Creative Entrepreneurship

Creative Entrepreneurship

Darren Herman

Taylor Davidson

a kbs+ partner

@kbspvc l #kbspvcbook

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+ Ventures160 Varick StreetNew 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


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Table of ContentsFOREWORD By Darren Herman p. 1

CHAPTER ONE

History & Context

Types of Innovation Blake Masters: Peter Thiel’s CS183: Startup – Class 1 Notes Essay p. 6The 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 p. 14 Paul Graham: Web 2.0 p. 36Theories about Web 3.0 Jay Jamison: Web 3.0: The Mobile Era p. 44

Groundbreaking Entrepreneurship Sarah Lacy: Inside the DNA of the Facebook Mafia p. 49


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CHAPTER TWO

The Funding Ecosystem

Types of Investors Paul Graham: How to Fund a Startup p. 58What Every Startup Should Know about Investors Paul Graham: The Hacker’s Guide to Investors p. 78 Mark Suster: Angel Funding Advice p. 93Why Everyone Does Not Need to Raise Dan Shapiro: Companies that Would do Best Without Venture Capital p. 99

CHAPTER THREE

Finance 201

What is Venture Capitalism? Marc Averitt & Matthew V. Waterman: Venture Capital Basics p. 104Convertible Debt Fred Wilson: MBA Mondays: Convertible Debt p. 107Preferred Equity Fred Wilson: MBA Mondays: Preferred Stock p. 110Intro to the Cap Table Mark Suster: Want to Know How VCs Calculate Valuation Differently from Founders? p. 112Critical Terms Fred Wilson: The Three Terms You Must Have in a Venture Investment p. 113

CHAPTER FOUR

How to be a VC

Maintaining Relationships Charlie O’Donnell: How to be a VC – Being Open p. 116 Chris Dixon: Being Friendly Has Become a Competitive Advantage in VC p. 120Touting Expertise Mark Suster: Domain Knowledge p. 121Understanding the Statistics Blake Masters: Peter Thiel’s CS193:Startup – Class 7 Notes Essay p. 124


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CHAPTER FIVE

How to be an Entrepreneur

Picking an Idea Chris Dixon: Founder/Market Fit p. 138 Andrew Chen: When Has A Consumer Startup Hit Product/Market Fit? p. 140Constructing a Team Seth Levine: Hiring as a Core Competency p. 144 Darren Herman: The Startup as a Band p. 146Culture Scott Weiss: 20 Rules of Thumb for Building a Great Startup Culture p. 148

CHAPTER SIX

Fundraising

How to Fundraise Mark Suster: A 6-Step Relationship Guide to VC p. 152 Chris Dixon: Pitch Yourself, Not Your Idea p. 156 Charlie O’Donnell: A Framework to Think About Pricing Seed, Angel, and Venture Capital Rounds p. 157From Whom to Fundraise Chris Dixon: How to Select Your Angel Investors p. 159When to Fundraise Mark Suster: VC Funding Season Ends Next Week p. 161How to Build a Deck Babak Nivi: What Should I Send to Investors? p. 163

CHAPTER SEVEN

Building a Business

Agile vs. Waterfall Software Development Rutul Dave: Web Development Methodologies: Agile vs. Waterfall p. 168Lean vs. Heavy Startup Methodology Wikipedia: Learn Startup p. 170Metrics to Consider Steve Blank: No Accounting for Startups p. 178 Dave McClure: Startup Metrics for Pirates p. 183


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Taylor Davidson: Why Financial Models are Easier Than You Think p. 192Focus on User Acquisition/ Marketing Blake Masters: Peter Thiel’s CS183: Startup – Class 9 Notes Essay p. 195Don’t Be Afraid to Pivot Adam L. Penenberg: Enter The Pivot: The Critical Course Corrections of Flickr, Fab.com, And More p. 209

CHAPTER EIGHT

Business Acceleration and Beyond

Business Development and Corporate Collaboration Chris Dixon: Business Development – The Goldilocks Principle p. 214 Robert Ackerman, Jr.: The Most Unlikely Place to Find Startup Funding p. 216Exits Walter G. Kortschak: Strategic Acquisition or IPO? p. 219 Chris Dixon: Three Types of Acquisitions p. 221 Felix Salmon: For High Tech Companies, Going Public Sucks p. 222All in All – Do Things that Matter Paul Graham: What You’ll Wish You’d Known p. 231

About the Contributors p. 244

FOREWORD


Creative Entrepreneurship2

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+’ 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/)


Creative Entrepreneurship 3

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 I about their entrepreneurial idea, or a new company they say, 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 (us teaching 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, they 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 ONEHISTORY & 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’ttreally 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 1960’s 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 1960’s. 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-in-Wonderland-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 sub problem. 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 in the past. 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 risk-takers. 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:



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.

