to fund a
fast-growing company. In 2009 Paul Kedrosky, a Kauffman Foundation senior
fellow and venture capitalist, looked at the Inc. 500 list of the fastest-growing
companies in the US for every year between 1997 and 2007—a period that
includes the VC boom of 1999-2000. He found about 900 companies in all,
of which only 16 percent had VC backing. “Such companies almost certainly
could have venture investors, if they wanted them,” Kedrosky wrote in a paper
for Kauffman. In other words, the overwhelming majority of the fastestgrowing companies decided that they didn’t need VCs.
If the tech industry is to move away from the IPO model, it will have to change
some deeply ingrained attitudes. Because most startups hand out equity, any
company not offering that perk risks dooming itself to irrelevance, unable to
hire the talent it needs to survive. And if a founder says he’ll never go public,
demand for his company’s shares will diminish and its valuation on private
markets will be lower; outside investors will always favor companies that are
heading toward an IPO. Until a groundswell of CEOs commit to not going
public, they’ll face overwhelming pressure to do so.
But it’s about to get easier for tech CEOs to ignore the IPO’s siren song.
Legislation wending its way through Congress would change SEC rules,
meaning no tech company would find itself forced to go public in the way that
Facebook has. The bills, which have been supported quite vocally by a number
of CEOs at pre-IPO companies in Silicon Valley, as well as VCs who want more
control over the timing of their companies’ IPOs, would not count employees
toward a company’s 500-investor limit. The legislation would also raise that
limit to 1,000 shareholders.
It will take a while for tech companies to fully explore the options available to
them. Entrepreneurs can be surprisingly conservative about such things. But
venture capitalists in the Valley are already resigned to the fact that most of
their portfolio companies will never go public. And the more alternatives there
are, the better the chance that some of those companies might find some other
way to survive or even thrive. Businesses that have choices tend to be worth
more money. Venture capitalists even have a term to describe it—option value.
It could just be the next big thing.
All in All – Do Things That Matter
Paul Graham: What You’ll Wish You’d Known
(I wrote this talk for a high school. I never actually gave it, because the school
authorities vetoed the plan to invite me.)
When I said I was speaking at a high school, my friends were curious. What
will you say to high school students? So I asked them, what do you wish
someone had told you in high school? Their answers were remarkably similar.
So I’m going to tell you what we all wish someone had told us.
I’ll start by telling you something you don’t have to know in high school: what
you want to do with your life. People are always asking you this, so you think
you’re supposed to have an answer. But adults ask this mainly as a conversation
starter. They want to know what sort of person you are, and this question is just
to get you talking. They ask it the way you might poke a hermit crab in a tide
pool, to see what it does.
If I were back in high school and someone asked about my plans, I’d say that
my first priority was to learn what the options were. You don’t need to be in a
rush to choose your life’s work. What you need to do is discover what you like.
You have to work on stuff you like if you want to be good at what you do.
It might seem that nothing would be easier than deciding what you like, but it
turns out to be hard, partly because it’s hard to get an accurate picture of most
jobs. Being a doctor is not the way it’s portrayed on TV. Fortunately you can
also watch real doctors, by volunteering in hospitals. [1]
But there are other jobs you can’t learn about, because no one is doing them
yet. Most of the work I’ve done in the last ten years didn’t exist when I was in
high school. The world changes fast, and the rate at which it changes is itself
speeding up. In such a world it’s not a good idea to have fixed plans.
And yet every May, speakers all over the country fire up the Standard
Graduation Speech, the theme of which is: don’t give up on your dreams. I
know what they mean, but this is a bad way to put it, because it implies you’re
supposed to be bound by some plan you made early on. The computer world
has a name for this: premature optimization. And it is synonymous with
disaster. These speakers would do better to say simply, don’t give up.
What they really mean is, don’t get demoralized. Don’t think that you can’t do
what other people can. And I agree you shouldn’t underestimate your potential.
People who’ve done great things tend to seem as if they were a race apart. And
most biographies only exaggerate this illusion, partly due to the worshipful
attitude biographers inevitably sink into, and partly because, knowing how the
story ends, they can’t help streamlining the plot till it seems like the subject’s
life was a matter of destiny, the mere unfolding of some innate genius. In fact
I suspect if you had the sixteen year old Shakespeare or Einstein in school with
you, they’d seem impressive, but not totally unlike your other friends.
Which is an uncomfortable thought. If they were just like us, then they had to
work very hard to do what they did. And that’s one reason we like to believe in
genius. It gives us an excuse for being lazy. If these guys were able to do what
they did only because of some magic Shakespeareness or Einsteinness, then it’s
not our fault if we can’t do something as good.
I’m not saying there’s no such thing as genius. But if you’re trying to choose
between two theories and one gives you an excuse for being lazy, the other one
is probably right.
So far we’ve cut the Standard Graduation Speech down from “don’t give up on
your dreams” to “what someone else can do, you can do.” But it needs to be cut
still further. There is some variation in natural ability. Most people overestimate
its role, but it does exist. If I were talking to a guy four feet tall whose ambition
was to play in the NBA, I’d feel pretty stupid saying, you can do anything if
you really try. [2]
We need to cut the Standard Graduation Speech down to, “what someone else
with your abilities can do, you can do; and don’t underestimate your abilities.”
But as so often happens, the closer you get to the truth, the messier your
sentence gets. We’ve taken a nice, neat (but wrong) slogan, and churned it up
like a mud puddle. It doesn’t make a very good speech anymore. But worse still,
it doesn’t tell you what to do anymore. Someone with your abilities? What are
your abilities?
Upwind
I think the solution is to work in the other direction. Instead of working
back from a goal, work forward from promising situations. This is what most
successful people actually do anyway.
