Chris Dixon

Google seems to be releasing or acquiring new products almost daily. It’s one thing for a couple of programmers to hack together a side project. It’s another thing for Google to put gobs of time and money behind it. The best way to predict how committed Google will be to a given project is to figure out whether it is “strategic” or not.

Google makes 99% of their revenue selling text ads for things like airplane tickets, dvd players, and malpractice lawyers. A project is strategic for Google if it affects what sits between the person clicking on an ad and the company paying for the ad. Here is my rough breakdown of the “layers in the stack” between humans and the money:

Human - device – OS – browser – bandwidth –  websites - ads – ad tech – relationship to advertiser – $$$

At each layer, Google either wants to dominate it or commoditize it. (For more on the strategic move known as commoditizing the complement, see here, here and here). Here’s my a brief analysis of the more interesting layers:

Device: Desktop hardware already commoditized. Mobile hardware is not, hence Google Phone (Nexus One).

OS: Not commoditized, and dominated by archenemy (Microsoft)!!   Hence Android/Google Chrome OS is very strategic. Google also needs to remove main reasons people choose Windows. Main reasons (rational ones – ignoring sociological reasons, organizational momentum etc) are Office (hence Google Apps), Outlook (hence Gmail etc), gaming (look for Google to support cross-OS gaming frameworks), and the long tail of Windows-only apps (these are moving to the web anyways but Google is trying to accelerate the trend with programming tools).

Browser: Not commoditized, and dominated by arch enemy! Hence Chrome is strategic, as is alliance with Mozilla, as are strong cross-browser standards that maintain low switching costs.

Bandwidth:  Dominated by wireless carriers, cable operators and telcos. Very hard for Google to dominate without massive infrastructure investment, hence Google is currently trying to commoditize/weaken via 1) more competition (WiMAX via Clearwire, free public Wi-Fi) 2) regulation (net neutrality).

Websites/search (“ad inventory”): Search is obviously dominated by Google. Google’s syndicated ads (AdSense) are dominant because Google has the highest payouts since they have the most advertisers bidding. This in turn is due largely to their hugely valuable anchor property, Google.com. Acquired Youtube to be their anchor property for video/display ads, and DoubleClick to increase their publisher display footprint. On the emerging but fast growing mobile side, presumably they bought AdMob for their publisher relationships (versus advertiser relationships where Google is already dominant). The key risks on this layer are 1) people skip the ads altogether and go straight to, say, Amazon to buy things, 2) someone like Facebook or MS uses anchor property to aggressively compete in syndicated display market.

Relationships to advertisers:  Google is dominant in non-local direct-response ads, both SMB self serve and big company serviced accounts.  They are much weaker in display. Local advertisers (which historically is half of the total ad market) is still a very underdeveloped channel – hence (I presume) the interest in acquiring Yelp.

This doesn’t mean Google will always act strategically. Obviously the company is run by humans who are fallible, emotional, subject to whims, etc. But smart business should be practiced like smart chess: you should make moves that assume your opponents will respond by optimizing their interests.

Short answer:  enough to get your startup to an accretive milestone plus some fudge factor.

“Accretive milestone” is a fancy way of saying getting your company to a point at which you can raise money at a higher valuation.  As a rule of thumb, I would say a successful Series A is one where good VCs invest at a pre-money that is at least twice the post-money of the seed round.  So if for your seed round you raised $1M at $2M pre ($3M post-money valuation), for the Series A you should be shooting for a minimum of $6M pre (but hopefully you’ll get significantly higher).

The worst thing a seed-stage company can do is raise too little money and only reach part way to a milestone. Pitching new investors in that case is very hard; often the only way keep the company alive is to get the existing investors to reinvest at the last round valuation (“reopen the last round”). The second worst thing you can do is raise too much money in the seed round (most likely because big funds pressure you to do so), hence taking too much dilution too soon.

How do you determine what an accretive milestone is? The answer is partly determined by market conditions and partly by the nature of your startup. Knowing market conditions means knowing which VCs are currently aggressively investing, at what valuations, in what sectors, and how various milestones are being perceived.  This is where having active and connected advisors and seed investors can be extremely helpful.

Aside from market conditions, you should try to answer the question: what is the biggest risk your startup is facing in the upcoming year and how can you eliminate that risk?  You should come up with your own answer but you should also talk to lots of smart people to get their take (yet another reason not to keep your idea secret).

For consumer internet companies, eliminating the biggest risk almost always means getting “traction” – user growth, engagement, etc. Traction is also what you want if you are targeting SMBs (small/medium businesses). For online advertising companies you probably want revenues. If you are selling to enterprises you probably want to have a handful of credible beta customers.

