If you want to start a company and are working on new ideas, here’s how I’ve always done it and how I recommend you do it.  Be the opposite of secretive.  Create a Google spreadsheet where you list every idea you can think, even really half-baked ones.  Include ideas you hear about (make sure you keep track of who had which idea so you can credit them/include them later).

Then take the spreadsheet and show it to every smart person you can get a meeting with and walk through each idea.  Talk to VCs, entrepreneurs, potential customers, and people working at big companies in relevant industries. You’ll be surprised how much you’ll learn.  The odds that someone will hear an idea and go start a competitor are close to zero.  The odds you’ll learn which ideas are good and bad and how to improve them are very high.

Every conversation will contain some signal and some noise. Separating the two is tricky. Here are some broad rules of thumb I’ve developed for how to filter feedback based to the profession of the person giving it to you.

1) Employees at relevant big companies. These people are great at providing facts (“Google has 100 people working on that problem”) but their judgment about the quality of startup ideas is generally bad. They tend to have goggles on that makes them think every good idea in their industry is already being built within their company.  For example, every security industry person I talked to thought SiteAdvisor was a bad idea.  (If it wasn’t, they think, someone at McAfee or Symantec company would have already built it!)

2) VCs. VCs are good at telling you about similar companies in the past and present and critiquing your idea in an “MBA-like” way:  will it scale? what are the economics? what is the best marketing strategy?  I would listen to them on these topics but pretty much ignore whether they think your idea is good or bad.

3) Potential customers.  If your product is B2B, remember you’ll be selling to that person 2-3 years from now and by then the world and their priorities will likely have radically changed.  If your product is B2C, it’s interesting to hear how regular consumers think about your product but often they really need to use it fully built and in the proper context to really judge it.

4) Entrepreneurs. This is the one group I listen to without a filter.

Even though I have no intention of starting a new company for a long time (if ever), I still keep my idea spreadsheet and update it periodically.  Some of the ideas I wrote down a few years ago are now companies started by other people (some successful, some not).  A few I had the chance to invest in. It’s interesting to compare my notes and ratings of each idea with how those companies have actually performed. I also keep a list of “on the beach” ideas in case I have time in between startups. These are mostly non-profit ideas.  I don’t know if I’ll ever get to those but they are particularly fun to think about.

* Thanks to James Cham for inspiring & contributing ideas to this post!

Suppose there is a pre-profitable company that is raising venture financing. Simple, classical economic models would predict that although there might be multiple VCs interested in investing, at the end of the financing process the valuation will rise to the clearing price where the demand for the company’s stock equals the supply (amount being issued).

Actual venture financings work nothing like this simple model would predict.  In practice, the equilibrium states for venture financings are: 1) significantly oversubscribed at too low a valuation, or 2) significantly undersubscribed at too high a valuation.

Why do venture markets function this way?  Pricing in any market is a function of the information available to investors. In the public stock markets, for example, the primary information inputs are “hard metrics” like company financials, industry dynamics, and general economic conditions. What makes venture pricing special is that there are so few hard metrics to rely on, hence one of the primary valuation inputs is what other investors think about the company.

This investor signaling has a huge effect on venture financing dynamics. If Sequoia wants to invest, so will every other investor.  If Sequoia gave you seed money before but now doesn’t want to follow on, you’re probably dead.

Part of this is the so-called herd mentality for which VC’s often get ridiculed. But a lot of it is very rational. When you invest in early-stage companies you are forced to rely on very little information. Maybe you’ve used the product and spent a dozen hours with management, but that’s often about it. The signals from other investors who have access to information you don’t is an extremely valuable input.

Smart entrepreneurs manage the investor signaling effect by following rules like:

- Don’t take seed money from big VCs – It doesn’t matter if the big VC invests under a different name or merely provides space and mentoring.  If a big VC has any involvement with your company at the seed stage, their posture toward the next round has such strong signaling power that they can kill you and/or control the pricing of the round.

- Don’t try to be clever and get an auction going (and don’t shop your term sheet). If you do, once the price gets to the point where only one investor remains, that investor will look left and right and see no one there and might get cold feet and leave you with no deal at all. Save the auction for when you get acquired or IPO.

