Drones were first developed by the military. But as component prices drop and software becomes more sophisticated, drones are starting to be used in non-military applications.

One application is precision farming, which aims to decrease costs, increase yields, and reduce the environmental impact of farming. Farming accounts for about 70% of global water usage. Most experts think this is unsustainable. Using drones, farmers can inexpensively survey crops to better allocate water and fertilizer. Studies show this can raise food yields over 25% while decreasing water usage by 40%.

Other large markets are mapping, infrastructure inspection (e.g. pipelines and power lines), and civil applications (police, firefighters, and first responders). We expect many other uses to emerge over time. One of Airware’s early customers is a Kenyan wildlife conservancy that’s buying drones to prevent Rhino poaching.

Airware makes operating systems for low-cost, non-military drones. It’s a combination of hardware and software that’s designed to be customized by customers and third-party developers. Other companies make the actual drone body (the “airframe”), which can come in many forms such as helicopters, quadcopters, and fixed-wing airplanes.

The founder of Airware, Jonathan Downey, spent most of his life studying aviation and engineering. Like his parents and grandfather, he is a licensed, instrument-rated pilot. He studied computer science and electrical engineering at MIT, where he represented the university in drone-building competitions. He then built drones at Boeing, but left when he realized he could make low-cost drones on his own.

As investors, we try to back brilliant founders pursuing audacious ideas. Robotics has long been a field that overpromised and underdelivered. We think drones are the most likely way to rectify that, and Jonathan is the person to make it happen.

Hardware does well on crowdfunding sites. The spread of tablets makes it possible to build new things controlled by and even incorporating them. Electric motors have improved. Wireless connectivity of various types can now be taken for granted. It’s getting more straightforward to get things manufactured. Arduinos, 3D printing, laser cutters, and more accessible CNC milling are making hardware easier to prototype. Retailers are less of a bottleneck as customers increasingly buy online.

Another important factor is what Chris Anderson calls “the peace dividend of the smartphone war”:

All the components in a smartphone — the sensors, the GPS, the camera, the ARM core processors, the wireless, the memory, the battery — all that stuff, which is being driven by the incredible economies of scale and innovation machines at Apple, Google, and others, is available for a few dollars. They were essentially “unobtainium” 10 years ago. This is stuff that used to be military industrial technology; you can buy it at RadioShack now.

It also doesn’t hurt that the most valuable company in the world (Apple) and some of the most exciting startups (e.g., Nest, Jawbone, Leap Motion) make hardware.

If you are thinking of doing a hardware startup, here are a few things to keep in mind:

- Manufacturing. Many hardware startups stumble when they try to go from prototype to large-scale manufacturing. There is no AWS-equivalent for hardware. To get manufacturing right, entrepreneurs often end up living in China for months and even years. The difficulty of manufacturing is one reason that hardware entrepreneurs tend to have more work experience than software entrepreneurs.

- Defensibility. Hardware companies generally have economies of scale but hardware products generally don’t have network effects. This means that as soon as you prove the market, you’ll face competition from lower cost manufacturers. The best startups complement hardware with software and services that have network or platform effects. Think of hardware as bringing the revenue and software/services as bringing the margin.

- Planning. The build-test-iterate model that is popular in software startups doesn’t translate well to hardware startups. Proper planning is essential because mistakes can be unrecoverable. For example, you might create a design that fails environmental tests but only discover this years later when you are about to go to market. (See all those symbols on the back of your phone? Those are regulatory certifications).

- B2C vs B2B. Consumer hardware tends to get more attention, but B2B hardware has a number of advantages. You’ll have fewer startup competitors, because entrepreneurs who have both hardware and business domain expertise are rare. You’ll also have fewer incumbent competitors, because B2B hardware usually requires local sales and service teams, making it harder for foreign competitors to copy you. Finally, manufacturing can be done locally because higher price points mean you can be less sensitive to labor costs.

Creative activities that involve physical things have mostly resisted this trend. Let’s say you are an entrepreneur who has designed a new line of jewelry. You need to find a factory, commit to a large batch size, and make a significant upfront investment. It is a risky and expensive endeavor.

Shapeways is a startup headquartered in NYC that eliminates the fixed costs of manufacturing. Making use of breakthrough advances in 3D printing, Shapeways manufactures objects in a variety of materials – including metals, ceramics, and plastics – with no upfront costs or minimum batch size. The results are indistinguishable from – and sometimes superior to – objects manufactured using traditional techniques.

Here’s a short video that shows the revolutionary potential of 3D printing:

Today, I’m excited to announce that Andreessen Horowitz is leading a $30M investment in Shapeways along with our friends at Union Square Ventures, Index Ventures, and Lux Capital. We believe that technology is at its best when it enables human creativity. The Internet unlocked the world of bits. 3D printing is unlocking the world of atoms.

Back in the early 90s, a lot of people thought the Internet was overhyped. Here’s one example from Newsweek:

Do our computer pundits lack all common sense? The truth in no online database will replace your daily newspaper, no CD-ROM can take the place of a competent teacher and no computer network will change the way government works…. What the Internet hucksters won’t tell you is tht the Internet is one big ocean of unedited data, without any pretense of completeness. Lacking editors, reviewers or critics, the Internet has become a wasteland of unfiltered data.

Today, it’s easy to find people expressing similar skepticism about emerging technologies like the Internet of things, robotics, 3D printing, Bitcoin, etc.

What the skeptics overlook is that platforms that are open to third-party developers have the following characteristic: it’s hard to think of important use cases before they are built, and hard to find examples where important use cases weren’t developed after they were built.

Just look at the founding years of top websites. Google: 1998. Wikipedia: 2001. YouTube: 2005. Twitter: 2006. No wonder it was so hard to imagine these services early on. It took years to imagine them even after the Internet had gone mainstream.

The fact that flip-flop wearing hobbyists spawn large industries is commonly viewed as an amusing eccentricity of the technology industry. But there is a reason why hobbies are so important.

Business people vote with their dollars, and are mostly trying to create near-term financial returns. Engineers vote with their time, and are mostly trying to invent interesting new things. Hobbies are what the smartest people spend their time on when they aren’t constrained by near-term financial goals.

Today, the tech hobbies with momentum include: math-based currencies like Bitcoin, new software development tools like NoSQL databases, the internet of things, 3D printing, touch-free human/computer interfaces, and “artisanal” hardware like the kind you find on Kickstarter.

It’s a good bet these present-day hobbies will seed future industries. What the smartest people do on the weekends is what everyone else will do during the week in ten years.

When we were an agrarian nation, all cars were trucks because that’s what you needed on the farms. Cars became more popular as cities rose, and things like power steering and automatic transmission became popular.

PCs are going to be like trucks. They are still going to be around…they are going to be one out of x people.

This transformation is going to make some people uneasy…because the PC has taken us a long ways. It’s brilliant. We like to talk about the post-PC era, but when it really starts to happen, it’s uncomfortable.

We are just scratching the surface on the kinds of apps for the iPad…I think there are lots of kinds of content that can be created on the iPad.

When I am going to write that 35-page analyst report, I am going to want my Bluetooth keyboard. That’s 1 percent of the time. The software will get more powerful. I think your vision would have to be pretty short to think these can’t grow into machines that can do more things, like editing video, graphic arts, productivity. You can imagine all of these content creation possibilities on these kind of things. Time takes care of lots of these things.

This year, about five times as many smartphones will be shipped versus PCs, and tablets will surpass PCs for the first time. According to Jobs, the right way to look at this isn’t that mobile devices are creating a new market. It’s that mobile devices are relegating PCs to special-purpose, mostly industrial devices.

Everyone you encounter will have doubts about what you’re doing—investors, potential employees, reporters, your family and friends. What you don’t realize until you start a startup is how much external validation you’ve gotten for the conservative choices you’ve made in the past. You go to college and everyone says, “Great!” Then you graduate get a job at Google and everyone says, “Great!”

But optimizing for external validation is a dangerous trap. You’re fighting over a fixed pie against well-credentialed peers. The most likely outcome is a middle management job where you’ll have little impact and never seriously attempt to realize your ambitions. Peter Thiel’s personal experience illustrates this well:

By graduation, students at Stanford Law and other elite law schools have been racking up credentials and awards for well over a dozen years. The pinnacle of post law school credentialism is landing a Supreme Court clerkship. After graduating from SLS in ’92 and clerking for a year on the 11th Circuit, Peter Thiel was one of the small handful of clerks who made it to the interview stage with two of the Justices. That capstone credential was within reach. Peter was so close to winning that last competition. There was a sense that, if only he’d get the nod, he’d be set for life. But he didn’t.

Years later, after Peter built and sold PayPal, he reconnected with an old friend from SLS. The first thing the friend said was, “So, aren’t you glad you didn’t get that Supreme Court clerkship?” It was a funny question. At the time, it seemed much better to be chosen than not chosen. But there are many reasons to doubt whether winning that last competition would have been so good after all. Probably it would have meant a future of more insane competition. And no PayPal. The pithy, wry version of this is the line about Rhodes Scholars: they all had a great future in their past.

Great institutions can prepare you for great things. Credentials can open doors. But don’t let them become an end in themselves.

Each revolution begins with a financial bubble that propels the (irrationally) rapid “installation” of the new technology.  Then there’s a crash, followed by a recovery and then a long period of productive growth as the new technology is “deployed” throughout other industries as well as society more broadly. Eventually the revolution runs its course and a new technological revolution begins.

In the transition from installation to deployment, the bulk of the entrepreneurial activity moves “up the stack”. For example, in the installation phase of the automobile revolution, the action was in building cars. In the deployment phase, the action shifted to the app layer: the highway system, shipping, suburbanization, big box retail, etc.

This pattern is repeating itself in the computing/internet revolution. Most of the successful startups in the 90s built core infrastructure (e.g. optical switching) whereas most of the successful startups since then built applications on top of that infrastructure (e.g. search). The next phase should see startups higher in the stack. According to historical patterns, these would be ones that require deeper cultural change or deeper integration into existing industries.

Some questions to consider:

- What industries are the best candidates for the next phase of deployment? The likely candidates are the information-intensive mega-industries that have been only superficially affected by the internet thus far: education, healthcare, and finance. Note that deployment doesn’t just mean creating, say, a healthcare or education app. It means refactoring an industry into its “optimal structure” – what the industry would look like if rebuilt from scratch using the new technology.

- How long will this deployment period last? Most people – at least in the tech industry – think it’s just getting started. From the inside, it looks like one big revolution with lots of smaller, internal revolutions (PC, internet, mobile, etc). Each smaller revolution extends the duration and impact of the core revolution.

- Where will this innovation take place? The historical pattern suggests it will become more geographically diffuse over time. Detroit was the main beneficiary of the first part of the automobile revolution. Lots of other places benefited from the second part. This is the main reason to be bullish on ”application layer” cities like New York and LA. It is also suggests that entrepreneurs will increasingly have multi-disciplinary expertise.

The mobile device industry is still in its infancy. Samsung’s fate depends largely on how the industry evolves. If the computer-in-your-pocket (smartphone/tablet) business ends up being like the computer-on-your-desk (personal computer) business, Samsung is on track to be the modern Dell. Dell had a good run as the low-cost provider in a highly commoditized business, but the vast majority of the industry profits went to Microsoft.

So the big questions for Samsung are:

1. Will the smartphone/tablet industry stratify the way the PC business did? 

The dominant view is that technology markets inevitably stratify. Clay Christensen is the most sophisticated proponent of this view. In his theory (more here and here), every tech market eventually “overshoots” the needs of its customers, at which point the benefits of horizontal specialization outweigh the benefits of vertical integration.

A minority view, held mostly by Apple faithful, is that Christensen et al are guilty of over-theorizing. Apple lost the PC business simply because, when Steve Jobs was fired, they stopped innovating. When Jobs returned, Apple started gaining PC market share again. In this view, the future mobile industry structure mostly depends on whether Apple management is innovative enough to keep making superior vertically-integrated products.

2. If the industry stratifies, will the lion’s share of the profits go to the OS and application layers as it did for PCs?

Generally, technology businesses that are defensible have network effects, and network effects usually arise from products with significant software components. Samsung’s competitors like HTC are just one hit product line away from stealing Samsung’s position. Eventually, handset designs will converge and, as happened in the PC market, consumers will stop paying premiums for performance improvements (arguably, this has already started happening). The OS and apps layer, on the other hand, are very hard to replicate. If you invest enough money you can usually build or acquire decent software, but it takes more than just capital to build a vibrant developer ecosystem (just look at Microsoft).

Samsung’s predicament is: their current strategy succeeds only in the scenario where both (a) the industry stratifies, and (b) significant profits flow to hardware. Samsung seems to understand the improbability of (b), which is why they’ve been hinting at throwing serious support behind a new OS. Getting traction with a new OS will be difficult, to put it mildly. Google and Apple have vastly more experience making software and a huge head start with developers. Moreover, Google’s strategic position is even stronger today than Microsoft’s was in their heyday. Google makes so much money from web services (mostly search, for now) that they can afford to lose money on handsets and OSs indefinitely – a very scary fact for Samsung and everyone else in the mobile hardware business.

However, before you commit yourself to working on a project for 5+ years, it’s prudent to think hard about what you are trying to build and some of the things that might go wrong. For many people, writing out a detailed business plan is the best way to enforce intellectual rigor.

My cofounders and I wrote a fairly long business plan for our first company, SiteAdvisor. We wrote it iteratively while getting lots of candid feedback from entrepreneurs, VCs, and industry executives (one of many reason you shouldn’t keep your idea secret).

I thought it might be useful to share our plan so I’ve embedded it below (at the time, we were temporarily calling the company InfiniTrust).

In retrospect, some things in the plan look prescient, some look naive, and some look downright goofy. But writing it was an extremely useful exercise. It made us think through issues we would have otherwise glossed over, and helped us stay focused when shiny new things could have led us astray.