The biggest mistake founders make is thinking that building a product by itself will be perceived as an accretive milestone. Building a product is only accretive in cases where there is significant technical risk – e.g. you are building a new search engine or semiconductor.

Now to the “fudge factor.”  Basically what I’d recommend here depends on what milestones you are going for and how experienced you are at developing and executing operating plans. If you are going for marketing traction, that almost always takes (a lot) longer than people expect.  You should think about a fudge factor of 50% (increasing the round size by 50%).  You should also have alternative operating plans where you can “cut the burn” to get more calendar time on your existing raise (“extend the runway”). If you are just going for product milestones and are super experienced at building products you might try a lower fudge factor.

The most perverse thing that I see is big VC funds pushing companies to raise far more money than they need to (even at higher valuations), simply so they can “put more money to work“. This is one of many reasons why angels or pure seed funds are preferable seed round investors (bias alert:  I am one of them!).

Mary Meeker’s presentation this year on internet trends was all about mobile. Inasmuch as data-heavy research report from a major investment bank can be said to have a “climax,” it was probably these slides:

The assertion seems to be that there is something special about the mobile internet that compels people to pay for things they wouldn’t pay for on the desktop internet.  It is this same thinking that has newspapers and magazines hoping the Kindle or a tablet device might be their savior.

It is certainly true that today people are paying for things on iPhones and Kindles that they aren’t paying for on the desktop internet. Personally, I’ve bought a bunch of iPhone games that I would have expected to get for free online. I also paid for the New York Times and some magazines on my Kindle that I never paid for on my desktop.

But longer term, the question is whether this is because of something fundamentally – and sustainably – different about mobile versus desktop or whether it is just good old fashioned supply and demand.

I think we are in the AOL “walled garden” days of the mobile internet. Demand is far outpacing supply, so consumers are paying for digital goods. I don’t pay for news or simple games on the desktop internet because there are so many substitutes that my willingness to pay is driven down to zero.

What are the arguments that the mobile internet is sustainably different than the desktop internet? One of the main ones I’ve heard is habit: digital goods providers made a mistake in the 90′s by giving stuff away for free. Now people are habituated to free stuff on the desktop internet. Mobile is a chance to start over.

I think this habit argument is greatly overplayed. The same argument has been made for years by the music industry: “kids today think music should be free” and so on. Back in the 90s, I bought CDs, not because I was habituated to paying for music, but because there was no other reasonably convenient way to get it. If tomorrow you waved a magic wand and CD’s were once again the only way kids could buy the Jonas Brothers and Taylor Swift, they’d pay for them. It’s the fact that there are convenient and free substitutes that’s killing the music industry, not consumers’ habits.

As the supply of mobile digital goods grows — the same way it did on the desktop internet — consumers’ willingness-to-pay will drop and either advertising will emerge as the key driver of mobile economic growth or the mobile economy will disappoint. I was going to buy a Chess app for my iPhone this morning but when I searched and found dozens of free ones I downloaded one of those.  At some point there will be lots of Tweetie, Red Laser, and Flight Control substitutes and they too will be free.

Here’s the really good news for the web economy over the next decade.  Consumers are spending more and more time online, yet only about 10% of all advertising dollars are spent there.

Let’s assume that, over time, ad spending on a medium becomes roughly proportional to the time consumers spend using that medium. I doubt there are any technologists reading this blog who doubt that in five years most people in industrialized countries will spend 50% or more of their “media time” on the web.  This means there are hundreds of billions of ad revenues waiting to move to the web.

Advertising is usually divided into two categories: direct-response and brand advertising. Direct-response advertising tries to get users to take immediate action. Brand advertising tries to build up positive associations over time in people’s minds. In the past decade, we saw a massive shift of direct response advertising to the web. The main beneficiary of this shift has been Google. We saw far less of a shift of brand advertising to the web.

It is therefore very likely that most of this new ad spending will be brand advertising.  This is why Google, Yahoo and Microsoft are all so intensely focused on display advertising. It is why they paid huge premiums to acquire Doubleclick, Right Media, and Avenue A.

Right now there are lots of inhibitors to brand advertising dollars flowing onto the web. Among them 1) most of the brand dollars are controlled by ad agencies, who seem far more comfortable with traditional media channels, 2) it is hard to know where your online advertising is appearing and whether it is effective, 3) banner ads seem extremely ineffective and are often poorly targeted, 4) big brand advertisers seem scared of user-generated content, today’s major source of ad inventory growth.

But economic logic suggests these problems will be figured out, because advertisers have no choice but to go where the consumers are.

Websites live or die based on how a small group of programmers at Google decide their sites should rank in Google’s main search results.  As the “router” of the vast majority of traffic on the internet, Google’s secret ranking algorithm is probably is the most powerful piece of software code on the planet.

