Chris Dixon

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The TV show The Wire is an incredibly instructive lesson on how the modern world works (besides being a great work of art). The recurring theme is how individuals with good intentions are stymied by large institutions. As the show’s creator says:

The Wire is a Greek tragedy in which the postmodern institutions are the Olympian forces. It’s the police department, or the drug economy, or the political structures, or the school administration, or the macroeconomics forces that are throwing the lightning bolts and hitting people in the ass for no reason. In much of television, and in a good deal of our stage drama, individuals are often portrayed as rising above institutions to achieve catharsis. In this drama, the institutions always prove larger, and those characters with hubris enough to challenge the postmodern construct of American empire are invariably mocked, marginalized, or crushed. Greek tragedy for the new millennium, so to speak.

What’s amazing about the show is you see in a very realistic and compelling way how, say, 1) the well intentioned mayor needs to get the crime numbers down to get his school reform passed so 2) he pressures the (well-intentioned) police chief to do so, 3) who in turn cuts off a (well-intentioned) investigation that wasn’t going to yield short term metrics, 4) which emboldens the gang leader being investigated, 5) who recruits a sympathetic high school student into a life of crime. And so on.

This blog is mostly about startups so let me tell a true Wire-like startup story. There is a large, publicly-traded company we’ll call BigCo. BigCo has a new CEO who is under heavy scrutiny and expected to get the stock price up over the next few fiscal quarters. Wall Street analysts who follow BigCo value the stock at a multiple of earnings, which are driven by Operating Expenses (“OpEx”), which are ongoing expenses versus “one time” expenses like acquisitions (called “CapEx”). (If you read analyst reports, you’ll see that stocks are generally considered, correctly or not, to have key financial drivers. The stock price is often those drivers times a “multiple” which in turn is often determined by the company’s expected growth rate). The “smart money” like hedge funds may or may not believe these analysts’ models, but they know other people believe them so place their bets according to how they think these numbers will move (see Keynes on the stock market as a “beauty contest”). (Financial academics who believe in “efficient markets” would say none of this is possible but anyone who’s actually participated in these markets knows the academics are living in fantasy land.)

All this means the CEO is fixated on growing BigCo’s revenues while keeping operating expenses down. A great way to do this is through acquisitons, which analysts consider one-time expenses (CapEx). Let’s say BigCo is currently growing at 20%, but their multiple suggests they need to grow at 30%. So the M&A team goes out and looks for companies they can acquire growing at, say, 50%, to get the average up. BigCo spends lavishly to buy these companies since the costs can be considered CapEx. They even have elaborate dinners and incur other large expenses that can be counted as part of the acquisition. Once the deal is closed they immediately start planning how to cut operating expenses from the newly acquired company. They decide the best way is to move the engineering offshore. This rips the heart out of the engineering-driven culture and as a result morale drops, product quality falls, and key people quit. But the short term revenues are up and operating expenses down, so BigCo’s CEO keeps her job and makes a lot of money off her stock options.

The winners here are the people who understand the system and play it cynically (hedge funds, BigCo’s CEO & board, perhaps the acquired company’s founders & investors). The losers are everyone else – the company’s customers, the employees who lose their jobs, and the stock market investors who don’t understand the game is rigged.

Over the last decade or two, the supply of venture capital dollars has increased dramatically at the same time as the cost of building tech startups has sharply decreased.  As a result, the balance of power between capital and startups has shifted dramatically.

Some VCs understand this. The ones that do try to stand out by, among other things, 1) going out and finding companies instead of expecting them to come to them, 2) working hard on behalf of existing investments to establish a good reputation, and 3) just being friendly, decent people.  Believe it or not, until recently, #3 was pretty rare.

As a seed investor in about 30 companies, I’ve been part of many discussions with entrepreneurs about which VC’s they want to pitch for their next financing round.  More and more, I’ve heard entrepreneurs say something like “I don’t want to talk to that firm because they are such jerks.” In almost all cases these are well-known, older firms who come from the era when capital was scarce.

Every experienced entrepreneur I know has a list of “toxic” VCs they won’t deal with. (Often because of horror stories like the “partner ambush“). There are so many VCs out there that you can do this and still have plenty of VCs to pitch to get a fair price for your company and only deal with decent, helpful investors. It sounds kind of crazy, but being a reasonably nice person has become a competitive advantage in venture capital.