As Eisenhower famously said: “plans are nothing, but planning is indispensable.”

***

InfiniTrust

January, 2005 

InfiniTrust intends to create a new type of desktop security product that we call a “web reputation service.”  The product will benefit users who value both unrestricted web access and security — primarily consumers and small and medium businesses.  At the core of the product will be a database that classifies URLs, IP addresses, program downloads, ActiveX objects, and other “web entities” according to their degree of trustworthiness.  There will also be a downloadable application that protects the desktop according to the security classifications in the core database.  In addition, the company will provide plug-ins to firewalls, routers and web proxies (allowing for, among other things, the possibility of a fully managed outsourced web filtering service).

We see InfiniTrust as having a large addressable market.  We believe the product will offer significant value to a large portion of the approximately 600M PCs in use today.  Pricing for comparable products ranges from $2-$20 per PC per year depending on the product and channel.  Since the marginal cost per customer will be extremely low (the main expense will be maintaining the database), we see the business as potentially having high gross margins.

Desktop security has become one of the top issues for individuals and organizations in the last few years and the problem has been only getting worse.  We believe InfiniTrust represents a fundamentally new and important category of desktop security software, and if executed properly could become a leader in this emerging category much the same way Symantec and McAfee did in anti-virus or Brightmail and Postini did in anti-spam.

Problem

The data security industry has consistently ignored a large class of desktop security threats that they have considered to be “social engineering” or “user education issues” and therefore not addressable through their usual defense methods.  Some examples are:

A user is confronted with an ActiveX prompt that asks him whether he trusts a company he has never heard of called Claria.  The user knows that last time he saw a similar prompt on the ofoto.com website he said “No” the website failed to work properly, so this time he says “Yes,” enabling Claria’s Gator spyware software to take full control of his PC.

Typical industry response:  The user should educate himself as to when to answer “Yes” or “No” to such prompts or should disable ActiveX altogether thereby rendering many popular websites dysfunctional.

A user receives a phishing email purporting to be from Citibank that is actually from a criminal in Uzbekistan trying to steal his credit card information.  Citibank detects that the phishing attack has occurred but has no effective way to propagate defensive information to customers.

Typical industry response:  The user should learn never to click on URLs in emails.

A user spends time browsing a music sharing website that exploits an unpatched hole in Internet Explorer to insert spyware on the user’s machine.

Typical industry response:  The user should learn not to browse untrusted websites without modifying his browser security settings to restrict functionality like Javascript and ActiveX that enable most browser exploits.

A user downloads Grokster, a popular P2P file-sharing application.  The user clicks “Agree” to Grokster’s 32-page End User License Agreement (EULA) without reading it carefully and therefore doesn’t realize that along with Grokster he is also downloading over a dozen different bundled spyware applications that will render his computer virtually unusable.

Typical industry response:  The user should read all EULA’s before downloading software.

The data security industry has gotten very good at dealing with traditional security threats such as worms and viruses. These threats are characterized as 1) being unambiguously malicious and 2) having attack vectors that are primarily technical in nature.   With more and more non-technical users having direct access to remote counterparties via email and the web, a new class of threats has emerged that are characterized as 1) having attack vectors that are primarily “social” in nature,  and 2) not being clearly good or bad but instead involving tradeoffs on the part of the user.

Related to this trend toward “social” and “grey-area” threats has been the rise of economically motivated hacking.  For example, spyware and phishing have quickly become big businesses.  Claria (maker of Gator) generated about $90M in ‘03, primarily due to their distribution relationship with Kazaa.  WhenU generated about $45M in revenue in ‘04, and there are literally dozens of other companies (e.g. 180Solutions, Direct Revenue) that are generating double digit millions in revenues.   Estimates of losses due to phishing vary, but the numbers seem to be conservatively in the hundred of millions.  In summary, there are literally billions of dollars generated every year by companies and criminals whose main “marketing” technique is exploiting the credulity and confusion of users.

Background on Spyware and Phishing

Spyware is an increasingly serious threat to desktop computer users.  According to a recent study by Dell, 90% of computers are afflicted with spyware.  Spyware help calls are the #1 issue handled by Dell customer support, accounting for 20% of all calls.  Only 24% of computer users said they were knowledgeable about how to handle spyware.

Somewhat more conservatively, IDC estimates that 67% of computers have some form of spyware and that the market for anti-spyware software will grow from $47M in 2004 to $305M in 2008 (we think these estimates are very low—we know of specific anti-spyware companies that combined generated far more than $47M in revenues in 2004).

Phishing came almost out of nowhere in 2004 to become a major security threat.  According to Gartner Group, 57M Americans have or think they have received phishing emails.   Of those, 11% clicked on phishing links and 3% actually gave away sensitive information to attackers.  The growth rates of phishing attacks have consistently been in the double and even triple digits month-over-month.

InfiniTrust Solution

The main features of the InfiniTrust product are as follows:

Site Protection:  Adjusts the browser functionality dynamically according to the security rating of the website currently being browsed.  For example, scripting calls to vulnerable ActiveX objects are disabled on untrusted websites but enabled on trusted sites.  The point of this is to drastically reduce browser exploits that insert spyware and viruses, as well as eliminating “annoying” scripts such as pop ups, without reducing functionality of trusted sites.

Download Protection:  Uses a whitelist approach to program downloads to warn or block the user before downloading an untrustworthy program (in an enterprise version,policy settings could be created to automatically block untrusted downloads without prompting).

Fraud Detection and Protection:  Redirects the user to a warning page if he visits a fraudulent website such as a phishing landing page.

ActiveX Protection:  Allows only whitelisted ActiveX objects to download or execute.  Non-whitelisted objects are simply blocked, eliminating the need for user prompts.

Exploit Protection:  Filters out browser scripting code associated with known exploits.

Ecommerce Protection:  Warns the user about a poor security rating of a website before he enters his credit card information.  In v2.0 will notify the user of summarized business-practice information about the site (using information from sources such as BizRate).

Privacy Protection (v2.0 only):  Warns the user about the trustworthiness of a website before he submits personal information such as an email address.  Also blocks cookies and other outbound transmissions of personal information to untrusted sites or ad networks.

In light of the recent high profile adoption of the Firefox browser (albeit mostly by the technical “elite” so far) it is interesting to note which of the Infinitrust features are “IE” specific and which provide a more general web security. Features #1, #4 and #5 are primarily for IE users.  The other four features apply to users of all platforms and browsers.

In the case where InfiniTrust is being used as software installed on the desktop (as opposed to the firewall or web proxy API), it will either take automatic action or prompt the user with an easy-to-understand prompt depending on what’s most appropriate in case at hand.  For example, when the user is browsing untrusted sites InfiniTrust will automatically restrict the browser’s functionality but when the user actively clicks on a downloadable program he will see a simple prompt explaining what, if any, malicious features the software contains.

In the case of the enterprise version the need for prompting will be obviated through policy settings created by the system administrator.  Increasingly, many organizations are blocking all downloads and ActiveX controls altogether out of fear of getting spyware on the network.  InfiniTrust will give them an alternative by providing them with 100% spyware prevention through its whitelist approach to ActiveX and downloads (in addition to browser exploit blocking).

Technology Plan

There are three main components to the InfiniTrust technology:

1) Data collection/analysis.  InfiniTrust will collect and analyze large amounts of disparate data sets to generate an “InfiniTrust Score” for every “web entity” (including downloadable programs, ActiveX objects, and website URLs/IPs).  Input data sources will include:

Static analysis of web-crawled HTML and JavaScript.

Analyzed results of automated installations of downloadable software.

Data gathered from third party deals (e.g. IP intelligence services, phishing blacklist feeds, website and program popularity data)

Active and passive user feedback from users who opt-in to InfiniTrust’s product improvement program.

Information mined from publicly available sources (e.g., whois data, public blacklists)

Web site link analysis.  As companies like Google has shown, if site X links to site Y, that is in some sense an endorsement by site X of site Y.  Google uses this insight to rank the relevancy of sites, but it can also be applied to rank the trustworthiness of sites.  If site X links to known untrusted site Y, then site X is more likely to be untrusted itself.  Another way to put this idea is that the “dark alleys” of the web tend to be highly clustered in terms of link structure.

All of this will be processed to determine the degree of trust that someone should have when going to a particular website, downloading a particular piece of software, or engaging in some sort of commercial relationship with an online entity.  Much of the true intellectual property of InfiniTrust will reside in the processes and tools for collecting and analyzing these input data sources.

2)  Data servers.  In order to balance load and decrease communication distances, the database will be replicated to a set of distributed data servers.  Desktop clients will connect to these data servers in order to query for the security ratings of particular entities, or to periodically download software updates.  The client software will include a caching mechanism to ensure that performance drag is negligible.  Data servers will also receive back-channel information from users who opt-in to the product improvement program.

3) Client agent.  The client side agent takes action on behalf of the user or provides the user with easy-to-understand, relevant information.  A client side agent consists of a core-agent that communicates with a data server, as well as an application-specific GUI agent that provides user-visible functionality.  Most of these GUI agents will be web browser extensions, but they could also be built in to web proxies, or the underlying OS to protect non-traditional applications (e.g. software update tools) that make use of HTTP.

InfiniTrust plans to publish APIs and release an open source Linux/Firefox version of the client-side agents to facilitate partnerships with other software and equipment vendors.  Access to the data feeds will be controlled with encrypted certificates.

In version 1.0, almost all of InfiniTrust’s data will be generated from public sources.  As the user base and revenues grow, InfiniTrust plans to seek out additional data licensing deals.  Examples could include phishing blacklists from anti-spam vendors and ecommerce data from companies like Bizrate.  With a sizable user base, InfiniTrust could also become an important enforcement mechanism for “self-regulating” (and therefore mostly ineffective) programs and protocols like Trust-e and P3P.  Down the road, we can also envision incorporating offshore manual labor into the data collection and analysis process.

Competition

Overview:  We expect that in 2005-6 a lot of attention will be paid to problems like spyware and phishing.  This is both good and bad for InfiniTrust.  The risk is that other companies, especially large incumbents, either mitigate these threats significantly (less likely) or else create enough noise in the market to make the need for InfiniTrust less obvious (more likely).  The good news is that InfiniTrust is specifically designed to complement existing security bundles.  As pressure to differentiate security bundles increases, InfiniTrust could become an attractive add-on product or acquisition target.  The historical pattern is that most of the innovation in consumer security has come from startups.  For example, the software-based firewall was pioneered by ZoneLabs and anti-spyware was pioneered by companies like PestPatrol, Lavasoft and WebRoot.

Summary of existing anti-spyware technologies:  Almost all of the anti-spyware products that currently exist are for removing spyware, not preventing it.  It is widely believed that even the best anti-spyware removers achieve highly unsatisfactory success rates.  For this reason, most experts recommend that users run multiple spyware removers (in addition, users are repeatedly instructed to be very careful where they browse, what they download, etc).  This poor success rate is due mostly to the fact that once spyware takes control of a user’s PC and starts performing tricks like copying itself, changing the HOSTS file, disguising its signature etc, the technological problem of removing it becomes extremely difficult.

There are a few existing anti-spyware programs that claim to have spyware prevention features (e.g. SpywareBlaster, Microsoft’s AntiSpyware) but in fact just use highly inaccurate behavior-based techniques (similar to Intrusion Prevention Systems).  In the near future, we expect security companies to develop blacklist-based preventative approaches to spyware.  Blacklist approaches have a number of problems:  1) it is extremely difficult to keep spyware blacklists up-to-date and even a single mistake can render a PC unusable, 2) they don’t properly address the many sources of spyware that are “grey area” downloads.   The problem of spyware is not nearly as black-and-white as problems like viruses and worms as most spyware comes through bundled adware where reasonable people can disagree about its maliciousness.  InfiniTrust believes the best way for users to be both protected and have a satisfying browsing experience is to 1) whitelist trusted programs, 2) blacklist purely malicious programs, and 3) inform users about the trade offs (and alternatives) in the grey area cases in a very easy-to-understand way.

Summary of existing anti-phishing technologies:  There are three primary methods for stopping phishing attacks today.

The first is simply for existing anti-spam companies to better filter phishing emails.  Anti-spam technologies have achieved 95+% accuracy but are not perfect.  Moreover, phishing emails can be particularly hard to detect as they often use zombie PC’s for delivery (thereby making IP-based blocking difficult) and contain content that looks very similar to legitimate content.

The second approach is to try to shut down the email delivery or landing page machines in the midst of an attack.  A number of security companies do this on behalf of their customers who tend to be large financial institutions.  We believe these methods are limited as they succeed only after the critical first few (~6) hours of phishing attacks.  Moreover, from the desktop user’s perspective, even if these companies stop phishing attacks for, say, the top banks there are many other types of phishing attacks that these companies are not even trying to stop, such as the Tsunami-relief phishing attacks that were recently seen in large volumes.

Client-side solutions:  These have the advantages of providing zero-hour defense and the ability to defend against fraud from all sources.   There have been a handful of client-side solutions released recently from companies like Earthlink, Netcraft, WebRoot, and GeoTrust.  InfiniTrust is a client-side solution that has distinct advantages over these client-side competitors.  For one, because InfiniTrust will be collecting a nearly comprehensive database of existing websites, it can take a (partial) whitelist approach to phishing detection.  The fact that a site clicked through to from an email doesn’t appear in InfiniTrust’s list of millions of legitimate websites is a strong indicator that the site is potentially fraudulent.  It also goes beyond these other solutions insofar as it prevents non-email based attacks (such as keyloggers inserted through browser exploits) and also more “grey-area” fraud such as dubious but not outright fake ecommerce sites.

