Start-up thinking

 

New technology tends to come from new ventures – start-ups. Small groups of people bound together by a sense of mission have changed the world for the better. The easiest explanation for this is negative: it’s hard to develop new things in big organisations, and it’s even harder to do it by yourself. Bureaucratic hierarchies move slowly, and entrenched interests shy away from risk. In the most dysfunctional organisations, signalling that work is being done becomes a better strategy for career advancement than actually doing work (if this describes your company, you should quit now). Positively defined, a start-up is the largest group of people you can convince of a plan to build a different future.

 

Peter Thiel’s favourite interview question – what important truth do very few people agree with you on? Brilliant thinking is rare, but courage is in even shorter supply than genius.

 

What important truth do very few people agree with you on? – is difficult to answer directly. It may be easier to start with a preliminary: what does everybody agree on? “Madness is rare in individuals – but in groups, parties, nations and ages it is the rule,” Nietzsche wrote (before he went mad). If you can identify a delusional popular truth, you can find what lies hidden behind it: the contrarian truth.

 

The business version of our contrarian question is: what valuable company is nobody building?

This question is harder than it looks, because your company could create a lot of value without becoming very valuable itself. Creating value is not enough – you also need to capture some of this value you create.

 

This means even very big businesses can be bad businesses. For example, US airline companies serve millions of passengers and create hundreds of billions of dollars of value each year. But in 2012, when the average airfare each way was $178, the airline made only 37 cents per passenger trip. Compare them to Google, which creates less value but captures far more. Google brought in $50 billion in 2012 (versus $160 billion for the airlines), but it kept 21% of those revenues as profits – more than 100 times the airline industry’s profit margins that year. Google makes so much money that its now worth more than three times every US airline combined.

 

The airline companies compete with each other, but Google stands alone. Economists use two simplified models to explain the difference: perfect competition and perfect monopoly.

 

Monopolies

 

“Perfect competition” is considered both the ideal and default state in Economics 101. So-called perfectly competitive markets achieve equilibrium when producer supply meets consumer demand. Every firm in a competitive market is undifferentiated and sells the same homogenous products. Since no firm has any market power, they must all sell at whatever price the market determines. If there is money to be made, new firms will enter the market, increase supply, drive prices down, and thereby eliminate the products that attracted them in the first place. If too many firms enter the market, they’ll suffer losses, some will fold, and prices will rise back to sustainable levels. Under perfect competition, in the long run no company makes an economic profit.

 

The opposite of perfect competition is monopoly. Whereas a competitive firm must sell at the market price, a monopoly owns a market, so it can set its own prices. Since it has no competition, it produces at the quantity and price combination that maximises its profits.

 

To an economist, every monopoly looks the same, whether it deviously eliminates rivals, secures a license from the state, or innovates its way to the top. In this book, we’re not interested in illegal bullies or government favourites: by “monopoly”, we mean the kind of company that’s so good at what it does that no other firm can offer a close substitute. Google is a good example of a firm that went from 0 to 1: it hasn’t competed in search since the early 2000s, when it definitely distanced itself from Microsoft and Yahoo.

 

Americans mythologise competition and credit it with saving us from socialist bread lines. Actually, capitalism and competition are opposites. Capitalism is premised on the accumulation of capital, but under perfect competition all profits get competed away. The lesson for entrepreneurs is clear: if you want to create and capture lasting value, don’t build an undifferentiated commodity business.

 

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 of better monopoly businesses replacing incumbents. Monopolies drive progress because the promise of years or even decades of monopoly products provides a powerful incentive to innovate. Then monopolies can keep innovating because profits enable them to make the long-term plans and to finance the ambitious research that firms locked in competition can’t dream of.

 

Perfect equilibrium may describe the void that is most of the universe. It may even characterise many businesses. But every new creation takes place far from equilibrium. In the real world outside economic theory, every business is successful exactly to the extent that it does something others cannot. Monopoly is therefore not a pathology or an exception. Monopoly is the condition of every successful business.

 

Tolstoy opens Anna Karenina by observing: “All happy families are alike; each unhappy family is unhappy in its own way.” Business is the opposite. 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.

 

Rivalry causes us to overemphasise old opportunities and slavishly copy what has worked in the past. If you can recognise competition as a destructive force instead of a sign of value, you’re already more sane than most.

 

Characteristics of a monopoly

 

Every monopoly is unique, but they usually share some combination of the following characteristics: proprietary technology, network effects, economies of scale, and branding.