It is almost religious orthodoxy in the tech community that “open” is better than “closed.” For example, there have widespread complaints about Apple’s “closed” iPhone app approval process. People also argue Apple is making the same strategic mistake all over again versus Android that it made versus Windows*. The belief is that Android will eventually beat the iPhone OS with an “open” strategy (hardware-agnostic, no app approval process) just as Windows beat Apple’s OS in the 90′s.

With respect to requiring apps to be approved, consider the current state of the iPhone platform. There are over 100,000 apps and thus far not a single virus, worm, spyware app etc. (I don’t count utterly farfetched theoretical scenarios). As a would-be iPhone developer, I can report firsthand that the Apple approval process is a nightmare and should be overhauled. But what’s the alternative? Before the iPhone, getting your app on a phone meant doing complicated and expensive business development deals with wireless carriers. At the other end of the spectrum: If the iPhone OS were completely open, would we really have better apps?  What apps are we missing today besides viruses?

With respect to the strategic issue of tightly integrating the iPhone/iPad software and hardware, a strong case can be made that Apple’s “closed” strategy is smart. Clay Christensen has given us the only serious theory I know of to predict when it’s optimal for a company to adopt an open versus closed strategy for (among other things) operating systems. The basic idea is that every new tech product starts out undershooting customer needs and then – because technology gets better faster than customers needs go up - eventually “overshoots” them. (PC’s have overshot today – most people don’t care if the processors get faster or Windows adds new features). Once a product overshoots, the basis of competition shifts from things like features and performance to things like price.

The key difference today between desktop computers and mobile devices is that mobile devices still have a long way to go before customers don’t want more speed, more features, better battery life, smaller size, etc. Just look at all the complaints yesterday about the iPad - that it lacks multitasking, a camera, is too heavy, has poor battery life, etc. This despite the fact that Apple is now even building their own semiconductors (!) to squeeze every last bit of performance out of the iPad. Until mobile devices compete mainly on price (probably a decade from now), tight vertical integration will produce the best device and is likely the best strategy.

*It’s worth noting that Steve Jobs wasn’t the one who screwed up Apple. Jobs co-founded Apple in 1976. He was pushed out in in May 1985 when the company was valued at about $2.2B. He returned in 1996 when Apple was worth $3B. Today it is worth $187B.

Almost every startup has big companies (“incumbents”) that are at some point potential acquirers or competitors.  For internet startups that primarily means Google and Microsoft, and to a far lesser extent Yahoo and AOL.  (And likely more and more Apple, Facebook and even Twitter?).

The first thing to try to figure out is whether what you are building will eventually be on the incumbent’s product roadmap. The best way to do predict this is to figure out whether what you are doing is strategic for the company. (I try to outline what I think is strategic for Google here). Note that asking people who work at the incumbents isn’t very useful – even they don’t know what will be important to them in, say, two years.

If what you are doing is strategic for the incumbents, be prepared for them to enter the market at some point. This could be good for you if you build a great product, recruit a great team, and are happy with a “product sale” or “trade sale” – usually sub $50M. If you are going for this size outcome, you should plan your financing strategy appropriately. Trade sales are generally great for bootstrapped or seed-funded companies but bad if you have raised lots of VC money.

If your product is strategic for the incumbent and you’re shooting for a bigger outcome, you probably need to either 1) be far enough ahead of the curve that by the time the big guys get there you’re already entrenched, or 2) be doing something the big guys aren’t good at. Google has been good at a surprising number of things. One important area they haven’t been good at (yet) is software with a social component (Google Video vs YouTube, Orkut vs Facebook, Knol vs Wikipedia, etc).

The final question to ask is whether your product is disruptive or sustaining (in the Christensen sense).  If it’s disruptive, you most likely will go unnoticed by the incumbents for a long time (because it will look like a toy to them). If the your technology is sustaining and you get noticed early you probably want to try to sell (and if you can’t, pivot). My last company, SiteAdvisor, was very much a sustaining technology, and the big guys literally told us if we didn’t sell they’d build it. In that case, the gig is up and you gotta sell.

