Mike Maples, Jr. is a Partner at Floodgate. Before becoming a full-time investor, Mike was involved as a founder and operating executive at back-to-back startup IPOs, including Tivoli Systems (IPO TIVS, acquired by IBM) and Motive (IPO MOTV, acquired by Alcatel-Lucent.) Some of Maples’ investments include Twitter, Twitch.tv, ngmoco, Weebly, Chegg, Bazaarvoice, Spiceworks, Okta, and Demandforce. This is the first time I have written about the son of someone else I previously profiled on this blog. Maples has an M.B.A. from Harvard Business School and a Bachelor’s degree in Industrial Engineering and BS degree from Stanford University. Next weekend I will profile the co-founder of Floodgate, Ann Miura-Ko. Floodgate is an early stage venture capital firm that wants to invest and assist “the iconic companies with the biggest impact. Floodgate backs these Prime Movers before the rest of the world believes.”
- “Floodgate uses a framework called the “value stack” [which is] a hierarchy of powers. Each is powerful on its own, but as these advantages are layered on top of each other they reinforce and amplify each other even further.” “We are proud to have been one of the tiny number of firms to have invented the micro-VC space over a decade ago. Back when we got started in 2005, it was very hard for a founder to raise $1M. They had to raise a whole lot less or be de-risked enough to raise $5M from a traditional VC.”
If you have read the work of Michael Mauboussin you have seen him make this point repeatedly: “elite performers in all probabilistic fields all think in terms of process versus outcome. So while our society may be conditioned to focus on outcomes, an emphasis on process makes the most sense for the long haul.” Maples has thought deeply about Floodgate’s investing process and can articulate a clear investing thesis. Floodgate believes that the right “stack” (the co-founders were trained as engineers after all) assembled in the right order will potentially generate value which is far more than the sum of the inputs. The first layer in the Value Stack is Proprietary Power which is when the conditions are right tightly coupled with Product Power (the second layer). The business model layer is next the stack and so on. When all the layers are skillfully put into place in the right order, Floodgate’s thesis is that the value created by the process increases non-linearly. This is an example of what Charlie Munger calls “a lollapalooza.”
Maples is naturally focused on the lower layers in the Value Stack since he is an early stage investor, but even then, the potential for the higher layers must be there and some groundwork done on the higher layers.
Maples depicts the Floodgate stack as follows:
PROPRIETARY POWER: “is about having a structural competitive advantage is critical for avoiding mindless competition.”
- “Whenever I look at a company that says they have a technology advantage, I’m interested in a couple things. One is, just what is the advantage, and why would it be hard to copy? But then the other part of the question is, why now? Why did something in the world change to open the world for this opportunity? [For example] if you’re doing topological data analysis, why couldn’t that have been done five years ago? Why couldn’t that have been done 10 years ago? Well it turned out that computational capacity in the cloud was improving, improving, improving at the rate of Moore’s Law, and eventually converged at a critical point where it became practical.” “The problem with mimetic desire is that it’s the wrong ‘personal operating system’ for coming up with a breakthrough idea — it is by definition an incrementalist view of the world that emphasizes following the rules and outcompeting others, rather than re-inventing the rules and transcending competition.”
Strategy is important at every stage of the life cycle of any business. If investors can’t see a source of sustainable competitive advantage it will be hard to raise a financing round. A startup can easily die an early death without some credible of path to achieving a sustainable competitive advantage. Someone may say: “Wait what does this competitive advantage concept really mean?” What it means is that unless there is some constraint on supply it will increase until profit is equal to the opportunity cost of capital. Here’s an example: Imagine you have a stand selling bananas on a city street. And 26 other people start going the same thing sourcing the bananas from your wholesale supplier. That is an extreme example of zero proprietary power. Maples adds: “The best way to compete is to choose not to.” Strategy is what you do differently than your competitors. It is about choosing what not to do.
If you want to understand more about strategy people like Bill Gurley suggest reading Porter’s book Competitive Strategy.
In his search for proprietary power Maples is looking for a breakthrough idea that re-invents rules and transcends competition. What is it that the business will do that is unique? What rule can it break that others thought it was sacrosanct? This is where thinking different can pay in a huge way once in a while. Thinking and acting different will not always succeed, but when it does: boom!
