Jason Devitt

An old friend of mine had this to say about one of the points in my post Don’t Ask:

You don’t ask is the sector hot. Your do explain why of course, but I think there is more to it. An old trading maxim, when a piece of new economic data comes out what do you do first? Analyze what the data means for the economy or something like that? Wrong. The first thing you do is analyze how other people are going to view the data. This is far more time critical than what you think of the data … Take this into start-ups and you get, if other people think the sector is hot it will positively change how they perceive my business and make everything I do easier (funding and of course staff).

For highly liquid securities in public markets, he is absolutely right. But successful VCs don’t usually think this way (even though they are essentially prop. traders, managing a private equity book). Neither should entrepreneurs. The reason is liquidity; in trading terms, if it is going to take three years on average to work out of every position that you put on, you can’t afford to bet on sentiment.

In English, for the entrepreneur:

1. Sure, you are more likely to get capital if the sector is hot, because there are fools out there who will give it to you. Then what? Leaving aside the craziness of 1999-2000, there are very few opportunities to flip privately held companies to greater fools in a couple of months. You have two to five years to build something that is (or has clear potential) to be a big, profitable business. Jason Fried summed it up like this: "Building to flip is building to flop."

2. If what you are doing happens to be in a hot sector then you should probably play that up. But first impressions last.  Once you tag your company as, say, P2P in the minds of customers,
journalists, and investors, it is incredibly difficult to change that
once the market sours. If P2P is fundamental to your business and your
business still makes sense, you just ignore the noise and carry on. But
if it’s not and you now need to re-invent yourself, good luck. The staff who joined you for this reason will quit. The investors who backed you will complain about having to explain the change to their LPs. The best you can hope for from the press is to
be tagged as a company that is … trying to reinvent itself. You will change the company’s name to escape your past, and confuse all your customers in the process.

3. If it’s on the cover of BusinessWeek, it’s too late. Hot sectors are almost by definition over-competed; the best opportunities are usually in categories that look picked over and abandoned. When Google started search was supposed to be over, done, finished. (David Cowan ran away from the house where Google was built.) P2P was hot when Napster was but untouchable by the time that Skype launched. In the early 1990s VCs lost over a billion dollars investing in tablet computers and PDAs;  Palm computing started after that and had to sell themselves to 3Com to get the capital that they needed. The market for electric cars was supposed to be dead in the US before Toyota launched the hybrid Prius, etc. etc.

4. Finally, if the company that you’ve been building for five years is getting a lot of attention because your sector has become hot, then you should seriously consider selling it. Be a seller, not a buyer, when the sector is hot.

***

One of my other points was on the limitations of market research. Michael Mace has an excellent post on this topic today, using mobile phones as an example.

As promised, three questions I never ask about a startup idea …

What does the market research say?

For a variety of reasons I am interested in developing brand new products and services, not minor variations on existing products. The problem is that market surveys about products that do not exist contain almost no information.

I don’t mean that they are always wrong; that would make them very helpful. I mean zero information content - no better than tossing a coin.

The main reason is that most people are terrible at visualizing what a completely new product might look like and how it might affect their lives. How would you have responded to a survey in 1994 about your level of interest in the Internet? What about mobile phones - in 1984?

Even people directly involved in the market that you are targeting are bad at this - or else they’d have had the same idea that you have. This is why they’re going to call you a visionary, right?

A more general problem is that many surveys are poorly designed. Here’s one list of potential errors. If all you have is the outline of an idea for a new product, you are guaranteed to commit most of them. Garbage in, garbage out.

Once there’s a working prototype, market research starts to get useful. If it’s hardware you can build a fully-functioning prototype and still face significant costs before going into production; proper market testing is essential. But on the web, if you have a working prototype then slap the word beta on and ship it. Make it an invitation-only trial if you think there is still a lot of work to do.

Research the market as it stands. Research your competitors. And definitely talk to potential customers; but if the concept is new, you have to be very careful about how you interpret their answers.

