1. “If everyone loves your idea, I might be worried that it’s not forward thinking enough.”
Anyone thinking about starting a business should be searching for mispriced opportunities. While markets are mostly efficient in eliminating opportunities for extraordinary profit, there are always areas of an economy in which there are significant uncertainty. These areas are excellent places for a startup to look for opportunities.
The best entrepreneurs have learned that large businesses are investing huge amounts of capital in areas in which extensive information is already available, and that it’s most advantageous to create new businesses where information is not available. In other words, the best opportunities for startups tend to be in areas that are overlooked and less well-known by others. What Chris Dixon is saying is that if everyone loves your idea, this may be a “tell” that there will not be opportunities for extraordinary profit. The venture investor Peter Thiel has said: “The best startups are good ideas that look like bad ideas. Good ideas that look like good ideas are already being worked on by big companies.”
Dixon also says in this insightful post that “you shouldn’t keep your startup idea secret.” He identifies a range of positive benefits that flow from sharing the idea and getting feedback, while pointing out “there are at best a handful of people in the world who might actually drop everything and copy your idea.”
While most businesses do not require a result that generates extraordinary profit to be a success, this is not the case for a startup that seeks to raise venture capital. Venture capitalists invest in a portfolio of startups, knowing that only one to three in every fund could likely be a massive success. Chris Dixon’s partner Marc Andreessen describes the approach of a venture capitalist more technically as ‘buying a portfolio of long–dated, deeply–out-of-the-money call options’. Entrepreneurs are in the business of creating those options and selling some of them to investors to fund the business.
Like a startup or any other investor, a venture capitalist is seeking a mispriced opportunity. All intelligent investors seek mispriced assets and if you want to explore this topic you can do no better than reading Howard Marks. Why do large businesses and others leave this opportunity in areas with significant uncertainty available for startups? Howard Marks traces the source to bias and closed mindedness, capital rigidity, psychological success, and herd behavior. Markets are not fully efficient. Private, emerging and obscure markets are especially inefficient.
2. “How do you develop a good idea that looks like a bad idea? You need to know a secret — in the Peter Thiel sense: something you believe that most other people don’t believe. How do you develop a secret? (a) know the tools better than anyone else; (b) know the problems better than anyone else; and/or (c) draw from unique life experience.”
“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 success 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’.”
Chris Dixon is saying that the people most likely to know the “a secret” about a business opportunity are people who have deep domain expertise. In other words, it is not nearly as likely that someone without deep domain expertise will be successful without understanding the technology, the best methods to create the product, the best ways to bring products to market or the needs of the customer. Another way to think about this point is in terms of a moat or sustainable competitive advantage. Founders and employees of the startup are themselves contributors to the moat of a company, both directly and indirectly.
People who work for the startup who have deep domain knowledge are a likely source of what is called “optionality” which I have explained in a previous blog post. When a team of people in a startup have what Dixon called “secrets” as a result of deep domain expertise, their ability to adapt and innovate gives the startup and the investors optionality. Teams that do not have this optionality usually can’t adapt to changing environments, and fail more often.
The other skill that people with deep understanding have is the ability to see a phenomenon that is emerging within a complex adaptive system. When something bigger than the sum of its parts is emerging in an economy, some people with deep domain expertise are going to see the potential (the secret) before other people.
3. “[The] business of seed investing, and frankly, early-stage entrepreneurship, is so much about getting good information. And almost all of that information, unfortunately, is not published.”
The fact that information about a business is hard to get is actually a great thing for a startup, since it can help create the mispriced opportunity they seek. Uncertainty in the early stages of a startup is the friend of the entrepreneur. As the team pushes forward to reduce technology risk, find product/market fit and discover methods to scale the business, uncertainty is retired and value is created. The job of a great venture capitalist is in no small part to provide entrepreneurs with an entry into networks that allows them to quickly and cost-effectively find this private information. The same principle applies to the venture capitalists themselves. Great venture capitalists are always trying to find good sources of information, particularly information that is not published.
4. “Ideas …matter, just not in the narrow sense in which startup ideas are popularly defined. Good startup ideas are well developed, multi-year plans that contemplate many possible paths according to how the world changes.”