Notes on primary competitors:

Symantec:  Generated $1.87B in revenue in 2004, 47% of which came from consumer products.  Symantec has not yet released a spyware removal tool but is expected to in Q105.  They have no client side phishing product today but will likely release one sometime this year.

McAfee:  McAfee is the #2 consumer security software bundle.  They currently have spyware detection but not removal.  It is likely they will release spyware removal sometime this year.

ZoneLabs:  ZoneLabs was acquired by Checkpoint in 2004 for approximately $250M.  Their primary product is ZoneAlarm, a software-based firewall that had, as of 2004, at least 30M (free) users.  They also sell a complete security bundle that has at least 1M paying subscribers.  ZoneLabs built their business almost exclusively through a free downloadable version that became popular in the press and among technology enthusiasts.

Computer Associates:  CA sells a traditional security bundle and recently added spyware removal tools through their acquisition of PestPatrol.

Trend Micro:  Trend Micro has recently added spyware removal and has features they describe as anti-phishing (actually just an outgoing firewall that looks for personal info being sent from the PC).

Microsoft:  Recently acquired an anti-spyware company (Giant) and an anti-virus company and is expected to release versions of each in Q105.  There have been conflicting reports about whether they plan to charge for these services.  Microsoft appears to see web-based security threats as a major headache.  Firefox has supposedly gotten 10% of the browser market in just the past 6 months due in large part to users’ frustration with Internet Explorer security issues.

WebRoot:  WebRoot is widely considered to have a very good spyware removal tool.  Their rate of innovation has generally been very impressive.  WebRoot generated $16M in revenues in Q404 alone, evidence that point solution security products can thrive in the consumer market. We had thought Webroot was likely to be acquired but last week announced a $108mm financing event.

Freeware:  Lavasoft’s Ad Aware and Spybot S&D have been extremely popular free spyware removal tools.  For example, Ad Aware consistently gets more than 2M downloads per week on download.com alone (there is also a paid version of Ad Aware that is rumored to have generated significant revenues for the company).

Websense:  Websense is a $1B market cap company that is considered to be the leader in so-called web filtering technology.  The primary focus of web filtering technology is to restrict corporate users from going to “bad topics” such as adult and gambling websites.  They have recently added an optional, add-on security module that basically works by altogether blocking access to large blocks of websites associated with insecure activity (e.g. Kazaa.com).  Websense severely restricts web access and is therefore only useful to (typically large) corporations that find such restrictions acceptable.

Would any of these competitors be likely to offer a product similar to InfiniTrust’s?

Today, InfiniTrust’s closest competitor in terms of the product itself is probably Websense.  Websense has a database that in many ways is similar to InfiniTrust’s although much more focused on topics rather than security ratings.  Websense has built a high growth business ($100M revs, $36M EBITDA, $1.2B market cap) focusing almost solely on larger enterprises.  We see their entry into the consumer market as being unlikely but if they did enter it that could be a serious threat to InfiniTrust.

Anti-spyware vendors could also conceivably take an approach like InfiniTrust’s, although it would mean a fundamental change in how they go about building their technology and database.  Right now their approaches are very similar to those of anti-virus technologies: they have databases of signatures they use to scan PC’s for existing infections (“parasites”), as opposed to InfiniTrust which has a database of all the “hosts” (websites, program downloads, ActiveX objects) that might carry those parasites.  Determining the trustworthiness of hosts is simply a different technology problem than detecting and removing the parasites.

We see InfiniTrust as being fundamentally about providing secure, “unannoying” yet unrestricted web access, just as anti-spam companies try to provide secure, “unannoying” yet unrestricted email access.  Spyware and phishing happen to be two important and growing security threats that have mostly web-based attack vectors. They are therefore important to InfiniTrust’s value proposition but that does not mean that InfiniTrust is just another anti-spyware or anti-phishing company.

Marketing Plan 

The target market will be individuals and organizations that care about both security and unrestricted web browsing.  InfiniTrust sees this as encompassing a large percentage of consumers and, to a somewhat lesser extent, small and medium businesses.  Larger businesses tend to be satisfied with much “blunter” security instruments such as Websense that significantly restrict user web access.

InfiniTrust plans to offer a limited-functionality free version that can be downloaded directly from infinitrust.com and will also be distributed through channels.   The current plan calls for the free version to offer the user basic defensive features but not have access to the full database. The free version will remind the user of its value by displaying periodic reminders of the specific dangers it has blocked or warned about.  The paid version will likely start at $30 per year for consumers (discounted strategically for different target populations) and something in the range of $5-20 per seat per year for enterprises with an upfront licensing fee for the admin console.

Distribution Partnerships:  ISPs, security software vendors, search engines, toolbar vendors and PC OEMs are natural distribution partners.

ISPs (especially dialup providers where consumer choice is greater) are increasingly trying to differentiate their services through security software they give to their customers.  For example, security is the primary focus of recent television campaigns by AOL and Earthlink.  Additionally, these companies incur significant costs handling customer support calls resulting from phishing and spyware. For example, Earthlink says that customer support costs them $120K per phishing attack.  Deals with ISPs could either be pay per user (AOL pays McAfee $2 per user for anti-virus functionality alone which is generally considered a commodity) or unpaid distribution of the free product.

Large consumer security software vendors try to provide a single package that includes every existing category of security software.  If InfiniTrust succeeds in convincing them that its product is complementary and useful, it could be seen as a critical addition to their bundles.

Toolbar vendors such as Google, Yahoo, Earthlink, MSN and Ebay have recently been incorporating security features for anti-phishing and anti-spyware.  For example, Yahoo distributes PestPatrol and Earthlink distributes WebRoot.   Earthlink built its own anti-phishing functionality.  InfiniTrust’s data feed can make these toolbars significantly more powerful.

PC OEMs receive numerous calls from customers about browser security issues. As mentioned earlier, 20% of Dell’s customer service calls are about spyware.  These companies are interested in not only reducing these costs but also differentiating their products.  Many of these companies have shown a willingness to work with startups (e.g. Dell distributes Sunbelt’s anti-spyware solution, generating a significant portion of Sunbelt’s $30M in revenue).

A recent internal survey by InterActive Corp. of web search users showed that the safety of the sites they find was users’ #1 concern (cited by 77% of respondents as a “major concern”).  As search engines are increasingly the “gatekeepers of the web,” it is natural for them to provide filtering and ranking based on security.  At the simplest level, a partnership with a search engine could provide an InfiniTrust score next to search results in exchange for showing the InfiniTrust logo.

Financial institutions affected by phishing have expressed interest in distributing client-side anti-phishing solutions such as InfiniTrust’s as a way to offer protection their customers.   For example, one recently developed anti-phishing toolbar, FraudEliminator, received business development cold calls from 3 major banks, Mastercard and Experian in just the past week despite having spent $0 on marketing.

PR:   Desktop security was by far the #1 topic of discussion in the technology-related press in 2004.  The fact that InfiniTrust solves growing, high-visibility problems like phishing and spyware as well as older problems such as browser exploits in a new way provides a great opportunity to leverage this attention.  Initially, the technology press will be targeted, but the benefits of the product are widespread enough to attract mainstream media coverage.

Word of mouth:  Most “unsophisticated” users choose their security software based on the recommendations of 1) the media, 2) their PC manufacturer or ISP, and 3) technologically sophisticated friends and family.  Strategies for addressing 1) and 2) were discussed above.   The strategy for addressing 3) is, among other things, to make the product and message amenable to technology enthusiasts.  InfiniTrust’s client software will be mostly or completely open source, thereby showing goodwill toward the technology-enthusiast community and assuaging concerns that the client software might be in some way malicious (importantly, open sourcing the client will not jeopardize the business as the value lies primarily in the centralized database which will not be open).  In addition, the company will build Firefox, Linux and Mac versions relatively early on and expose popular portions of the database to the public via search engines.

Paid marketing:  In the past few years, online advertising channels such as search engines and banner ad networks have transformed the marketing possibilities for consumer software downloads and services.  In particular, it is now possible to target customers by demographic and context far more efficiently than in the past.  Moreover, startups are able to compete on a level playing field in keyword and banner auctions instead of having to, say, fight for shelf space in retail stores or suffer huge payouts to powerful distributors.  Some consumer software products and services that have built interesting businesses primarily through web-based advertising and had recent successful exits include Gotomypc (acquired by Citrix for $237M), ZoneLabs (acquired by Checkpoint for $250M), Classmates.com (acquired by United Online for $100M), TripAdvisor (acquired by IAC for $250M), and Shopping.com ($750M market cap).

Risks.

Market risks:

Competitive offerings: Companies such as Symantec, McAfee and Microsoft could improve their products enough to substantially solve the same problems that InfiniTrust is trying to solve. These companies have superior brand recognition and distribution so even if they merely solve the same problems, say, 75% as well as InfiniTrust does, they will likely succeed in the marketplace.

Insufficient or inaccurate data:  InfiniTrust may launch with a data set that is simply not sufficient to show real benefits to early adopters. It may be that deeper or broader data is required in order to cover an acceptable percentage of actual user browsing.  Initial diligence, however, suggests this outcome to be unlikely because web browsing tends to be fairly highly concentrated.  It has been shown, for example, that 50% of page views on the web are for the top 5000 websites, and the top 2000 downloads account for over 95% of total downloads.

Unwillingness to pay: While the InfiniTrust product may provide incremental value to users, there may not be a willingness to pay for it.

Lack of awareness: Despite attempts to build distribution partnerships and generate PR, customers may simply not hear about InfiniTrust. The cost of running a concerted advertising or paid inclusion program may simply be too high for a start up to muster.

Problems decrease for other reasons: Legal changes, software quality improvements or other external factors may lead to a reduction in the type of security problems that InfiniTrust solves, thereby reducing the need for the product.

Technical risks:

Data collection:  The data required to make InfiniTrust work can be difficult to collect.  Programs must be automatically installed, phishing attacks must be recognized, and web exploits must be discovered and analyzed. The company believes it has a solid plan for tackling these problems, but if it is wrong the product quality could suffer.

“Arms race”: Once attackers realize how InfiniTrust operates they may put more effort into hiding their spyware, phishing attacks, web exploits etc.  This may result in a reduced data quality.  Since most of the “hackers” InfiniTrust is targeting are economically motivated, the company believes this will only happen when the company is quite successful distributing its product.  At that point the company expects to have the resources to fight back.

Budget

The company is raising $2.7M, which would allow for a 12 month product development plan plus an additional 12 months of marketing, business development, and product refinement.  After the v1.0 product is built, the company would hire an additional team member to help with marketing and business development, and would also engage a PR firm and do online advertising to build market traction.  A summary of the budget plan is below.

Two markets

Startups sit in the middle of two markets: one between VCs and startups, and one between startups and customers. These markets are correlated but only partially. When the financing supply is low but customer demand is high, entrepreneurs that are able to finagle funding generally do well. When financing and startup supply is high, customers do well, some startups do well, and VCs generally don’t. And so on.

When VCs get too excited, people talk about a bubble. When VCs get too fearful, people talk about a crash. Historically, downturns were great times for startups that were able to raise money because competition was low but customer demand for new technology remained fairly steady. Downturns also tended to coincide with big platform shifts, which usually meant opportunities for entrepreneurs.

These markets shift independently between different stages and sectors, although there are connections. The amount of financing available is relatively constant, because of the longevity of VC funds and the way most VCs are compensated (management fees). Less financing in one sector or stage usually leads to more financing in others.

The stages are related because the early stages depend on the later stages for exits and financings. The result is a bullwhip effect where changes in later stages (the latest stage being public markets) lead to magnified changes in early stages.

Smart VCs understand these dynamics and adjust their strategies accordingly. Smart entrepreneurs don’t need to think about these things very often. Fundraising is necessary (at least for companies that choose to go the VC route – many shouldn’t), but just one of the many things an entrepreneur needs to do. The best advice is simply to raise money when you can, and try to weather the vicissitudes of the financial markets.

The product lens

Good entrepreneurs spend most of their time focusing on the other market: the one between their company and their customers. This means looking at the world through the lens of products and not financing. This lens is particularly important when you are initially developing your idea or when you are thinking about product expansions.

The product lens suggests you should ask questions like: have the products in area X caught up to the best practices of the industry? Are they reaching their potential? Are they exciting? Are there big cultural/technological/economic changes happening that allow dramatically better products to be created? Sometimes the product lens guides you to the same conclusion as the finance lens and sometimes it doesn’t.

For example, there has been a lot of hand wringing about a financing crunch for consumer internet startups. One theme is that investors are pivoting from consumer to enterprise. The finance lens says: for the last five years or so, consumer was overfunded and enterprise was underfunded – let’s correct this. It also helps that enterprise IPOs have performed much better than consumer IPOs in the last year or so.

The product lens is tricky. My sense is that, at least for the non-mobile consumer internet, the product lens and financing lens agree. Anyone who has had the misfortune to use enterprise technology lately will tell you that the hardware and software they use at home (iPhone, Gmail, etc) is far and away more sophisticated and elegant than the software they use at work. It feels like the enterprise tech is way behind in the product upgrade cycle.

Mobile seems like a case where the lenses disagree. The finance lens says: billions of dollars have been invested in mobile apps. It has become hit driven and there have been very few “venture-scale” startups created.

The product lens says: the modern smartphone platform began about four years ago when the iOS app store launched. This is clearly a major new platform. Platforms and apps interact in a push-pull relationship that takes decades to play out. Innovative new apps, designs and technologies are created all the time. It would be surprising – and contrary to all the historical patterns – if the mobile product evolution were already played out.

That is not to dismiss the finance lens. It could be painful along the way:  financing markets might dry up, and profits might accrue to the platforms over the apps. But clearly mobile is just getting started.

Some of the biggest mistakes I’ve made as an angel investor stemmed from being beholden to the finance lens. The finance lens feels more scientific and therefore appeals to analytical types. It might sound unsophisticated to say “the products for X are crappy, and I have an idea for how to make them great.” But in many cases, it’s actually that simple.