1. Proprietary technology. Proprietary technology is the most substantive advantage a company can have because it makes your product difficult or impossible to replicate. Google’s search algorithms, for example, return results better than anyone else’s. As a good rule of thumb, proprietary technology must be at least 10 times better than its closest substitute in some important dimension to lead to a real monopolistic advantage.
   1. The clearest way to make a 10x improvement is to invent something completely new.
   2. Or you can radically improve an existing solution: once you’re 10x better, you escape competition. PayPal, for instance, made buying and selling on eBay at least 10 times better.
   3. Amazon made its first 10x improvement in a particularly visible way: they offered at least 10 times as many books as any other bookstore.
   4. You can also make a 10 x improvement through superior integrated design. [Despite many tablet launches before Apple] Apple released the iPad. Design improvements are hard to measure, but it seems clear that Apple improved on anything that had come before by at least an order of magnitude: tablets went from unusable to useful.
2. Network effects. Network effects make a product more useful as more people use it. For example if all your friends are on Facebook, it makes sense for you to join Facebook, too. Network effects can be powerful, but you’ll never reap them unless your product is valuable to its very first users when the network is necessarily small. Paradoxically, then, network effects businesses must start with especially small markets. Facebook started with just Harvard students – Mark Zuckerberg’s first product was designed to get all his classmates signed up, not to attract all people of earth. This is why successful network businesses rarely get started by MBA types: the initial markets are so small that they often don’t appear to be business opportunities at all.
3. Economies of scale. A monopoly business gets stronger as it gets bigger: the fixed costs of creating a product (engineering, management, office space) can be spread out over ever greater quantities of scale. Software start-ups can enjoy especially dramatic economies of scale because the marginal cost of producing another copy of the product is close to zero. A good start-up should have the potential for scale built into its first design.
4. A company has a monopoly on its own brand by definition, so creating a strong brand is a powerful way to claim a monopoly. Brands need to contain substance; beginning with branding rather substance is dangerous.

 

Building a monopoly

 

1. Start small and monopolise. Every start-up is small at the start. Every monopoly dominates a large share of its market. Therefore, every start up should start with a very small market. Always err on the side of starting too small. The reason is simple: it’s easier to dominate a small market than a large one. If you think your initial market might be too big, it almost certainly is. The perfect target market for a start-up is a small group of particular people concentrated together and served by few or no competitors. Any big market is a bad choice, and a big market already served by competing companies is even worse. This is why it is always a red flag when entrepreneurs talk about getting 1% of a $100 billion market. In practice, a large market will either lack a good starting point or it will be open to competition, so it’s hard to ever reach that 1%.
2. Scaling up. Once you create and dominate a niche market, then you should gradually expand into related and slightly broader markets. Amazon’s founding vision was to dominate all of online retail, but they very deliberately started with books, before moving into CDs, videos, and software, and eventually all products. 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.
3. Don’t disrupt. Silicon Valley has become obsessed with ‘disruption’. Disruption has become a self-congratulatory buzzword or anything posing as trendy and new. This seemingly trivial fad matters because it distorts an entrepreneur’s self-understanding in an inherently competitive way. The concept was coined to describe threats to incumbent companies, so start-ups’ obsession with disruption means they see themselves through the older firms’ eyes. If you think of yourself as an insurgent battling dark forces, it’s easy to become unduly fixated on obstacles in your path. But if you truly want to make something new, the act of creation is far more important than the old industries that might not like what you create. Indeed, if your company can be summed up by its opposition to already existing firms, it can’t be completely new and it’s probably not going to be a monopoly.

 

The last will be first

 

You’ve probably heard about “first mover advantage”: if you’re the first entrant into a market, you can capture significant market share while competitors scramble to get started. But moving first is a tactic, not a goal. What really matters is generating cash flows in the future, so being the first mover doesn’t do you any good if someone else comes along and unseats you. 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.”

 

The return of design

 

The most contentious question in business is whether success comes from luck or skill. Did Bill Gates simply win the intelligence lottery? Was Sheryl Sandberg born with a silver spoon, or did she “lean in”? When we debate historical questions like these, luck is in the past tense. Far more important questions are about the future: is it a matter of luck or design?