“Characteristics of the best ideas: (a) powerful people dismiss them as toys; (b) they unbundle functions done by others; (c) they often start off as hobbies and/or (d) they often challenge social norms.”
“The best ideas come through direct experience. …When you differentiate your direct experience from conventional wisdom, that’s where the best startup ideas come from.”
My deepest exposure to what Chris Dixon is talking about immediately above (direct experience) came during the time I worked for Craig McCaw, who without question is a savant when it comes to ideas that can be developed into great businesses. In the very early days, the “cell phone” only offered enough value to be a commercial success to a very small number of users. In the beginning, the device was so big it required a suitcase or a car installation to be useful. I remember real estate agents and construction sites as the biggest users. On the infrastructure side, a city like Seattle could be served by radios on only three very tall towers.
Eventually mobile phones appeared, but they were very expensive, analog, heavy and large. During that time period, McKinsey famously predicted that no one would ever use a mobile phone if a land line phone was available. McKinsey placed little or no value on what Craig McCaw called the ability of people to be “nomadic.” The mobile phone had each of the attributes Chris Dixon noted above. Some people thought of the mobile phone as a toy. Since my first mobile phone cost more than $4,000 dollars I actually felt awkward using it in some social settings. Talking into a mobile phone in some pubic settings would cause people to frown at you.
To continue my example, Craig McCaw was also an enthusiastic personal user of what we then called “cellular” phones. Craig McCaw loved working out of the ‘mobile office’ – meaning cars, planes, boats and ships. Which meant he was a natural enthusiast for the product. When the time came to sell his cable TV business in order to double down on the mobile phone business, the choice was made easy by his love of the mobile phone.
5. “There is a widespread myth that the most important part of building a great company is coming up with a great idea.” “What you should really be focused on when pitching your early stage startup is pitching yourself and your team. 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.”
Great ideas matter, as the previous quotations noted. But the ability of a team to execute is a more important consideration than a clever idea. Most everyone has said more than once “I thought of that idea first” when they see a new business being formed. The best idea in the world without a team to make it happen, won’t amount to a hill of beans. Chris Dixon is saying that the best evidence that a team can actually execute, is actually executing on something like a demo. The best evidence that you can do something like create software, is actually creating software. As the old proverb points out, the proof of the pudding is in the eating.
6. “What the smartest people do on the weekend is what everyone else will do during the week in ten years.” “Hobbies are what the smartest people spend their time on when they aren’t constrained by near-term financial goals.” Chris Dixon is not referring to smart people who play ping pong in their garage or pay fantasy baseball in their dorm rooms on weekends. He is referencing the smartest people that are building things like the first PCs, drones, or a better search engine. The Homebrew Computer Club, an early hobbyist group which had it first meeting on March 5, 1975, is just one example. The critical element here is an advanced technology that is useful to very smart hobbyists but does not yet have obvious financial returns associated with its use. Inevitably, technologies driven by phenomena like Moore’s law drive costs to lower levels and performance to high enough levels so that what was once a hobby becomes a thriving business.
As an aside, it is easier to understand Moore’s law now. But I will say that although I am probably in the top few percent in the US who understand its power, I underestimate that power every single year.
7. “This era of technology, it seems to be the core theme is about moving beyond bits to atoms. Meaning technology that affects real word, and transportation and housing and healthcare and all these other things, as opposed to just moving bits around. And those areas tend to be more heavily regulated and, this issue is only beginning to be significant and will probably the defining issue of the next decade in technology.”
I include this quotation since it is an example of something that I value, which is an ability of a person to make a genuine non-consensus prediction about the future rather than predicting the present. Too many venture capitalists are camp followers. They are moving into a trend when others have long since moved on to other opportunities. To outperform, a venture capitalist must think like Howard Marks described here: “To achieve superior investment results, your insight into value has to be superior. Thus you must learn things others don’t, see things differently or do a better job of analyzing them – ideally all three.” Deviating from a consensus view for its own sake is suicidal, but doing it occasionally and being very right is what makes a great venture capitalist like Dixon.
8. “Anyone who has pitched VCs knows they are obsessed with market size.” “If you can’t make the case that you’re addressing a possible billion dollar market, you’ll have difficulty getting VCs to invest. (Smaller, venture-style investors like angels and seed funds also prioritize market size but are usually more flexible – they’ll often invest when the market is “only” ~$100M). This is perfectly rational since VC returns tend to be driven by a few big hits in big markets.”