Startups that have tried to go head-to-head against the entirety of Craigslist (the “horizontal approach”) have struggled. Startups that have tried to go up against pieces of Craigslist (the “vertical approach”) have been much more successful (e.g. StubHub, AirBnB).

Recruiting looks like it’s going through a similar evolution. Last-generation products like LinkedIn are broad but not deep. Everyone I know who recruits uses LinkedIn, but none of them think it has solved their recruiting problems. Now we are seeing the rise of vertical solutions that are significantly better, e.g. Stack Overflow for developers and Behance for designers (at least that’s what I believe – I’m an angel investor in both).

The benefits of focusing are: 1) you can create a dramatically better user experience when it’s tailored to a specific use, 2) you can do unscalable hacks when starting out (e.g. AirBnb paying photographers to take pictures of apartments), 3) you need far fewer users to get to minimum viable liquidity, and 4) brand building is easier when you solve a straightforward, narrow problem (e.g. “I need a place to stay this weekend”).

This pattern – horizontal first, vertical second – is common. But you need to be careful. Back in 2003-2004, there was a lot of speculation that vertical search engines would eventually take down Google. A few categories worked (e.g. travel), but Google adapted in other categories (e.g. video, news) and lots of startups suffered.

Two years ago I wrote a post where I argued that innovative new VC firms are finally starting to change this:

Top tier entrepreneurs are frequently selecting their investors, not vice versa. The VCs most sought after are mostly new firms: big firms like Andreessen Horowitz, Union Square Ventures, and First Round, and micro-VCs like Floodgate (fka Maples), Betaworks, and Ron Conway.

Since then, the trend has become even more pronounced. VC is only partly about investing. It is primarily a service business whose purpose is to help entrepreneurs.

When Andreessen Horowitz (“a16z”) started out three years ago, like a lot of people I thought “OK, really interesting entrepreneurial founders, but how will they be as investors?” Then I started hearing chatter among entrepreneurs that they really wanted to raise money from them. “We’re talking to X, Y, & Z — but Andreessen is the firm we really want” became an increasingly common refrain.

Earlier this year I got to meet the a16z team and observe the operation directly. There are over 60 people at the firm. Only six people do traditional VC activities: investing, joining boards, and helping out. The rest are exclusively focused on helping entrepreneurs.

The “startup idea” behind a16z is: instead of spending the bulk of the fund fees on partner salaries, spend it on operations to help entrepreneurs. There is a marketing team (=helps you get noticed), a talent team (=helps you recruit), a market development team (=helps you get customers), and a research team (=helps you figure stuff out).

Spending time there, I had the same feeling I have whenever I meet a great startup: “This is obviously the future, why didn’t someone do it before?”

So I’m super excited to say that I’m joining a16z as their seventh General Partner. I’ll specialize in consumer internet investments but will be open to anything ambitious that involves technology. I’ll be based in California, but plan to do a lot of investing in NYC.

I’ll miss seeing my Hunch colleagues on a daily basis. Many of us have been working together for eight years, through two startups. I’d also like to thank everyone at eBay for being so welcoming and supportive.

Large companies are in a constant state of agency crisis. A primary role of senior management is to counter agency problems through organizational structures and incentive systems. For example, most big companies divide themselves into de facto smaller companies by creating business units with their own P&L or similar metric upon which they are judged. (Apple is a striking counterexample: I once pitched Apple on a technology that could increase the number of iTunes downloads. I was told “nobody optimizes that. The only number we optimize here is P&L in the CFO’s office”).

If you are selling technology to large companies, you need to understand the incentives of the decision makers. As you go higher in the organization, the incentives are more aligned with the firm’s incentives. But knowledge and authority over operations often reside at lower levels. Deciding what level to target involves nuanced trade offs. Good sales people understand how to navigate these trade offs and shepherd a sale. The complexity and counter-intuitiveness of this task is why it’s so difficult for inexperienced entrepreneurs to sell to large companies.

Agency problems also exist in startups, although they tend to be far less dramatic than at big companies. Simply having fewer people means everyone is, as they say in programming, “closer to the metal”. The emphasis on equity compensation also helps. But there are still issues. Some CEOs are more interested in saying they are CEOs at parties than in the day-to-day grind of building a successful company. Some designers are focused on building their portfolio. Some developers are only interested in intellectually stimulating projects. Every job has its own siren song.

One of the reasons The Wire is such a great TV show is that it shows in realistic and persuasive detail how agency problems in large organizations consistently thwart well intentioned individual efforts. The depressing conclusion is that our major civic institutions are doomed to fail. Those of us who are technology optimists counter that the internet allows new networks to be created that eliminate the need for large organizations and their accompanying agency problems. Ideally, those networks recreate the power of large organizations but operate in concert like startups.

Here is a really simplified example. Suppose you are a large company generating $1B in revenue, and you have a market cap of $5B. You want to build an important new product that your CTO estimates will increase your revenue 10%. At a 5-1 price-to-revenue ratio, a 10% boost in revenue means a $500M boost in market cap. So you are willing to spend something less than $500M to have that product.

You have two options: build or buy. Build means 1) recruiting a team and 2) building the product. There is a risk you’ll have significant delays or outright failure at either stage. You therefore need to estimate the cost of delay (delaying the 10% increase in revenue) and failure. Acquiring a relevant team takes away the recruiting risk. Acquiring a startup with the product (and team) takes away both stages of risk. Generally, if you assume 0% chance of failure or delay, building internally will be cheaper. But in real life the likelihood of delay or failure is much higher.

Suppose you could build the product for $50M with a 50% chance of significant delays or failure. Then the upper bound of what you’d rationally pay to acquire would be $100M. That doesn’t mean you have to pay $100M. If there are multiple startups with sufficient product/talent you might be able to get a bargain. It all comes down to supply (number of relevant startups) and demand (number of interested acquirers).

Every big company does calculations like these (albeit much more sophisticated ones). This is a part of what M&A/Corp Dev groups do. If you want to sell your company – or simply understand acquisitions you read about in the press – it is important to understand how they think about these calculations.

Sometimes the businesses that change regulations are startups. Startups don’t have the resources to change regulations through lobbying. Instead, they need to start with regulatory hacks: “back door” experiments that demonstrate the benefits of their ideas. With luck, regulators are forced to follow.

Nextel was one of the all-time great regulatory hacks. In the late 80s and early 90s, the FCC’s rules banned more than two cellular operators per city. As Nextel’s cofounder said, “the FCC thought a wireless duopoly was the perfect market structure”. Nextel (called Fleet Call at the time) circumvented these rules by acquiring local (e.g. taxi, pizza truck) dispatch radio companies, which they then connected to create a nationwide (non-dispatch) cell phone service.

Predictably, the cellular incumbents tried to regulate Nextel out of existence. From a 1991 New York Times article:

In a move that could threaten cellular telephone companies, the Federal Communications Commission may decide on Wednesday to grant a small radio company’s request to provide a new form of mobile telephone service in six major cities, including New York. If the request is approved, the action could inject new competition into the industry. At the moment, Federal rules permit only two cellular systems to operate in any city. But the new proposal could open up a regulatory back door, allowing companies that provide private radio service for taxi fleets and delivery services to offer mobile telephone services to individuals…. The proposal has alarmed the industry, which has heatedly opposed it and enlisted support in Congress late last year to delay the F.C.C.’s decision.

The incumbents argued that Nextel’s service would interfere with public safety frequencies and therefore endanger the public. They also argued that Nextel’s service would be too expensive:

Some analysts contend that the radio handsets for Fleet Call and its imitators will be more expensive than cellular units. The technical features of cellular equipment are now standardized nationwide, making it possible to bring down costs through higher selling volumes. Specialized mobile services are currently different in each city.

And their call quality would be inferior:

Some analysts contend that Fleet Call’s local service is likely to be inferior as well. “It is highly unlikely to be as good as cellular service,” said Denise Jevne, telecommunications analyst with T. Rowe Price Associates in Baltimore.

The FCC eventually decided not to block Nextel. Nextel grew to become a top five US cellular operators before it was acquired by Sprint in 2004 for $35B. Their service turned out to be cost-competitive, high quality, and safe. The only thing endangered were the incumbents’ profits.

What Nextel faced in 1991 is very similar to what many startups face today. Uber is being threatened by the taxi industry, Aereo by the TV broadcasting industry, and Airbnb by the hotel industry. Some industries, like finance, are so heavily regulated that almost any new idea runs into regulatory objections.

Of course regulations that truly protect the public interest are necessary. But many regulations are created by incumbents to protect their market position. To try new things, entrepreneurs need to find a back door. And when they succeed, it will all look obvious in retrospect. Today’s regulatory hack is tomorrow’s mainstream industry.

Internet-based delivery (“SaaS”, “cloud”) dramatically lowered installation costs, letting individuals or small groups buy software on discretionary budgets or use basic versions for free. As adoption spread throughout the organization, the value of the software eventually percolated up to high-level business people who could write large checks to get features big companies need, such as administration, security, integration, compliance, and support. This ”bottom-up” approach was pioneered by Salesforce and open source companies like MySql. Recent enterprise success stories also follow this model, e.g. New Relic, Yammer, Twilio, and Github. Many of these companies have processes that would have seemed crazy ten years ago – e.g. sales people only handle inbound inquiries or only call customers who already use their product.

Thus enterprise software went from being about sales (one-to-one) to being about marketing (one-to-many). Marketing requires crafting a compelling message, figuring out the right channels and then optimizing. But the most effective marketing is a compelling product that can be easily tried. As a result, as Benchmark’s Peter Fenton said recently: ”We’re seeing a fundamental shift from sales-driven companies to product-driven companies. The companies that are leading the way there let this consumer and product focus permeate the culture of their companies.”

One of the most visible manifestations of this shift is the refreshingly accessible language on modern enterprise websites. Sales-driven enterprise software companies speak the arcane language of CIOs. Marketing-driven companies talk directly to business users (e.g. Yammer) or developers (e.g. Github).

This is good news all around. Enterprises are more likely to get software that incorporates the advances made over the last decade in consumer software. Startups get a shot at creating this software, and get to do so on a fairly level playing field. The product and marketing focus should also attract a lot more technologists who were turned off by sales. The only losers are incumbents who continue to pursue the old model.

Optionality not in the model: further potential upside

While not in our model, as [Facebook] has not publicly expressed pursuit of these areas, we believe there are three obvious opportunities that the company could leverage its platform to capitalize on:

- Developing an external ad network

- Monetizing paid search

- Entering China

Of the three options, search is clearly the most interesting. An external ad network is inevitable. Google proved this model with Adsense. With an already huge base of advertisers bidding on CPCs, it is impossible for most other ad networks to compete on publisher payouts. But Facebook’s traffic is so great now that an external ad network might increase their revenues by 2x or so. The same goes for entering China. They might get another half a billion users who monetize at lower ad rates than US users. Neither move would put them in Google’s revenue range. They need a better business model for that. The only (known) models that deliver RPMs high enough to compete with Google are search, payments, and e-commerce.

At TechCrunch Disrupt last week, Mark Zuckerberg talked about possibly entering the search business. Investors had been concerned that maybe Zuckerberg really meant what he said in his IPO letter – that he just didn’t care that much about making money. By expressing an interest in search, Zuckerberg signaled that he understood Facebook’s immensely valuable embedded option and was thinking about ways to exercise it.

- Raising money from famous people/firms who aren’t really going to help your company (e.g. Hollywood celebrities).

- Partnerships with brand name organizations that aren’t really going to help your company.

- Getting press (e.g top lists) that focuses on founders and not your company.

- Almost all tech press (unless your product targets developers or tech companies).

This doesn’t mean it’s bad to hit vanity milestones. Good companies hit lots of vanity milestones along the way, and sometimes they can be a morale boost for employees. What is worrisome is when founders equate vanity milestones with success. The attention will go away very quickly if your company fails.

- There is an old saying that startups are bought not sold. Clearly it is better to be in high demand and have inbound interest. But for product and tech acquisitions especially, it is often about getting the attention of the right people at the acquirer. Sometimes the right person is corp dev, other times product or business unit leads, and other times C-level management.

- Don’t use a banker unless your company is late stage and you are selling based on a multiple of profits or revenues. I’ve seen many acquisitions bungled by bankers who were either too aggressive on terms or upset the relationship between the startup and acquirer.

- Research the potential acquirer before the first meeting. Try to understand management’s priorities, especially as they relate to your company.  Talk to people who work in the same sector. Talk to industry analysts, investors, etc. If an acquirer is public, Wall Street analyst reports can be helpful.

- Develop relationships with key people – corp dev, management, product and business unit leads. The earlier the better.

- Don’t try to be cute. Leaking rumors to the press, creating a false sense of competition, etc. is generally a bad idea. Besides being ethically questionable, it can create ill will.

- What you tell employees is particularly tricky. Being open with employees can lead to press leaks and can annoy acquirers. Moreover, some public companies insist that you don’t talk to employees until the deal is closed or almost closed. Employees usually get a sense that something is going on and this can put you in the awkward situation of being forced to lie to them. I don’t know of a good solution to this problem.

- Understand the process and what each milestone along the way means. As with financings, acquisitions take a long time and involve lots of meetings and difficult decisions. Inexperienced entrepreneurs tend to get overly excited about a few good meetings.

- Strike while the iron is hot. Just as with financings, you need to be opportunistic. Waiting 6 months to hit another milestone might improve your fundamentals, but the acquirer’s interest might wane.

- There are two schools of thought on price negotiation: anchor early or wait until you’ve gotten strong interest. Obviously having multiple interested parties makes finding a fair price a lot easier.