Is this technology cool?

Who cares? Does the product work, does it meet a need (or create its own), is it cheaper than the alternatives?

Getting excited about a cool technology is probably the most common mistake made by brilliant engineers when they start companies.

YouTube used someone else’s technology - Macromedia’s Flash player - to create a brand new service - syndicated video. Network effects from syndicated video grew their traffic to 100 million video streams per day. And that traffic was valued by Google at $1.65 billion. To say that YouTube has no interesting technology of its own is both correct and irrelevant.

But YouTube’s success points to another question which does matter: does the technology scale? As the New York Times explained earlier this week, Friendster could not scale; MySpace did. Again, there is nothing cool about MySpace’s technology. It just worked.

Is this category hot?

If simply adding ‘Web 2.0′ to the first page of your business plan makes an investor more excited than they were before, think very carefully before taking their money. They do not know what they are doing. And if this is the only way that you can get anyone interested in backing your idea, start over.

Panning for Gold by Jon Kneller

Last time I wrote about the questions you should ask yourself before starting a business. Any business. They apply no matter who you are and no matter what business you have in mind, be it cafe, shipyard, or gunsforkillingnanobots.com.

How you decide whether a given business is right for you is much more personal; it depends on your skills, your interests, your ambitions, and the kind of people and resources that you can call upon to help you. I want to grow a very small business into a very large one; I really enjoy the challenges that brings. You may not want to employ more than five people provided you’re generating the income you want. Our criteria for sizing up potential businesses will be very different.

First-time entrepreneurs often don’t think about this at all. They have a great idea and dive right in. Second-time entrepreneurs like me have bad memories about doing that, and we also get offered more choices - which forces us to develop some sort of process for sorting through them.

Here are the questions that I ask myself about each new idea. Thoughts and comments welcome; your process may be very different and/or much better.

Am I going to enjoy this?

I am going to spend 60 to 100 hours a week working on this for, say, 5 years without a guaranteed return. It had better be fun, or worthwhile, or intellectually challenging. Ideally all three.

Do I know a lot about the market, or does no one know anything about the market?

If I enter a market that I know nothing about, I’ll waste time and money learning how it works and making avoidable errors while more experienced competitors watch me suffer. I’d rather be on the other side, or else enter a market that’s entirely new. I’ll still waste time but so will everyone else.

How large will the market be?

If the market will never be larger than $10 million, neither will my revenues. The challenge is the gap between "is" and "will be." The mobile advertising market may be worth $10 billion one day, but not yet. CD sales are headed in the opposite direction.

Is there a concentration of suppliers or vendors in the market today?

Then there are powerful people who can stop me from succeeding in ways that I may not be able to anticipate. I wrote about this in a previous post. 

How many potential revenue streams are there?

There’s no way of knowing what direction the business may take. The more potential revenue streams I can see, the more degrees of freedom I will have.

Advertising can be a great business model. But it’s seasonal, it’s the first budget cut in a recession and the last one raised in a recovery, most of your revenue is non-recurring, and even your best customers often pay you 90 days late.

Is this idea genuinely disruptive? How? To whom?

Clayton Christensen’s ideas on innovation inform a lot of my thinking about strategy. Unfortunately, like most interesting concepts in management theory, they’ve been diluted. Almost every tech entrepreneur describes his or her business as disruptive (and viral and web 2.0 and industry-leading), although if you ask them whether they are competing against non-consumption or providing a low-cost alternative to over-served customers their faces go blank.

Read the books if you haven’t, and check out the cover story of this month’s Business 2.0. (I don’t agree with all of their picks, but Zopa is a standout.)

A disruptive business model offers me the best chance of growing a very small business into a very large one with the least amount of capital and the least threat of competition from big established companies.

WIll this scale?

Put simply, will revenues grow faster than costs? This rules out service businesses completely. eBay is better than Amazon; Amazon is better than WalMart.

How will I reach customers?