In the graduation-speech approach, you decide where you want to be in twenty
years, and then ask: what should I do now to get there? I propose instead
that you don’t commit to anything in the future, but just look at the options
available now, and choose those that will give you the most promising range of
options afterward.
It’s not so important what you work on, so long as you’re not wasting your time.
Work on things that interest you and increase your options, and worry later
about which you’ll take.
Suppose you’re a college freshman deciding whether to major in math or
economics. Well, math will give you more options: you can go into almost any
field from math. If you major in math it will be easy to get into grad school in
economics, but if you major in economics it will be hard to get into grad school
in math.
Flying a glider is a good metaphor here. Because a glider doesn’t have an engine,
you can’t fly into the wind without losing a lot of altitude. If you let yourself get
far downwind of good places to land, your options narrow uncomfortably. As a
rule you want to stay upwind. So I propose that as a replacement for “don’t give
up on your dreams.” Stay upwind.
How do you do that, though? Even if math is upwind of economics, how are
you supposed to know that as a high school student?
Well, you don’t, and that’s what you need to find out. Look for smart people
and hard problems. Smart people tend to clump together, and if you can find
such a clump, it’s probably worthwhile to join it. But it’s not straightforward to
find these, because there is a lot of faking going on.
To a newly arrived undergraduate, all university departments look much the
same. The professors all seem forbiddingly intellectual and publish papers
unintelligible to outsiders. But while in some fields the papers are unintelligible
because they’re full of hard ideas, in others they’re deliberately written in an
obscure way to seem as if they’re saying something important.
This may seem a scandalous proposition, but it has been experimentally
verified, in the famous Social Text affair. Suspecting that the papers published
by literary theorists were often just intellectual-sounding nonsense, a physicist
deliberately wrote a paper full of intellectual-sounding nonsense, and submitted
it to a literary theory journal, which published it.
The best protection is always to be working on hard problems. Writing novels is
hard. Reading novels isn’t. Hard means worry: if you’re not worrying that something
you’re making will come out badly, or that you won’t be able to understand
something you’re studying, then it isn’t hard enough. There has to be suspense.
Well, this seems a grim view of the world, you may think. What I’m telling you
is that you should worry? Yes, but it’s not as bad as it sounds. It’s exhilarating to
overcome worries. You don’t see faces much happier than people winning gold
medals. And you know why they’re so happy.
Relief
I’m not saying this is the only way to be happy. Just that some kinds of worry
are not as bad as they sound.
Ambition
In practice, “stay upwind” reduces to “work on hard problems.” And you can
start today. I wish I’d grasped that in high school.
Most people like to be good at what they do. In the so-called real world this
need is a powerful force. But high school students rarely benefit from it, because
they’re given a fake thing to do. When I was in high school, I let myself believe
that my job was to be a high school student. And so I let my need to be good at
what I did be satisfied by merely doing well in school.
If you’d asked me in high school what the difference was between high school
kids and adults, I’d have said it was that adults had to earn a living. Wrong. It’s
that adults take responsibility for themselves. Making a living is only a small
part of it. Far more important is to take intellectual responsibility for oneself.
If I had to go through high school again, I’d treat it like a day job. I don’t mean
that I’d slack in school. Working at something as a day job doesn’t mean doing
it badly. It means not being defined by it. I mean I wouldn’t think of myself as
a high school student, just as a musician with a day job as a waiter doesn’t think
of himself as a waiter. [3] And when I wasn’t working at my day job I’d start
trying to do real work.
When I ask people what they regret most about high school, they nearly all say
the same thing: that they wasted so much time. If you’re wondering what you’re
doing now that you’ll regret most later, that’s probably it. [4]
Some people say this is inevitable—that high school students aren’t capable of
getting anything done yet. But I don’t think this is true. And the proof is that
you’re bored. You probably weren’t bored when you were eight. When you’re
eight it’s called “playing” instead of “hanging out,” but it’s the same thing. And
when I was eight, I was rarely bored. Give me a back yard and a few other kids
and I could play all day.
The reason this got stale in middle school and high school, I now realize, is that
I was ready for something else. Childhood was getting old.
I’m not saying you shouldn’t hang out with your friends—that you should all
become humorless little robots who do nothing but work. Hanging out with
friends is like chocolate cake. You enjoy it more if you eat it occasionally than
if you eat nothing but chocolate cake for every meal. No matter how much you
like chocolate cake, you’ll be pretty queasy after the third meal of it. And that’s
what the malaise one feels in high school is: mental queasiness. [5]
You may be thinking, we have to do more than get good grades. We have to
have extracurricular activities. But you know perfectly well how bogus most of
these are. Collecting donations for a charity is an admirable thing to do, but it’s
not hard. It’s not getting something done. What I mean by getting something
done is learning how to write well, or how to program computers, or what life
was really like in preindustrial societies, or how to draw the human face from
life. This sort of thing rarely translates into a line item on a college application.
Corruption
It’s dangerous to design your life around getting into college, because the people
you have to impress to get into college are not a very discerning audience.
At most colleges, it’s not the professors who decide whether you get in, but
admissions officers, and they are nowhere near as smart. They’re the NCOs of
the intellectual world. They can’t tell how smart you are. The mere existence of
prep schools is proof of that.
Few parents would pay so much for their kids to go to a school that didn’t
improve their admissions prospects. Prep schools openly say this is one of their
aims. But what that means, if you stop to think about it, is that they can hack
the admissions process: that they can take the very same kid and make him
seem a more appealing candidate than he would if he went to the local public
school. [6]
Right now most of you feel your job in life is to be a promising college
applicant. But that means you’re designing your life to satisfy a process so
mindless that there’s a whole industry devoted to subverting it. No wonder you
become cynical. The malaise you feel is the same that a producer of reality TV
shows or a tobacco industry executive feels. And you don’t even get paid a lot.