- Deal structure: the cap table is an agreement between you and the shareholders that says, in effect: “If we sell the company, this is how we pay out founders, employees, and investors.” Acquirers have gotten increasingly aggressive about rewriting cap tables to 1) hold back key employee payouts for retention purposes, and 2) give a greater share of proceeds to employees/founders.  Some even go so far as to try to cut side deals with key employees to entice them to abandon the other employees and investors. In terms of ethics and reputations, it is important to be fair to all parties involved: the acquirer, founders, employees, and investors.

- Research the reputation of the acquirer, especially how they have behave between LOI and closing (good people to talk to: investors, other acquired startups, startup lawfirms). This is when acquirers have all the leverage and can mistreat you. Some acquirers treat LOIs the way VCs treat term sheets, as a contract they’ll honor unless they discover egregious issues like material misrepresentations. Others treat them as an opportunity to get free market intelligence.

- Certain terms beyond price can be deal killers. The most prominent one lately is “IP indemnification.” This is a complicated issue, but in short, as a response to patent trolls going after IP escrows, acquirers have been trying to get clawbacks from investors in case of IP claims. This term is a non-starter to institutional investors (and most individual investors). You need to understand all the potential deal-killer terms and hire an experienced startup law firm to help you.

- Ignore the cynical blog chatter about “acqui-hires” (or, as they used to be called, “talent acquisitions”). Only people who have been through the process understand that sometimes these outcomes are good for everyone involved (including users when the alternative is shutting down).

Finally, acquisitions should be thought of as partnerships that will last long after the deal closes. Besides the commitments you make as part of the deal, your professional reputation will be closely tied to the fate of the acquisition. This is one more reason why you should only raise money if you are prepared for a long-term commitment.

Venture capital markets are perhaps the most inefficient of mainstream financial markets. Complicating factors include: heavy reliance on comparables for valuations, desire of VCs to be associated with “hot” companies, tendency to overreact to macro changes, illiquidity of startup financings, illiquidity of financings for VCs themselves, perverse financial incentives of VCs, inability to short stocks, extreme uncertainty of startup financial projections, vagaries of the M&A market, dependency on moods of downstream investors, concentration of capital among a small group of VCs, the difficulty of developing accurate financial models, rapid shifts of supply and demand across sectors and stages, and non-uniform distribution of accurate market data.

The title of this post is an old venture capital adage (via Bill Gurley) that reflects a hard-earned truth about financing and M&A markets. For social consumer startups, the hors d’oeurves were being passed in the build up to the Facebook IPO. They are being passed now for B2B and e-commerce companies. In the M&A markets, the most extreme example is probably in adtech, where there were waves of acquisitions in ad exchanges (DoubleClick, RightMedia, Avenue A), then mobile ads (AdMob, Quattro), and then social advertising (Buddy Media, Wildfire). If you didn’t sell during these M&A waves, you’re suddenly stuck with lots of powerful competitors and few potential acquirers/partners.

It is common to hear entrepreneurs say things like “I am waiting 6 months to raise money/sell the company, when we’ve hit new milestones.” Of course milestones matter, and companies are ultimately valued based on fundamentals. But along the way you’ll likely need capital and sometimes need to exit, and for that you are dependent on highly inefficient markets.

As Josh Kopelman points out, the list of the top 15 e-commerce companies has barely changed over the past decade, in sharp contrast to the list of overall top internet companies. This can be interpreted in one of two ways.

The bull case is that startups neglected e-commerce and are now waking up to the opportunity. The key equation driving e-commerce is: profit = lifetime customer value minus customer acquisition costs. New marketing strategies (“content plus commerce”, social commerce, etc) lower acquisition costs enough to make startups competitive with incumbents.

The bear case is that scale and brand effects make e-commerce incumbents nearly unbeatable. As one entrepreneur said, “If it has a UPC code, Amazon will beat you.” A lower price is just one search away. The only way to compete is to sell used stuff or make your own products (or provide a marketplace for those things). The fat head (large incumbents) and the long tail (artisanal shops) will thrive, but the middle of the distribution will suffer. (The public markets seem to agree with this assessment, e.g. Overstock trades at 0.2x revenues.)

What most people agree on is that e-commerce as a whole will continue to grow rapidly and eat into offline commerce. In the steady state, offline commerce will serve only two purposes: immediacy (stuff you need right away), and experiences (showroom, fun venues). All other commerce will happen online.

Some observations:

- Thousands of early-stage consumer web/mobile companies were started and funded in last 24 months.

- There are only a few dozen VCs who actively write consumer Series A checks, and those VCs will only do a few deals a year.

- Facebook’s market cap is about half of what most tech investors expected before the IPO.

- A few breakout early-stage consumer hits (Instagram, Pinterest) have reached tens of millions of users in record time.

- Internet users have tens of thousands of services/apps to choose from but limited time and attention.

Some consequences:

- For consumer startups with non-transactional models (ad-based or unknown business models), you need something closer to 10 million users versus 1 million users to get Series A funded.

- For consumer startups with transactional models, e.g. e-commerce, the number of users required is often far lower because revenue is the more important metric. Hence, many early-stage consumer startups are switching to transactional models.

- It’s becoming increasingly common for early-stage consumer startups to do bridge financings (raising more money from past investors, usually on terms similar to the prior round) instead of Series As.

- VCs are increasingly focusing on B2B for early-stage investments.

- There will be a lot more consumer talent acquisitions.

Some advice:

- If you are thinking of starting a non-transactional consumer startup, be aware that you are entering what is perhaps the most competitive sector in tech in the last decade.

- If you can raise more money, do it. (Especially pre-launch: remember, there’s nothing like numbers to screw up a good story).

- Be prepared for lower valuations for non-transactional early-stage consumer startups (breakout later-stage companies, on the other hand, will likely continue to command high valuations).

I’m an investor in BuzzFeed and friends with Jonah so of course I’m biased. But to me what makes BuzzFeed great is their highly unusual combination of capabilities and sensibilities – the capabilities of a first-rate tech startup with the sensibilities of media industry veterans. I think Jonah’s email captures this well.

From: Jonah Peretti 
Subject: The Top 7 Reasons BuzzFeed Is Killing It
To: BuzzFeed Employees 

Hello BuzzFeeders,

As you just heard at the all hands meeting, things are going great at BuzzFeed. We passed 30M unique visitors last month, our revenue is on pace to be more than 3 times what we did in 2011, we have grown from 26 full-timers at the start of last year to 117 today, and we have published entertaining and important stories enjoyed by millions of people.  Our revenue is surging as brands shift their budgets to social ads and our recent growth is driven more by revenue than VC funding – an amazing milestone for any startup. We still have a long way to go but it has been a great year so far.

Whenever a company has this kind of success the press, competitors, and the public start asking: “how do they do it??!?”  Unfortunately, this speculation is often unkind and unfair.  The default assumption is that a company must be cheating somehow or using some trick to grow traffic or revenue.

This skepticism is actually justified because many startups actually do use tricks or shortcuts to succeed.  Some companies figure out ways to juice their numbers so they can quickly sell for millions and then a year later it all comes crashing down.  The dotcom era was as famous for Geocities, Broadcast.com, and Pets.com as it was for Amazon, Yahoo, or eBay.  Based on industry precedent, it is understandable that people are skeptical when a startup starts to really take off.

Nevertheless, BuzzFeed has received a very positive reception from the public, readers, our partners, and the press. But occasionally someone engages in uninformed negative speculation about us, mostly because they are confused about what we are doing.  This confusion is likely to increase in the future. As we grow it is important that we help people understand what we are doing and why it is interesting and different.

In that spirit, I want to share some of my thoughts of about why things are going well, why our success is based on hard work and a unique approach, and how you might explain what we are doing to a drunk, misguided hater at a party.

Why BuzzFeed Is Succeeding Right Now?

1) Long Term Focus 

When you compare web publishing today with what Hearst and Conde Nast built in the last century, it is clear that online publishing has a long long way to go.  As sites like Facebook and Twitter mature, the moment is right to build a defining company for a world where content is distributed through sharing and social media instead of transitional print and broadcast channels. Why shouldn’t we be one of the companies that builds this future?

This big opportunity is why we are focused on building an enduring, independent, and self-sustaining company. Nobody has built a truly great publishing company for the social age and we have a good shot to be the ones who do it. But it means that we can’t take short cuts, we need to always invest in the future, and this is why we spend so much time and money building technology and products that don’t have an immediate impact on the company but will help us down the road.

We could juice our traffic and revenue by dropping everything and focusing entirely on the short term.  And that is what companies do when they are trying to flip for a fast payday. But when you are building something enduring, you have to care as much about next year as you do about next week.  That is how you build something big and that’s our goal.

2) Respecting our Readers 

We care about the experience of people who read BuzzFeed and we don’t try to trick them for short term gain.  This approach is surprisingly rare.

How does this matter in practice? First of all, we don’t publish slideshows. Instead we publish scrollable lists so readers don’t have to click a million times and can easily scroll through a post. The primary reason to publish slideshows, as far as I can tell, is to juice page views and banner ad impressions.  Slideshows are super annoying and lists are awesome so we do lists!

For the same reason, we don’t show crappy display ads and we make all our revenue from social advertising that users love and share.  We never launched one of those “frictionless sharing” apps on Facebook that automatically shares the stories you click because those apps are super annoying. We don’t post deceptive, manipulative headlines that trick people into reading a story.  We don’t focus on SEO or gaming search engines or filling our pages with millions of keywords and tags that only a robot will read.  We avoid anything that is bad for our readers and can only be justified by short term business interests.

Instead, we focus on publishing content our readers love so much they think it is worth sharing. It sounds simple but it’s hard to do and it is the metric that aligns our company with our readers. In the long term is good for readers and good for business.

3) We Build The Whole Enchilada  

Most publishers build their site by stapling together products made by other companies. They get their CMS from one company, their analytics package from another, their ad tech from another, their related content widgets are powered by another, sometimes even their writers are contractors who don’t work for the company. This is why so many publisher sites look the same and also why they can be so amazingly complex and hard to navigate.  They are Frankenstein products bolted together by a tech team that integrates other people’s products instead of building their own.

At BuzzFeed we take the exact opposite approach. We manage our own servers, we built our CMS from scratch, we created our own realtime stats system, we have our own data science team, we invented own ad products and our own post formats, and all these products are brought to life by our own editorial team and our own creative services team. We are what you call a “vertically integrated product” which is rare in web publishing. We take responsibility for the technology, the advertising, and the content and that allows us to make a much better product where everything works together.

It is hard to build vertically integrated products because you have to get good at several things instead of just one.  This is why for years Microsoft was seen as the smart company for focusing on just one layer and Apple was seen as dumb for trying to do everything.  But now Apple is more than twice (!) as valuable as Microsoft and the industry is starting to accept that you need to control every layer to make a really excellent product.  Even Microsoft and Google has started to make their own hardware after years of insisting that software is what matters.

BuzzFeed is one of the very few publishers with the resources, talent, and focus to build the whole enchilada.  And nothing is tastier than a homemade enchilada.

4) We Are Doing Something Hard 

Vertical integration means we have to be good at lots of things which is hard.  But doing something hard can actually be an advantage for a business.  It means that there are not that many other people trying to do what we do or capable of doing what we do.  For example, venture capitalists don’t like funding companies that have reporters on staff.  In the early days of BuzzFeed, I had several VCs say they were interested in investing if we could figure out a way to fire all the editors and still run the site. I’m not joking.Tech investors prefer pure platform companies because you can just focus on the tech, have the users produce the content for free, and scale the business globally without having to hire many people.  Startups that promise this vision have an easier time attracting funding which is why there are so many startups trying to be the next Twitter or Facebook or the Instagram or Pinterest for X, Y, or Z.  Meanwhile, companies that employ reporters, editors, and creative people usually struggle to get funding which is why so few publishing companies or agencies are venture backed.

Fortunately, we have been able to convince a few, smart contrarian investors to back our business including NEA, the biggest venture fund in the world.  As one of the few venture backed publishers, we are in a unique position to be one of the leading creators of web content crafted by true professionals. There are lots and lots of things that random, unpaid web users suck at doing.  In particular, the best reporting and the most entertaining media is usually created by people who do it for a living – that means us!

5) We Got Lucky!

A big part of our recent success has also been luck.  People don’t like to admit it but skill is 63% luck.

In our case, we got very lucky with timing.  We were a company focused on making content for people to share just as the social web came of age, at the moment when Facebook and Twitter and other platforms reached scale, and at exactly the moment when it became possible to build a big publishing company through social distribution.

This same lucky shift made our business model work for the first time.  A couple years ago, we were trying unsuccessfully to sell social advertising to a market that only wanted to buy banners but things have changed dramatically since then.  Now many agencies and brands are refusing to buy banners, companies that rely on traditional display units are suffering, and budgets are shifting rapidly to social advertising. One of our board members, who was initially skeptical of our decision to not run banners, recently said that “social advertising will be the biggest media business since cable television.” Times have changed.

Now we are leading the market, which is a huge opportunity, but it was pure luck that a social advertising market even exists for us to lead.  It’s like we happened to start surfing a few minutes before a great wave rolled in.  Or we built a locomotive and a few days later the train tracks got built. We were obsessed with social content and ads before anyone else cared and it was extremely lucky that the world shifted toward us when it did.  The question now is how well we capitalize on our good fortune.

6) We Don’t Treat Half Our Team Like Losers

BuzzFeed is unique in that we are equally obsessed with 1) entertaining content, 2) substantive content, and 3) social advertising.  The teams that focus on each of these areas are equally important which is a key part of our success. We want our cute animals, humor, and animated gifs to be the best of their kind on the web – they aren’t just a cheap way to generate traffic.  We want our reporters to have the best scoops, the smartest analysis, and the most talked about items – they aren’t just a hood ornament to lend the site prestige. And we want our advertising to be innovative, inspiring, and lead the shift to social – and not just be a necessary evil that pays the bills.