I love businesses where customers have a good reason to recruit
other customers, beyond merely liking the product. Nothing beats
messaging in this regard: ICQ, Skype, now Jajah. MMOGs are a lot more
fun for you if you can persuade your friends to play. [1] 

How far can I get without Other People’s Money?

I am not obsessed with ownership or control. Outside investors can help a business grow much more quickly by bringing knowledge and relationships to bear as well as capital. And owning 50% of a successful business is much better than 100% of a failed one. But the further I can get without OPM, the less of my business I will have to sell when I do decide to take it.

Ideally, can I get to cashflow-positive without taking a dime from anyone except friends and family? [2]

Forget accounting profits; cash is king. A business that throws off more cash than it takes to keep the doors open is not only more valuable to outside investors, it has far more exit options. And thinking about how to get there from day one helps me to ensure that I am building a real company, not a science project.

How do I create barriers to entry?

For the kind of businesses
that interest me, the only barriers to entry anymore are network
effects, plus good old-fashioned brand loyalty and out-innovating the
competition. I am skeptical about the value of patents to a tech
startup because of the cost of acquiring and enforcing them. Smart
customers hate getting locked into proprietary technologies, and my
first customers are likely to be very smart. And exclusive partnerships
are rare in fast-moving industries; nobody wants to commit.

But sometimes with a little thought a business idea that has no
network effects can be reworked so that it does. For example, if SixApart did more to bring me
readers from other Typepad blogs, by leveraging the data that only they
have, then I would have a great reason to keep my blog here. [Update: I have since left Typepad.]

Next: questions I never ask myself about a business idea.

[1] It’s not to late to save ‘disruptive’, but I can’t say ‘viral’ with a straight face.

[2] I recommending letting friends and family in at the beginning, even if you don’t need the money. It gives the people closest to you a stake in your success, and not wanting to let them down is a great motivator. If you are successful, they probably won’t be able to afford to invest later on. But never take money from anyone who can’t afford to lose it.

Earlier this week a friend asked me how I screen ideas for new businesses; how do I decide what to do next. Do I ask people I trust for their opinions? Do I look at revenue projections? The buzz on Techcrunch? What Google paid for YouTube?

I was about to write a post about this, but then I remembered something more important.

Back up. Start with what makes you happy. Carried away with ideas for new widgets, a lot of entrepreneurs never stop to think about this.

Do you hate working for someone else? If so, why? Is it just because you have a lousy boss? Changing your job or even your career may seem hard, but both are a lot easier than starting your own business. Or is it because you would rather bear all the responsibility for being wrong than be overruled and later proven right?

Do you hate having other people report to you? Unless you can find a partner who will do that while you make all the important decisions - and good luck with that search - you will be working with a handful of partners or all by yourself.

You have an idea for a product or service that doesn’t exist. Great. Have you considered licensing the idea to someone else? Or, since a raw idea is worth approximately zero, just giving it away? Or do you have good reason to believe that no one else could do it better than you can?

Do you value your free time? Do you "work to live, not live to work"? Or does the thought of bringing your idea to market make you happier than almost anything else in the world? (Don’t be ashamed.)

Do you enjoy spending all of your time designing new products or writing code or talking to customers? If you start your own business you will be lucky to spend 10% of your time doing what you most enjoy.

Does asking people for help or for money make you feel uncomfortable? Or do you think that when you ask someone to invest or work with you, you are doing them a favor?

Do you have a routine that make you very comfortable, or do you prefer frequent change? You had better like change. A lot.

What about your spouse and kids? Can they stand the upheaval? Or can they not imagine you doing anything else? Could you cancel a family vacation for the sake of a customer? An anniversary dinner? Miss your daughter’s holiday concert? This may not happen often, but I promise you that it will happen.

Can you deal with failure?

Finally, do you just want to be rich? Then become a corporate lawyer. The odds are better.

If you answered all these questions the right way and you are not running your own business, then you ought to be.

Tomorrow I will write about how I screen business ideas.

Kids? Sure, but I have known some startup CEOs who could use this.