Charles Ponzi in 1910

I have 216 subscriptions in my RSS reader as I write this.  While I like to read the Google News page at least once a day, I much prefer blogs for any kind of real insights beyond just news.  I’ve cast such a broad net because I have broad interests and because there are a lot of very smart people out there blogging away their best ideas–it’s a gold mine of inspiration and understanding, and well worth the time I spend sifting through the articles.  My favorite insights come from finding the correlations, connections, and harmonies between multiple seemingly disparate posts.  For today, what got my juices flowing well enough to take out the blogging pen were these two articles:

–  Paul Graham’s ode to growth entitled, “Startup = Growth”

–  Jason Cohen’s potentially career limiting, “The Rise of the Successful Unsustainable Company”

I say career limiting of Jason’s piece because as he mentions in the post, it is going to annoy some people.  This is probably a career limiting post I am writing too, but that’s okay, I don’t want a career with a successful unsustainable company.

Speaking of which, let’s start there.  What is a “Successful Unsustainable Company?”

Whenever people have asked me why I like Enterprise Software startups more than B2C Internet plays, I always use the same response:

B2C Internet plays are all about fashion trends and I’m not an arbiter of fashion.  I can’t tell you whether this is the right time to make millions using sock puppets to sell pet food.  I can tell you how to solve a hard problem that has valuable ROI in the Enterprise.  I prefer the latter as a way to maximize the value of my career investment portfolio.

That’s actually a bit mellower than my true philosophy, which I’ll say more about below, but it’s where I started.

With that said, not every B2C play is a fashion play.  The fashion play is not sustainable because inevitably, fashions will change and it is hard to keep up when that happens.  There are many B2C companies that have sustainably created value for consumers:  Apple, Amazon, and Starbucks, to name a few.

I well remember the first fashion play I came across.  It was a company called “Pointcast”, and many of the hottest VC’s loved it.  I used to see it running on machines in the lobby of their offices.  Pointcast was a screen saver that delivered news gleaned via the Internet to your screen.  It was intended to be monetized via an advertising model.  It made absolutely no sense to me whatsoever:  How can we sell ads that are only “seen” when the computer decides we have walked away from our PC’s?  Yet, they ultimately received, rejected, and regretted rejecting a $400 million acquisition offer from News Corp before they ultimately went bankrupt.

What went wrong?

They were a fashion.  They were solely focused on growth.  They delivered virtually no value.  They were not sustainable.  Most of all, they self-selected users that were not committed.

This is where I start to wonder when I read that startups are about growth, growth, growth, and dare I mention, “Growth!”  Paul Graham is Paul Graham, but geez, isn’t there more to it than Growth?

Fred Wilson is a smart VC, and though I don’t always agree with him, he is careful to point out that while he loves Graham’s article on growth and generally agrees, his firm wants sustainable growth:

One thing that Paul did not touch on is the difference between organic and sustainable growth and temporary stimulated growth. Things like gaming Facebook’s open graph can temporarily stimulate growth that is not sustainable long term. Investors can be faked out by things like that. Gaming Google’s search algorithms is another way that has been done in the past. When we look at growth, we look for authentic, organic, and sustainable growth that is not overly dependent on a single source, particularly a source the startup doesn’t control. That takes some experience to detect. We’ve messed up there as have most investors.

Sustainable and organic growth that can continue for five or ten years unabated will produce extraordinary returns.

This is laudable, but I’m not sure it really captures very well what I think of as Sustainable Growth.  For one thing, he telegraphs one of the key drivers of the rush to Unsustainable Growth–his firm plans to get out in five or ten years so the rest doesn’t matter so much.

Jason Cohen’s article chronicles the career of Bill Nguyen’s awesome track record at building unsustainable growth.  Putting aside his most recent one, Color, which blew up $41M without accomplishing anything, Jason offers the following list:

• Forefront — IPO’ed in 1995 by CBT — CBT stock fell 85% in 1998 and prompted class-action lawsuits.
• Freeloader — On $3m invested, sold for $38m in 1996 — shut down in 1997.
• Support.com — On 2.5m invested, IPO’ed in 2000 for $32/share — stock price now $2.
• OneBox.com — On $60m invested, sold for $850m 18 months after launch to J2 just before market crash — score!
• Seven — On $60m invested, still private, cancelled an IPO.
• Lala — On $35m invested, sold to Apple for $80m — shut down in June.

Much sound and capital ultimately signifying nothing.  They cashed out, got acquired, and achieved liquidity by any means possible and then died suddenly.

What’s with these deals, and why do so many deals recently look destined to follow the same path?