- Don’t be perceived as being “on the market” too long.  Once you’ve pitched your first investor, the clock starts ticking. Word gets around quickly that you are out raising money. After a month or two, if you don’t have strong interest, you risk being perceived as damaged goods.

- If you get a great investor to lead a follow-on round, expect your existing investors to want to invest pro-rata or more, even if they previously indicated otherwise.  This often creates complicated situations because the new investor usually has minimum ownership thresholds (15-20%) and combining this with pro-rata for existing investors usually means raising far more money than the company needs.

Lastly, be very careful not to try to stimulate investor interest by overstating the interest of other investors. It’s a very small community and seed investors talk to each other all the time. If you are perceived to be overstating interest, you can lose credibility very quickly.

There is a widespread myth that search engines have taken profits away from news websites. A few months ago, Rupert Murdoch said: “Google has devised a brilliant business model that avoids paying for news gathering yet profits off the search ads sold around that content.”

The reality is that news is a lousy business. Period. Even Google doesn’t make money on it. For example, here are Google’s search results for the phrase “afghanistan war”:

Notice there aren’t any ads on the page. This is because ads for “afghanistan war” generate such low revenues per query that Google doesn’t think it’s worth hurting the user experience with a cluttered page. Google can afford to do this on news queries (along with many other categories of queries) because their real business is selling ads on queries where the user likely has purchasing intent. Big money-making categories include travel, consumer electronics and malpractice lawyers. News queries are loss leaders.

It’s an historical accident that hard news categories like international and investigative reporting were part of profitable businesses. The internet upended this model by 1) providing a new delivery method for classified ads (mainly Craigslist), 2) increasing the supply of newspapers from 1-2 per location to thousands per location, thereby driving the willingness-to-pay for news dramatically down, and 3) unbundling news categories, making cross subsidization increasingly hard.

The internet exposed hard news for what it is: a lousy standalone business. Google arguably contributed to this in many indirect ways, including by helping users find substitute news sources. But the idea that Google takes profits directly from newspapers is simply misinformed.

I’ve written a few times about what seems to be an exploding tech scene in NYC.  This is sometimes interpreted as arguing that NYC is a better place to start a company than the Valley. Most recently, Matt Mireles seems to be addressing people like me with his critique of the NYC startup scene (he makes some good points as does Caterina Fake in her response).

I’ve never meant my arguments to be about where it is better to start a company. California is a phenomenal place to start a tech company. NYC is a great place as well. (Note to Matt – it’s hard for first time founders everywhere). To me, the important question isn’t which place is better, but rather how we import the things that make the Valley great into NYC. As I said last year:

New York City has many of the same strengths as Silicon Valley – merit-driven capitalism, the embrace of newcomers and particularly immigrants, and a consistent willingness to reinvent itself.   Silicon Valley will always be the mecca of technology, but now that people here are getting back to, as Obama says, making things, New York City has a shot at becoming relevant again in the tech world.

I spent the past week in California and had the honor of meeting some legendary venture investors. I was deeply impressed: they are legends for a reason. Of course, they are incredibly smart and hard working and all of that, but most impressively, it was clear that they truly believe in making big bets on ambitious, seemingly wacky ideas to try to change the world. Every VC has this rhetoric on their website, but – at least in my experience – most just want to make incremental money on incremental technologies. (Side note: I noticed that the more powerful the VC, the more likely they were to pay close attention, show up on time, and not bring phones/computers into meetings.  I guess when you are changing the world, emails can wait an hour for a response).

California should be NYC’s role model and ally. The enemy should be people and institutions who make money but don’t actually create anything useful. In NYC, this mostly means Wall Street, along with the Wall Street mindset that sometimes infects East Coast VC’s (emphasis on financial engineering, needing to see metrics & “traction” vs betting on people and ideas, etc).

Matt should do what’s best for his company. God knows it’s hard enough doing a startup – you don’t need to carry the weight of reinvigorating a region on your back as well. That might mean moving to California. Meanwhile, forward-thinking investors and founders in NYC will continue trying to make things that change the world – in other words, trying to make NYC more like the Valley.

In an earlier blog post, I talked about how sites that generate purchasing intent (mainly “content” sites) are being under-allocated advertising dollars versus sites that harvest purchasing intent (search engines, coupon sites, comparison shopping sites, etc).  As a result, most content sites are left haggling over CPM-based brand advertising instead of sponsored links for the bulk of their revenue.