Some companies only care about journalism and as a result the people focusing on lighter editorial fare or advertising are second class citizens.  Some companies only care about traffic which creates an environment where good journalists can’t take the time to talk to sources or do substantive work.  Some companies only care about ad revenue and actually force editors to create new sections or content just because brands want to sponsor it.

People don’t do good work when they feel like losers and are second class citizens within their own company.  Fortunately we have avoided that problem.  We love the silly, we love the substantive, and we love making advertising that is actually compelling.  And when we are good at these three things it benefits everyone and the world.

7) Our Awesome Team 

This next one will sound a bit cliche and sappy, but a huge reason we are doing well now is…….you.  We have an amazing team of extremely talented people who really know what they are doing.

We have a group of culture editors who are insanely tapped into the flow of culture on the web, from 4chan to Reddit to Tumbler to Twitter to Pinterest to blogs to pop culture to memes and know how to add their own ideas to the mix and create entertaining posts that people love to share.

In just the past 6 months (!), we have assembled an incredibly talented group of reporters and writers who are regularly breaking news, unearthing scoops, advancing ideas, and engaging business leaders, US Senators, Presidential candidates, the White House, and leading media outlets. Politics was our first vertical and has already become THE defining outlet of the 2012 presidential campaign and the newer verticals are already on their way to owning there respective areas.

Our teams focused on social advertising are totally killing it, with a consultative sales team full of ideas for clients, a creative services team making incredibly entertaining and sharable ads, a social discovery team expanding campaigns to Facebook, Twitter, and across the web, and an ad ops team that traffics our campaigns with skill, grace, and dogged determination – it’s not surprising we are blowing away all our revenue goals. Gong!

And finally the tech, product, and data teams are inventing and building an unparalleled social publishing platform that powers everything we do, including a massive non-relational realtime stats database that tracks billions of data points for our Social Intelligence Report (launched today!), machine learning system for predicting viral hits, elegant publishing tools for editors, and a beautiful front end design that is continually tested, improved, and evolved with the benefit of smart multivariate testing.

You rock and you keep getting better and better with each passing day.  It is really amazing to watch.

But Success Is Fragile…

It’s easy to get excited and arrogant when things are going well but it is important to remember that success is very fragile.  Digg sold for $500K after being worth $200 million just a few years ago. In the same time period, RIM, maker of the Blackberry, lost 95% (!) of its value.  There is continual disruption in our industry and you are likely to fail if you get complacent or stop evolving.

This is why we met today to discuss our “Next Level” plans and why we are always focused on pushing what we do to the next level.  We have done amazing work in the past year and we should all feel proud.  But to thrive in the future, we need to stay humble, enjoy the journey, and continually evolve and improve.

I’m really looking forward to the rest of the year.

Thank you all for doing such inspiring work.

A startup should raise venture capital (or “venture-style” angel/seed funding) only if: 1) the goal is to build a billion-dollar (valuation) company, and 2) raising millions of dollars is absolutely necessary or will significantly accelerate growth.

There are lots of tech companies that are very successful but don’t fit the VC model. If they don’t raise VC, the founders can make money, create jobs, and work on something they love. If they raise VC, a wide range of outcomes that would otherwise be good become bad.

Unfortunately, many of these startups graft VC-friendly narratives onto their plans and raise too much money. Short term it might seem like a good idea but long term it won’t.

The best source of capital is customers. The next best is the founders (cash or forgone salaries), or investors who are less aggressive about returns than VCs. Every startup has its natural source of financing. Venture capital is the natural source of financing for only a small fraction of startups, despite what the press might lead you to believe.

“The test of a first-rate intelligence is the ability to hold two opposed ideas in the mind at the same time, and still retain the ability to function.” – F. Scott Fitzgerald

One reason running a startup is so interesting is the constant tension between opposing ways of thinking: short-term vs. long-term, internal vs. external, saving vs. investment, etc. At large companies, responsibility for these ways of thinking is often spread across multiple business units. In startups they fall on a few people, usually the founders.

As a founder, the most important tension is between your capabilities and sensibilities. Capabilities are your talents and resources. Sensibilities are the way you see the world. Successful founders usually have an unlikely combination of capabilities and sensibilities. The right sensibilities without the right capabilities means a good vision, poorly executed. The right capabilities without the right sensibilities means building something your market doesn’t want. Getting both right creates founder-market fit.

There are advantages and disadvantages to being an experienced entrepreneur. Disadvantages include the fact that, with age, you are more likely to have obligations outside of your startup. You also risk having calcified sensibilities. Counterbalancing this is greater self-awareness, and, ideally, the wisdom to choose markets that match your sensibilities and cofounders who augment your capabilities.

Consider the following simple model for the willingness-to-pay of two cable buyers, the “sports lover” and the “history lover”:

What price should the cable companies charge to maximize revenues? Note that optimal prices are always somewhere below the buyers’ willingness-to-pay. Otherwise the buyer wouldn’t benefit from the purchase. For simplicity, assume prices are set 10% lower than willingness-to-pay. If ESPN and the History Channel were sold individually, the revenue maximizing price would be $9 ($10 with a 10% discount). Sports lovers would buy ESPN and history lovers would buy the History Channel. The cable company would get $18 in revenue.

By bundling channels, the cable company can charge each customer $11.70 ($13 discounted 10%) for the bundle, yielding combined revenue of $23.40. The consumer surplus would be $2 in the non-bundle and $2.60 in the bundle. Thus both buyers and sellers benefit from bundling.

This model is obviously dramatically oversimplified. In real life, bundling tends to flatten the demand curve (here is some background on demand curves, and here is academic paper that presents this argument in rigorous mathematical terms). Suppose the demand curves for ESPN and the History Channel look like this:

The green boxes represent revenue for the seller. The deadweight loss areas to the right of the green boxes are transactions that would have benefited buyers and sellers but are not occurring because the revenue-maximizing prices are set too high.

Now consider what happens when you bundle channels. The key assumption is that individual buyers lie on different x-axis points of the demand curves of different channels. Sports lovers lie on the left of the ESPN demand curve but on the right side of the History Channel curve. To aggregate demand curves, you don’t stack one on top of the other. You add consumers’ willingness-to-pay separately for each channel.

Using the above simplified model, the two demand curves that go from $10 to $3 become one curve that stays flat at $13. In general, adding the individual demand curves creates a flatter demand curve:

A flatter demand curve lets sellers charge prices that capture larger areas under the curve and pass more surplus back to consumers. The only  loser is the deadweight loss area.

Some things to note about bundled pricing:

1. Bundled pricing is one reason why subscription models like Spotify should ultimately win out over à la carte models like iTunes. Subscription commerce can also be thought of as a form of bundling.

2. There are other ways to get some of the benefits of bundled pricing – for example versioning goods, and offering bulk discounts.

3. The benefits of bundled pricing are proportionate the buyers’ variance of preferences for the goods. Hence bundled pricing works best in highly “taste-based” goods like media, and wouldn’t have any benefit for fully commoditized goods (e.g. a bundle of stocks)

4. Bundled pricing can also hurt consumers if it is used by incumbents to exploit their broader catalog to “deter entry” by new competitors. This was a common complaint against Microsoft in the 90′s when they bundled applications like Internet Explorer with Windows.

The y-axis is the students’ “willingness-to-pay” and the x-axis is the students sorted from highest to lowest bids. The line is known as the demand curve.

Now imagine you’re the company selling these trips. For simplicity, suppose you’ve already bought the trips, so your marginal cost is zero. What’s the optimal price you should charge? If you set the price at, say, $500, then the students who are willing to pay above $500 would buy the trip, and the rest wouldn’t:

Your total revenue and (assuming zero marginal cost) profit will be the area of the green square (revenue times quantity).

Notice the sections under the curve to the right and above the green box. To the right are students who were willing to pay but were priced out. Those are missed sales opportunities. Above the green box are students who were willing to pay more than you charged. That is lost revenue. (Since the underpricing benefits customers, the area above the green box is called the consumer surplus).

After you have chosen the right price, the only way to make the area under the curve greener is to charge different customers different prices. The theoretically optimal way to do this is to look at each notecard and offer to charge each student, say, 10% less than the prices he or she bid. In real life you can’t do this (although Priceline has gotten close by asking customers to enter their willingness to pay). Some companies – most famously Amazon - have attempted outright price discrimination, but this tends to anger customers and can even run afoul of the law.

So the goal of pricing is to capture as much area under the demand curve as possible. In practice, the best way to do this is to find proxies for willingness-to-pay that are easy to observe and that customers will accept.

For example, airlines know that business customers will pay more than vacation travelers. They therefore look for acceptable proxies to segment business and vacation travelers and capture more of the area under the demand curve.

This is why flights are cheaper when you book early, stay over on weekends etc. The airline pricing models assume you are a vacation traveller.

Book publishers would like to price their books according to customer enthusiasm. Hardcore fans will pay more for books when they are first published, and casual readers will wait. If publishers offer the same book at different prices at different times, their price discrimination will be too obvious (interestingly, time windowing for movies doesn’t provoke much outrage). So book publishers offer modestly better goods – hardcovers – to early buyers.

Enterprise software companies price using proxies for the customer’s budget. Oracle databases are priced by the number of processors. Salesforce is priced by the number of end users (“seats”). Many enterprise software companies obfuscate the highest tier of pricing, telling sales prospects at that level to “call us.” What this really means is: “Call us, so our sales people can attempt to estimate your budget and price discriminate accordingly.”

Sometimes, the search for pricing proxies can lead to absurdity. I once heard someone from a prominent hardware company tell a story about how his company had offered two versions of a printer. The cheaper model was identical to the more expensive one, except the cheaper one printed fewer pages per minute. To accomplish this, the cheaper printer had the same hardware as the expensive one, except the cheaper one had an additional chip that forced it to slow down. This made the cheaper printer more expensive to produce. Situations where cost and price have zero or negative correlation are far more common than most people assume.

The best way to figure out what these companies are really doing is to read Wall Street analyst reports. For example, here’s what a prominent Wall Street analyst recently said:

Most cable companies we met with have embraced tiered data plans, with tiering starting to move to total monthly usage rather than tiered speeds. The minimum tiers are set higher enough at this point that they impact only 1%-2% of users. However, we believe the concept is to establish an early precedent of usage tiers and then let the average consumer usage patterns move in their direction over time, as usage is growing 60% per year. This puts in place an effective long-term hedge against internet video. [emphasis added]

- Goldman Sachs research. “Americas: Communication Services”, May 23, 2012

In 2011, Comcast generated $55B in revenue and $8.4B in pre-tax profits. Goldman rates the stock a “buy” because Comcast “pushed through rate hikes on both video and broadband access across two-thirds of the [customer] base in Q1 2102″ (Goldman Sach, “Comcast Corp”, May 2, 2012).

There is a trade off between integrated and non-integrated approaches to building devices. The non-integrated approach lowers costs, but adds friction between components that compromises performance. Consider this anecdote from Microsoft’s previous attempts to build tablets with hardware partners:

The H.P. tablet was thick, the Intel processor it used made the device hot, and the software and screen hardware did not work well together, causing delays whenever a user tried to perform a touch action on its screen. “It would be like driving a car, and the car not turning when you turn the wheel,” the former H.P. executive said.

- ”With Tablet, Microsoft Takes Aim at Hardware Missteps,” New York Times

What is the difference between mobile devices today where the integrated approach is winning and desktops PCs in, say, 1995, when the non-integrated approach dominated? The best way to understand the difference is through the lens of Clay Christensen’s disruptive technology theory*. When a new category of device first launches, it is usually not “good enough” for most customers. Chistensen illustrates this with a famous graph:

According to Christensen, technology gets better at a faster rate than customers’ demands on technology do (in the graph, the black line goes up faster than the other lines). Eventually, new device categories become “good enough” (the black line crosses the purple/blue lines), and customers become unwilling to pay significantly higher prices for improved versions of the device. At this point it doesn’t make sense for manufacturers to invest in greater performance if customers won’t reward that investment. Instead, manufacturers should spend the “performance surplus” on making devices less expensive. The best way to do this is to let different companies produce the core software and hardware components, i.e. to switch from an integrated to non-integrated approach.

If you believe Christensen’s theory (and most senior people at large technology companies do), the interesting question now is: when will smartphones and tablets be “good enough” (respectively) for non-integrated to beat integrated approaches? My guess is it will be at least 5-10 years before customers are no longer willing to pay significantly more for faster bandwidth, more features, longer battery life, increased storage, faster processors, etc. But no one really knows.

It isn’t hard to see how Google, Microsoft and pretty much everyone but Apple missed the key difference between PCs and the new generation of mobile devices. Christensen himself missed it:

Christensen’s most embarassing prediction was that the iPhone would not succeed. Being a low-end guy, Christensen saw it as a fancy cellphone; it was only later that he saw it also being disruptive to laptops.

- When Giants Fail: What Business has learned from Clayton Christensen, The New Yorker. [paywall]

Seen as high-end smartphones, iPhones were “sustaining” innovations (above the blue line) that would only appeal to the highest end of the market. Seen as low-end laptops, iPhones were disruptive innovations that would eventually subsume the PC business. With support from the iPad, they seem to be doing exactly that.

* If you aren’t familiar with Clay Christensen, this talk is a great way to learn about his theories.

1) The good people bounce up, the bad ones bounce down. I was told this by my boss once when he was firing one of my friends. At the time, I thought this just made him feel better about himself. Over time, I’ve seen the wisdom in what he said. Some people who get fired react by fixing their weaknesses. Others spiral down.

2) Do it early. If you think you’re going to fire someone over the next six months, you probably will. Don’t wait too long. Too many founders do. It’s better for management and employees if it happens fast.