Sarah Lacy has a very interesting post on TechCrunch where she conjectures that the internet is finally starting to disrupt Wall Street. I’d love nothing more than to see Wall Street get nailed by the internet the way, say, publishing and advertising have.

While I agree on the big picture, I disagree with some of her specifics. She cites Mint and Square as examples of startups that potentially disrupt Wall Street. As I see it, these companies have merely built nice UI’s to Wall Street: Mint connects to your banks and Square to Visa and Mastercard and the bank that issued the credit card. If people at farmers’ markets use credit cards instead of cash, that means more money for Wall Street, not less.

I would argue the best way to try to disrupt Wall Street is to look at how it currently makes money and attack it there. Here are some of the big sources of revenue.

1) Retail banks. Retail banks make money on fees and by paying low interest rates on deposits and then doing stuff with those deposits (buying stocks, mortgages, issuing credit cards, etc) that gets them a much higher return. To disrupt them you need to get people to stop depositing money in them. Zopa and Prosper are trying to do that. Unfortunately the regulatory system seems to strongly favor the incumbents.

2) Credit cards. Charging 20% interest rates (banks) and skimming pennies off every transaction (Visa and Mastercard) is a very profitable business. Starting a new payment company that doesn’t depend on the existing banks and credit card companies could be disruptive. Paypal seems to have come the closest to doing this.

3) Proprietary trading. A big trend over the last decade is for more of big banks’ profits to come from “proprietary trading” – which basically means operating big hedge funds inside banks (this trend is one of the main causes of the financial crisis and why the new “Volcker rule” is potentially a very good thing). For example, most of Goldman Sachs’ recent massive profits came from proprietary trading. Basically what they do is hire lots of programmers and scientists to make money on fancy trading algorithms.  (Regrettably, I spent the first four years of my career writing software to help people like Goldman do this).  Given that the stock market was flat over the last decade and hedge funds made boatloads of money, the loser in this game are mostly unsophisticated investors (e.g. my parents in Ohio). Any website that encourages unsophisticated investors to buy specific stocks is helping Wall Street. Regular people should buy some treasury bonds or maybe an S&P 500 ETF and be done with it. That would be a huge blow to Wall Street.

4) Trading. The more you trade stocks, the more Wall Street makes money. The obvious beneficiaries are the exchanges – NYSE, NASDAQ etc. There were attempts to build new exchanges in the 90′s like Island ECN. The next obvious beneficiaries are brokers like Fidelity or E-Trade. But the real beneficiaries aren’t the people who charge you explicit fees; it’s the people who make money on your trading in other ways.  For example, the hot thing on Wall Street is right now is high frequency “micro structure” trading strategies, which is basically a way to skim money off the “bid-ask spread” from trades made by less sophisticated investors.

5) Investment banking. Banks make lots of money on “services” like IPOs and big mergers. A small way to attack this would be to convince tech companies (Facebook?) to IPO without going via Wall Street (this is what Wit Capital tried to do). Regarding mergers, there have been endless studies showing that big mergers only enrich CEOs and bankers, yet they continue unabated. This is part of the massive agency problem on Wall Street and can probably only change with a complete regulatory overhaul.

6) Research. Historically, financial research was a loss leader used to sell investment banking services. After all the scandals of the 90′s, new regulations put in stronger walls between the research and banking. As a result, banks cut way back on research. In its place expert networks like Gerson Lehrman Group rose up. LinkedIn and Stocktwits are possible future disrupters here.

7) Mutual fund management. Endless studies have shown that paying fees to mutual funds is a waste of money. Maybe websites that let your peers help you invest will disrupt these guys. I think a much better way to disrupt them is to either not invest in the stock market or just buy an ETF that gives you a low-fee way to buy the S&P 500 index.

This is by no means an exhaustive list and I have no idea how to solve most of these problems. But I’d love to see the financial industry be one of the next targets of internet innovation.

There are techies (if you are reading this blog you are almost certainly one of them) and there are mainstream users – some people call them “normals” (@caterina suggested “muggles”). A lot of people call techies “early adopters” but I think this is a mistake: techies are only occasionally good predictors of which tech products normals will like.

Techies are enthusiastic evangelists and can therefore give you lots of free marketing. Normals, on the other hand, are what you need to create a large company. There are three main ways that techies and normals can combine to embrace (or ignore) a startup.