So what do you do? What you should not do is rebel. That’s what I did, and it
was a mistake. I didn’t realize exactly what was happening to us, but I smelled a
major rat. And so I just gave up. Obviously the world sucked, so why bother?
When I discovered that one of our teachers was herself using Cliff’s Notes, it
seemed par for the course. Surely it meant nothing to get a good grade in such
a class.
In retrospect this was stupid. It was like someone getting fouled in a soccer
game and saying, hey, you fouled me, that’s against the rules, and walking off
the field in indignation. Fouls happen. The thing to do when you get fouled is
not to lose your cool. Just keep playing.
By putting you in this situation, society has fouled you. Yes, as you suspect, a
lot of the stuff you learn in your classes is crap. And yes, as you suspect, the
college admissions process is largely a charade. But like many fouls, this one was
unintentional. [7] So just keep playing.
Rebellion is almost as stupid as obedience. In either case you let yourself be
defined by what they tell you to do. The best plan, I think, is to step onto an
orthogonal vector. Don’t just do what they tell you, and don’t just refuse to.
Instead treat school as a day job. As day jobs go, it’s pretty sweet. You’re done at
3 o’clock, and you can even work on your own stuff while you’re there.
Curiosity
And what’s your real job supposed to be? Unless you’re Mozart, your first task
is to figure that out. What are the great things to work on? Where are the
imaginative people? And most importantly, what are you interested in? The
word “aptitude” is misleading, because it implies something innate. The most
powerful sort of aptitude is a consuming interest in some question, and such
interests are often acquired tastes.
A distorted version of this idea has filtered into popular culture under the name
“passion.” I recently saw an ad for waiters saying they wanted people with a
“passion for service.” The real thing is not something one could have for waiting
on tables. And passion is a bad word for it. A better name would be curiosity.
Kids are curious, but the curiosity I mean has a different shape from kid
curiosity. Kid curiosity is broad and shallow; they ask why at random about
everything. In most adults this curiosity dries up entirely. It has to: you can’t get
anything done if you’re always asking why about everything. But in ambitious
adults, instead of drying up, curiosity becomes narrow and deep. The mud flat
morphs into a well.
Curiosity turns work into play. For Einstein, relativity wasn’t a book full of hard
stuff he had to learn for an exam. It was a mystery he was trying to solve. So it
probably felt like less work to him to invent it than it would seem to someone
now to learn it in a class.
One of the most dangerous illusions you get from school is the idea that doing
great things requires a lot of discipline. Most subjects are taught in such a
boring way that it’s only by discipline that you can flog yourself through them.
So I was surprised when, early in college, I read a quote by Wittgenstein saying
that he had no self-discipline and had never been able to deny himself anything,
not even a cup of coffee.
Now I know a number of people who do great work, and it’s the same with all
of them. They have little discipline. They’re all terrible procrastinators and find
it almost impossible to make themselves do anything they’re not interested in.
One still hasn’t sent out his half of the thank-you notes from his wedding, four
years ago. Another has 26,000 emails in her inbox.
I’m not saying you can get away with zero self-discipline. You probably need
about the amount you need to go running. I’m often reluctant to go running,
but once I do, I enjoy it. And if I don’t run for several days, I feel ill. It’s the
same with people who do great things. They know they’ll feel bad if they don’t
work, and they have enough discipline to get themselves to their desks to start
working. But once they get started, interest takes over, and discipline is no
longer necessary.
Do you think Shakespeare was gritting his teeth and diligently trying to write
Great Literature? Of course not. He was having fun. That’s why he’s so good.
If you want to do good work, what you need is a great curiosity about a
promising question. The critical moment for Einstein was when he looked at
Maxwell’s equations and said, what the hell is going on here?
It can take years to zero in on a productive question, because it can take years to
figure out what a subject is really about. To take an extreme example, consider
math. Most people think they hate math, but the boring stuff you do in school
under the name “mathematics” is not at all like what mathematicians do.
The great mathematician G. H. Hardy said he didn’t like math in high school
either. He only took it up because he was better at it than the other students.
Only later did he realize math was interesting—only later did he start to ask
questions instead of merely answering them correctly.
When a friend of mine used to grumble because he had to write a paper for
school, his mother would tell him: find a way to make it interesting. That’s
what you need to do: find a question that makes the world interesting. People
who do great things look at the same world everyone else does, but notice some
odd detail that’s compellingly mysterious.
And not only in intellectual matters. Henry Ford’s great question was, why do
cars have to be a luxury item? What would happen if you treated them as a
commodity? Franz Beckenbauer’s was, in effect, why does everyone have to stay
in his position? Why can’t defenders score goals too?
Now
If it takes years to articulate great questions, what do you do now, at sixteen?
Work toward finding one. Great questions don’t appear suddenly. They
gradually congeal in your head. And what makes them congeal is experience.
So the way to find great questions is not to search for them—not to wander
about thinking, what great discovery shall I make? You can’t answer that; if you
could, you’d have made it.
The way to get a big idea to appear in your head is not to hunt for big ideas,
but to put in a lot of time on work that interests you, and in the process keep
your mind open enough that a big idea can take roost. Einstein, Ford, and
Beckenbauer all used this recipe. They all knew their work like a piano player
knows the keys. So when something seemed amiss to them, they had the
confidence to notice it.
Put in time how and on what? Just pick a project that seems interesting: to
master some chunk of material, or to make something, or to answer some
question. Choose a project that will take less than a month, and make it
something you have the means to finish. Do something hard enough to stretch
you, but only just, especially at first. If you’re deciding between two projects,
choose whichever seems most fun. If one blows up in your face, start another.
Repeat till, like an internal combustion engine, the process becomes selfsustaining, and each project generates the next one. (This could take years.)
It may be just as well not to do a project “for school,” if that will restrict you or
make it seem like work. Involve your friends if you want, but not too many, and
only if they’re not flakes. Friends offer moral support (few startups are started
by one person), but secrecy also has its advantages. There’s something pleasing
about a secret project. And you can take more risks, because no one will know if
you fail.