Web 1.0

DoubleClickOfotoAkamaimp3.comBritannica Onlinepersonal websitesevite

domain name speculation

page viewsscreen scrapingpublishingcontent management systemsdirectories (taxonomy)stickiness

Web 2.0

--> Google AdSense --> Flickr--> BitTorrent--> Napster--> Wikipedia--> blogging--> upcoming.org and EVDB

--> search engine

optimization--> cost per click--> web services--> participation--> wikis--> tagging (“folksonomy”)--> syndication



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 ‘90s 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, context-sensitive, 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 TimeIn 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. Communications-oriented systems, as the internet-as-platform most certainly is, require interoperability. Unless a vendor can



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

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.



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.

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.

The Architecture of ParticipationSome 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 competi-tor, 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 compa-nies 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.



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 value-added 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 context-appropriate 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.

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

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 consid-ered 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



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-basedpresentationusingXHTMLandCSS;• dynamicdisplayandinteractionusingtheDocumentObjectModel;• datainterchangeandmanipulationusingXMLandXSLT;• asynchronousdataretrievalusingXMLHttpRequest;• andJavaScriptbindingeverythingtogether.”

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 internet’s the 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.”



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

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.



• 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 $2800, 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(alwaysconnected,alwayswithyou)• Locationaware• Sensors• Tailored,smallerscreen• Highqualitycameraandaudiotheseelementshavetwokey 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. Compress 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 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 Oscar-nominated 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 dimeing 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.WC

CHAPTER TWOTHE 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 jiujitsu 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 VC-scale 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 full-time. 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 start 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 know 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 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

Shareholder

Angel

Uncle

Each Founder

Option Pool

Total

Shares

200

50

250

200

1200

Percent

16.7

4.2

20.8

16.7

100



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 have 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:



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.

Shareholder

VCs

Angel

Uncle

Each Founder

Employee

Option Pool

Total

Shares

650

200

50

250

36*

264

1950

Percent

33.3

10.3

2.6

12.8

1.8

13.5

100

*unvested



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 self-reinforcing 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 VC’s 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 start-ups 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 VC’s – 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 mitzvah’s 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 start ups 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 hyper connected 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 make 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 VC’s 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 THREEFINANCE 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 as 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 VC’s 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 VC’s talked so we should. Duh.



Critical Terms

Fred Wilson: The Three Terms You Must Have in a Ventures 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 preference2. 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. Its 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 FOURHOW 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 VC’s 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 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, back-channel 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, day-out 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 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 venture fund look like? The naïve response is just to rank companies from best to worst according to their return in multiple 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 2000’s, 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 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 100-page 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 taught. 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 rounds 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 take 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 create 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 that 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 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 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 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 power law world.



CHAPTER FIVEHOW 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 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% consumer-centric. 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 Tool3. 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 color and that’ll work. Picking the right attribute is it’s 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. Thee above tests are interesting in that they 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 from 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 start-ups 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 start-up 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 start-ups 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 SIXFUNDRAISING

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 VC’s. 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 VC’s will only fund businesses with revenue. Unfortunately your advisers are wrong.

The “more traction” feedback is a very typical scenario is 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 well-known 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 VC’s 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 VC’s 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 VC’s 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 VC’s wouldn’t fund the first time we meet you. Given that many VC’s base their decision on the team, the longer they have to get to know you the better.

2. Over deliver

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 VC’s showing the progress you’ve made.

3. Keep on the radar screen

I know the VC’s 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. VC’s 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 VC’s 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?

Its 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 world-class 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 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 VC’s 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 VC’s 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 VC’s 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 VC’s 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 VC’s work in August and he’s right. VC’s 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 VC’s 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 SEVENBUILDING 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 cost-effective 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 productA 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 deploymentContinuous 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 testingA 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 metricsVanity 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.