But there is an additional problem:  even among sites that monetize via sponsored links there is a large overallocation of advertising spending on links that are near the “end of the purchasing process” (or “end of the funnel”). For example, an average camera buyer takes 30 days and clicks on approximately 3 sponsored links from the beginning of researching cameras to actually purchasing one.   Yet in most cases only the last click gets credit, by which I mean:  1) if it’s an affiliate (CPA) deal, it is literally usually the case that only the last affiliate (the site that drops the last cookie) gets paid, 2) if it’s a CPC or CPM deal, most advertisers don’t properly track the users across multiple site visits so simply attribute conversion to the most recent click, causing them to over-allocate to end-of-funnel links 3) if it’s a non-sponsored link (like Google natural search links) the advertiser might over-credit SEO when in fact the natural search click was just the final navigational step in a long process that involved sponsored links along the way.

What this means is there are two huge misallocations of advertising dollars online: the first from intent generators to intent harvesters; the second from intent harvesters that are at the beginning or middle of the purchasing process to those at the end of the purchasing process.  This is not just a problem for internet advertisers and businesses – it affects all internet users.  Where advertising dollars flow, money gets invested. It is well known that content sites are suffering, many are even on their way to dying. Additionally, product/service sites that started off focusing on research are forced to move more and more toward end-of-funnel activities.  Take a look at how sites like TripAdvisor and CNET have devoted increasing real estate to the final purchasing click instead of research.  For the most part, you don’t get paid for the actual research since it’s too high in the funnel.

As with all large problems, this misallocation of advertising dollars also presents a number of opportunities.  One opportunity is for advertisers to correctly attribute their spending by tracking users through the entire purchasing process (in the case of cameras, the full 30 days and multiple sponsored clicks).  Very likely, these sites are currently overpaying end-of-funnel sites (e.g. coupon sites) and underpaying top-of-funnel sites (e.g. research sites). There is also an opportunity for companies that provide technology to help track this better. Finally, if over time advertising dollars do indeed shift to being correctly allocated, this will allow research sites to be pure research sites, content sites to be pure content sites, etc instead of everyone trying to clutter their sites with repetitive, “last click” functionality.

When founding a tech startup, there are certain areas where you should spend time trying to be creative/innovative. Generally these should be:  product, recruiting, marketing etc. One slightly disturbing trend I’ve noticed is founders trying to creative about stuff like legal terms that really are better left in their “default” form.

Here’s my advice: hire a “default” law firm like Gunderson and take their “default” advice. Yes, you should form a C corp in Delaware of CA or wherever they tell you; yes you should have 4 year vesting with a 1 year cliff; yes founders should have vesting; yes your deal terms should be plain vanilla. Etc. These things are time tested and you are far more likely to screw things up than create value by tinkering with them. Also, they are just not what you should be spending your time on.

Significant new technologies often emerge as “stacks.” You can look at stacks through a technological (e.g. OSI stack) or business lens. Here I am using a business lens, thus dividing layers by function and including things that aren’t technologies but have economic value, e.g. relationships with customers and users.

Normally stacks are constructed from the bottom up and some layers turn out to be valuable and others do not (Christensen argues compellingly that stacks tend to alternate between commodity and non-commodity layers).

The PC is a famous stack.  In the 80’s and 90’s the most valuable layers were the processor (Intel won), OS (Microsoft won), and applications (Microsoft mostly won with Office). Assembly of desktops became a commodity which Dell exploited (you can still make profits on commodity layers, you just need to take a low-cost strategy). The PC demonstrates how hard it is to predict which layers will become valuable: otherwise IBM would never have allowed Microsoft to own the OS.

The internet is another famous stack. In the 90’s a ton of investment went into the infrastructure layer – switches, fiber, CDNs etc. Innovation on that layer continues (particularly in wireless), but mostly the action has moved up the stack to web apps.

An interesting new, emerging stack is the “geo stack.”  The first layer is latitude/longitude location detection. This is mainly provided by satellites and GPS chips which seem to be getting so affordable they will be in every mobile device soon.

