My Rating: 8 of 10
Summary
Full of counterintuitive ideas around business and start-ups, this is an important read to help you rethink your approach to building a big business. Some ideas I found interesting: (1) competition is destructive and not a sign of value, (2) monopolies all start with a combination of proprietary technology, network effects, economies of scale, and branding, and (3) all startups should start with a small market.
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Notes
The act of creation is singular, as is the moment of creation, and the result is something fresh and strange.
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Today’s “best practices” lead to dead ends; the best paths are new and untried.
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WHENEVER I INTERVIEW someone for a job, I like to ask this question: “What important truth do very few people agree with you on?”
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Because globalization and technology are different modes of progress, it’s possible to have both, either, or neither at the same time.
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Any generation excepting our parents’ and grandparents’, that is: in the late 1960s, they expected this progress to continue. They looked forward to a four-day workweek, energy too cheap to meter, and vacations on the moon. But it didn’t happen. The smartphones that distract us from our surroundings also distract us from the fact that our surroundings are strangely old: only computers and communications have improved dramatically since midcentury.
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Positively defined, a startup is the largest group of people you can convince of a plan to build a different future. A new company’s most important strength is new thinking: even more important than nimbleness, small size affords space to think.
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The first step to thinking clearly is to question what we think we know about the past.
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By the fall of ’99, our email payment product worked well—anyone could log in to our website and easily transfer money. But we didn’t have enough customers, growth was slow, and expenses mounted. For PayPal to work, we needed to attract a critical mass of at least a million users.
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The entrepreneurs who stuck with Silicon Valley learned four big lessons from the dot-com crash that still guide business thinking today:
1. Make incremental advances
2. Stay lean and flexible
3. Improve on the competition. Don’t try to create a new market prematurely.
4. Focus on product, not sales If your product requires advertising or salespeople to sell it, it’s not good enough: technology is primarily about product development, not distribution.
And yet the opposite principles are probably more correct:
1. It is better to risk boldness than triviality.
2. A bad plan is better than no plan.
3. Competitive markets destroy profits.
4. Sales matters just as much as product.
The lesson for entrepreneurs is clear: if you want to create and capture lasting value, don’t build an undifferentiated commodity business.
The fatal temptation is to describe your market extremely narrowly so that you dominate it by definition. Suppose you want to start a restaurant that serves British food in Palo Alto. “No one else is doing it,” you might reason. “We’ll own the entire market.” But that’s only true if the relevant market is the market for British food specifically. What if the actual market is the Palo Alto restaurant market in general?
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In contrast to the competitive local restaurant market, PayPal was at that time the only email-based payments company in the world. We employed fewer people than the restaurants on Castro Street did, but our business was much more valuable than all of those restaurants combined. Starting a new South Indian restaurant is a really hard way to make money. If you lose sight of competitive reality and focus on trivial differentiating factors—maybe you think your naan is superior because of your great-grandmother’s recipe—your business is unlikely to survive.
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You’re not that different from dozens of your competitors, so you’ve got to fight hard to survive. If you offer affordable food with low margins, you can probably pay employees only minimum wage. And you’ll need to squeeze out every efficiency: that’s why small restaurants put Grandma to work at the register and make the kids wash dishes in the back. Restaurants aren’t much better even at the very highest rungs, where reviews and ratings like Michelin’s star system enforce a culture of intense competition that can drive chefs crazy.
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If the tendency of monopoly businesses were to hold back progress, they would be dangerous and we’d be right to oppose them. But the history of progress is a history of better monopoly businesses replacing incumbents.
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All happy companies are different: each one earns a monopoly by solving a unique problem. All failed companies are the same: they failed to escape competition.
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Then when you apply your skills, you’re a little less likely than others to give up your own convictions: this can save you from getting caught up in crowds competing for obvious prizes.
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If you can recognize competition as a destructive force instead of a sign of value, you’re already more sane than most.
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The answer is cash flow. This sounds bizarre at first, since the Times was profitable while Twitter wasn’t. But a great business is defined by its ability to generate cash flows in the future. Investors expect Twitter will be able to capture monopoly profits over the next decade, while newspapers’ monopoly days are over.
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Simply stated, the value of a business today is the sum of all the money it will make in the future.
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An Old Economy business (like a newspaper) might hold its value if it can maintain its current cash flows for five or six years. However, any firm with close substitutes will see its profits competed away. Nightclubs or restaurants are extreme examples: successful ones might collect healthy amounts today, but their cash flows will probably dwindle over the next few years when customers move on to newer and trendier alternatives.
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Those who succumb to measurement mania obsess about weekly active user statistics, monthly revenue targets, and quarterly earnings reports. However, you can hit those numbers and still overlook deeper, harder-to-measure problems that threaten the durability of your business.
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Every monopoly is unique, but they usually share some combination of the following characteristics: proprietary technology, network effects, economies of scale, and branding.