PivotA 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 bookRies’ 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 “lean-startup 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]



Notes1. ^ a b c d e f g h i j k Ries, Eric (2011). The Lean Startup: How Today’s Entrepreneurs Use Continuous

Innovation to Create Radically Successful Businesses. Crown Publishing. p. 103. ISBN 978-0-307-88791-7.

2. ^ a b c d e f g h i Roush, Wade. Eric Ries, the Face of the Lean Startup Movement, on How a Once-Insane Idea Went Mainstream. Xconomy. July 6, 2011.

3. ^ The Lean Startup TESS Search. United States Patent and Trademark Office. September 6, 2011.

4. ^ a b c d e Penenberg, Adam. Eric Ries Is A Lean Startup Machine. Fast Company. September 8, 2011.

5. ^ a b c Adler, Carlye. Ideas Are Overrated: Startup Guru Eric Ries’ Radical New Theory. Wired. August 30, 2011.

6. ^ a b c Bury, Erin. How Eric Ries Changed the Framework for Startup Success. Sprouter. December 7, 2011.

7. ^ a b Lohr, Steve. The Rise of the Fleet-Footed Start-Up. The New York Times. April 24, 2010.8. ^ Solon, Olivia. Interview: Eric Ries, Author Of The Lean Startup. Wired. January 17, 2012.9. ^ a b Eric Ries. Business Week.10. ^ a b c d e Loizos, Connie. “Lean Startup” evangelist Eric Ries is just getting started. Reuters. May

26, 2011.11. ^ a b c d e f g Venture Capital: Eric Ries, author of “The Lean Startup”. YouTube. November 21,

2009.12. ^ Wealth Front. Advisors to Weathfront. Wealthfront Inc.. 2012.13. ^ a b c d What is Lean Manufacturing?. wiseGEEK.14. ^ a b c Creating the Lean Startup. Inc. Magazine. October 2011.15. ^ The lean startup. Startup Lessons Learned. September 8, 2008.16. ^ a b Tam, Pui-Wing. Philosophy Helps Start-Ups Move Faster. The Wall Street Journal. May

20, 2010.17. ^ Ries, Eric. Are You Building The Right Product? “ TechCrunch. September 11, 2011.18. ^ a b Schonfeld, Erick. Don’t Be Fooled By Vanity Metrics. Tech Crunch. July 30, 2011.19. ^ Butcher, Mike. Interview with Eric Ries, author, The Lean Startup. January 17, 2012.20. ^ Ries, Eric. Minimum Viable Product: a guide. Startup Lessons Learned. August 3, 2009.21. ^ a b Ries, Eric. Continuous deployment in 5 easy steps. O’Reilly Radar. March 30, 2009.22. ^ Continuous Deployment at IMVU: Doing the impossible fifty times a day. Timothy Fitz.

February 10, 2009.23. ^ Ferriss, Tim. Vanity Metrics vs. Actionable Metrics – Guest Post by Eric Ries. May 19, 2009.24. ^ a b Wellons, Mary Catherine. Startup Lessons From a Pro: Eric Ries on ‘The Lean Startup’.

TechCrunch. September 19, 2011.25. ^ NYTimes. October 2, 2011 Best Sellers. The New York Times. October 2, 2011.26. ^ Kopytoff, Verne. Trendspotting at TechCrunch Disrupt. The New York Times. September 14,

2011.27. ^ a b Lohr, Steve. The Rise of the Fleet-Footed Start-Up. The New York Times. April 24, 2010.28. ^ Parsons, Sabrina. Pitching Your Business vs. PLanning Your Business. Forbes. February 29,

2012.29. ^ a b Greenwald, Ted. Upstart Eric Ries Has the Stage and the Crowd Is Going Wild. Wired.

May 18, 2012.30. ^ Best Books of 2011: Business & Investing. Amazon.31. ^ Ries, Eric. Announcing 2012 Lean Startup Conference StartupLessonsLearned.com. June 27,

201232. ^ Glenn, Devon. Eric Ries on What Every Startup Should Ask Their Customers. Media Bistro.

August 9, 201033. ^ Lean Startup Circle San Francisco34. ^ Ewel, Jim. Why Marketing Must Also be Lean. Agile Marketing. March 3, 2012.35. ^ Collins, Rich. New Leadership Lean Startup Circle. April 28, 2012.36. ^ Faircloth, Kelly. Startup News: Let’s Launch the Summer with a New York Tech Meetup and

Loads of New Features. BetaBeat. May 30, 2012.37. ^ Eric Ries - Lean Startup Dublin. Eventbrite.38. ^ Wilson, Fred. Lean. Business Insider. September 16, 2011.39. ^ Goodison, Donna. ‘Lean Startup’ Guru Shares His Secrets. Hispanic Business. September 27,

2011.