 

What would it mean to prioritise design over chance? Today, “good design” is an aesthetic imperative, and everyone from slackers to yuppies carefully “curates” their outward appearance. It’s true that every great entrepreneur is first and foremost a designer. Anyone who has held an iDevice or a smoothly machined MacBook has felt the result of Steve Jobs’ obsession with visual and experiential perfection. But the most important lesson to learn from Jobs has nothing to do with aesthetics. 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.

 

Long-term planning is often undervalued by our indefinite short-term world. When the first iPod was released in October 2001, industry analysts couldn’t see much more than “a nice feature for Macintosh users” that “doesn’t make any difference” to the rest of the world. Jobs planned the iPod to be the first of a new generation of portable post-PC devices, but that secret was invisible to most people.

 

The power law

 

Most businesses never need to deal with venture capital, but everyone needs to know exactly one thing that even venture capitalists struggle to understand: we don’t live in a normal world; we live under a power law. [The typical] “spray and pray” approach usually produces an entire portfolio of flops, with no hits at all. This is because venture returns don’t follow a normal distribution overall. Rather, they follow a power law: a small handful of companies radically outperform all others. If you focus on diversification instead of single-minded pursuit of the very few companies than can become overwhelmingly valuable, you’ll miss those rare companies in the first place.

 

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. 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. That’s 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.

 

What to do with the power law

 

Investors who understand the power law make as few investments as possible. The kind of portfolio thinking embraced by both folk wisdom and financial convention, by contrast, regards diversified betting as a source of strength. The more you dabble, the more you are supposed to be hedged against the uncertainty of the future.

 

Our schools teach the opposite: institutionalised education traffics in a kind of homogenised, 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. Every student proceeds at s similar pace. At college, model students obsessively hedge their futures by assembling a suite of exotic and minor skills. Every university believes in “excellence”, and hundred-page course catalogues arranged alphabetically according to arbitrary departments of knowledge seem designed to reassure you that “it doesn’t matter what you do, as long as you do it well.” That is completely false. It does matter what you do. You should focus relentlessly on something you are good at doing, but before that you must think hard about whether it will be valuable in future.

 

If you do start your own company, you must remember the power law to operate it well. The most important things are singular: one market will probably be better than all others. One distribution strategy usually dominates all others, too. Time and decision-making themselves follow a power law, and some moments matter far more than others. However, you can’t trust a world that denies the power law to accurately frame your decisions for you, so what’s most important is rarely obvious. It might even be secret. But in a power law world, you can’t afford not to think hard about where your actions will fall on the curve.

 

The case for secrets

 

Recall the business version of our contrarian question: what valuable company is nobody building? Every correct answer is necessarily a secret: something important and unknown, something hard to do but doable. If there are many secrets left in the world, there are probably many world-changing companies yet to be started.

 

The actual truth is that there are many more secrets left to find, but they will yield only to relentless searchers. There is more to do in science, medicine, engineering and technology of all kinds. We are within reach not just of the marginal goals set at the competitive edge of today’s conventional disciplines, but of ambitions so great that even the boldest minds of the Scientific Revolution hesitated to announce them directly. We could cure cancer, dementia and all the diseases of age and metabolic decay. We can find new ways to generate energy that free the world from conflict over fossil fuels. We can invest faster ways to travel from place to place over the surface of the planet; we can even learn how to escape it entirely and settle new frontiers. But we will never learn any of these secrets unless we demand to know them and force ourselves to look.

 

The same is true for business. Great companies can be built on open but unsuspected secrets about how the world works. Consider the Silicon Valley start-ups that have harnessed the spare capacity that is around us but often ignored. Before Airbnb, travellers 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. The same is true of private car services Lyft and Uber. Few people imagined that is was possible to build a billion-dollar business by simply connecting people who want to go places with people willing to drive them there. We already had state-licensed taxi cabs and private limousines; only by believing in and looking for secrets could you see beyond the convention to an opportunity hidden in plain sight. The same reason that so many companies, including Facebook, are often underestimated – their very simplicity – is itself an argument for secrets. If insights that look so elementary in retrospect can support important and valuable businesses, there must remain many great companies still to start.

 

How to find secrets

 

There are two kinds of secrets: secrets of nature and secrets about people. Natural secrets exist all around us; to find them, one must study some undiscovered aspect of the physical world. Secrets about people are different: they are things that people don’t know about themselves or hide because they don’t want others to know. So when thinking about what kind of company to build, there are two distinct questions to ask: what secrets is nature not telling you? What secrets are people not telling you?