1. If you are loved first by techies and then by normals you get free marketing and also scale.  Google, Skype and YouTube all followed this chronology.  It is startup nirvana.

2. The next best scenario is to be loved by normals but not by the techies. The vast majority of successful consumer businesses fall into this category. Usually the first time they get a lot of attention from the tech community is when they announce revenues or close a big financing. Some recent companies that fall in this category are Groupon, Zynga, and Gilt Group. Since these companies don’t start out with lots of free techie evangelizing they often acquire customers through paid marketing.

(My last company – SiteAdvisor – was a product tech bloggers mostly dismissed even as normals embraced it.  When I left the company we had over 150 million downloads, yet the first time the word “SiteAdvisor” appeared on TechCrunch was a year after we were acquired when they referred to another product as “SiteAdvisor 2.0″.)

3. There are lots of products that are loved just by techies but not by normals. When something is getting hyped by techies, one of the hardest things to figure out is whether it will cross over to normals. The normals I know don’t want to vote on news, tag bookmarks, or annotate web pages.  I have no idea whether they want to “check in” to locations.  A year ago, I would have said they didn’t want to Twitter but obviously I was wrong. Knowing when something is techie-only versus techie-plus-normals is one of the hardest things to predict.

In Clay Shirky’s brilliant essay “Newspapers and thinking the unthinkable” one line stood out to me as odd:

“The Wall Street Journal has a paywall, so we can too!” (Financial information is one of the few kinds of information whose recipients don’t want to share.)

It is true that The Wall Street Journal is one of two newspapers (along with the Financial Times) that seems to have been pretty successful getting people to pay. It’s not clear why Shirky thinks people don’t want to share financial information. Hopefully he doesn’t think business people want to keep the Journal to themselves to keep some competitive advantage. Pretty much everyone in finance and business that I know reads the Journal every day – no one would seriously consider anything in there a competitive advantage. People send Journal links to each other all the time. It is background knowledge that everyone is expected to know.

The reason people are willing to pay for the Journal has nothing to do with their unwillingness to share or pirate financial information. It’s quite simply the fact that the Journal is a valuable business input that can’t be found anywhere else. Most people, when presented with something of value that is scarce and reasonably priced, don’t pirate (especially when they can charge it to their business). The revenue-maximizing price of any good – including digital goods – is determined by value and scarcity, not what it costs to produce it.

The fact that the cost of distributing newspapers is dropping to near zero only affects the price of newspapers if the content is commoditized. The problem the New York Times has isn’t that people are willing to share or pirate their content.  It’s that with the advent of the internet, competition for general news went from one or two per market to thousands per market. (The other big blow was classifieds getting decoupled from newspapers).

Most business people I know consider the Times an essential daily read, not just for its business and finance news, but also its section A news and op-eds. If you are a running an operating company or investment firm you want to know not just narrow business news but the broader context of what’s happening in the world.

Most smaller newspapers will go out of business over the next few years, vastly increasing the scarcity of news. If the Times creates content that is scare and valuable – and remains an essential “business input” – it can have the same success online as the Journal.

I think you could make a strong argument that the most important technologies developed over the last decade are a set of systems that are sometimes called “collective knowledge systems”.

The most successful collective knowledge system is the combination of Google plus the web. Of course Google was originally intended to be just a search engine, and the web just a collection of interlinked documents. But together they provide a very efficient system for surfacing the smartest thoughts on almost any topic from almost any person.

The second most successful collective knowledge system is Wikipedia. Back in 2001, most people thought Wikipedia was a wacky project that would at best end up being a quirky “toy” encyclopedia. Instead it has become a remarkably comprehensive and accurate resource that most internet users access every day.

Other well-known and mostly successful collective knowledge systems include “answer” sites like Yahoo Answers, review sites like Yelp, and link sharing sites like Delicious.  My own company Hunch is a collective knowledge system for recommendations, building on ideas originally developed by “collaborative filtering” pioneer Firefly and the recommendation systems built into Amazon and Netflix.

Dealing with information overload

It has been widely noted that the amount of information in the world and in digital form has been growing exponentially. One way to make sense of all this information is to try to structure it after it is created. This method has proven to be, at best, partially effective (for a state-of-the-art attempt at doing simple information classification, try Google Squared).

