Chris Dixon

There is a certain well respected venture capital firm (VC) that has a program for fledgling entrepreneurs.   The teams that are selected get a desk, a small stipend, and advice for a few months from experienced VCs.  I could imagine back when I was starting my first company thinking this was a great opportunity – especially the advice part.

Here’s the problem.  A few years into the program, approximately 25 teams have gone through it.  The sponsoring VC funded one team and passed on the other 24.  None of those other 24 have gotten financing from anyone else.  Why?  Because once you go through the program and don’t get funded by the sponsoring VC, you are perceived by the rest of the investor community as damaged goods.

Most early stage investors are bombarded with new deals.  There is no way they could meet with all of them, or even spend time seriously reading their investor materials.  In order to filter through it all, they rely heavily on signals.  The person referring you to them is a very big signal.  Your team’s bios is a very big signal. And if you were in the seed program of a VC who has a multi-hundred million dollar fund and who decided to pass, that is a huge signal.

Meanwhile, the unsuspecting entrepreneurs think: “I was at a prestigious VC this summer – this will look great on our bios and company deck.”  The truth is exactly the opposite:  the better the VC, the stronger the negative signal when they pass.

Thus, the most important question to ask before taking seed money is: How many companies that the sponsor passed on went on to raise money from other sources?

The best programs don’t have sponsors who are even capable of further funding the company.  Y Combinator simply doesn’t do follow ons, so there is no way they can positively or negatively signal by their follow on actions. (Although now that they have taken money from Sequoia people are worried that Sequoia passing could be seen as a negative signal.  I just invested in a Y Combinator company and was reassured to see Sequoia co-investing).  Other seed programs lie somewhere in between — they aren’t officially run by big VCs but they do have big VCs associated with them so there is some signaling effect.   (I would call this the “hidden sponsor” problem.  I didn’t realize the extent of it until I got emails responding to my earlier seed program posts from entrepreneurs who had been burned by it).

The most dangerous programs are the ones run by large VCs.  I would love for someone to prove me wrong, but from my (admittedly anecdotal) knowledge, no companies that have been in large VC seed programs where the VC then stopped supporting the company went on to raise more money from other sources.

As has been widely noted, startups – especially internet-related ones – require far less capital today than they did a decade ago.  The VC industry has responded by keeping their funds huge but trying to get options on startups via seed programs.  Ultimately the VC industry will be forced to adapt by shrinking their funds, so they can invest in seed deals with the intention of actually making money on those investments, instead of just looking for options on companies in which they can invest “real money.”  In the meantime, however, a lot of young entrepreneurs are getting an unpleasant introduction to the rough-and-tumble world of venture capital.

Disclosure:  I am biased because as an early stage investor I sometimes compete with these programs.

An obvious but surprisingly under-practiced design principle is to “embrace the medium.”  Applied to software, this means building applications that take advantage of the strengths of the platform instead of trying to mimic the strengths of another platform.

iPhone and Wii games provide many stark abuses of this principle. Call of Duty is perhaps the single best franchise on the XBox and PS3, but the Wii version is almost unplayable.   They basically just did a straight port of the game, with worse graphics and using the Wiimote as a shaky aiming device.  It’s not an accident that the best Wii games are made exclusively for the Wii (and that most of those games are made by Nintendo itself).

iPhone games are perhaps even worse violators of the “embrace the medium” principle.  Recently I was thinking about downloading Madden 2010, but as soon as I saw the screenshots I knew I’d hate it:

You can see they are trying to force the XBox/PS3 control scheme onto a device with completely different set strengths and weaknesses. The iPhone’s strengths are:  touchscreen, gestures, accelerometer, networked, always with you. Its weaknesses:  no buttons, small screen, poor graphics/processor (compared to consoles).  The best games – Flight Control, Spider, Rolando – are designed from scratch to take advantage of the iPhone’s strengths.  Take Flight Control as an example:

You guide the planes by mapping their routes with your finger.  It’s such a simple, elegant and fun game, and one that could only exist on the iPhone.  It embraces the iPhone-ness instead of fighting it.

Generally speaking, there are two approaches to relating to other people in the business world. The first approach is transactional and legalistic:  work is primarily an exchange of labor for money, and agreements are made via contracts.   Enforcement is provided by organizations, especially the legal system.  The second approach relies on trust, verbal agreements, reputation and norms, and looks to the community to provide enforcement when necessary.