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Yahoo! demonstrated design awareness by overhauling its logo, it asserted youthful relevance by acquiring hot startups like Tumblr, and it has gained media attention for Mayer’s own star power. But the big question is what products Yahoo! will actually create. When Steve Jobs returned to Apple, he didn’t just make Apple a cool place to work; he slashed product lines to focus on the handful of opportunities for 10x improvements. No technology company can be built on branding alone.
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BUILDING A MONOPOLY Brand, scale, network effects, and technology in some combination define a monopoly; but to get them to work, you need to choose your market carefully and expand deliberately.
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Every startup is small at the start. Every monopoly dominates a large share of its market. Therefore, every startup should start with a very small market. Always
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Sequencing markets correctly is underrated, and it takes discipline to expand gradually. The most successful companies make the core progression—to first dominate a specific niche and then scale to adjacent markets—a part of their founding narrative.
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As you craft a plan to expand to adjacent markets, don’t disrupt: avoid competition as much as possible.
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It’s much better to be the last mover—that is, to make the last great development in a specific market and enjoy years or even decades of monopoly profits. The way to do that is to dominate a small niche and scale up from there, toward your ambitious long-term vision. In this one particular at least, business is like chess. Grandmaster José Raúl Capablanca put it well: to succeed, “you must study the endgame before everything else.”
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In 1912, after he became the first explorer to reach the South Pole, Roald Amundsen wrote: “Victory awaits him who has everything in order—luck, people call it.” No one pretended that misfortune didn’t exist, but prior generations believed in making their own luck by working hard.
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Technological advance seemed to accelerate automatically, so the Boomers grew up with great expectations but few specific plans for how to fulfill them. Then, when technological progress stalled in the 1970s, increasing income inequality came to the rescue of the most elite Boomers. Every year of adulthood continued to get automatically better and better for the rich and successful. The rest of their generation was left behind, but the wealthy Boomers who shape public opinion today see little reason to question their naïve optimism. Since tracked careers worked for them, they can’t imagine that they won’t work for their kids, too.
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But they miss the even bigger social context for their own preferred explanations: a whole generation learned from childhood to overrate the power of chance and underrate the importance of planning. Gladwell at first appears to be making a contrarian critique of the myth of the self-made businessman, but actually his own account encapsulates the conventional view of a generation.
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The greatest thing Jobs designed was his business. Apple imagined and executed definite multi-year plans to create new products and distribute them effectively. Forget “minimum viable products”—ever since he started Apple in 1976, Jobs saw that you can change the world through careful planning, not by listening to focus group feedback or copying others’ successes.
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When a big company makes an offer to acquire a successful startup, it almost always offers too much or too little: founders only sell when they have no more concrete visions for the company, in which case the acquirer probably overpaid; definite founders with robust plans don’t sell, which means the offer wasn’t high enough. When Yahoo! offered to buy Facebook for $1 billion in July 2006, I thought we should at least consider it. But Mark Zuckerberg walked into the board meeting and announced: “Okay, guys, this is just a formality, it shouldn’t take more than 10 minutes. We’re obviously not going to sell here.” Mark saw where he could take the company, and Yahoo! didn’t. A business with a good definite plan will always be underrated in a world where people see the future as random.
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The biggest secret in venture capital is that the best investment in a successful fund equals or outperforms the entire rest of the fund combined.
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This implies two very strange rules for VCs. First, only invest in companies that have the potential to return the value of the entire fund. This is a scary rule, because it eliminates the vast majority of possible investments. (Even quite successful companies usually succeed on a more humble scale.) This leads to rule number two: because rule number one is so restrictive, there can’t be any other rules.
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After all, less than 1% of new businesses started each year in the U.S. receive venture funding, and total VC investment accounts for less than 0.2% of GDP. But the results of those investments disproportionately propel the entire economy. Venture-backed companies create 11% of all private sector jobs. They generate annual revenues equivalent to an astounding 21% of GDP. Indeed,
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But life is not a portfolio: not for a startup founder, and not for any individual. An entrepreneur cannot “diversify” herself: you cannot run dozens of companies at the same time and then hope that one of them works out well.
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Our schools teach the opposite: institutionalized education traffics in a kind of homogenized, generic knowledge. Everybody who passes through the American school system learns not to think in power law terms. Every high school course period lasts 45 minutes whatever the subject.
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It does matter what you do. You should focus relentlessly on something you’re good at doing, but before that you must think hard about whether it will be valuable in the future.
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in 2005, Perkins may as well have been a time-traveling visitor from a bygone age of optimism: he thought the board should identify the most promising new technologies and then have HP build them. But Perkins’s faction lost out to its rival, led by chairwoman Patricia Dunn. A banker by trade, Dunn argued that charting a plan for future technology was beyond the board’s competence. She thought the board should restrict itself to a night watchman’s role: Was everything proper in the accounting department? Were people following all the rules?