Don’t worry if a project doesn’t seem to be on the path to some goal you’re
supposed to have. Paths can bend a lot more than you think. So let the path
grow out the project. The most important thing is to be excited about it,
because it’s by doing that you learn.
Don’t disregard unseemly motivations. One of the most powerful is the desire
to be better than other people at something. Hardy said that’s what got him
started, and I think the only unusual thing about him is that he admitted it.
Another powerful motivator is the desire to do, or know, things you’re not
supposed to. Closely related is the desire to do something audacious. Sixteen
year olds aren’t supposed to write novels. So if you try, anything you achieve
is on the plus side of the ledger; if you fail utterly, you’re doing no worse than
expectations. [8]
Beware of bad models. Especially when they excuse laziness. When I was in
high school I used to write “existentialist” short stories like ones I’d seen by
famous writers. My stories didn’t have a lot of plot, but they were very deep.
And they were less work to write than entertaining ones would have been.
I should have known that was a danger sign. And in fact I found my stories
pretty boring; what excited me was the idea of writing serious, intellectual stuff
like the famous writers.
Now I have enough experience to realize that those famous writers actually
sucked. Plenty of famous people do; in the short term, the quality of one’s work
is only a small component of fame. I should have been less worried about doing
something that seemed cool, and just done something I liked. That’s the actual
road to coolness anyway.
A key ingredient in many projects, almost a project on its own, is to find good
books. Most books are bad. Nearly all textbooks are bad. [9] So don’t assume
a subject is to be learned from whatever book on it happens to be closest. You
have to search actively for the tiny number of good books.
The important thing is to get out there and do stuff. Instead of waiting to be
taught, go out and learn.
Your life doesn’t have to be shaped by admissions officers. It could be shaped
by your own curiosity. It is for all ambitious adults. And you don’t have to wait
to start. In fact, you don’t have to wait to be an adult. There’s no switch inside
you that magically flips when you turn a certain age or graduate from some
institution. You start being an adult when you decide to take responsibility for
your life. You can do that at any age. [10]
This may sound like bullshit. I’m just a minor, you may think, I have no
money, I have to live at home, I have to do what adults tell me all day long.
Well, most adults labor under restrictions just as cumbersome, and they manage
to get things done. If you think it’s restrictive being a kid, imagine having kids.
The only real difference between adults and high school kids is that adults
realize they need to get things done, and high school kids don’t. That
realization hits most people around 23. But I’m letting you in on the secret
early. So get to work. Maybe you can be the first generation whose greatest
regret from high school isn’t how much time you wasted.
Notes
[1] A doctor friend warns that even this can give an inaccurate picture. “Who knew how much time it
would take up, how little autonomy one would have for endless years of training, and how unbelievably
annoying it is to carry a beeper?”
[2] His best bet would probably be to become dictator and intimidate the NBA into letting him play. So far
the closest anyone has come is Secretary of Labor.
[3] A day job is one you take to pay the bills so you can do what you really want, like play in a band, or
invent relativity.
Treating high school as a day job might actually make it easier for some students to get good grades. If you
treat your classes as a game, you won’t be demoralized if they seem pointless.
However bad your classes, you need to get good grades in them to get into a decent college. And that is
worth doing, because universities are where a lot of the clumps of smart people are these days.
[4] The second biggest regret was caring so much about unimportant things. And especially about what
other people thought of them.
I think what they really mean, in the latter case, is caring what random people thought of them. Adults care
just as much what other people think, but they get to be more selective about the other people.
I have about thirty friends whose opinions I care about, and the opinion of the rest of the world barely
affects me. The problem in high school is that your peers are chosen for you by accidents of age and
geography, rather than by you based on respect for their judgement.
[5] The key to wasting time is distraction. Without distractions it’s too obvious to your brain that you’re
not doing anything with it, and you start to feel uncomfortable. If you want to measure how dependent
you’ve become on distractions, try this experiment: set aside a chunk of time on a weekend and sit alone
and think. You can have a notebook to write your thoughts down in, but nothing else: no friends, TV,
music, phone, IM, email, Web, games, books, newspapers, or magazines. Within an hour most people will
feel a strong craving for distraction.
[6] I don’t mean to imply that the only function of prep schools is to trick admissions officers. They also
generally provide a better education. But try this thought experiment: suppose prep schools supplied the
same superior education but had a tiny (.001) negative effect on college admissions. How many parents
would still send their kids to them?
It might also be argued that kids who went to prep schools, because they’ve learned more, are better college
candidates. But this seems empirically false. What you learn in even the best high school is rounding error
compared to what you learn in college. Public school kids arrive at college with a slight disadvantage, but
they start to pull ahead in the sophomore year.
(I’m not saying public school kids are smarter than preppies, just that they are within any given college.
That follows necessarily if you agree prep schools improve kids’ admissions prospects.)
[7] Why does society foul you? Indifference, mainly. There are simply no outside forces pushing high
school to be good. The air traffic control system works because planes would crash otherwise. Businesses
have to deliver because otherwise competitors would take their customers. But no planes crash if your
school sucks, and it has no competitors. High school isn’t evil; it’s random; but random is pretty bad.
[8] And then of course there is money. It’s not a big factor in high school, because you can’t do much that
anyone wants. But a lot of great things were created mainly to make money. Samuel Johnson said “no man
but a blockhead ever wrote except for money.” (Many hope he was exaggerating.)
[9] Even college textbooks are bad. When you get to college, you’ll find that (with a few stellar exceptions)
the textbooks are not written by the leading scholars in the field they describe. Writing college textbooks is
unpleasant work, done mostly by people who need the money. It’s unpleasant because the publishers exert
so much control, and there are few things worse than close supervision by someone who doesn’t understand
what you’re doing. This phenomenon is apparently even worse in the production of high school textbooks.