In the startup world, the latter approach dominates.  It is almost unheard of, for example, to see entrepreneurs or VCs sue each other.  The ones who do tend to leave the startup world, either by choice or by having ruined their reputation.  It is very rare to see someone in the startup world break a verbal agreement.  And, in most cases, employees and employers show loyalty far beyond what is seen in larger companies or what is economically “rational.”   (Most startups do spend considerable legal fees on financing, employee, and IP documents, but that is mostly because they know that those are necessary if they decide to sell themselves to a large company where the legalistic approach dominates.)

For this reason, if you are an employee working at a startup where the managers are honest, inclusive and fair, you should disregard everything you’ve learned about proper behavior from people outside of the startup world.

For example, let’s suppose you are a two years out of college and have a job at a startup.  You like your job but decide you want to go to graduate school.   The big company legalistic types will tell you to secretly send in your applications, and, if you get accepted and decide to attend, give your boss two weeks notice.

What you should instead do is talk to your boss as soon as you are seriously considering graduate school.  Give them twelve months notice.  Any good startup manager won’t fire you, and in fact will go out of her way to help you get into school and get a good job afterwards.  They will appreciate your honesty and the fact that you gave them plenty of time to find a replacement.

(Now don’t get me wrong:  if you work for bosses who have a legalistic, transactional mindset, by all means give two weeks notice.  I gave 4 months notice once to a boss with that mindset and was duly punished for it.  But hopefully if you are at a startup you work with people who have the startup, relationship-centric mindset.)

This way of relating to other people is one of the main things people are talking about when they talk about “startup culture.”  It is why so many people coming from other industries have difficulty fitting into startups (especially people coming from Wall Street where the transactional mindset is at its most extreme).  I personally find the community approach a much nicer way to operate, and try to only professionally associate myself with people who prefer that approach as well.

For most people I know who join or start companies, the primary goal is not to get rich – it is to work on something they love, with people they respect, and to not be beholden to the vagaries of the market- in other words, to be independent.  The reality is being independent often means having made money and/or being able to raise money from others.

A while back, I posted about how I recommend thinking about non-founder option grants.  In the comments, Aaron Cohen made the point that given today’s “good” exit sizes and standard equity grants, most non-founders will not gain independence even in the (non-extreme) good cases:

Most startup employees need to realize they are on a journey and that in addition to making a few hundred thousand dollars on a good outcome they are learning how to become more senior at the next company. Real wealth creation will take founding, seniority, or staggeringly large exits.

As Aaron said, you shouldn’t think of joining a startup as just joining a company. You should think of it as joining the startup career path. This career path could mean starting a company as your first job.  It could also mean working at a few startups and then starting a company.   (In my view, if your goal is to start a company, it is mostly a waste of time to work anywhere but a startup – with the possible exception of a short stint in venture capital).

Maybe you will make some money working at a startup, but more importantly you will hopefully work for founders and managers who are smart and willing to mentor you and eventually fund or help you fund your startup.

The startup world is extremely small.  If you’re smart, work really hard, and act with integrity, people will notice.  Contrary to popular wisdom, you will actually have more job stability than working at a big company.  And hopefully you’ll go on to start your own company, gain independence, and then help others do the same.

One of the hardest things to do as a startup is to create a new category.  Bloggers and press have a natural tendency to “pigeonhole” – to group startups into cleanly delineated categories, and then do side-by-side comparisons, comment on the “horserace” between them, and so forth.

At my last startup, SiteAdvisor, we were at first consistently pigeonholed as an anti-phishing toolbar, even though what we did was help search engine users avoid spyware, spam, and scams, which (for various technical reasons) had almost no functional overlap with anti-phishing toolbars. My co-founder at Hunch, Caterina Fake, had a similar experience at Flickr.  Early on, people compared Flickr to existing photo sharing websites – Shutterfly, Ofoto, SnapFish - and found Flickr lacking in features around buying prints, sending greeting cards, etc.

Pigeonholing is one reason startups should actually welcome direct competitors.   It was only once a direct competitor to SiteAdvisor appeared that people started treating “web safety” as its own category (Walt Mossberg was the first one to legitimize the category with this article).