40. ^ Lean Startup Rio. Meetup.41. ^ Lean Startup Meetup Beijing. Meetup.42. ^ The Lean Startup SxSW Track. SxSW.43. ^ Lean Startup Author Eric Ries Added to 2012 Programming. SxSW.44. ^ Mashable. Why Startup Founders Need to Talk to Their Customers.45. ^ Case Studies. The Lean Startup.46. ^ Stacy, Michael. U.S. CIO VanRoekel talks startups, savings, new tech in Iowa visit. Silicon

Prairie News. April 5, 2012.47. ^ Lean Government. Startup Lessons Learned. May 30, 2012.48. ^ Government as a Startup with ‘The Lean Startup’ Author Eric Ries. Fed Scoop Radio. March

19, 2012.49. ^ McKendrick, Joe. In search of the US government’s inner ’startup:’ federal CIO. Smartplanet.

October 28, 2011.50. ^ Making a Difference: Innovation Pathway and Entrepreneurs in Residence U.S. Food and

Drug Administration. April 10, 2012.51. ^ Foley, John. Busting Through The Federal IT Budget Ceiling. InformationWeek. April 30,

2012.52. ^ Wilson, Paul. The top five Lean Startup myths. Net Magazine. April 2, 2012.53. ^ Park, Todd. Wanted: A Few Good Women and Men to Serve as Presidential Innovation

Fellows. The White House Blog. May 23, 2012.54. ^ 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 VC’s 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 VC’s 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 VC’s, you need a financial model showing VC’s 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 youbelieve the cost of getting customers will be less than the revenues thecustomers will generate. For web startups, this is when the cost of customeracquisition is less than the lifetime value of that customer. For biotechstartups, it’s when the cost of the R&D required finding and clinically test adrug is less than the market demand for that drug. These measures are vastlydifferent 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 creatingwill support the company you’re trying to become?

Startup Metrics

Startups need different metrics than large companies. They need metrics totell how well the search for the business model is going, and whether at theend 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 tomeasure how well their hypotheses in Customer Discovery and Validation arefaring in the real world.

For example, at a minimum, a web based startup needs to understand theCustomer Lifecycle, Customer Acquisition Cost, Marketing Cost, ViralCoefficient, Customer Lifetime Value, etc. Dave McClure’s AARRR Model isone illustration of the web sales pipeline.

At a web startup, our board meetings were discussions of the real worldresults of testing our hypotheses from Customer Discovery.

We had made some guesses about the customer pipeline and now we had alive web site. So we put together a spreadsheet that tracked these actual customer numbers every month. Every month we reported to our boardprogress on registrations, activations, retained users, etc. They looked likethis:

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: averageorder size, Customer Lifetime Value, average time to first order, average timeto follow-on orders, revenue per sales person, time to salesperson becomeseffective.

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 shift. 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 constrains 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 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 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 communitypromoting 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 “zoom-in 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 start-up 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 EIGHTBUSINESS ACCELERATION AND BEYONDPowerful 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 joint-stock 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.



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-

Year of IPODollars Raised# ofemployees at time of IPOfilling

Revenue in Fiscal Yearbefore IPO

Profit (loss) inyear beforeIPOQuote fromProspectus

Netscape

1995$207 million257

$8 million

($16.5 million)

“There can be noassurance that themarket for theCompany’sproducts andservices willdevelop … or thatindividual PC userswill use theInternet forcommerce andcommunication.”

Google

2004$1/5 billion2,292

$1.8 billion

128.9 million

“Don’t be evil.We believestrongly that inthe long term,we will be betterserved by acompany thatdoes goodthings for theworld even if weforgo someshort-termgains.””

Facebook

2012*$5 billion*3,200

$3.7 billion

$1 billion

“Simply put: wedon’t buildservices to makemoney; wemake money tobuild betterservices.”

*projected



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 fastest-growing 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 self-sustaining, 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’s 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 FounderInstitute since it was founded. He led the FounderInstitute’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. Suster 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 Microsystemsin 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 the firm’s 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 start-up 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 processNow 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 early-stage 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 start-up 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 start-up 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.”

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