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.

According to Gizmodo, Samsung has decided to exit the market for low-end phones, those old-fashioned devices that just let you make phone calls. They are unable to compete with the likes of Nokia. Meanwhile Nokia’s earnings are down 4% even as revenues grow 20%. So who is winning?

Five years ago I had a conversation with Shannon Maher about the future development of mobile phones. At the time most phones in the US did nothing but voice calls; most American consumers had never heard of SMS. Repeating the conventional wisdom in tech circles, I claimed that Moore’s Law would inevitably lead to ever more powerful and complex cellphones that would be like miniature PCs. Shannon surprised me with the first plausible argument I’d ever heard against this claim. [1]

He pointed out that for 20 years Moore’s Law had been driving the development of desktop PCs and mobile phones in different ways. PCs had gotten more and more powerful every year while staying roughly the same price. Mobile phones on the other hand had gotten smaller and cheaper every year without adding any new capabilities. Why wouldn’t this trend continue, he asked?

Shannon was right about the trend. But then two things happened. First, phones got so cheap that in the US, where carriers subsidize handsets to encourage people to sign up for long-term contracts, the price to the consumer reached zero. Second, almost everyone in the developed world who was ever likely to buy a mobile phone finally bought one.

If phones are essentially free and everyone already has one, there are only two ways for carriers to grow their businesses. They can keep cutting the price of phone service to take customers from each other, or they can persuade customers to buy more powerful phones and new data services. Handset makers don’t have much room left to cut prices on low-end phones, so they too want to sell us more powerful handsets. Or they can sell phones for a few dollars each to people in the developing world and seek The Fortune at the Bottom of the Pyramid.

As the largest handset maker, Nokia bet on its economies of scale and has come to dominate the low end with hundreds of millions of nearly identical handsets. Much smaller rivals like Samsung could not compete. But every disadvantage is a potential source of advantage; because of their small size, Samsung, LG and others were more willing to do small runs of experimental handsets in hundreds of different configurations, with various combinations of color screens, cameras, keyboards, thumbwheels,
GPS receivers, Java, stored-value chips, music players, FM radios,
music players, 3D graphics engines, and memory. This was exactly the sort of expensive Darwinian process necessary to find out what consumers really wanted, and it is still going on.

Samsung briefly overtook Motorola to become the number two manufacturer in the world, but Motorola fought back with weapons that Asian manufacturers still haven’t mastered (and that a lot of people thought Motorola had forgotten): design and branding. Thanks largely to the RAZR, Motorola now has a ten percentage point lead on Samsung again.

Meanwhile Nokia still seems complacent about this vast middle of the mobile phone market. So do many of the entrepreneurs that I meet who want to develop applications and content for the mobile phone. Like Nokia, when they look to the future they look to smartphones, the $500 plus high-end devices powered by Symbian (or Windows Mobile), and they think that they just have to wait for consumers to catch up with them.

I am not so sure. While there are a lot of business customers for whom a smartphone makes sense as a low-cost alternative to a laptop, and a lot of rich consumers who just want to buy the most expensive phone on the market no matter what it does, the future of phones is being decided in the mid-market by Motorola and Samsung.

Despite their recent troubles - the loss of share to Motorola and the downward pressure on earnings caused by all that expensive experimentation - I think Samsung’s approach to the market makes more sense than Nokia’s. The future belongs to them. Or to LG, or Haier, or Motorola or whichever one of the dozen other players can best combine continuous innovation with design to own the mid-market.

And I see no evidence that what most people want is a miniature PC.

[1] ‘People don’t need that stuff’ doesn’t count. People didn’t need the wheel.

Photo by Christian Oth

Happy First Anniversary to my beautiful wife.

It’s been a wonderful year. (I do admit that spending most of it traveling around the Pacific didn’t hurt.)

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.

Photo uploaded by tychay

Are there ever any advantages to starting a technology company in New York versus Silicon Valley?

Summer and I have spent the last nine months traveling; all of our things are in storage; we could live anywhere. I want to start another technology company. We’re trying to decide where to go.

Let me simplify things. Obviously my wife’s career is important too, but I am not going to discuss her career here. And obviously we have friends in New York and strong feelings about the place, strong enough perhaps to keep us here no matter what. But we’ll weigh all these things ourselves. The fact is we have no children, jobs, or apartment, and it is very easy for us to move. What I want to focus on here is the business advantages, if any, of starting a technology company in New York.

Fred Wilson thinks that "entrepreneurs should start businesses where they want to work and then organize the company according to what works best for them. The whole company, particularly development, does not need to be in one location anymore." I agree, but as in all things just because you can doesn’t mean you should.

It is true that you can start a company almost anywhere. The founder of RightNow moved to Bozeman, Montana after selling his previous company, got bored, and started another - in Bozeman.

But certain places have undeniable advantages: high concentrations of talent, capital, infrastructure, service providers, and more. In tech, nowhere beats Silicon Valley. (Paul Graham has written two essays on the subject, comparing the Valley to the rest of America and America to the rest of the world, and without repeating his arguments let me say that I agree with most of them.)

Build your business in Bozeman and on top of all the usual risks of starting a new business - market acceptance, competition, execution, e. coli. - you add the risk that it will take six months longer to find staff, investors, office space, and lawyers with expertise writing contracts in your market. You should only do it if the risk is worth it to you in order to live in Bozeman (or New York). Otherwise you will find yourself moving, like the companies in this recent article in the Wall Street Journal (registration required). There are also the intangibles.

There are of course other considerations. Where are your likely customers? Suppliers? Other business partners? If you were opening a bodega and planning to live above it, you would be crazy to choose the location based on which street you wanted to live on. You would put your store wherever the customers were (and far away from the competition). Jeff Bezos left new York to found Amazon.com, but he didn’t go to the Valley. He moved to Seattle, home of Ingram - the largest wholesaler of books in the country. Not surprisingly, technology companies that focus on finance or advertising are often based in New York, and ones that focus on music or film in L.A.

Note that these are arguments for putting sales, business development, and marketing in New York, not necessarily engineering. Fred points out that many of his NYC portfolio companies have engineers scattered around the country or even the globe.

Which brings me to his second point: "The whole company, particularly development, does not need to be in one location anymore."

Again, it is true that you do not need to be based in one location. But there are real advantages. Successful startups need to be highly flexible, responsive, able to change direction. At the same time they need to have a strong team culture, a sense of unity and purpose: "We may all be changing direction, but we understand why and we’re doing it together." This is much harder to accomplish when the team is widely distributed.

Don’t tell me that IM and wikis solve the problem. They help, a lot, but if you believe that they are a complete substitute for daily human contact then you need therapy. Again, you can take the risk, but the risk is not zero.

Which brings me back to my original question. Leave aside personal considerations, lifestyle. Let’s agree that you can start a tech business in New York, just as you can start one in Bozeman or Topeka. And let’s also agree that depending on your customers, New York may be the best place to locate sales and marketing and business development. Let’s even forget the disadvantages of New York, chiefly the high cost of living and consequently high salaries.

My question is are there ever any advantages to starting a technology company in New York versus Silicon Valley?