The next layer is connecting lat/long to human-understandable locations. Google Maps, NAVTEQ etc. do this by connecting lat/long to roads. Location-based apps like Foursquare, Gowalla, and Yelp do this by connecting lat/long to “venues.” It seems Gowalla is building their own venue database.  I assume Yelp has built their own.  I don’t know how Foursquare gets theirs. I suspect venue databases will become mostly a commodity as they are fairly inexpensive to build and once built mostly interchangeable.

The next layer is the relationship with the user, particularly getting a user’s permission to track her location.  Apps like Foursquare require explicit check-ins at each venue. Other apps like Loopt automatically check in for you. Building this trust relationship with users could be very valuable.

The next layer is what I’ll call “recommendations”:  giving useful advice to users based on their location.  Maps do this by providing driving direction, traffic info etc. Foursquare is doing this with “tips.” I think recommendations will be critical for geo apps to appeal to Normals.  Geo apps are currently wooing early adopters with badges, games, and the idea that you might have a serendipitous meeting with your friends at a bar.  I suspect these incentives won’t work for the broader population, but recommendations could.  Recommendation data is hard to build and vast, hence could be a very valuable layer. (I am biased here as Hunch is working on this layer).

Social graphs could be a geo layer. It’s rumored that Facebook will be adding venue check ins soon.  Facebook has by far the largest (opt in) social graph.  As the recent Google Buzz debacle demonstrated, it’s not obvious that the people you email with are the same as the people you friend on Facebook.  Perhaps the people you want to share your location with are different than the people you friend on Facebook. If so, there could emerge valuable geo-specific social graphs.

Finally, monetization could be a very valuable layer.  There are (at least) two parts to monetizing location. Getting local businesses to embrace the internet has been very slow going. Companies that make money on local businesses today (Yelp, Yext, ReachLocal) use expensive outbound calling and other “push” techniques to sign up local businesses. There remains a huge opportunity to supplant the yellow pages as the default advertising platform in local business owners’ minds. If apps like Foursquare can build up enough marketing / PR momentum that every restaurant, dry cleaner etc feels like they need to “get on Foursquare” this could finally open the floodgates for local business advertising.

The second part of monetizing location is facilitating and tracking offline purchases. 90%+ of purchases are still offline, although for many of those transactions people do research and make their decisions online. The internet doesn’t get paid for these transactions.  Companies like Milo (disclosure: I’m an investor) are doing interesting things in this space and I expect we’ll see a lot more activity on this layer soon.

VC returns over the last decade have been poor. The cause is widely agreed to be an excess of venture capital dollars to worthy startups. Observers seem to universally assume that the solution is for the VC industry to downsize.

For example, Fred Wilson says about VC:

You cannot invest $25bn per year and generate the kinds of returns investors seek from the asset class. If $100bn per year in exits is a steady state number, then we need to work back from that and determine how much the asset class can manage…. I think “back to the future” is the answer to most of the venture capital asset class problems. Less capital in the asset class, smaller fund sizes, smaller partnerships, smaller deals, and smaller exits

Similarly, Bill Gurley writes:

There are many reasons to believe that a reduction in the size of the VC industry will be healthy for the industry overall and should lead to above average returns in the future.

All of these analyses start with the assumption that aggregate venture-backed exits (acquisition and IPOs) will remain roughly constant. I don’t see why we need to accept that assumption. The aggregate value of venture-backed startups, like all valuations, is a function of profits generated (or predicted to be generated). In technology, profits are driven by innovation. I don’t see any reason we should assume venture-backed innovation can’t be dramatically increased.

For example, innovation has varied widely across times and places – the most innovative region in the world for the last 50 years being Silicon Valley. What if, say, Steve Jobs hadn’t grown up in Silicon Valley? What if he had gone to work for another company? Does anyone really think Apple – and all the innovation and wealth it created – would exist if Jobs hadn’t happened to grow up in a culture that was so startup friendly? Jobs is obviously a remarkable person, but there are probably 100 Steve Jobs born every year. The vast majority just never have a chance or give a thought to starting a revolutionary new company.

Some people blame our education system, or assume that there is some fixed number of entrepreneurs born every year. I think the problem is cultural. As much as we like to think of our culture as being entrepreneurial, the reality is 99% of our top talent doesn’t seriously contemplate starting companies. Colleges crank out tons of extremely smart and well-educated kids every year. The vast majority go into “administrative” careers that don’t really produce anything – law, banking and consulting. Most of the rest join big companies. As I’ve argued many times before, big companies (with a few notable exceptions) aren’t nearly as successful as startups at creating new products.  The bigger the company, the more likely it suffers from agency issues, strategy taxes, and myopia. But most of all: nothing is more motivating and inspiring than the sense of ownership and self-direction only a startup can provide.