[10] Your teachers are always telling you to behave like adults. I wonder if they’d like it if you did. You
may be loud and disorganized, but you’re very docile compared to adults. If you actually started acting like
adults, it would be just as if a bunch of adults had been transposed into your bodies. Imagine the reaction
of an FBI agent or taxi driver or reporter to being told they had to ask permission to go the bathroom, and
only one person could go at a time. To say nothing of the things you’re taught. If a bunch of actual adults
suddenly found themselves trapped in high school, the first thing they’d do is form a union and renegotiate
all the rules with the administration.
ABOUT THE CONTRIBUTORS
Listed in Order of Appearance
Blake Masters
Blake Masters graduated from Stanford Law and is now working on a legal
technology startup called Amicus Labs.
The notes found in this book are Blake’s essay version of his class notes of
CS:183: Startups, a class taught by Peter Thiel at Stanford University.
Blake would like to be clear about the nature of the work. He wants people to
understand that it is really Peter Thiel’s content, and that he was just absorbing
it into essay form.
Tim O’Reilly
Tim O’Reilly is the founder and CEO of O’Reilly Media, Inc., thought by
many to be the best computer book publisher in the world. In addition to Foo
Camps (“Friends of O’Reilly” Camps, which gave rise to the “un-conference”
movement), O’Reilly Media also hosts conferences on technology topics,
including the Web 2.0 Summit, the Web 2.0 Expo, the O’Reilly Open Source
Convention, the Gov 2.0 Summit, and the Gov 2.0 Expo. Tim’s blog, the
O’Reilly Radar, “watches the alpha geeks” to determine emerging technology
trends, and serves as a platform for advocacy about issues of importance to the
technical community. Tim’s long-term vision for his company is to change the
world by spreading the knowledge of innovators. In addition to O’Reilly Media,
Tim is a founder of Safari Books Online, a pioneering subscription service
for accessing books online, and O’Reilly AlphaTech Ventures, an early-stage
venture firm.
Paul Graham
Paul Graham is an essayist, programmer, and investor. In 1995 he developed
with Robert Morris the first web-based application, Viaweb, which was
acquired by Yahoo! in 1998. In 2002 he described a simple statistical spam filter
that inspired a new generation of filters. In 2005 he was one of the founders
of Y Combinator. He and Robert Morris are currently working on a new Lisp
dialect called Arc.
Paul is the author of On Lisp (Prentice Hall, 1993), ANSI Common Lisp
(Prentice Hall, 1995), and Hackers & Painters (O’Reilly, 2004). He has an
AB from Cornell and a PhD in Computer Science from Harvard, and studied
painting at RISD and the Accademia di Belle Arti in Florence.
Paulgraham.com got 8.9 million page views in 2009.
Jay Jamison
Jay Jamison is a partner at BlueRun Ventures, an early stage venture capital
firm investing out of Menlo Park, Beijing, and Seoul. He loves working with
founders and striving to support and help them build great companies.
He works with and serves on the boards of several of our portfolio companies,
including Foodspotting, AppCentral, Thumb, and AppRedeem. He is also a
board observer at EggCartel, the makers of EggDrop, the easiest way to sell
stuff using your smartphone, and Zmanda, an open source cloud backup
company.
Jay has also been an entrepreneur and founder. He co-founded Moonshoot,
whose mission is to help children anywhere learn English as a foreign language,
and he’s been a partner in the independent software development company,
Bema Studios, LLC.
Jay is passionate about helping and mentoring startups, whether he invests
in them or not. He’s worked with Adeo Ressi‘s Founder Institute since it was
founded. He led the Founder Institute’s San Francisco chapter in 2011, and has
mentored in several Silicon Valley and Seattle sessions.
Sarah Lacy
Sarah Lacy writes for PandoDaily, a news site which she founded.
She is also an award winning journalist and author of two critically acclaimed
books, “Once You’re Lucky, Twice You’re Good: The Rebirth of Silicon Valley
and the Rise of Web 2.0” (Gotham Books, May 2008) and “Brilliant, Crazy,
Cocky: How the Top 1% of Entrepreneurs Profit from Global Chaos (Wiley,
February 2011).
Lacy has been a reporter in Silicon Valley for nearly fifteen years, covering
everything from the tiniest startups to the largest public companies. She was
formerly a staff writer and columnist for BusinessWeek, the founding co-host of
Yahoo! Finance’s Tech Ticker, and a senior editor at TechCrunch. She lives in
San Francisco.
Mark Suster
Mark Suster is a 2x entrepreneur who has gone to the Dark Side of VC. He
joined GRP Partners in 2007 as a General Partner after selling his company to
Salesforce.com. He focuses on early-stage technology companies. They include:
Affordit, EagleCrest Energy, EcoMom, ExpenseCloud, Gendai Games, and
LaughStub
Dan Shapiro
Dan Shapiro works at Google following the acquisition of his most recent
company, Sparkbuy Inc. Dan was the founder and CEO of Sparkbuy, a
comparison shopping website that offered unprecedented depth and accuracy of
information through a simple and innovative user interface.
Previously, Shapiro was founder and CEO of Ontela, a pioneering mobile
imaging company, where he was named CEO of the Year by MobileBeat.
Ontela was frequently recognized including the Dow Jones Top 10 in Wireless
list, receiving the CTIA award for Best Social Networking Application, and
being named Breakthrough Startup of the Year by the WTIA. Ontela merged
with Photobucket in December of 2009 where Shapiro now holds a seat on the
Board of Directors.