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Wiles started working on it in 1986, but he kept it a secret until 1993, when he knew he was nearing a solution. After nine years of hard work, Wiles proved the conjecture in 1995. He needed brilliance to succeed, but he also needed a faith in secrets. If you think something hard is impossible, you’ll never even start trying to achieve it. Belief in secrets is an effective truth.
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The same is true of business. Great companies can be built on open but unsuspected secrets about how the world works. Consider the Silicon Valley startups that have harnessed the spare capacity that is all around us but often ignored. Before Airbnb, travelers had little choice but to pay high prices for a hotel room, and property owners couldn’t easily and reliably rent out their unoccupied space. Airbnb saw untapped supply and unaddressed demand where others saw nothing at all.
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your views on the compromises reached that summer in Philadelphia, they’ve been hard to change ever since: after ratifying the Bill of Rights in 1791, we’ve amended the Constitution only 17 times. Today, California has the same representation in the Senate as Alaska, even though it has more than 50 times as many people. Maybe that’s a feature, not a bug. But we’re probably stuck with it as long as the United States exists. Another constitutional convention is unlikely; today we debate only smaller questions. Companies are like countries in this way. Bad decisions made early on—if you choose the wrong partners or hire the wrong people, for example—are very hard to correct after they are made.
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It may take a crisis on the order of bankruptcy before anybody will even try to correct them. As a founder, your first job is to get the first things right, because you cannot build a great company on a flawed foundation.
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Whenever an entrepreneur asks me to invest in his company, I ask him how much he intends to pay himself. A company does better the less it pays the CEO— In no case should a CEO of an early-stage, venture-backed startup receive more than $150,000 per year in salary.
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Low CEO pay also sets the standard for everyone else. Aaron Levie, the CEO of Box, was always careful to pay himself less than everyone else in the company—four years after he started Box, he was still living two blocks away from HQ in a one-bedroom apartment with no furniture except a mattress.
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Equity is a powerful tool precisely because of these limitations. Anyone who prefers owning a part of your company to being paid in cash reveals a preference for the long term and a commitment to increasing your company’s value in the future. Equity can’t create perfect incentives, but it’s the best way for a founder to keep everyone in the company broadly aligned.
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But taking a merely professional view of the workplace, in which free agents check in and out on a transactional basis, is worse than cold: it’s not even rational. Since time is your most valuable asset, it’s odd to spend it working with people who don’t envision any long-term future together. If you can’t count durable relationships among the fruits of your time at work, you haven’t invested your time well—even in purely financial terms.
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From the start, I wanted PayPal to be tightly knit instead of transactional. I thought stronger relationships would make us not just happier and better at work but also more successful in our careers even beyond PayPal. So we set out to hire people who would actually enjoy working together. They had to be talented, but even more than that they had to be excited about working specifically with us. That was the start of the PayPal Mafia.
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On the inside, every individual should be sharply distinguished by her work. When assigning responsibilities to employees in a startup, you could start by treating it as a simple optimization problem to efficiently match talents with tasks.
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The best thing I did as a manager at PayPal was to make every person in the company responsible for doing just one thing. Every employee’s one thing was unique, and everyone knew I would evaluate him only on that one thing.
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If anything, people overestimate the relative difficulty of science and engineering, because the challenges of those fields are obvious. What nerds miss is that it takes hard work to make sales look easy.
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Whatever the career, sales ability distinguishes superstars from also-rans. On Wall Street, a new hire starts as an “analyst” wielding technical expertise, but his goal is to become a dealmaker. A lawyer prides himself on professional credentials, but law firms are led by the rainmakers who bring in big clients.
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If you’ve invented something new but you haven’t invented an effective way to sell it, you have a bad business—no matter how good the product.
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Superior sales and distribution by itself can create a monopoly, even with no product differentiation. The converse is not true. No matter how strong your product—even if it easily fits into already established habits and anybody who tries it likes it immediately—you must still support it with a strong distribution plan.
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Most businesses get zero distribution channels to work: poor sales rather than bad product is the most common cause of failure. If you can get just one distribution channel to work, you have a great business. If you try for several but don’t nail one, you’re finished.
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Most cleantech companies crashed because they neglected one or more of the seven questions that every business must answer: 1. The Engineering Question Can you create breakthrough technology instead of incremental improvements? 2. The Timing Question Is now the right time to start your particular business? 3. The Monopoly Question Are you starting with a big share of a small market? 4. The People Question Do you have the right team? 5. The Distribution Question Do you have a way to not just create but deliver your product? 6. The Durability Question Will your market position be defensible 10 and 20 years into the future? 7. The Secret Question Have you identified a unique opportunity that others don’t see?
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But you can’t dominate a submarket if it’s fictional, and huge markets are highly competitive, not highly attainable.
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