At my current startup, Hunch, being pigeonholed as a so-called Answers site is one of our main marketing challenges.  Hunch is a user-generated website similar to Wikipedia except, instead of creating encyclopedia entries, contributors create decision trees that help other users make choices and decisions.  For example, about 50 computer enthusiasts came together to create this decision tree about computer laptops that helps users with less expertise find the right laptop.  Hunch gets smarter over time as more people contribute to it.  So far, about 10,000 users have made 115,000 contributions to the site.  Last month, our third month after launch, over 600,000 unique visitors used those contributions to make decisions.

Many of the initial reviews of Hunch accurately reflected that Hunch is trying to create a new category of website.  Nevertheless, the tendency to pigeonhole Hunch as an Answers site remains. Answers sites allow users to ask a question and get back direct answers from other people.  There are many Answer sites including Yahoo Answers, Mahalo Answers, Vark, Answerbag, and ChaCha. These are all excellent and useful services – but have as much to do with Hunch as Ofoto had to do with Flickr.

There is no easy solution to avoid being pigeonholed.  All you can do is consistently, straightforwardly describe what you do, and then keep beating that drum over and over until the message gets through.

I carry around an iPhone and a Blackberry Tour.  I know that’s ridiculous. The iPhone is a great device on an awful network; the Tour is an awful device on a great network.  If the rumors are true and the Verizon “Droid” is a great device on a great network, I’ll be the first in line to get one.  But for the wireless ecosystem as a whole, it would be a bad thing.

Some people are saying a great Droid would mean more competition amongst handsets.  But you can’t really choose a handset – you choose a handset-carrier pair.  The real innovation inhibitor in the cellular world has been the power of the carriers to dictate what devices you can use and what apps go on those devices.  Just ask an entrepreneur who tried to create handsets or cellular apps.  They are completely beholden to the whims of the carriers.

Apple has gotten very close to breaking the carrier stranglehold – just look at how many people put up with AT&T’s atrocious network to have one.  Had Verizon capitulated and accepted Apple’s presumably stringent terms in order to carry the iPhone, we might have finally started to see a true decoupling of handsets from carriers.

Finally, don’t think just because the Droid runs Android it’s going to be truly open.  Verizon knows a truly open OS – one that allows you to run Google Voice, Skype, 3rd party SMS apps – would make their network a dumb pipe.  They’ve shown in the past they won’t let that happen.

People who criticize Obama’s economic policies forget that, around the beginning of this year, a lot of serious people thought we were entering a second Great Depression.  Here are the Google News mentions of the words “Great Depression” (in blue) and “economic recovery” (in red) over the last three years:

Moreover, most experts thought we were being led into a Great Depression not by “fundamentals” but by the collapse of the financial system.

Back around when Obama proposed his bank bailout plan (which was mostly an extension of Bush and Bernanke’s plan) he was widely criticized.  The consensus criticism was succinctly summarized by Nobel Laureate Joseph Steiglitz:

Paying fair market values for the assets will not work. Only by overpaying for the assets will the banks be adequately recapitalized. But overpaying for the assets simply shifts the losses to the government. In other words, the Geithner plan works only if and when the taxpayer loses big time.

Around this time, I happened to bump into an old friend who was working at a hedge fund where his full-time job was trading these so-called toxic assets (CDSs, CDOs, etc).  I asked him the trillion dollar question:  what did he think the “fair market value” for these assets was? Were they worth, say, 80 cents on the dollar as the banks were claiming, or 20 cents on the dollar as the bidders in the market were offering.

His answer:  These assets are essentially bets on home mortgages, which in turn are dependent on housing prices, which in turn are dependent on the economy, which in turn is highly dependent on whether the banks stay solvent, which is dependent on what these assets are worth.

This circularity is not unique to these particular assets.  As George Soros has argued for decades, all economic systems are profoundly circular, a property that he calls reflexivity.

The bank bailouts were extremely distasteful in many ways.  Lots of underserving people got rich.  Institutions that should have failed didn’t.  Dangerous “moral hazard” precedents were set. But the fact remains:  by altering perceptions, the Bush/Obama/Bernanke plan seems to have turned the second Great Depression into “merely” a bad recession.