Prior to founding Ontela, Shapiro managed development of the RealArcade
service at RealNetworks, enabling thousands of end-users to play classic games
such as Monopoly, Scrabble and Rollercoaster Tycoon on their desktops. He
arrived at RealNetworks by way of Wildseed, where he managed software
development for the Identity Cellular Phone. Shapiro started his career at
Microsoft working on Windows 98, Windows 2000, and Windows XP.
Shapiro’s articles have been published in the Washington Post, Wireless Week,
and the Seattle PI, and he is a frequent speaker at conferences and events.
He serves on the board of Bonanzle, an ecommerce company backed by
Ignition, Matrix, and Voyager, and on the board of the nonprofit Washington
Technology Industry Association. He is a mentor for both the Founder’s
Institute and Techstars. He has been awarded five US patents, and received his
B.S. in Engineering from Harvey Mudd College.
Marc Averitt
Marc Averitt is a Co-Founder and Managing Director of Okapi Venture
Capital and is responsible for Okapi Ventures’ technology and digital media
investments. He has held leadership positions of increasing responsibility in
business development, legal, operations, corporate development, and strategy
in the technology industry since the mid-90s. Prior to founding Okapi, Marc
was with Intel Corporation first as an attorney for the Microprocessor Products
Group and then as the Managing Director, Strategic Business Development
for the Software & Solutions Group worldwide. Prior to Intel, Marc worked
for Sun Microsystems in business development and legal roles. Marc received
his bachelors from the University of Southern California, where he studied
philosophy and business, and went on to earn his Juris Doctor from Pepperdine
University School of Law. He also attended the Stanford University Graduate
School of Business executive education program. Marc’s past board affiliations
include DATAllegro (acquired by MSFT), TrueEcho, Jabez, and SecondVoice
while his present board affiliations include My Damn Channel, RF Nano
Corporation, Transaction Wireless, and Welltok. He is also on the Advisory
Board of the University of California, Irvine’s Don Beall Center for Innovation
& Entrepreneurship. Marc maintains a personal blog about being a VC in “The
OC” at http://ocvcblog.com and can be followed as “OCVC” on Twitter. Marc
lives with his wife and two kids in Orange County, CA and is active with his
kids’ school and the local community.
Matthew V. Waterman
Matthew Waterman is a partner in CCCs Corporate and Technology
Transactions Groups. He specializes in venture capital financings (and other
private equity and debt offerings), mergers and acquisitions, and software/
technology licensing.
Prior to joining CCG, Mr. Waterman founded and managed General Counsel
Partners, a boutique law firm focused exclusively on corporate and technology
transactions. Before founding General Counsel Partners, Mr. Waterman was
an associate and Of Counsel in the business and technology practice group of
Brobeck, Phleger & Harrison LLP and an associate in the litigation practice
group of Robins, Kaplan, Miller & Ciresi LLP.
Mr. Waterman has also served as the General Counsel, on either a full-time
or part-time basis, of a number of emerging growth companies in Southern
California, including Alteer Corporation (an electronic health records software
company), Octave Software, Inc. (a content management software company),
ThinkTank Holdings LLC (an incubator and venture capital fund), and
InTouch Communications, Inc. (a telecommunications company). Before
his career in private practice, Mr. Waterman served as a judicial clerk to the
Honorable Ronald S.W. Lew of the United States District Court for the Central
District of California.
Fred Wilson
Fred Wilson has been a venture capitalist since 1987. He currently is a
managing partner at Union Square Ventures and also founded Flatiron
Partners. Fred has a Bachelors degree in Mechanical Engineering from MIT
and an MBA from The Wharton School of Business at the University of
Pennsylvania. Fred is married with three kids and lives in New York City.
Charlie O’Donnell
Charlie O’Donnell is a Partner at Brooklyn Bridge Ventures, working on very
early stage investments in the “Greater Brooklyn” area, which also includes
Manhattan and the other boroughs of New York City. He previously spent
two plus years at First Round Capital, where he sourced the firm’s investments
in GroupMe (sold to Skype), Backupify, chloe + isabel, Refinery29, Docracy,
Singleplatform, and Salescrunch. He founded New York’s largest independent
innovation community group, nextNY, and was voted one of the 100 Most
Influential People in New York Technology three consecutive years by Alley
Insider.
Charlie was the Co-Founder & CEO of Path 101, an innovative startup in the
career guidance and recruiting space, which raised half a million dollars and
was a Business Insider Startup 2009 Finalist.
Chris Dixon
Chris Dixon is the Co-founder/CEO of Hunch (acquired by eBay). He is an
Early-stage personal investor in technology startups, including Hipmunk,
Foursquare, Kickstarter, Stripe, Dropbox, Skype, OMGPOP (acquired by
Zynga), Behance, Canvas, Codecademy, Stack Overflow, Gerson Lehrman
Group, Knewton, Bloomreach, Optimizely, TrialPay, Panjiva, DocVerse
(acquired by Google), Invite Media (acquired by Google), ScanScout (acquired
by Tremor Video), and some other startups that haven’t publicized investments
yet. Chris co-founded Founder Collective, a seed-stage venture fund. He is also
the Co-founder/CEO of SiteAdvisor which was acquired by McAfee.
Andrew Chen
Andrew Chen is a blogger and entrepreneur focused on consumer internet,
metrics and user growth. He is an advisor/angel for early-stage startups
including AppSumo, Cardpool (acquired by Safeway), Gravity, Kiva,
Mocospace, Qik (acquired by Skype), Wanelo, WeeWorld, Votizen, and is also a
500 Startups mentor. Previously, he was an Entrepreneur-in-Residence at Mohr
Davidow Ventures, a Silicon Valley-based firm with $2B under management.
Prior to MDV, Andrew was director of product marketing at Audience Science,
where he started up the ad network business that today reaches over 380 million
uniques. He also co-authored a patent on personalized advertising, USPTO
#7,882,175 and holds a B.S. in Applied Mathematics from the University of
Washington.