There are at least two problems endemic to the system that are guaranteed to produce a lot more unsustainable hyper growth companies with unhappy ultimate ends.

The Use of Other People’s Money Leads to Bubble Exits

As a generally financially savvy culture, we have a shockingly limited menu of options when it comes to investing in companies.  We either take debt with its associated meager interest returns and a desire to only take debt in stolid safe organizations, or we make an equity investment and expect skyrocketing growth to let us bail out with enough return to justify the risky business we’ve engaged in.  Despite much evidence that momentum investing is fundamentally unsafe, nobody wants to follow Warren Buffet’s strategy of buying and holding forever.  What a pity given he is the most successful investor of all time.

Most of the exits are engineered to be bubbles in this world.  The IPO is designed to either take as much capital off the table now and sink as Facebook did, or to sandbag the heck out of the value of the company so all the early investors feel so good that the stock can’t help but rise, as Workday did.  Both are bubbles, it’s only a question of who profits–company with more capital raised or subsequent investors and underwriters with more headroom to profit from.  Nobody wants to be in the middle and price at a fair multiple that doesn’t immediately take off in one direction or the other after the opening bell.  IPO markets are dynamically unstable systems.  They are undamped oscillators.  Some of our best fighter planes are dynamically unstable too–it gives them an edge in maneuvering against adversaries when they want to snap suddenly in one direction or another.  It also means the pilot ejects and they crash if the fly by wire system fails because humans can’t fly aircraft that are that unstable.

But moreover, what a shame that we haven’t managed to invent some way of sharing the returns so that we don’t have to create a bubble exit and we can enjoy buying and holding forever.  As a proponent of bootstrapped companies that never raise capital, I believe those companies are awesome.  Yet, I have yet to see a viable structure for how to invest and profit from them in a way that will keep their founders happy as well.  We live in an age when many new models (Kickstarter, anyone?) are being invented, so perhaps it will come to pass.

Meanwhile, the use of Other People’s Money leads to Bubble Exits.

This is due to the inefficiencies of the distribution and management of the capital.  VC funds expect to get lousy returns on most of their ventures.  Ironically, it seems the later they wait to invest in the interest of reducing risk, the lower the returns of the industry seem to go.  But this is no matter because the biggest players still catch enough Google and Facebook-sized waves to prosper and new funds keep rolling in.  Perhaps if you really aren’t that confident in predicting who the real winning companies are the best proxy is to pick the fastest growth companies who will be in a position to monetize at the end of the shortest window of risk exposure.  Hence we’ll be less and less interested in those long-term SaaS plays.

So, we are self-selecting bubbles because we think that minimizes the risk profile, because the other money middle men already set up the IPO markets and such to work as bubbles so they make their returns, and because only the bubbles return enough to win for the portfolio.

Hyper Growth Requires Eliminating Friction, But Commitment is Friction in and of itself

This one is a bit awkward to express and bit abstract, but it is the more important of the two points, so bear with me.

If growth is the only yardstick, then we should design the entire Customer Experience to promote growth.  One way to do that is to minimize the friction while maximizing the viral desire to help get the word out.  Twitter is my favorite example of this.  Among all the Social Software, it requires so little commitment; there is almost no friction.  A signup is needed to get credentials, and then just the occasional 140 character Tweet.  Who can’t come up with 140 characters to say about something, even if only what they had for lunch?  Combine that with making it easy to follow, and we’re off to the races.

There are many examples of engineering for friction-free participation.

Pinterest is great fun, I love it, and the friction is even less than for Twitter.  With Pinterest, I don’t even have to be creative enough to come up with my own Tweets, er photos.  I can borrow everyone else’s photos.  I may not have ever uploaded a single photo, yet by simply pointing and clicking I can assemble some phenomenal boards.  It is stamp collecting for the New Millenium.

Or, how about LinkedIn’s recent business of having everyone endorse each other’s skills.  What a wonderful use of the principal of creating obligation.  You get an email telling you that people are endorsing your skills.  You’re gratified, you want to see who is being so kind, suddenly you feel the obligation to endorse a few of their skills, but of course you get handed random people in your network to endorse.  Chances are you wind up endorsing more people than were in the email that came to you and got you started, so the viral factor is going strong.

We’ve learned a lot about how to do this sort of thing, but along the way with all of this single-minded focus on growth, we have minimized commitment.

Just because I have pinned a few photos of Ferraris does not mean I am a Ferrari customer.  Just because I Tweeted 140 characters does not mean those are my most profound let alone my most monetizable thoughts.  What we have is the New Millenium no-ROI marketing.  All those kazillions of dollars spent by the Madison Ave Mad Men are still being spent on the Internet trying to use vehicles like these to move the masses to buy our products.