“If you are arguing market size with a VC using a spreadsheet, you’ve already lost the debate.” For early-stage companies, you should never rely on quantitative analysis to estimate market size. Venture-style startups are bets on broad, secular trends. Good VCs understand this.” “Startups that fill white spaces [areas where there is latent demand without supply] aren’t usually world-changing companies, but they often have solid exits. They force incumbents to see a demand they had missed, and those incumbents often respond with an acquisition.”
It is not possible to make silk purse out of a pig’s ear. For a startup to generate the necessary financial return for a VC, the potential market being addressed must be massive. The entrepreneur who pulls out a spreadsheet and tries to make the case that the market is large enough based on fake quantitative assumptions does little but destroy his or her credibility. Venture capitalists hate to see hockey stick shaped distribution curves based on unrealistic assumptions that don’t map to reality. Chris Dixon is saying that what they do want to see for markets that can’t be defined with much certainty is a strongly argued narrative which explains that the market has or will attain the required size. Yes, they want to see as many related facts as possible that support the narrative. No, they don’t want to hear wild guesses presented as facts.
9. “There are two kinds of investors: Ron Conways who try to create value by finding good people and helping them create something great, and others, who want a piece of someone else’s things. The builders and the extractors. Avoid the extractors.”
“Founders too often view raising capital as a transaction, when it is actually a very deep relationship. They think of money as money, when there is actually smart money, dumb money, high-integrity money, and low-integrity money.”
Particularly in the United States, money is not the scarce resource in venture capital. The scarce resource is fundable startups. The outcome for any startup will increasingly be determined by access to networks of people and resources. If a startup has a choice between (1) just money and (2) money plus access to these networks, is it wise to choose the latter. Because startups most compete in an Extremistan environment (i.e., winner-take-all or winner-take-most-all) even the smallest advantage can end up topping the balance of success and cumulative advantage to one company. Perhaps some founders are cheered up by a venture capitalist who is mostly a cheerleader, but the smart entrepreneurs want someone who can directly help with tasks like recruiting and problems like pricing and distribution.
10. “VCs have a portfolio, and they want to have big wins. They’d rather have a few more lottery tickets.. while for the entrepreneurs, it’s their whole life, and let’s say you raised five million bucks, and you have a fifty million dollar offer, and the entrepreneurs are like, “Look, I make whatever millions of dollars. I’ll be able to start another company.” And the VCs are like, ‘Wait! We invested billions of dollars.’ That is usually where tension comes.”
Chris Dixon has been both a founder and a VC. He has empathy for both venture capitalists and founders on this set of issues. He is most certainly correct that this type of situation creates tension. The wave of discussion about this topic is proof of that. The question is: what is the best way to resolve the tension in ways that are mutually beneficial? First, a brief note about what is at stake. The economist Harry Markowitz called diversification the only free lunch investing. Warren Buffett discussed the issues involved as follows:
“Of course, some investment strategies require wide diversification. If significant risk exists in a single transaction, overall risk should be reduced by making that purchase one of many mutually-independent commitments. Thus, you may consciously purchase a risky investment – one that indeed has a significant possibility of causing loss or injury – if you believe that your gain, weighted for probabilities, considerably exceeds your loss, comparably weighted, and if you can commit to a number of similar, but unrelated opportunities. Most venture capitalists employ this strategy. Should you choose to pursue this course, you should adopt the outlook of the casino that owns a roulette wheel, which will want to see lots of action because it is favored by probabilities, but will refuse to accept a single, huge bet.
Another situation requiring wide diversification occurs when an investor who does not understand the economics of specific businesses nevertheless believes it in his interest to be a long-term owner of American industry. That investor should both own a large number of equities and space out his purchases. By periodically investing in an index fund, for example, the know-nothing investor can actually out-perform most investment professionals. Paradoxically, when “dumb” money acknowledges its limitations, it ceases to be dumb.