It turns out that imposing even minimal structure on information, especially as it is being created, goes a long way. This is what successful collective knowledge systems do. Google would be vastly less effective if the web didn’t have tags and links. Wikipedia is highly structured, with an extensive organizational hierarchy and set of rules and norms. Yahoo Answers has a reputation and voting system that allows good answers to bubble up. Flickr and Delicious encourage user to explicitly tag items instead of trying to infer tags later via image recognition and text classification.

Importance of collective knowledge systems

There are very practical, pressing needs for better collective knowledge systems. For example, noted security researcher Bruce Schneier argues that the United States’ biggest anti-terrorism intelligence challenge is to build a collective knowledge system across disconnected agencies:

What we need is an intelligence community that shares ideas and hunches and facts on their versions of Facebook, Twitter and wikis. We need the bottom-up organization that has made the Internet the greatest collection of human knowledge and ideas ever assembled.

The same could be said of every organization, large and small, formal and and informal, that wants to get maximum value from the knowledge of its members.

Collective knowledge systems also have pure academic value. When Artificial Intelligence was first being seriously developed in the 1950′s, experts optimistically predicted they’d create machines that were as intelligent as humans in the near future.  In 1965, AI expert Herbert Simon predicted that “machines will be capable, within twenty years, of doing any work a man can do.”

While AI has had notable victories (e.g. chess), and produced an excellent set of tools that laid the groundwork for things like web search, it is nowhere close to achieving its goal of matching – let alone surpassing – human intelligence. If machines will ever be smart (and eventually try to destroy humanity?), collective knowledge systems are the best bet.

Design principles

Should the US government just try putting up a wiki or micro-messaging service and see what happens? How should such a system be structured? Should users be assigned reputations and tagged by expertise? What is the unit of a “contribution”? How much structure should those contributions be required to have? Should there be incentives to contribute? How can the system be structured to “learn” most efficiently? How do you balance requiring up front structure with ease of use?

These are the kind of questions you might think are being researched by academic computer scientists. Unfortunately, academic computer scientists still seem to model their field after the “hard sciences” instead of what they should modeling it after — social sciences like economics or sociology. As a result, computer scientists spend a lot of time dreaming up new programming languages, operating system architectures, and encryption schemes that, for the most part, sadly, nobody will every use.

Meanwhile the really important questions related to information and computer science are mostly being ignored (there are notable exceptions, such as MIT’s Center for Collective Intelligence). Instead most of the work is being done informally and unsystematically by startups, research groups at large companies like Google, and a small group of multi-disciplinary academics like Clay Shirky and Duncan Watts.

Someone asked me the other day whether I thought the United States was vulnerable to a large scale “cyber” attack. While I have no doubt that any particular organization can be compromised, what comforts me at the national level is the sheer diversity of our systems. We have – unintentionally – employed a very effective defensive strategy known as “security through diversity.”

Every organization’s IT system is composed of multiple layers: credential systems, firewalls, intrusion detection systems, tripwires, databases, web servers, OS builds, encryption schemes, network topologies, etc.  Due to a variety of factors — competitive markets for IT products, lack of standards, diversity of IT managers’ preferences — most institutions make independent and varied choices at each layer. This, in turn, means that each insitution requires a customized attack in order to be penetrated. It is therefore virtually impossible for a single software program (virus, worm) to infiltrate a large portion of them.

On the web, a particular form of uniformity that can be dangerous are the centralized login systems like Facebook Connect. But this is preferable to the current dominant “single sign on system”:  most regular people use the same weak password over and over for every site because it’s too hard to remember more than that (let along multiple strong passwords). This means attackers only need to penetrate one weak link (like the recent Rock You breach), and they get passwords that likely work on many other sites (including presumably banking and other “important” sites).  At least with Facebook Connect there is a well funded, technically savvy organization defending its centralized repository of passwords.

I first heard the phrase “security through diversity” from David Ackley who was working on creating operating systems that had randomly mutated instances (similar ideas have since become standard practice, e.g. stack and address space randomization). It struck me as a good idea and one that should be built into systems intentionally. But meanwhile we get many of the benefits unintentionally. The same factors that frustrate you when you try to transfer your medical records between doctors or network the devices in your house are also what help keep us safe.