Seth Godin does the best job of anyone I know teasing apart the value of having customers who are truly committed and not just brand following sheep.  He has endless posts about the subject.  A great recent post is, “Nobody ever bought anything on an elevator.”  I read it as a cautionary tale about gradually building a following and not trying to close the sale too soon.  You can’t close the sale with 140 characters or a picture.  But you can get millions or even a billion people to do something.  Is it something of value?  Is there real scalable ROI?  By scalable ROI, I mean we can keep writing bigger and bigger checks and make more and more profit?

The conundrum is that valuable commitment is a form of friction all by itself.  People are skeptical.  They need convincing before their hearts and minds will fall into line.  They need even more convincing before they go out on a limb and tell their friends.  Look at all that Apple has investment over so many years to build their level of customer commitment.  Sure they see hyper growth in new products now, but it took years to build the foundation of committed customers that enable that kind of growth.  It just might be that when you see a company that is too new to have achieved that level of commitment, that you should decide there isn’t much commitment there.  And if there isn’t much commitment, there can’t be much value being created.

The reason hyper growth is so unsustainable yet so lucrative is it lives in the unique intersection of these two issues.  It revolves around getting more and more people to do something, however trivial, with the promise that later they’ll do something that is not trivial, while being secure in the knowledge that you can exit before that is ever put to the test.

Whaddya mean you want to sell?

How do you position and maneuver your VC-funded startup for acquisition?

The short answer is, “You can’t.”  

The VC’s didn’t sign up for an acquisition.  They are seeking a billion dollar revenue opportunity because that’s what it takes to move the needle on their portfolio.  If they are willing to talk about an acquisition at all, it is either a totally insane IPO-level valuation, or they have serious deal fatigue and you’d better watch out lest you find yourself walking the “sell-it-before-the-next-round-or-we-shut-the-doors-or-replace-you” plank.  Those sharks below the end of that plank look mighty hungry and the water there is cold.

I’m not going to spend a lot more time trying to convince you of that truth.  I’ve written about it before, and I have lived it more than once.  You may think you’re doing your investors a big favor offering them an early 10x return, but you’re not, so don’t kid yourself.  VC’s are VC’s, they don’t mean anything by it, but they have a job to do and they try hard to be good at it.  Don’t get cross-ways with those gears.

In particular, don’t think you can decide how much money to raise in a way that keeps your options open.  Your options will be determined based on how the VC’s feel about your company’s prospects.  If they’re bullish, they won’t let you sell absent a major hostage terrorist negotiation (been there, done that, do not want any more of those T-shirts).  If they are not bullish, you have much worse problems than deciding to raise a little less money to preserve your options.  Your first problem is you won’t have the luxury of raising less if they aren’t bullish.  At best, they will agree to participate pro-rata if you can find some new sucker to set the price and pony up.  At worst, they don’t go pro-rata and it becomes nearly impossible to raise any money.  I had the joy of trying to operate under those conditions in the wake of the 2008 crash, Sequoia memos, and the rest of the gloom and doom.  One of my VC’s would go pro rata, the other wouldn’t, having already invested in larger competitors.  I walked the plank.

So forget that idea.  It’s a non-starter.  The only way to win is to figure out how to fly faster to the goal, not slower.  And hasn’t that always been true for your startup?

The other reason it is a non-starter is that companies are bought and not sold. Unless you’ve already been in talks that convince you that you have the opportunity to be bought, forget about it until you do have those talks. If you’re thinking you need to preserve the option for talks later, reread the first part of this article where the VC’s are going to decide anyway and then do as follows:

Raise enough to be able to accomplish something in the next 12-18 months that significantly reduces risk and raises the valuation. That aggressive risk-reducing goal you intend to accomplish is central to a good pitch anyway. This is a proposition your Board will understand and can buy into, it is a prudent use of capital, it is a good test of whether everyone is wasting their time (you are if you can’t figure out how to significantly reduce the risk with a defined mission), and it still sets the stage for acquisition talks as the acquirer is acquiring to reduce their own risk, which is almost always the case. If you reduce your risk, it either reduces theirs too or it positions you as closer to the top of the list they could acquire to solve their problem.

Raising less than enough to significantly reduce risk is a sure recipe to show up the next time you need money without having made enough progress. That’s not going to go well at all. See the various excellent posts out there on dilution. Some of those meetings where you need to raise more without having accomplished enough are inevitable, but why set a plan in motion that guarantees it?