 

It’s easy to assume that natural secrets are the most important: the people who look for them can sound intimidatingly authoritative. Secrets about people are relatively underappreciated. Maybe that’s because you don’t need a dozen years of higher education to ask the questions that uncover them: what are people not allowed to talk about? What is forbidden or taboo?

 

What to do with secrets

 

If you find a secret, you face a choice: do you tell anyone? Or do you keep it to yourself? Unless you have perfectly conventional beliefs, it’s rarely a good idea to tell everybody everything you know. So who do you tell? Whoever you need to, and no more. In practice, there’s always a golden mean between telling nobody and telling everybody – and that’s a company. The best entrepreneurs know this: every great business is built around a secret that’s hidden from the world outside. A great company is a conspiracy to change the world; when you share your secret, the recipient becomes a fellow conspirator.

 

The mechanics of mafia

 

Start with a thought experiment: what would the ideal company culture look like? Employees should love their work. They should enjoy going to the office so much that formal business hours become obsolete and nobody watches the clock. The workspace should be open, not cubicled, and workers should feel at home: beanbag chairs and Ping-Pong tables might outnumber file cabinets. Free massages, on-site sushi chefs, and maybe even yoga classes would sweeten the scene. Pets should be welcome, too: perhaps employees’ dogs and cats could come and join the office’s tankful of tropical fish as unofficial company mascots.

 

What’s wrong with this picture? It includes some of the absurd perks that has made Silicon Valley famous, but none of the substance – and without substance perks won’t work. You can’t accomplish anything meaningful by hiring an interior decorator to beautify your office, a “human resources” consultant to fix your policies, or a branding specialist to hone your buzzwords. “Company culture” doesn’t exist apart from the company itself: no company has a culture; every company is a culture. A start-up is a team of people on a mission, and a good culture is just what that looks like on the inside.

 

You’ll attract the employees you need if you can explain why your mission is compelling: not why it’s important in general, but why you’re doing something important that no-one else is going to get done. That’s the only thing that can make its importance unique. At PayPal, if you were excited by the idea of creating a new digital currency to replace the US dollar, we wanted to talk to you; if not, you weren’t the right fit.

 

However, a great mission is not enough. The kind of recruit who would be most engaged as an employee will also wonder: “Are these the kind of people I want to work with?” You should be able to explain why your company is a unique match for her personally. And if you can’t do that, she’s probably not the right match.

 

Above all, don’t fight the perk war. Anybody who could be more powerfully swayed by free laundry pickup or pet day care would be a bad addition to your team. Just cover the basics like health insurance and then promise what no others can: the opportunity to do irreplaceable work on a unique problem alongside great people. You probably can’t be the Google of 2014 in terms of compensation or perks, but you can be like the Google of 1999 if you already have good answers about your mission and team.

 

If you build it, will they come?

 

Even though sales is everywhere, most people underrate its importance. Silicon Valley underrates it more than most. The Field of Dreams conceit is especially popular in Silicon Valley, where engineers are biased toward building cool stuff rather than selling it. Customers will not come just because you build it. You have to make that happen, and it’s harder than it looks.

 

If you don’t know any sales grandmasters, it’s not because you haven’t encountered them, but rather because their art is hidden in plain sight. Tom Sawyer managed to persuade his neighbourhood friends to whitewash the fence for him – a masterful move. But convincing them to actually pay him for the privilege of doing it his chores was the move of a grandmaster, and his friends were none the wiser. Not much has changed since Twain wrote in 1876.

 

Like acting, sales works best when hidden. This explains why almost everyone whose job involves distribution – whether they’re in sales, marketing or advertising – has a job title that has nothing to do with those things. People who sell advertising are called “account executives.” People who sell customers work in “business development”. People who sell companies are “investment bankers”. And people who sell themselves are called “politicians”. There’s a reason for these re-descriptions: none of us wants to be reminded when we’re being sold.

 

Whatever the career, sales ability distinguishes superstars from the 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 the big clients. Even university professors, who claim authority from scholarly achievement, are envious of the self-promoters who define their fields. Academic ideas about history or English don’t just sell themselves on their intellectual merits. Even the agenda of fundamental physics and the future path of cancer research are the results of persuasion. The most fundamental reason that even businesspeople underestimate the important of sales is the systematic effort to hide it at every level of every field in a world secretly driven by it.