Maples has said on other occasions that lower costs at seed stage are both good news and bad news. Here is his slide:
Let’s be clear that this is a discussion about startups that are suitable for an investment by a leading venture capitalist like Maples. This post is not about opening a new bicycle repair shop. As will be explained below, a business must have a number of essential qualities to be suitable for a venture investment. To put the challenge in context, only 800 new firms raised a Series A round in venture capital in the US in 2016. While this represents a tiny percentage of overall business starts in that year or any year, a few of these business will have an out-sized impact on society. Can the number of series A investments in a given year go up? Organizations like Y Combinator, 500 Startups and Angel List are pushing hard to change this. I hope they are successful, but we do not know the outcome yet.
- “The most valuable businesses in the world are going to be networks. I believe the big companies of the world today, if they don’t position themselves to be network-centric, they will fail. I believe that Tesla is a network centric car company. I believe Apple is a network centric phone company. I believe that the twin powers of Moore’s Law and Metcalfe’s Law are what is going to bring abundance to the world in the next 10 or 15 years.” “If you’re going to build a network effects business, it’s important to ask yourself, what is my network? What are the nodes of the network? How do they connect with each other? Where are the connections strong? Where are they not strong? Is it a global network? Is it a hub and spoke network? What does it mean for me to be the network operator? Interestingly, network effect businesses have existed for a long time. They existed with the railroads, they existed with canals, they existed with RCA, with records, and TV. They existed with Craig McCaw and McCaw Cellular.”
The factor that creates the most competitive advantage in the business world today is network effects. The increased importance of network effects is explained by what Marc Andreessen calls “software eating the world” (the increased important of software in business value chains). Another multiplier of the importance of network effects is that so many systems and networks are now interconnected. Other factors that can potentially create product power like patents, economies of scale and regulatory advantages are still important, especially when combined with network effects, but they are relatively less important than they were in the past. I do appreciate the shout out by Maples to McCaw Cellular and Craig McCaw since that is part of my heritage. People in many cases have forgotten how capital intensive the early cellular business was particularity for new entrants and how much money had to be raised in places like the high yield markets to make the business model work. They were not the “capital light” platform businesses that Warren Buffet marveled about at the last Berkshire shareholder meeting.
PRODUCT POWER: “is about achieving product/market fit.”
- “Have you ever seen a startup where you’re like, ‘how in the hell could they have been successful?’ It’s because they met a great market. And sometimes, your product, your market, it just has the magic. You can’t beat customers off with a stick. They just want it. I’ve had this happen to me before, where in spite of the fact that the product just seemed horrible on the surface, it just didn’t matter. People wanted it really bad. Product market fit is more of like a dance between the product and the market. You know it’s like if you ever see two people doing the tango, I look at it like the product is leading the dance, but the market is tangoing with the product. I’ll try to be G-rated in my language, but sort of an intimate sort of back and forth between them. And what I find is that if you want to get the tango right, the first thing is to really identify the market. Large, strong customer desire and the right time. You want to find markets where people gravitate to your idea and want it right now, as soon as possible, even if it’s half done. And then that market pulls the product. When a market pulls a product, this is what it feels like inside the building. Nobody’s debating what the features of the next version ought to be, because they’re like, oh my god. This stuff is flying off the shelves, and our customer needs us to fix x, y, and z. And you’re like, OK well let’s fix it. And so that’s what it feels like when the market’s pulling the product. Whereas where the market’s not pulling the product, the conversations in the building are arguments over, why aren’t those customers smart enough to figure out how awesome our stuff is?”
When a business has discovered genuine product/market fit the business will know it. The primary focus of the business will be on satisfying demand. If the team is spending all their time adding features, the business has not yet found product/market fit. The best businesses generate organic growth and do not need Herculean spending on marketing and sales.
- “Most investors are overly focused on traction right now. The problem with that is it can be gamed in the short term. And even worse, it often instills a mindset of iterating metrics to nowhere. It’s more important to us that the startup has a structural competitive advantage and is on the path to creating a product that blows people away in large potential numbers. I have never seen an awesome product with a fundamental advantage and lots of potentially delighted customers not be able to make money.”