Google talks a lot about openness and their commitment to open source software. What they are really doing is practicing a classic business strategy known as “commoditizing the complement“*.

Google makes 99% of their revenue by selling text ads for things like plane tickets, dvd players and malpractice lawyers. Many of these ads are syndicated to non-Google properties. But the anchor that gives Google their best “inventory” is the main search engine at Google.com.  And the secret sauce behind Google.com is the algorithm for ranking search results. If Google is really committed to openness, it is this algorithm that they need to open source.

The alleged argument against doing so is that search spammers would be able to learn from the algorithm to improve their spamming methods. This form of argument is an old argument in the security community known as “security through obscurity.” Security through obscurity is a technique generally associated with companies like Microsoft and is generally opposed as ineffective and risky by security experts. When you open source something you give the bad guys more info, but you also enlist an army of good guys to help you fight them.

Until Google open sources what really matters – their search ranking algorithm – you should dismiss all their other open-source talk as empty posturing. And millions of websites will have to continue blindly relying on a small group of anonymous engineers in charge of the secret algorithm that determines their fate.

* You can understand a large portion of technology business strategy by understanding strategies around complements. One major point: companies generally try to reduce the price of their products complements (Joel Spolsky has an excellent discussion of the topic here). If you think of the consumer as having a willingness to pay a fixed N for product A plus complementary product B, then each side is fighting for a bigger piece of the pie. This is why, for example, cable companies and content companies are constantly battling. It is also why Google wants open source operating systems to win, and for broadband to be cheap and ubiquitous. [link to full post]

In a post last week, Paul Kedrosky noted his frustration when looking for a new dishwasher using Google.  I thought it might be interesting to do some forensics to see which sites rank highly and why.

Paul started by querying Google with the phrase dishwasher reviews:

Pretty much every link on this page has an interesting story to tell about the state of the web.  I’ll just focus here on the top organic (non-sponsored) result:

http://www.consumersearch.com/dishwasher-reviews

clicking through this link takes you here:

Consumersearch is owned by About.com, which in turn is owned by the New York Times.

So how did consumersearch.com get the top organic spot? Most SEO experts I talk to (e.g. SEOMoz‘s Rand Fishkin) think inbound links from a large number of domains still matter far more than other factors. One of the best tools for finding inbound links is Yahoo Site Explorer (which, sadly, is supposed to be killed soon). Using this tool, here’s one of the sites linking to the dishwasher section of Consumersearch:

http://www.whirlpooldishwasher.net/

(Yes, this site’s CSS looks scarily like my own blog – that’s because we both use a generic WordPress template).

This site appears has two goals: 1) fool Google into thinking it’s a blog about dishwashers and 2) link to consumersearch.com.

Who owns this site?  The Whois records are private. (Supposedly the reason Google became a domain registrar a few years ago was to peer behind the domain name privacy veil and weed out sites like this.)

I spent a little time analyzing the “blog” text (it’s actually pretty funny – I encourage you to read it).  It looks like the “blog posts” are fragments from places like Wikipedia run through some obfuscator (perhaps by machine translating from English to another language and back?).  The site was impressively assembled from various sources. For example, the “comments” to the “blog entries” were extracted from Yahoo Answers:

Here is the source of this text on Yahoo Answers:

The key is to have enough dishwaster-related text to look like it’s a blog about dishwashers, while also having enough text diversity to avoid being detected by Google as duplicative or automatically generated content.

So who created this fake blog?  It could have been Consumersearch, or a “black hat” SEO consultant, or someone in an affiliate program that Consumersearch doesn’t even know. I’m not trying to imply that Consumersearch did anything wrong. The problem is systematic. When you have a multibillion dollar economy built around keywords and links, the ultimate “products” optimize for just that:  keywords and links. The incentive to create quality content diminishes.

Microsoft used to be considered the king of feature creep.  Here was Microsoft Word when it was most cluttered:

I don’t use any of Microsoft’s software anymore, but from what I hear they’ve toned down the feature creep a lot in recent versions of Windows and Word.

Google has been adding so many new features to its results page, they are starting to feel like the new Microsoft.  Here’s an approximation of what Google used to look like (I couldn’t find an image of actual Google 1998 SRPs — anyone have one?)

And here is Google today:

Options on the left, ads on top and on the right, news results up top, images, and buttons to vote results up/down and annotate them.  But worst of all are the new scrolling “real time” results.  The static image I’ve embedded doesn’t do justice to how annoying this is. Random, out-of-context, and mostly asinine fragments of conversations scrolling by.  I think it might be Google’s Clippy.