Whenever I see a brilliant kid decide to join Goldman Sachs, McKinsey, or Google, I think to myself: a startup just died, and as a result our world is a little less wealthy, innovative, and interesting.

For some reason when you are selling information technology, big companies are referred to as “enterprises.” I’m guessing the word was invented by a software vendor who was trying to justify a million-dollar price tag. As a rule of thumb, think of enterprise sales as products/services that cost $100K/year or more.

I am by no means an expert in enterprise sales. Personally, I vastly prefer marketing (one-to-many) versus sales (one-to-one), hence only start companies making consumer or small business products (advertising based or sub-$5000 price tags). But I have been involved in a few enterprise companies over the years. Here’s the main thing I’ve observed. Almost every enterprise startup I’ve seen has a product that would solve a problem their prospective customers have. But that isn’t the key question. The key question is whether it solves a problem that is one of the prospective customer’s top immediate priorities. Getting an enterprise to cough up $100K+ requires the “buy in” of many people, most of whom would prefer to maintain the status quo. Only if your product is a top priority can you get powerful “champions” to cut through the red tape.

My rule of thumb is that every enterprise (or large business unit within an enterprise) will, at best, buy 1-3 new enterprise products per year.  You can have the greatest hardware/software in the world, but if you aren’t one of their top three priorities, you won’t be able to profitably sell to them.

One final note: enterprise-focused VC’s sometimes refer to products priced between (roughly) $5k and $100K as falling in the “valley of death.” Above $100K, you might be able to make a profit given the cost of sales. Below $5k you might be able to market your product, hence have a very low cost of sales. In between, you need to do sales but it’s hard to do it profitably. Your best bet is a “channel” strategy; however, for innovative new products that is often a lot like trying to push a string.

Venture capital term sheets are not legally binding (except certain subclauses like confidentiality and no-shop provisions). That said, there is a well-established norm that VC’s don’t back out of signed term sheets unless they discover something really, really bad – fraud, criminal backgrounds of founders etc. The best VC in the world, Sequoia Capital, whose companies account for an astounding 10% of NASDAQ’s market cap, has (according to trustworthy sources) only backed out on one term sheet in the last 10 years.

Yesterday, one of the 40 or so startups I’ve invested in (either personally or through Founder Collective) had a well-known VC back out of a term sheet for no particular reason besides that they decided they no longer liked the business concept. It’s the first time I’ve seen this happen in my career.

In later stage private equity (leveraged buyouts and such) it is a common trick to “backload diligence” – you give the company a quick, high-valuation term sheet, which then locks the company in (the no-shop clause prohibits them from talking to other investors for 30 days or more). Then the firm does their diligence, finds things to complain about and negotiates the price down or walks away. If they walk away, the company is often considered “damaged goods” by other investors who wonder what the investor discovered in diligence. This gives the investor a ton of negotiating leverage. In later stage private equity, this nasty tactic can work repeatedly since the companies they are buying (e.g. a midwestern auto parts manufacturer) are generally not part of a tight knit community where investment firms depend heavily on their reputation.

I learned the basics of VC when I apprenticed under Jeremy Levine and Rob Stavis at Bessemer.  It was at Bessemer that I learned you never back out on a term sheet except in cases of fraud etc. I never saw them back out on one nor have I heard of them doing so. In fact, I remember one case where Rob signed a term sheet and while the final deal documents were being prepared (which usually takes about a month), the company underperformed expectations. The CEO asked Rob if he was going to try to renegotiate the valuation down. Rob said, “Well, if you performed better than expected I don’t think you would try to renegotiate the valuation up, so why should I renegotiate when you performed worse than expected.” That’s how high quality investors behave.

Besides simply acting ethically, firms like Sequoia and Bessemer are acting in their own interest: the early-stage tech community is very small and your reputation is everything. Word travels fast when firms trick entrepreneurs. What happened yesterday was not only evil but will also come back to haunt the firm that did it.