Maples is pointing out that without a proven value hypothesis a decision by a business to proceed with proving they have a solid growth hypothesis is counterproductive since resources are being wasted. Traction with a product that lacks core product value won’t last. That some investors and business put too much focus on traction at seed stage does not mean that traction does not matter.
Yes, eventfully the growth hypothesis must be proven. Maples once included these benchmarks in a slide deck:
BUSINESS MODEL POWER: “involves translating a startup’s innovation into attractive profits that can improve rapidly.’
“A business model is the way that a business converts innovation into economic value.” “You just have to discover it, but is there always. And then increasing margins and pricing power are proof that the first two layers are strong. It’s axiomatic that if your pricing power is going down, the first two layers aren’t that strong. Either that, or you’re dumb at pricing. But it’s more likely that you’ve overestimated how compelling your product is or how strong your competitive advantage is. The Business Model Canvas by Alex Osterwalder is good to look at for this. But a lot of what I find about business modeling is it is just intuition. When you get to know the customer really well and what they value, it just seems to work.’
Business models fascinate me since they are all unique and are always changing in an environment that is always changing. They all also must cope with nests of complex adaptive systems. The number of potential business model permutations are endless. How can any game on Earth be more interesting than that?
Maples and a group of people like his partner Ann Miura-Ko as well as Steve Black and Eris Reis clearly talk a lot and share many of the same ideas. The output of this process is interesting since it reflects an engineering approach to creating new businesses. Actually going through the Business Model Canvas by Alex Osterwalder (see below) with real examples is quite an instructional process.
COMPANY POWER “is about avoiding management and technical debt.”
- “The common element of Twitter, Lyft, Twitch.tv, Okta, Demandforce, Weebly, Chegg, Xamarin, Refinery29, Spiceworks, Playdom, and ngmoco] as startups is that their teams were amazing. They were amazing in their domain knowledge for the products they were building and they were amazing at their ability to ‘McGyver’ great outcomes in harrowing and uncertain circumstances. It’s surprisingly rare for a startup team to be able to execute at the level of speed, urgency, and precision required to build a real company.”
Three essential elements in a startup are team, market and product. Or market, team and product. This is essentially another mental model or stack that is useful in understanding a business. The degree of emphasis varies on the first two elements depending on the venture capitalist. Certain people and teams in certain situations are capable of amazing feats of creativity. More money is not necessary and in some cases is a hindrance.
Before proceeding to the next quote, a side bar on technical and management debt is perhaps useful. Let’s start with a Wikipedia definition:
“Technical debt (also known as design debt or code debt) is ‘a concept in programming that reflects the extra development work that arises when code that is easy to implement in the short run is used instead of applying the best overall solution’. If technical debt is not repaid, it can accumulate ‘interest’, making it harder to implement changes later on.”
Management debt is incurred when a founder or manager makes expedient, short-term management decisions which have costly long-term consequences. If management debt is not repaid, it can accumulate ‘interest’, making it harder to implement changes later on.
- “A lot of the good companies that I’ve seen actually proactively define their culture. And they emphasize what that is their first 20 employees, and then it kind of takes a life of its own. Why do you want that? It’s sort of like when ducks fly south for the winter, you don’t have to tell the ducks in the back of the v, get in the v. They just know. And when a company gets into blitz scaling mode, you don’t have time to tell the hundreds of new employees that you hire, here’s how decisions get made here, here’s what we value, here’s how we make tradeoffs at the margin. They have to be programmed in the DNA of how they participate in the company. Basic management systems. This has to do with just one-on-one meetings, board meetings, team meetings, forecasting frameworks. You know, what gets covered in those meetings, what shouldn’t get covered in those meetings. Just having a sort of a philosophy of that going in can save a lot of time and avoid a lot of management debt.”