 

The engineer’s grail is a product great enough that “it sells itself.” But anyone who would actually say this about a real product must be lying: either he’s delusional (lying to himself) or he’s selling something (and thereby contradicting himself). The polar opposite business cliché warns that the “best product doesn’t always win”. Economists attribute this to “path dependence”: specific historical circumstances independent of objective quality can determine which products enjoy widespread adoption. That’s true, but it doesn’t mean the operating systems we use today and the keyboard layouts on which we type were imposed by mere chance. It’s better to think of distribution as something essential to the design of your product. 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.

 

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.

 

Two metrics set the limits for effective distribution. The total net profit that you earn on average over the course of your relationship with a customer (Customer Lifetime Value or CLV) must exceed the amount you spend on average to acquire a new customer (Customer Acquisition Cost or CAC). In general, the higher the price of your product, the more you have to spend to make a sale – and the more it makes sense to spend it.

 

Viral marketing

 

A product is viral if its core functionality encourages users to invite their friends to become users too. This is how Facebook and PayPal both grow quickly: every time someone shares with a friend or makes a payment, they naturally invite more and more people into their network. This isn’t just cheap – it’s fast, too. If every new user leads to more than one additional user, you can achieve a chain reaction of exponential growth. The ideal viral loop should be as quick and as frictionless as possible. Funny YouTube videos or internet memes get millions of views very quickly because they have extremely short cycle times: people see kitten, feel warm inside, and forward it to their friends in a matter of seconds.

 

At PayPal, our initial user base was 24 people, all of whom worked at PayPal. Acquiring customers through banner advertising proved too expensive. However, by directly paying people to sign up and then paying them to refer more friends, we achieved extraordinary growth. This strategy cost us $20 per customer, but it also led to 7% daily growth, which meant that our user base nearly doubled every 10 days. After four or five months, we had hundreds of thousands of users and a viable opportunity to build a great company by servicing money transfers for small fees that ended up greatly exceeding our customer acquisition cost.

 

The power law of distribution

 

One of these [sales] methods [ie complex sales, personal sales, marketing and advertising, viral marketing] is likely to be far more powerful than every other for any given business: distribution follows a power law of its own. This is counterintuitive for most entrepreneurs, who assume that more is more. But the kitchen sink approach – employ a few salespeople, place some magazine ads, and try to add some kind of viral functionality to the product as an afterthought – doesn’t work. 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.

 

Man and machine

 

Futurists can seem like they hope the answer is yes [to ‘will a machine replace you?’]. Luddites are so worried about being replaced that they would rather we stop building new technology altogether. Neither side questions the premise that better computers will necessarily replace workers. But that premise is wrong: computers are complements for humans, not substitutes. The most valuable businesses of coming decades will be built by entrepreneurs who seek to empower people rather than try to make them obsolete.

 

The most valuable companies in the future won’t ask what problems can be solved with computers alone. Instead, they’ll ask: how can computers help humans solve hard problems?

 

Seeing green

 

Why did cleantech fail? Conservatives think they already know the answer: as soon as green energy became a priority for the government, it was poisoned. But there really were (and there still are) good reasons for making energy a priority. And the truth about cleantech is more complex and more important than government failure. 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 a 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?

 

We’ve discussed these elements before. Whatever your industry, any great business plan must address every one of them. If you don’t have good answers to these questions, you’ll run into lots of “bad luck” and your business will fail. If you nail all seven, you’ll master fortune and succeed. Even getting five or six correct might work. But the striking thing about the cleantech bubble was that people were starting companies with zero good answers – and that meant hoping for a miracle.

 

Some concluding words

 

Ray Kurzweil, the best-known Singularitarian, starts from Moore’s law and traces exponential growth trends in dozens of fields, confidently projecting a future of superhuman artificial intelligence. According to Kurzweil, “the Singularity is near,” it’s inevitable, and all we have to do is prepare ourselves to accept it.

 

But no matter how many trends can be traced, the future won’t happen on its own. What the Singularity would look like matters less than the stark choice we face today between the two most likely scenarios: nothing or something. It’s up to us. We cannot take for granted that the future will be better, and that means we need to work to create it today.

 

Whether we achieve Singularity on a cosmic scale is perhaps less important than whether we seize the unique opportunities we have to do new things in our own working lives. Everything important to us – the universe, the planet, the country, your company, your life, and this very moment – is singular.

 

Our task today is to find singular ways to create the new things that will make the future not just different, but better – to go from 0 to 1. The essential first step is to think for yourself. Only by seeing our world anew, as fresh and strange as it was to the ancients who saw it first, can we both re-create it and preserve it for the future.