Google has created a multibillion-dollar economy based on keywords.  We use keywords to find things and advertisers use keywords to find customers.  As Michael Arrington points out, this is leading to increasing amounts of low quality, keyword-stuffed content. The end result is a very spammy internet. (It was depressing to see Tim Armstrong cite Demand Media, a giant domain-name owner and robotic content factory, as a model for the new AOL.)

Some people hope the social web — link sharing via Twitter, Facebook etc — will save us.  Fred Wilson argues that “social beats search” because it’s harder to game people’s social graph.  Cody Brown tweeted:

On Twitter you have to ‘game’ people, not algorithms. Look how many followers @demandmedia has. A lot less then you guys: @arrington @jason

These are both sound points. Lost amid this discussion, however, is that the links people tend to share on social networks – news, blog posts, videos – are in categories Google barely makes money on. (The same point also seems lost on Rupert Murdoch and news organizations who accuse Google of profiting off their misery).

Searches related to news, blog posts, funny videos, etc. are mostly a loss leaders for Google. Google’s real business is selling ads for plane tickets, dvd players, and malpractice lawyers. (I realize this might be depressing to some internet idealists, but it’s a reality). Online advertising revenue is directly correlated with finding users who have purchasing intent. Google’s true primary competitive threats are product-related sites, especially Amazon. As it gets harder to find a washing machine on Google, people will skip search and go directly to Amazon and other product-related sites.

This is not to say that the links shared on social networks can’t be extremely valuable.  But most likely they will be valuable as critical inputs to better search-ranking algorithms. Cody’s point that it’s harder to game humans than machines is very true, but remember that Google’s algorithm was always meant to be based on human-created links. As the spammers have become more sophisticated, the good guys have come to need new mechanisms to determine which links are from trustworthy humans. Social networks might be those new mechanisms, but that doesn’t mean they’ll displace search as the primary method for navigating the web.

Founder Collective has already made a number of investments. Some are listed on the Founder Collective companies page and some aren’t yet. I thought it might be interesting to explain the rationale behind our investments from time to time.

One recent investment we made is in a website called 20×200 (“20 by 200″). I first became a fan of the site when I read about an artist who created a New Yorker magazine cover with the iPhone app Brushes. I thought it was so cool that I bought one of the artist’s prints on 20×200. Only later on did I meet the founder – Jen Bekman – and learn that there might be an investment opportunity.

Apple I (from 20x200)

As with all early-stage investments, the main reason we invested is that we really love the founding team.  Most of Founder Collective’s investments are seed investments so the founding team is pretty much all we have on which to base our decision.  20×200 was unusual insofar as they already had a successful, sustainable business and just needed capital to accelerate their growth.

True Ventures (the lead investor in 20×200) eloquently characterized the company’s vision as the “the democratization of art.”  Here’s what that means to me.  Today, the art market is highly polarized. At one end, there are Manhattan socialites going to fancy openings and multimillionaires bidding at exclusive auctions. At the other end, there are generic landscapes, portraits, dogs playing poker, etc. purchased at, say, Walmart or Art.com mostly just to fill up wall space.  20×200 envisions creating a vast middle market, where anyone with an interest and a reasonable budget can become an art collector.  Since 20×200 splits revenues 50-50 with the artist, it also strives to create a new way for artists to get funded that doesn’t involve groveling to Upper East Side socialites.

Anyways, if you are interested, 20×200 prints make great gifts. Here are some of my favorite prints, and here’s a Hunch topic “20×200 art” to help you choose one.

Skype and Joost are interesting companies to compare – they are about as close as you can get to one of those sociological studies that track identical twins who are raised separately.  Skype was a spectacular success.   Joost never got traction and was shut down.  Both were started by Nicklas Zennstrom and Janus Friis, two of the great technology visionaries of our time.  Both were big ideas, trying to disrupt giant, slow-moving incumbents.

There are likely multiple reasons for their different outcomes.  Joost had day-to-day management that didn’t have much startup experience.  The P2P technology that required a download made sense for chat but not for video.  The companies were started at different times:  Skype when there was far less investment in – and therefore competition among – consumer internet products.

But the really important difference was that Joost’s product had a critical input that depended on a stubborn, backward-thinking industry – video content owners.  Whereas Skype could brazenly threaten the industry it sought to disrupt, Joost had to get their blessing.  Eventually the content companies licensed some content to Joost, but not nearly enough to make it competitive with cable TV or other new platforms like Hulu and iTunes.

Real life, non-techie users care almost exclusively about “content.”  They want to watch American Idol and listen to Jay-Z. They don’t really care how that content is delivered or what platform it’s on. Which is why Joost failed, and why so many video and music-related startups have struggled. Skype, on the other hand, didn’t have significant dependencies on other companies – its content, like its technology, was truly peer to peer.