Seth Levine
Seth Levine’s career spans venture capital investing as well as operational,
transactional and advisory roles at both public and private companies. Prior to
co-founding Foundry Group, Seth began his venture capital career at Mobius
Venture Capital.
He currently serves on the boards of CrowdTap, Federated Media Publishing,
Integrate, LinkSmart, Medialets, SideTour, Spanning Cloud Apps,
StockTwits,Trada and Triggit for Foundry Group. Seth previously served on
the boards of AdMeld(acquired by Google in 12/11) and Lijit (acquired by
Federated Media Publishing 9/11).
Seth is an avid outdoorsman and enjoys spending his free time cycling,
snowboarding, mountaineering and spending time with his family. He writes a
blog on technology, venture capital and living in Colorado at www.sethlevine.
com. He also wrote “The Startup Owner’s Manual,” which can be found on
Amazon.com
Darren Herman
Darren Herman is the Chief Digital Media Officer of New York based media
communications planning and buying agency, The Media Kitchen and
President of kbs+ Ventures, a corporate investment arm focusing on marketing
technology by parent agency, kirshenbaum bond senecal + partners. He sits on
the board of Varick Media Management, Madison Avenue’s pioneering trading
desk that he founded in 2008. In 2011, Herman was named one of the Top 25
Marketing Innovators and Thought Leaders by iMedia and honored as a Media
All Star by Media Post. Prior to joining the agency world in 2007, Herman
spent 12 years a marketing technology entrepreneur having raised over $40MM
for his own ventures from top tier venture capitalists such as Intel Capital and
NBC Universal.
Scott Weiss
Scott Weiss is a partner at Andreessen Horowitz. Scott was formerly the vice
president and general manager of the Security Technology Group at Cisco
Systems, a $1.3 billion line of business. Prior to this role, he served as the
co-founder and CEO of IronPort Systems. Now part of Cisco, IronPort is a
product of Scott’s past experiences with companies that innovate with their
use of security technology. He was one of the early team members at Hotmail,
the world’s largest Web-based email service. At Hotmail, Scott was responsible
for all partnership and revenue generating business development efforts. After
Hotmail’s acquisition by Microsoft, Scott led a business development team at
Microsoft with the MSN division. Scott left Microsoft to pursue new startup
opportunities. He developed a concept in the e-commerce space, and pulled
together the core team to incubate the idea. In the process of seeking funding
for the concept, he ultimately joined idealab! as managing director and
entrepreneur in residence. Prior to joining Hotmail, Scott had been a consultant
at McKinsey & Co. He also worked at EDS for five years, completing a
rotational management development program and ultimately promoted to
group manager. Scott holds an MBA from Harvard Business School and a BA
from the University of Florida. He serves on the board of App.net, Bluebox,
Jumio, Platfora, Quirky, Silver Tail Systems and Skout, and blogs at http://scott.
a16z.com/.
Babak Nivi
Nivi is a co-founder of AngelList and Venture Hacks. Previously, he was an
entrepreneur-in-residence at Bessemer Venture Partners and Atlas Venture. He
has worked on startups including Songbird, Grockit, and Kovio. He went to
school at MIT where received 2 patents and published in Science.
Rutul Dave
Rutul Dave is an entrepreneur with a background in software and marketing.
He has over 10 years of experience in software and product development.
He has been involved in building large-scale distributed software systems at
various bay-area startups like Procket Newtorks and Topspin Communications
(acquired by Cisco), and Coverity,Inc. He has a Master’s in Computer Science
from USC, and an MBA from UCLA Anderson School of Management.
He is currently the cofounder and Chief Product Officer at Bright Funds.
Steve Blank
Steve Blank is a Silicon Valley-based retired serial entrepreneur, founding
and/or part of 8 startup companies in California’s Silicon Valley. A prolific
educator, thought leader and writer on Customer Development for Startups,
Blank teaches, refines, writes and blogs on “Customer Development,” a rigorous
methodology he developed to bring the “scientific method” to the typically
chaotic, seemingly disorganized startup process
Now teaching Entrepreneurship at three major Universities and the National
Science Foundation Innovation Corps (I-Corps), Blank co-founded his first of
eight startups after several years repairing fighter plane electronics in Thailand
during the Vietnam War, followed by several years of defense electronics work
for U.S. intelligence agencies in “undisclosed locations.”
Blank’s first book, “The Four Steps to the Epiphany,” detailed the Customer
Development process and remains required reading among entrepreneurs,
investors, and established companies alike, when the focus is optimizing a
startup’s chances for scalability and success. Blank views entrepreneurship as a
practice that can be managed rather than purely an art form to be experienced.
“The Startup Owner’s Manual” was Blank’s second book and is a step-by-step
guide to building a successful startup, offering practical advice for any startup
founder, entrepreneur, investor or educator.
His Customer Development methodology launched the lean startup movement.
It is rooted on startups “getting out of the building,” talking to customers and
using that feedback to develop and refine their product.
Dave McClure
Dave McClure is an entrepreneur and prominent angel investor based in the
San Francisco Bay Area, who founded and runs the business incubator 500
Startups. He is often described as one of the super angel investors.
McClure founded Aslan Computing, a technology consultancy, in 1994,
and later sold the company to Servinet/Panurgy in 1998. He later worked as
a technology consultant to Microsoft, Intel, and other companies. He was
Director of Marketing at PayPal from 2001 through 2004. He launched and
ran marketing for Simply Hired in 2005 and 2006.
After leaving PayPal, McClure became a frequent investor in consumer Internet
startup companies. He led the fbFund incubator on behalf of Facebook. 500
Startups is a business accelerator and related investment fund McClure founded
in 2010.
