Increasing velocity

Two common discussions in the startup world right now are 1) the increasing speed at which new apps/websites can gain mass adoption (Instagram, Pinterest, OMGPOP’s Draw Something, etc), and 2) the rise in seed stage valuations. These two trends are real and related.  An investor with a broad portfolio of companies might rationally invest at an average valuation of, say, 10m (which is historically considered very high for that stage) if they have a chance for one of the investments to become the next Instagram or Pinterest. A billion dollar hit pays for a lot of misses.

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.

Some thoughts on incumbents

Reposted from Oct 7, 2010 from cdixon.posterous.com

By “incumbents” I mean the big companies that are loosely competitive to your startup.

– The first thing to do is try to understand the incumbent’s strategy.  For example, see my analysis of Google’s strategy.

– Being on an incumbent’s strategic roadmap is a double-edged sword.  On the one hand, they might copy what you build or acquire a competitor.  On the other hand, if you build a valuable asset you could sell your company the acquirer at a “strategic premium.”

– Incumbents that don’t yet have a successful business model (e.g. Twitter) might think they have a strategy, but expect it to change as they figure out their business model.  An incumbent without a successful business model is like a drunk person firing an Uzi around the room.

– Understand the incumbent’s acquisition philosophy. More mature companies like Cisco barely try to do R&D and are happy to acquire startups at high prices.  Incumbents that are immature like Facebook only do “talent acquisitions” which are generally bad outcomes for VC-backed startups (but good for bootstrapped or lightly funded startups). Google is semi-mature, and does a combination of talent and strategic acquisitions.

– Understand the incumbent’s partnership philosophy.  Yahoo and Microsoft are currently very open to partnerships with startups.  Google and Facebook like to either acquire or build internally. If you don’t intend to sell your company, don’t talk seriously about partnerships to incumbents that don’t seriously consider them.

– Every incumbent has M&A people who spend a lot of their time collecting market intelligence. Just because they call you and hint at acquisition doesn’t mean they want to buy you – they are likely just fishing for info. If they really want to buy you, they will aggressively pursue you and make an offer.  As VCs like to say, startups are bought, not sold.

– Try to focus on features/technologies that the incumbents aren’t good at.  Facebook is good at social and social-related (hard-core) technology.  Thus far they’ve kept their features at the “utility level” an haven’t built non-utility features (e.g. games, virtual goods, game mechanics).  Google thus far has been weak at social and Apple has been weak at web services.

– Try to focus on business arrangements that the incumbents aren’t good at.  Facebook and Google only do outbound deals with large companies.  With small companies (e.g. local venues, small publishers) they try to generate business via inbound/self service. Building business relationships that the incumbents don’t have can be a very valuable asset.

– Be careful building on platforms where the incumbent has demonstrated an inconsistent attitude toward developers. Apple rejects apps somewhat arbitrarily and takes a healthy share of revenues, but is generally consistent with app developers.  You can pretty safely predict what they will will allow to flourish. Twitter has been wildly inconsistent and shouldn’t be trusted as a platform.  Facebook has been mostly consistent although recently changed the rules on companies like Zynga with their new payment platform (that said, they generally seem to understand the importance of partners thriving and seem to encourage it).

– Take advantage of incumbents’ entrenched marketing positioning.  The masses think of Twitter as a place to share trivial things like what you had for lunch (even if most power users don’t use it this way) and Facebook as a place to talk to friends.  They are probably stuck with this positioning.  Normals generally think of each website as having one primary use case so if you can carve out a new use case you can distinguish yourself.

– Consider the judo strategy.  When pushed, don’t push back.  When Facebook adds features like check-ins, groups, or likes, consider interoperating with those features and building layers on top of them.

Incumbents

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

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

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

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

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

Why did Skype succeed and Joost fail?

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

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

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

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