On the other hand, if you are a know-something investor, able to understand business economics and to find five to ten sensibly priced companies that possess important long-term competitive advantages, conventional diversification makes no sense for you. It is apt simply to hurt your results and increase your risk. I cannot understand why an investor of that sort elects to put money into a business that is his 20th favorite rather than simply adding that money to his top choices – the businesses he understands best and that present the least risk, along with the greatest profit potential. In the words of the prophet Mae West: ‘Too much of a good thing can be wonderful.’ ”
The wisest outcome on founder and employee liquidity issues will depend on the facts and circumstances of each case. There is no connect-the-dots-formula that is right in all cases. Fred Wilson has written a very thoughtful post on this issue. He points out that even from the view of the VC there is an incentive to create some liquidity: “providing some founder liquidity, at the appropriate time, will incentivize the founders to have a longer term focus and that will result in exits at much larger valuations because, contrary to popular belief, founders drive the timing of exit way more than VCs do.”
In addition to what Fred Wilson notes, it is one thing to concentrate your investments if you have a net worth measured in millions and quite another if you have little financial cushion if the business fails. The important point that Chis Dixon raises is that there is an issue here, and it can create tension if not dealt with intelligently. Founders are smarter and better informed than ever before and they want a venture capitalist who is empathetic and thoughtful.
11. “If you aren’t getting rejected on a daily basis, your goals are not ambitious enough. The most valuable lesson I had starting out in my career was when I was trying to break in the tech world and I applied to jobs at big companies and at startups, at VC firms. I got rejected everywhere. I had sort of an unusual background. I was a philosophy major, a self-taught programmer. It turned out to be the most valuable experience of my career because I eventually developed such thick skin that I just didn’t care anymore about getting rejected. And, in fact, I kind of turned it around and started embracing it. I eventually — that sort of emboldened me. Through those sort of bolder tactics, eventually landed a job that got my first startup funded. So every day to this day I try to make sure I get rejected.”
The ability to handle rejection in a sales process is something that has always fascinated me. Why can some people knock on door after door and suffer rejection and after rejection and still maintain a positive attitude long enough to generate the eventual sale? For some people a single rejection turns them into a nervous wreck, while others power through to close a sale. It seem to me to be explained by a combination of innate personality and a learned skill.
In any event, starting a business and even building a successful career involves way more selling than people who have never done it before imagine. Entrepreneurs are constantly selling themselves, their business and its products to potential employees, suppliers, distributors, investors and customers. If you can’t sell, starting a business is probably unwise.
12. “Before I started my first company, an experienced entrepreneur I know said, ‘Get ready to feel sick to your stomach for the next five years.’ And I was, ‘Eh, whatever.’ Then later, I was, ‘Shoot, I should listen to the guy.'”
“You’ve either started a company or you haven’t. ‘Started’ doesn’t mean joining as an early employee, or investing or advising or helping out. It means starting with no money, no help, no one who believes in you (except perhaps your closest friends and family), and building an organization from a borrowed cubicle with credit card debt and nowhere to sleep except the office. It almost invariably means being dismissed by arrogant investors who show up a half hour late, totally unprepared and then instead of saying ‘no’ give you non-committal rejections like ‘we invest in later stage companies.’ It means looking prospective employees in the eyes and convincing them to leave safe jobs, quit everything and throw their lot in with you. It means having pundits in the press and blogs who’ve never built anything criticize you and armchair quarterback your every mistake. It means lying awake at night worrying about running out of cash and having a constant knot in your stomach during the day fearing you’ll disappoint the few people who believed in you and validate your smug doubters.”
I was the third employee of a company founded by Craig McCaw, and although I wasn’t a founder it was nevertheless a life changing experience. It was a particularly notable day since I received two job offers the very same day. One job was a very safe position with an established company. The other was with the startup. What tipped the decision was that I wanted to have the life experience of being part of a startup. I wanted the experience more than the immediate monetary rewards that the other position offered.
From a post by Chris Dixon on climbing the wrong hill in your career: “People tend to systematically overvalue near-term over long-term rewards. This effect seems to be even stronger in more ambitious people. Their ambition seems to make it hard for them to forgo the nearby upward step.”
There were lots of times I thought that I had made a mistake in not taking the safer and better-paying job. I experienced all the things Chris Dixon talks about in that post, including attacks from armchair critics. I worried often about other employees and how my family would cope with failure if that happened. The tale of this startup is actually one of the great untold stores in business history. It resulted in a 4X return for early investors which was not terrible, but not great either. That’s a story for another time.