3) It’s awful. You’re in control of a situation that will meaningfully hurt someone. It’s an awful place to be. The fired person will go home and tell his/her family about how terrible it was. It was your fault. Perhaps your mismanagement caused it. Who knows. You’ll question it, and perhaps you are right to do so.

4) The other choice is firing everyone. You’re the founder of the company. If you run out of money, you’re forced to fire everyone. If you don’t fire the bad employees, you risk everyone else’s jobs. It’s an impossible situation.

5) The feeling is more likely to be mutual than you think. Most of the time, the person getting fired was already about to quit. The antipathy you feel is likely reciprocated. It’s surprising how often this happens and management doesn’t see it coming.

It would be great if startups were all about growth, hiring, and success. But the reality is that founding a company is a brutal job and lots of the pain gets passed down to employees. Creative destruction sounds nice in textbooks, but in the real world it means telling friends to go home, stop getting paid, and find new jobs.

“When art critics get together they talk about Form and Structure and Meaning. When artists get together they talk about where you can buy cheap turpentine.” – Picasso (via Ribbonfarm)

When I was a kid, I tagged along with my grandfather who was an oboist in a big city symphony. I was struck by the dramatic discrepancy between the culture of the audience and the culture of the musicians. Before the show, the audience attended fancy events, and talked in abstract terms about classical music. After the show, the musicians played poker, told jokes, swigged bourbon, and traded tips about the best places to get parts for their instruments.

In the context of startups, it’s convenient to read the Picasso quote as a tidy summarization of the difference between critics (VCs and the tech press) and practitioners (entrepreneurs). There is some truth to this. When entrepreneurs get together, they tend to talk about tactical details. VCs and the press talk about trends, markets, and other abstractions.

But Picasso was just being modest. He thought about the meaning of his art far more deeply than his critics did. The same is true of great entrepreneurs. “Cheap turpentine” is important, but so is “Form and Structure and Meaning”. The best ideas emerge from the interplay between the two modes of thought.

Buy into a business that’s doing so well an idiot could run it, because sooner or later, one will.

This is a useful way to understand the meaning of “equity value”. You learn in finance that equity value is the overall value of a the stock (i.e. equity) of a business, which in turn is the present value of all future profits. Of course with startups the future is extremely uncertain, leading to a huge variance in valuations.

In perfectly competitive markets, all profit margins tend toward zero. So equity value is a function of the degree to which you can make your market inefficient by making your business hard to copy (so called “defensibility”). If your defensibility depends solely on having superior people, you have what VCs call a “service business.” In a competitve labor market, service businesses tend to have low margins and therefore low equity value. A popular saying about service businesses is “the equity value walks out of the building every night.”

Different types of tech businesses exhibit different relationships between capital, revenue, profits, and equity value. Enterprise software companies tend to require lots of capital to get to scale but command high equity values once they do, partly because enterprises are risk averse and like to adopt the most popular technology, leading to winner-take-all dynamics. Adtech companies tend to be quick to revenue but slower to equity value, and sometimes risk becoming service businesses. The equity value of consumer internet companies vary widely, depending on their defensibility (usually networks effects and brand) and business models (e.g. transactional vs ad supported). Biotech companies require boatloads of capital for R&D and regulatory approval but then can generate lots of equity value, with the defensibility coming primarily from patents. (Patents introduce market innefficiencies, but, proponents argue, are necessary to create sufficient incentives for entrepreneurs and investors). E-commerce companies generally require a lot of capital as well, since their defensibility comes mostly through brand and economies of scale.

- Financing risk: You can’t raise money at various stages because you haven’t hit accretive milestones or your space isn’t appealing to investors.

- Product risk: You can’t translate your concept into a working and compelling product.

- Technology risk: You can’t build a good enough or, if necessary, breakthrough technology.

- Business development risk: You can’t get deals with other companies that you depend on to build or distribute your product.

- Market risk: Customers or users won’t want your product.

- Timing risk: You are too early or too late to the market.

- Margin risk: You build something people want but that you can’t defend, and therefore competitors will squeeze your margins.

At the early stage, the main way to mitigate these risks is to recruit great people as cofounders or early employees. You shouldn’t recruit people that will give you a high likelihood of reducing these risks. You should recruit people that give you an unfair advantage. You should try to win the game before it starts.

Startups are hard, and risky. But if you lump all the risks together, you are playing the lottery. Talented entrepreneurs identify specific risks and do everything they can to overcome them.

- In the private markets, macro tends to dominate micro. Venture valuations have swung by roughly a factor of 4 over the last decade. In finance speak, venture tends to be high beta, moving as a multiple of the public markets, which themselves tend to move more dramatically than economic fundamentals. Hence, it is easy to imagine scenarios where the same private company will command 1/2 the valuation in 6 months due to macro events, but it’s rare for a company to increase their valuation 2x through operations alone in 6 months.

- Therefore, when it seems to be the top of a venture cycle, it’s almost always better to raise money sooner rather than later, unless you have a plausible story about how waiting will dramatically improve your company’s fundamentals.

- Prior to the Facebook IPO, the consensus seemed to be that private valuations were near the top of the cycle. Today, FB is valued at up to 50% below what private investors expected. Moreover, the financial crisis in Europe seems to have worsened, and unemployment numbers in the US suggest the possibility of a double dip recession.

- It takes many months to understand how macroeconomic and public market shifts affect private company valuations since (with the exception of secondary markets) private transactions happen slowly. So we don’t know yet what these recent events mean for private markets. According to a basic rule of finance, however, it is safe to assume that companies “comparable” to Facebook are worth up to 50% less than private investors thought they were worth a few weeks ago.

- The question then is what companies are comparable to Facebook. Clearly, other social media companies with business models that rely on display or feed based advertising are comparables. Internet companies that have other business models (freemium, marketplaces, commerce, hardware, enterprise software, direct response advertising, etc) are probably not comparables. The public markets seems to agree with this. Defensible companies with non-display-ad business models have maintained healthy public market valuations.

- One counterargument to the “all social media companies are now worth less” argument is the discrepency between how the smart Wall Street money and smart internet money views Facebook and social media companies generally. The smart Wall Street money thinks like Mary Meeker’s charts. They draw lines through dots and extrapoloate. This method would have worked very poorly in the past for trying to value tech companies at key inflection points (and tech investors know that what matters are exactly those inflection points). In Facebook’s case, Wall Street types look at revenue and margin growth and the trend toward mobile where monetization is considerably worse (for now). Smart internet investors, by contrast, look at Facebook in terms of its power and capabilities. They see a company that is rivaled only by Google and Apple in terms of their control of where users go and what they do on the internet. Smart internet investors are far more bullish than smart Wall Street investors on Facebook. Thus if you believe the internet perspective over the Wall Street perspective, you’d likely believe that Facebook and social media in general is undervalued by the public markets.

Today, people increasingly realize they own more than enough stuff, and don’t want to pay for feature-rich versions of that stuff. Four blades in your razors are enough. In the language of Clay Christensen’s disruptive innovation framework, the product economy overshot the mass market’s needs.

An economy of experiences is emerging in its place. Experiences make people happier than products (a fact that scientific studies support). The popularity of experiences like music concerts has skyrocketed compared to corresponding products like music recordings. Apple, the most valuable company in the world, maniacally focuses on product experiences, down to minute details like the experience of unboxing an iPhone. Customers want to know where their food and clothes come from, so they can understand the experiences surrounding them. The emphasis on experiences also helps explain other large trends like the migration to cities. Cities have always offered the trade-off of fewer goods and less space in exchange for better experiences.

The trend toward experiences is important for technology startups. The era of competing over technical specifications is over. Users want better experiences from devices, applications, websites, and the offline services they enable. It is no coincidence that interaction design is replacing technical prowess as the primary competency at startups. People who create great experiences will be the most valuable to startups, and startups that create great experiences will be the most valuable to users.

If the pre-product/market-fit phase of a startup is about efficiently testing hypotheses, then continuing to test an idea only makes sense if you have a strong theory about what has gone wrong and how things will improve.

Specifically, you should have a theory about: 1) how to modify your product, 2) how to modify your marketing/distribution strategy, and/or 3) how external events (a new technology wave, cultural events, regulatory change, etc) might make your product take off. In other words, you need a plausible argument as to why the future will be different than the past.

Another way to think about this is using what Jeff Bezos calls the “regret-minimization framework.” Imagine you do give up on your idea. Have you explored most of its plausible implementations? Are you confident that another entrepreneur won’t come along and make it work? You’ll regret it more if you nearly created a big company than if you spent an extra six months iterating.

Finally, beware of the temptation to get distracted by new shiny ideas. When you are deep in the weeds, new ideas seem refreshing but this is usually the false signal of “uninformed optimism” that accompanies all new things.

1. Time wasters: Apps that can be used for short bursts when you are waiting in line, etc. The most popular time wasters are games. Some apps are used sometimes as time wasters and sometimes as utilities – e.g. Facebook is both a time waster (checking status updates few minutes) and a utility (sending Facebook messages).

Time wasters tend to be faddish. It is easy to get hooked on new games and also easy to tire of them. If you want to build a big company that builds time wasters, you need to build a machine that builds, markets and monetizes apps, as Zynga has done.

2. Core utilities: As a rule of thumb, core utilities are the apps on your home screen: camera, phone, contacts, texting, calendar, etc. Core utilities map to deeply engrained use patterns that usually existed before modern smart phones. In the past people might have carried around a paper calendar, a standalone camera, etc. Core utilities tend to be very sticky – if you gain widespread adoption for a core utility you can build long-lasting value.

One entry strategy for a startup is to replace a core utility. This is what Instagram did to the built-in camera app. It is unclear whether the “Instagram for video” companies are core utilities (video app replacements) or time wasters. Creating a new core utility that doesn’t replace an existing core utility is very hard. Foursquare seems to have done this for the users who regularly check-in.

3. Episodic utilities: Episodic utilities are apps that typically aren’t on the home screen but are extremely useful in certain situations. Some examples: Hipmunk when buying plane tickets, Uber when you need a car, and OpenTable for making restaurant reservations. Successful episodic utilities target a well-defined situation and then become deeply associated with that situation. Making an app that is too broad or has multiple use situations can hurt you. Because many of these situations involve purchasing, these apps tend to be monetizable.

4. Notification-driven apps: This is an emerging category. Android has had a good notification system for a while, but the iPhone only made notifications useful in IOS 5. People tend to enable notifications for communication apps like email, texting etc. Thus far, notifications for other apps haven’t gotten widespread adoption because, among other things: it is easy to annoy users by over-notifying them, and running non-communications apps in the background tends to drain battery life. Expect this category to grow as apps get smarter about when to notify, and battery life improves dramatically over the next year or two.

A friend of mine got a job at a big company and was shocked to see his colleagues worked just a few productive hours a day. They didn’t seem to care about their work or have relevant expertise. My friend said: “Wow, this company is going under.” Then the company released its quarterly reports and profits rose to an all-time high. The momentum of the company’s brand and relationships was sufficient to propel it forward.

On the flip side, first-time entrepreneurs often fail to realize that when you build something new, no one will care. People won’t use your product, won’t tell people about it, and almost certainly won’t pay for it. (There are exceptions – but these are as rare as winning the lottery). This doesn’t mean you’ll fail. It means you need to be smarter and harder working, and surround yourself with extraordinary people.

The default state of the world is to stay the way it is, which means the default state of a startup is failure.

Facebook relies on an old internet business model: display ads. Display ads generally hurt the user experience, and are also not very efficient at producing revenues. Facebook makes about 1/10th of Google’s revenues even though they have 2x the pageviews. Some estimates put Google’s search revenues per pageviews at 100-200x Facebook’s.

The good news for Facebook is there is a lot of room to target ads more effectively and put ads in more places. The bad news is that, if there is one consistent theme in both online and offline advertising, it’s that ads work dramatically better when consumers have purchasing intent. Google makes the vast majority of their revenues when people search for something to buy or hire. They don’t have to stoke demand – they simply harvest it. When people use Facebook, they are generally socializing with friends. You can put billboards all over a park, and maybe sometimes you’ll happen to convert people from non-purchasing to purchasing intents. But you end up with a cluttered park, and not very effective advertising.

The key question when trying to value Facebook’s stock is: can they find another business model that generates significantly more revenue per user without hurting the user experience? (And can they do that in an increasingly mobile world where display ads have been even less effective.) Perhaps that business model is sponsored feed entries, as Facebook seems to be hoping (along with Twitter and perhaps Tumblr). The jury is still out on that model. Personally, I have trouble seeing how insertions into the feeds aren’t just more prominent display ads. You still have to stoke demand and convert people from non-purchasing to purchasing intents. A more likely outcome is that Facebook uses their assets – a vast number of extremely engaged users, it’s social graph, Facebook Connect – to monetize through another business model. If they do that, the company is probably worth a lot more than the expected $100B IPO valuation. If they don’t, it’s probably worth a lot less.

- Start every morning by skimming through news, blogs, articles, etc. Much of this is tech related. I used to get tech news in the newspaper, then in Google Reader, and now mostly from Twitter. If someone I meet mentions something interesting that was published that I didn’t read, I go back and figure out how I missed it and change who I follow on Twitter so it doesn’t happen again.

- Try to meet with interesting people during the week. The reason being up on tech news is important is so that we can get the most out of the meetings. Often we’ll talk about whatever each of us is working on at the time but it’s also good to have news or blog posts as shared reference points. This makes the meetings more interesting for everyone.

- Try to learn at least one interesting thing each week and then blog about it. Then see how people react in comments, on Twitter etc. I guess some bloggers don’t like comments but for me they are the crucial so that I can get feedback on new hypotheses. Blogging new hypotheses also means a decent portion of your blog posts need to be ignored or ridiculed. Otherwise you are playing it too safe.