The Dow passed the symbolic milestone of 10,000 recently.  People who say it’s an illusion and doesn’t reflect economic fundamentals don’t understand that in economics, perception and fundamentals are inextricably linked.

What’s the relationship between price – the ability to charge for your product – and cost – how much it costs you to produce it?

Price is a function of supply and demand.  Notice the word “cost” doesn’t occur there.  It is true that cost is, over the long term, a lower bound for price – otherwise you’d go out of business.  It is also true that high upfront fixed costs can create barriers to entry and therefore lower supply.

The only case in which price is determined by (variable) costs is in a commoditized market.  A market is commoditized when competing products are effectively interchangeable and therefore customers make decisions based solely on price.  In commoditized markets, price tends to converge toward cost.

In non-commoditized markets, variable costs have no effect on price.  Most information technology companies are not commoditized, therefore variable cost and price are unrelated.  That is why there can exist companies like Google and Microsoft that are so insanely profitable.  If the cost of producing and distributing a copy of Microsoft Office dropped tomorrow, there is no reason to think that would affect their pricing.  The most profitable industry historically has been pharmaceuticals, because they are effectively granted monopolies, via patents, reducing the supply of a given drug to one.

There are two ways people get confused about cost and price – a rudimentary way and a more advanced way.  The rudimentary way is confusing fixed and variable costs.  People who gripe about the price/cost gap of SMS messages seem to not realize the telecom industry is like the movie industry in that they make huge upfront investments but have relatively low marginal costs.   I, for one, have always thought movies are a great deal – they spend $100M making a movie, I pay $12 to see it.  It would be silly to compare how much you pay to see a movie to the variable cost of projecting the movie.

The more advanced way people get confused about cost and price is to think that because costs are dropping, prices will necessarily follow. For example, the cost of distributing newspapers has dropped almost to zero.  This is not the primary cause of the downfall of the newspaper industry.  The downfall of newspapers has been caused by a number of things – losing the classifieds business was huge – but mainly because when newspapers went online and were no longer able to partition the market geographically, supply in each region went up by orders of magnitudes.  Once the majority of newspapers go out of business causing supply to go way down, pricing power should return to the survivors.

In Rules of Thumb, Alan Weber quotes legendary venture capitalist John Doerr discussing the original business plans for companies he invested in such as Google, Intuit, and Amazon:

In every case you can find the one sentence or paragraph that describes their unique business model advantage.  It could be their unique distribution system or the retailing model.  It’s the factor that accounts for their success. It turns out the factor that explains their success at the beginning is what accounts for their failure later.

As a former philosophy student, I was reminded of Aristotle’s concept of “hamartia,” sometimes known as a “fatal flaw”:

In Aristotle’s understanding, all tragic heroes have a “hamartia,” but this is not inherent in their characters, for then the audience would lose respect for them and be unable to pity them; likewise, if the hero’s failing were entirely accidental and involuntary, the audience would not fear for the hero. Instead, the character’s flaw must result from something that is also a central part of their virtue, which goes somewhat awry, usually due to a lack of knowledge.

It’s an interesting exercise to apply this principle to technology companies:

1) Google’s strength is its uber-engineering mindset.  This seems to increasingly be a liability as the web becomes ever more social.

2) Yahoo’s strength was its breadth.  Now they call it the “peanut butter” problem.

3) AOL’s strength was being a closed garden.  As users became internet savvy, they were no longer afraid of venturing outside of it.

4) Apple’s strength lies in its genius, authoritarian leader.  Apple’s decline will begin when he leaves (sadly).

5) Facebook’s strength is authenticity and privacy – your friends are (mostly) your real friends, and only they see your activity.  Facebook has been trying to respond to Twitter’s rise with “open” features like the public micro-messaging.   It remains to be seen whether they can successfully go against their own core strengths.  I’m skeptical, but give them credit for trying.

6) Twitter’s strength is its simplicity and openness.  Will its openness be its downfall?  For example, will Twitter end up fighting its apps?  Or will it be its simplicity?

This principle also implies how to use incumbents’ strengths against them (sometimes called the “Judo Strategy”).  In the chess game of competitive strategy, you can usually bet that incumbents won’t make moves that undermine their core strengths – until it’s too late.