Taylor Davidson
Taylor Davidson is a venture capitalist at kbs+ Ventures, the thematic earlystage venture investment arm of the advertising agency kbs+. He is an advisor to
a range of early-stage ventures and a mentor with Launch Pad Ignition and The
Brandery. Over 6,000 entrepreneurs have downloaded one of his Excel template
financial models for startups, and hundreds have taken one of his classes about
financial modeling for entrepreneurs.
He is also a professional photographer (@tdavidson on Instagram), focusing
on business and event photography through his agency Narratively. Clients
and features have included Clinton Global Initiative, The Economist, CNN,
The Rockefeller Foundation, and many others. In his personal work, he
focuses on landscapes and cityscapes and explores how humans create, shape,
and live in their environment. Taylor is often noted as one of the top travel
photographers on the web. He supports the Young Photographers Alliance and
the International Center of Photography.
He loves creating things, traveling, baseball statistics, and whisky. The two
most popular things he has ever written on the web are about how to fail in
business and how to pack for a nomadic life, two things he would rather not be
known for.
Adam L. Penenberg
Adam L. Penenberg is a journalism professor and assistant director of the
Business and Economic Program at New York University. Previously a
contributing writer to Fast Company, he has also written for Inc., Forbes, The
New York Times, Slate, Wired, Economist, Playboy and Mother Jones, Alan
is now the Editor of PandoDaily. A former senior editor at Forbes and reporter
for Forbes.com, Penenberg garnered national attention in 1998 for unmasking
serial fabricator Stephen Glass of The New Republic. Penenberg’s story was
a watershed for online investigative journalism and is portrayed in the film
“Shattered Glass” (Steve Zahn plays Penenberg).
His first book, Spooked: Espionage in Corporate America (Perseus Books,
2000), was excerpted in the Sunday New York Times Magazine and received
a starred review in Publishers Weekly. His second, Tragic Indifference:
One Man’s Battle With the Auto Industry Over the Dangers of SUVs
(HarperBusiness, 2003) was optioned for the movies by Michael Douglas
and excerpted in USA Today. Reviewers called it “gripping” (Mother Jones)
“dramatic” (Boston Globe), “stinging,” “comprehensive” and “disturbing”
(Publishers Weekly), a book that has a “narrative with rich, detailed characters”
(San Francisco Chronicle) and “offers a comprehensive look at a notorious
corporate scandal and a courtroom drama and investigation that ends in
triumph for the many victims” (Booklist). His latest book is Viral Loop: From
Facebook to Twitter, How Today’s Smartest Businesses Grow Themselves
(Hyperion, 2009) has been excerpted in Fast Company and TechCrunch in the
U.S. and in Wired magazine in the UK.
A journalism professor at New York University, Penenberg is the assistant
director of the Business & Economic Program, heads the department’s ethics
committee—he wrote the department’s journalism handbook for students,
which received unanimous faculty approval and the ethics pledge, which all
students must sign—and teaches multimedia, magazine writing, and hard news
and investigative reporting to graduate and undergraduate students. In addition
to the Today Show, he has appeared on CNN’s “American Morning” and
“Money Line,” ABC World News and News Now, FoxNews, MSNBC, CNBC,
and NPR and been quoted about media and technology in the Washington
Post, Christian Science Monitor, Wired News, Ad Age, Marketwatch, Politico,
etc.
Robert R. Ackerman, Jr.
Robert R. Ackerman, Jr. (Bob) is the Founder and Managing Director of
Allegis Capital and currently sits on the Boards of Apprion and Purewave. His
prior investments include security lead IronPort Systems - acquired by Cisco
Systems for $830M, LGC Wireless (TEL), iBeam Broadcasting (NASDAQ),
Comparnet (MSFT), StepUp Commerce (INTU), Driverside (AAP) and
Classroom Connect (ENL). With more than 15 years of venture capital
investment experience, in addition to his track record as both technology
operating executive and strategic mergers and acquisition advisory experience,
Mr. Ackerman works closely with the Firm’s startup portfolio to transform their
business visions into executable business plans.
Prior to Allegis Capital, Bob’s operating experience included the CEO of
UniSoft Systems (a world leading UNIX systems house operating in the U.S.,
Europe and Asia) and the founder and Chairman of InfoGear Technology
Corporation (the first internet appliance company; acquired by CISCO in
2000). Mr. Ackerman has been named as one of the Top 100 technology
investors by both Forbes Magazine and AlwaysOn. He is a leading advocate
and authority on matters related to collaboration between startup companies,
venture capital firms and strategic corporate investors. He chairs the Annual
Corporate Venturing and Innovation Conference and is a frequent speaker
at industry conferences and contributor to publications on matters related to
venture capital, innovation, information security and public policy related to
economic development. Mr. Ackerman is a member of the Board of Trustees
of the San Francisco-based Asian Art Museum. He is also an instructor on
subjects related to venture capital and new venture finance at the University of
California’s Haas Graduate School of Business at Berkeley and has a Bachelor of
Science degree in Computer Science.
Walter G. Kortschak
Walter G. Kortschak is a Senior Advisor of Summit Partners, a growth equity
firm that invests in rapidly growing companies. Founded in 1984, Summit has
raised nearly $15 billion in capital and has offices in Boston, Palo Alto, London
and Mumbai. For more information about Summit Partners, please visit www.
summitpartners.com.
Felix Salmon
Felix Salmon is a financial journalist, formerly of Portfolio Magazine and
Euromoney, and a blogging editor for Reuters. In his blog, which is hosted
by Reuters, he analyzes economic and occasionally social issues in addition to
financial commentary.
He began blogging in 1999 for the wire service Bridge News, segueing into a
job for noted economist Nouriel Roubini..
The American Statistical Association presented Salmon with the 2010
Excellence in Statistical Reporting Award “for his body of work, which
exemplifies the highest standards of scientific reporting. His insightful use
of statistics as a tool to understanding the world of business and economics,
areas that are critical in today’s economy, sets a new standard in statistical
investigative reporting.”