The right company culture not only allows a business to scale, but minimize and resolve problems as they arise. It allows decision-making to be distributed, optimized and expedited. Warren Buffett has written: “In businesses, culture counts….Cultures self-propagate. Winston Churchill once said, ‘You shape your houses and then they shape you.’ That wisdom applies to businesses as well.” A partner from the venture capital firm Greylock had a blog posted recently in which they said: “Culture Is How You Act When No One Is Looking.” The title alone makes a strong point. When you are working with people you know and trust, tremendous efficiencies are created. Charlie Munger has said on the importance of culture:
“The highest form a civilization can reach is a seamless web of deserved trust.” “The right culture, the highest and best culture, is a seamless web of deserved trust.” “Not much procedure, just totally reliable people correctly trusting one another. That’s the way an operating room works at the Mayo Clinic.” “One solution fits all is not the way to go. All these cultures are different. The right culture for the Mayo Clinic is different from the right culture at a Hollywood movie studio. You can’t run all these places with a cookie-cutter solution.”
- CATEGORY POWER: “is [about] designing and owning a category [so as to make] the business the “Category King” [which] usually capture 70–80% of the profit pool in their markets.”
This is the least important layer for a seed stage business, but as I noted above the potential for this layer is attractive to an early stage investor. In this layer along with the Company Power layer ground work is still being done at seed stage says Maples. Ann Miura Ko describes the Category Power layer this way:
“One thing we have noticed is the best companies will spend the time to create a whole new category in the market for themselves, because they don’t want to compete on other people’s terms. They want to be the only Thunder Lizard on the block. For example, Netflix didn’t start out trying to be a better Blockbuster. They created their own separate category and then completely destroyed Blockbuster. Another example is Starbucks — who would have ever thought people would buy $5 coffees when other coffees at that time was selling for 50 cents. They created their own new category. Category power is the ability for the founders to think about the language of the market they are going into, and how they define this for their company. If they are allowing the existing market to define who they are — we get worried about this.”
VENTURE CAPITAL AND STARTUP OUTCOMES:
- “I’m interested in not just companies that are doing a startup, but companies that are doing something hyper-exceptional. And I was seeking a metaphor to describe these companies. And I wanted it to combine the ideas of being big, adaptable, fearsome, radioactive. And it just didn’t seem right to use a term like ‘disruptive innovation’ or something to academic-y sounding, even though we are in an esteemed academic institution right now. So I came up with this term ‘thunder lizard’ about 20 years ago. And thunder lizards, for those of you who are not familiar with Godzilla, were hatched from radioactive atomic eggs. And this is actually the stage of the market that we, at Floodgate, like to invest in. And so we like to say that our job is to spot radioactive atomic eggs. When we invested in Twitter, they weren’t sure whether they were going to call it TWTR, or TWTTR, or Voicemail 2.0. And when we invested in Lyft before it launched, we had to get comfortable with the legal ambiguity of that service. And so at the time that we see this stuff, it’s hard to even know what it’s going to mutate into. But the goal is to find companies that have radioactivity at their roots. And then they swim across the ocean, and emerge with an attitude. And then they begin to devour their startup competitors right as they hit the beach. And then not long after that, they begin to disrupt even more, swiping holes into the sides of buildings, and then eventually, they attack the incumbents. The incumbents in the market are represented by those trains that he’s eating like sausage links. So now you know what thunder lizards are.” “My job is to spot radioactive eggs and to determine if they have that energy to morph into something, to mutate.” “Of tens of thousands of companies started a year, 97 percent of the exit profits will likely come from less than ten….the point one percent. Our job is to find the point-one percent. But we have an extra twist. We want to avoid competing in a fiercely crowded landscape of established Series A funds. So we have to find these companies at the crazy, risky, and early time before Sand Hill Road is excited. When we are right, we will be rewarded because we will have been able to invest smaller amounts of money at lower valuations. That’s what makes our math work. So, as a general rule we like to see any startup idea that has the chance to be meaningful enough to be in the top point-one percent. But we try not to be too dogmatic about the areas we are focused on. We believe that knowing the rare exceptional startup when you see it is the more important skill.”
What I like about the term Thunder Lizard and I don’t like about Unicorn is that the “U” word does not refer to a business that has actually generated a financial exit for investors. The term Unicorn encourages bad behavior. I actually use the term Grand Slam myself and definite that term like Maples does with Thunder Lizard to include an actual financial exit.
Maples says he is looking for “radioactive eggs” that can turn into “Thunder Lizards.” I like his taxonomy since not all startups are eggs that can eventually produce a lizard that is as powerful as Godzilla. There are more “radioactive eggs” today that are possible investments by top tier venture firms. Business formation in this Thunder Lizard category is up. But in the non Thunder Lizard category the numbers are down, This statistic makes the point: “the economy hatched 154,000 fewer new companies in 2014.” A bicycle repair shop or food tuck are not a radioactive egg. To grow the economy and create new jobs we need lots more new business that are not radioactive eggs.