1) Public tech companies: Anyone with a basic understanding of finance would have trouble arguing many large public tech companies are trading at “bubble valuations” – e.g. Apple (14 P/E), Google (18 P/E), eBay (16 P/E), Yahoo (17 P/E). You could certainly debate other public tech stock valuations (there are a number of companies that recently IPOd that many reasonable people think are overvalued), but on a market-cap weighted average the tech sector is trading at a very reasonable 17 P/E.

2) Instagram seems to be the case study du jour for people arguing we are in a bubble. Reasonable people could disagree about Instagram’s exit price but in order to argue the price was too high you need to argue that either: 1) Facebook is overvalued at its expected IPO valuation of roughly $100B, 2) it was irrational for Facebook to spend 1% of its market cap to own what many people considered one of Facebook’s biggest threats (including Mark Zuckerberg – who I tend to think knows what is good for Facebook better than pundits).

3) Certain stages of venture valuations do seem on average over-valued, in particular seed-stage valuations and (less obviously) later-stage “momentum valuations.” The high seed-stage valuations are driven by an influx of angel/seed investors (successful entrepreneurs/tech company employees, VC’s with seed funds, non-tech people who are chasing trends). The momentum-stage valuations are driven by a variety of things, including VC’s who want to be associated with marquee startup names, the desire to catch the next Facebook before it gets too big, and the desire of mega-sized VC funds to “put more money to work”.

4) Certain stages – most notably the Series A – seem under valued. Many good companies are having trouble raising Series As and the valuations I’ve seen for the ones who do have been pretty reasonable. Unfortunately, since the financials and valuations of these companies aren’t disclosed, it is very difficult to have a public debate on this topic. But many investors I know are moving from seed to Series A precisely because they agree with this claim.

5) No one can predict macro trends. The bear case includes: something bad happens to the economy (Euro collapses, US enters double dip recession). The warning sign here will be a drop in profits by marquee tech companies.  The bull case includes: economy is ok or improves, and tech continues to eat into other industries (the “software is eating the world” argument). Anyone who claims to know what will happen over the next 3 years at the macro level is blowing hot air. That’s why smart investors continue investing at a regular pace through ups and downs.

6) The argument that sometimes startups get better valuations without revenue is somewhat true. As Josh Koppelman said “There’s nothing like numbers to screw up a good story.” This is driven by the psychology of venture investors who are sometimes able to justify a higher price to “buy the dream” than the same price to “buy the numbers.” This doesn’t mean the investors think they will invest and then get some greater fool to invest in the company again. For instance, at the seed stage, intelligent investors are quite aware that they are buying the dream but will need to have numbers to raise a Series A.

7) No good venture investors invest in companies with the primary strategy being to flip them. This isn’t because they are altruistic – it is because it is a bad strategy. You are much better off investing in companies that have a good chance to build a big business. This creates many more options including the option to sell the company. Acquisitions depend heavily on the whims of acquirers and no good venture investors bet on that.

- Dell thrived when PCs dominated the computer market and Dell was the low cost provider of commodity hardware products. The shift to mobile and tablet computing meant that hardware quality (not price) was once again the primary basis of competition. As a result, Dell’s laser-like focus on cost reduction became a liability.

- The New York Times was, for many decades, one of the few premium channels through which brand and classified advertisers could reach mass consumers. Thus car companies and real estate brokers subsidized foreign reporting and investigative business journalism. The internet provided a vast alternative channel, and the Times became far less relevant. At the same time, the internet provided many new sources for breaking news, editorials etc, hurting the Times on the subscriber side.

- Yahoo didn’t lose because Google out-competed them on search. They lost because they didn’t really care about search – indeed, they outsourced algorithmic search to Alta Vista, Inktomi and then Google itself. The leading portals back in circa 2000 (Yahoo, Excite, Lycos etc) desperately wanted to keep keep users on their site – the buzzword was “stickiness” – but Google knew better and focused on getting users off of Google to other places on the web. Yahoo became just another place to read celebrity gossip and use generic web services.

- Netflix thrived when they could simply ignore the movie companies and rely on the first-sale doctrine to get DVDs. The market shift to streaming video created a new and brutal dependency. They had to go make deals with content companies. Now they are even trying to create their own content to lessen this dependency. They have a brilliant and visionary management team but this is a tough transition to make.

- Sony relied on its Steve-Jobs-like founder, Akio Morita, to repeatedly develop incredibly innovative products (among them: the first transistor radio, the first transistor television, the Walkman, the first video cassette recorder, the compact disc) that seemed to come out of nowhere and create massive new markets. Since he left, the company has floundered and the stock has fallen dramatically.

- Google’s biggest risk isn’t a direct competitor. Startups and incumbents who’ve tried to create better search engines have barely cut into Google’s market share. Google’s primary risk – and they seem to know this – is that they are no longer relevant when people find content through social sites, and where an ever increasing portion of the web is uncrawlable.

Google released their “Dropbox-killer” a few days ago. I don’t know if Dropbox has yet achieved incumbent status, but they certainly seem to be the market leader. They also seem to have a very competent management team. So if history is a guide, Dropbox’s biggest risk isn’t a competitor but irrelevance – if, for example, files become less and less important in a web services world and Dropbox doesn’t adapt accordingly.

1) Issuing of senior securities with multiple liquidation preferences. Example:

Series A: Small investor invests in $1m round, getting 1x straight preferred

Series B: Large investor invests $10m, getting 4x senior straight preferred

Company gets sold for $30m. Management gets $3m carveout, Series B investors get $27m, and Series A investors get zero.

2) Issuing of massive option grant to management along with new financing at a below-market valuation. Example:

Series A: Small investor invests in $1m round, getting 1x straight preferred for 10% of the company.

Company is doing well and is offered a Series B at a significantly higher valuation. Instead, large investor invests $5m at below-market valuation, getting 40% of the company, and simultaneously issues options worth 50% of the company to management.

Result: Series A investors are diluted from 10% to 1% of the company, even though the company was doing well and in a normal financing would have only been slightly diluted.

3) The company is actually multiple entities, with the smaller investor investing in the less valuable entity. Example:

Company has entity 1 and 2. Small investors invest in entity 1 that licenses IP from entity 2. Value of IP increases and entity 2 is sold and eventually cancels entity 1′s license, making entity 1 worthless.

4) Pay-to-play or artificially low downrounds. Example:

Series A: Small investor invests in $1m round, getting 1x straight preferred

Series B: Large investor invests $10m in pay-to-play round (meaning any investor that doesn’t participate has their preferred shares converted to common). Smaller investor doesn’t have the cash to re-invest in Series B, but deeper pocketed investors do.

Company sells for $10m. Series B investors get $10m. Series A investors get nothing.

There are ways to protect against these shenanigans. Protections can be written into the Series A financings documents (pro-rata rights, ability to block senior financings, etc). There are also some legal protections all minority investors are granted under, say, Delaware or California law. But usually even when these protections exist (and they exist far less frequently these days than in the past), smaller investors usually can’t, say, invoke blocking rights by themselves (indeed, it’s often not economically viable for smaller investors to hire lawyers to review every financing document for every company they invest in). Another way smaller investors can protect themselves is to set aside capital amounting to, e.g. 30% of every investment made, in case they need it later for defensive purposes (I do this). But in my experience this is all very complicated and difficult to execute in practice, even when the small investors are “professional” investors. I worry it will be even harder for “amateur” investors to protect themselves.

A lot of startups over outsource. A few years ago, you’d sometimes hear tech startups say they were going to outsource software development. Thankfully, founders have gotten smart about this and it rarely ever happens except as a stopgap. It is still common for startups to hire outside PR firms. If you decide to hire an outside PR firm, that means you don’t care about PR. Just because you are willing to spend some of money on it doesn’t mean you think it’s important. You probably shouldn’t hire an investment banker during an acquisition unless your company is later stage. And you might occasionally use an outside recruiter but the core recruiting activity needs be done by founders.

The excitement over mobile-first apps is justified. Smartphones have unleashed a wave of creativity, resulting in entirely new categories of applications. But to me an even more exciting trend is what people have been calling (for lack of a better phrase) ”offline first, mobile enabled” apps.

For example, Foursquare is primarily about improving your offline experiences (meeting friends and finding new places to go). And it couldn’t exist without smartphones (ok, Dodgeball existed on feature phones but had a fraction of the utility). Similarly, Uber couldn’t exist without smartphones. The Uber apps (one for drivers and one for customers), while essential, are all about enabling for the car service. Square is about making payments more convenient and giving small businesses better analytics. The mobile app is just an enabler.

It seems natural that the first wave of mobile apps would be about improving core smartphone apps (e.g. photo apps) or porting apps from other devices (e.g. games). And there is probably a lot of interesting innovation remaining there. But the really massive opportunity is dreaming up new ways that the little computers loaded with sensors that we carry around with us everywhere can improve our real-world experiences.

What we’ve seen have been evolutionary improvements on the patterns established five years ago. The platforms that have seemed hot in the last couple of years — Tumblr, Instagram, Pinterest — add a bit of design or mobile intelligence to the established ways of thinking.

One thing these critics need to be careful about is that, as Clay Christensen has long argued, many important new inventions start out looking like toys. Twitter (Founder Fund’s headline example of a “trivial” startup) started out looking like a toy but has since transformed the way information is distributed for tens of millions of people. Madrigal dismisses cloud computing as “a rebranding of the Internet” whose only effect has been to make “the lives of some IT managers easier,” overlooking that cloud-based services solve the “third party payer” problem of enterprise sales, thereby completely changing how enterprises adopt new technology.

That said, I generally agree with the sentiment that the startup world is too focused on chasing trends. I don’t think this is the fault of entrepreneurs. I meet entrepreneurs all the time who are working on ideas that seem quite meaningful to me. Some of them are building futuristic new technologies. Some are trying to disintermediate incumbents and thereby restructure large industries. Others are trying to solve stubborn problems in important sectors like education, healthcare, or energy.

The problem I encounter is that many of these “meaningful” startups have trouble raising money from VCs. An entrepreneur working on groundbreaking robot technology recently joked to me that he’d have an easier time raising money if his robots were virtual and existed only on Facebook. He was only partly joking. His startup will require a lot of capital and doesn’t have an obvious near term acquirer. Only a small group of VCs today will even consider such an investment.

One of the most important lessons I’ve learned is that there are only two ways to make useful products out of large data sets. Algorithms that deal with large data sets tend to be accurate at best 80%-90% of the time (an old “joke” about machine learning is that it’s really good at partially solving any problem). Consequently, you either need to accept you’ll have some errors but deploy the system in a fault-tolerant context, or you need to figure out how to get the remaining accuracy through manual labor.

What do I mean by fault-tolerant context? If a search engine shows the most relevant result as the 2nd or 3rd result, users are still pretty happy. The same goes for recommendation systems that show multiple results (e.g. Netflix). Trading systems that hedge funds use are also often fault tolerant: if you make money 80% of the time and lose it 20% of the time, you can still usually have a profitable system.

For fault-intolerant contexts, you need to figure out how to scalably and cost-effectively produce the remaining accuracy through manual labor. When we were building SiteAdvisor, we knew that any inaccuracies would be a big problem: incorrectly rating a website as unsafe hurts the website, and incorrectly rating a website as safe hurts the user. Because we knew automation would only get us 80-90% accuracy, we built 1) systems to estimate confidence levels in our ratings so we would know what to manually review, and 2) a workflow system so that our staff, an offshore team we hired, and users could flag or fix inaccuracies.

* My first job was as a programmer at a hedge fund, where we built systems that analyzed large data sets to trade stock options. Later, I cofounded SiteAdvisor where the goal was to build a system to assign security safety ratings to tens of millions of websites. Then I cofounded Hunch, which was acquired by eBay – we are now working on new recommendation technologies for ebay.com and other eBay websites.

The increasing velocity has implications for the valuations of incumbent tech companies. Users have limited time, and while web and app usage are growing, hit startups are growing much faster and therefore gaining adoption, at least in part, at the expense of incumbents. It’s not clear this risk is priced into the valuations of companies like Facebook (P/E expected to be ~100) and Zynga (P/E ~31). In other words, faster velocity should lead to a narrower distribution of valuations from seed to late stages. We’ve seen the seed stage adjust but not the late stage.

The current posture of big VCs seems to be to wait to see what takes off and then chase the winners. Tons of investors tried to invest in Instagram’s A and B rounds, and I’m sure VC interest in Pinterest is intense.

The problem with this model of Series A and B investing is that, in reality, many of the companies with big hits weren’t overnight successes. Pinterest, OMGPOP, Twitter, and Tumblr were around for years before taking off and all benefited greatly from having patient investors. In the current financing environment, a lot of good companies won’t live to get Series As and Bs and big VCs will pay valuations on hits that are priced to perfection.

Increasing velocity is great for users and for the winning companies and investors. But when good companies aren’t getting follow on rounds because they aren’t yet “hockeysticking”, the long term health of the startup ecosystem suffers.

Angry Birds was Rovio’s 52nd game. They spent eight years and almost went bankrupt before finally creating their massive hit. Pinterest is one of the fastest growing websites in history, but struggled for a long time. Pinterest’s CEO recently said that they had “catastrophically small numbers” in their first year after launch, and that if he had listened to popular startup advice he probably would have quit.

Fast company on April 3, the opening of “The dirty little secret of overnight success“:

Angry Birds, the incredibly popular game, was software maker Rovio’s 52nd attempt. They spent eight years and nearly went bankrupt before finally creating their massive hit.

Pinterest is one of the fastest-growing websites in history, but struggled for a long time. Pinterest’s CEO recently said that it had “catastrophically small numbers” in its first year after launch and that if he had listened to popular startup advice he probably would have quit.

No link or attribution.

Update: Thanks to Fast Company for a fast response and changing it to a quote with citation.