- “The first thing that I like to emphasize to people when they start a company is, start a company that’s worthy of your talents that you think represents the absolute utmost gift you have to offer to this world in your life. Because to be one of those, that’s what it takes. People shouldn’t just be doing a startup. Well, I should back up. If you decide to just be doing a startup, that’s fine. But that’s kind of like the decision to join a nonprofit. Or it’s kind of like a decision to– it’s kind of a labor of love, it may make the world better. But don’t do it because you think you’re going to make money approaching it that way. Because that’s not what the objective function of the industry is.”
Starting a business that has the potential to be a Thunder Lizard is far more of a calling rather than a rational act. Missionaries are far more likely to succeed than mercenaries when the act is not rational. It is impossible to fake the feeling that makes someone a missionary rather than a mercenary. The founder may fool some of the people some of the time, but in the end the truth will come out. They will eventually hit one of the lows that are an inevitable part of what Ben Horowitz calls “the Struggle” and you will bail out. Hoping that the economics of the venture capital world will bend just for them is a triumph of hope over experience.
People say flying a commercial airplanes is composed of long periods of boredom interspersed with a few minutes of terror. A startup is the reverse: long periods of struggle and terror interspersed with a few minutes terror. Am I exaggerating a bit? Sure, comedy requires exaggeration. Did I often have a weird kind of fun and feel accomplishment when I was helping to build Teledesic? Absolutely. Would a team of mercenaries have been able to do what the team of Teledesic missionaries accomplished? No way. My startup experience give me lots to be humble about. I learned a lot. It was also financially rewarding for me since as I explained in my blog post on Teledesic, early investors and employees received a significant multiple on their investment or stock options. Later investor were not so lucky.
- “Bill Gates didn’t need to be in Silicon Valley to start Microsoft. Jeff Bezos didn’t need to be in Silicon Valley to start Amazon. Great companies happen because of great founders, not because of where they are or who the VCs are or any of that nonsense.” “I just don’t believe that VCs animate much. I believe that entrepreneurs animate things.”
There will never be another Silicon Valley. But other cities and regions can create a successful technology-driven economy in their own way. In order to achieve this goal, a city or region must and find its own comparative/competitive advantage. The best way to do that is to create a pool of great founders since venture capital will always follow great founders. As an example, when venture capital started in northern California the venture capitalists had their offices in San Francisco. When the founders moved south toward the Stanford campus the venture capitalists moved to Sand Hill Road. When the founders started moving back to San Francisco so did the venture capitalists. Another example of capital chasing great founders is Benchmark investing in Zillow in Seattle and Snap in Los Angeles. Money will always follow opportunity and the opportunity is created by great founders.
The best single way for a city to create a supply of great founders is to have at least one world class research university. Any city or region that wants to well in a modern economy that does not have a major research university is operating at a serious handicap. There are other things a city can do like having a culture that does not treat failure at trying something hard as anything but a great learning experience. Great K-12 schools, a diverse population and a healthy environment help too. Success feeds back on itself in that great founders inspire and attract more great founders.
One final note relates to the power laws that are pervasive in venture capital. With power laws most values are below average and a few outliers are far above. This means that average figures are close to meaningless. Power laws apply not just the distribution of success of venture-backed companies in a country or globally, but to the success of startups within a city or the success of venture firms operating in a city. For example if you take the “multiple on invested capital” of the top 10% of venture firms in Silicon Valley that MOIC will be far above the average MOIC since the distribution is not a bell curve. If you take the MOIC of the top 1% of venture firms in Silicon Valley, the MOIC will be even higher. In venture capital it is the outliers that matter most. This power law distribution exists in an industry but also within a city.
Dare to do Legendary Things http://ecorner.stanford.edu/videos/3740/Dare-to-Do-Legendary-Things-Entire-Talk
Dare to Make your Startup Legendary https://medium.com/floodgate-fund/dare-to-make-your-startup-legendary-dc8eb68ba1fc