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The World is a Supply Chain

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Lisa Morales-Hellebo, and Brian Laung Aoaeh. Kicking off #SCIT2019, June 19, 2019 in NYC. Photo Credit: Ray Neutron.

Originally published at www.refashiond.com on Friday, October 18, 2019.

Note: 3,749 Words, 14 Minutes Reading Time

Authors: Brian Laung Aoaeh, CFA, and Lisa Morales-Hellebo

The world is a supply chain. It’s that simple. 

But what does that really mean?  Whether we like it or not, current economic, political, social, and technology trends will compel more people to think about the implications of that statement more consciously each day.

In this blog post we;

  • Share a definition of supply chain,
  • Put the challenges confronting supply chains in context,
  • Discuss why socio-cultural forces will act as the leading catalyst for the innovations that will define supply chains of the future,
  • Explain why the refashioning of supply chains matters,
  • Explain why the technological transformation of supply chains is an economic issue, as well as one driven by evolving consumer preferences,
  • Describe the role that early stage technology venture capital can play in the transformation of supply chains,
  • Describe how individuals, private sources of capital, and governments can play a role in the transformations that will lead us to the supply chains of the future. 

What Is A Supply Chain?

First, let’s answer the question: What is a supply chain? 

A supply chain is a network of organizations that work collaboratively to move products and services from producers to consumers. At a high level, the business of supply chain can be subdivided into: 

  • Supply chain management;  which is about supply chain network design and management; 
  • Supply chain logistics; which is about the storage, transportation, and movement of physical goods from one place to another;
  • Supply chain finance; which is about ensuring that producers, and other supply chain participants and intermediaries get paid for the value they create and deliver to consumers.

Supply chains play two critical functions: 

  • First, they enable the flow of goods and services from producers to consumers. 
  • Second, they facilitate the transfer of information about the movement of goods and services between every entity that is part of the supply chain network.  

The world we’ve become accustomed to will not exist without supply chains.  And further, the world is a mechanism for providing humanity with the resources we need to survive on Earth.  We know this to be true — “when supply chains function, societies thrive”.

The Challenges Confronting Supply Chains

Today, we face an inflection point as our world confronts some big crises. If current trends hold, between 2015 and 2050 the world’s population is expected to increase by about a third, to roughly 10 billion people. According to Our World in Data, the world’s population stood at about 190 million people in the Year 0, and approximately 4 billion in 1975. In other words, the world’s population will jump by about 6 billion people over the 75 years between 1975 and 2050 after having only climbed to 4 billion people over the previous 1,975 years. This is happening, according to Our World in Data, despite the world’s population growth rate peaking at 2.2% per year in 1962 and 1963, and then declining to its current rate of about 1% per year. 

While this rapid increase in the world’s population is occuring, global supply chains face some big challenges: 

  • An ongoing increase in the frequency of severe weather events that cause large-scale disruptions to local and global supply chains. 
  • Trade disputes threaten to dismember the system of world trade established following the end of World War II. 
  • The growing world population has created a critical need for significantly better dynamic resource allocation throughout supply chain networks in every industry around the world. 
  • Changes in consumer behavior are putting the world’s supply chains under increasing strain and business competitiveness is increasingly tied to supply chain mastery.

Socio-cultural Attitudes Will Be The Catalyst For Supply Chain Innovation

Perhaps counterintuitively, innovation in global trade and supply chains will be driven most immediately by changing social attitudes towards climate change. A recent poll of adults and teenagers in the United States conducted between July 9 and August 5, 2019 by The Washington Post and the Kaiser Family Foundation offers some early evidence of the changes taking place. 

When asked if human activity is causing climate change, 79% of the adults polled responded yes, while 86% of teenagers responded yes. When asked if reducing the negative effects of global warming and climate change would require major sacrifices, more than 30% of adults, and more than 40% of the teenagers surveyed said yes. Also, at least 70% of adults and nearly 80% of teenagers said that technological advances will be able to reduce most of the negative effects of climate change. 

There are more conversations than ever about decarbonizing supply chains. At about the same time this poll was published, Quartz reported that two states in India have said they will not build new coal power plants. Earlier this year, governments in Europe called on the fashion industry to tackle its waste and pollution problems more aggressively and some are looking at passing legislation to that end. In Asia, more governments are moving to address issues around plastic waste imported from abroad. Starting in January 2020, the International Maritime Organization will begin adopting new regulations to curb harmful emissions from the container shipping industry. 

Another example of the rapidly evolving social and cultural attitudes that will drive innovation in supply chains and global trade is the growing movement led by young people such as Greta Thunberg, Jamie Marglois and others like them. Political, business, and technological leadership is shifting into the hands of a generation of men and women who do not want to leave a more inhospitable planet as their legacy to their children and grandchildren.

What does this mean? 

In the next half-decade or so we will see political and business leaders facing increasing pressure to adopt policies and business practices that reflect how voters and consumers feel about climate change. Those who do not risk losing political power and market share, respectively, to their opponents and competitors who do. As this social and cultural movement gains strength, it will accelerate the economic drivers of innovation, which in turn will propel the drivers of technological innovation in global trade and supply chain. 

In his August 2011 article, Why Software is Eating The World, Marc Andreessen said: “Companies in every industry need to assume that a software revolution is coming.” The process he described has only accelerated over the intervening 8 years, and that statement is more true now than it was then. As information technologies that were pioneered in the 1950s have reached maturity, technology startups around the world are developing new innovations to solve some of the supply chain problems that seemed intractable in the recent past.

Why The Refashioning Of Supply Chains Matters

However, before we can understand why the confluence of software and hardware engineering is going to be transformative to the supply chains on which the world runs, we must understand why that matters.

Supply chains exist to connect producers and consumers in an ongoing exchange of value. As a result, innovations in supply chain drives innovations in the rest of the economy. Given that supply chains are about the back-and-forth movement of physical goods, services, and information, it is easy to understand why advances in information technology must necessarily precede cycles of innovation in supply chain.

Because innovation in supply chain acts as an accelerant for increases in production and consumption, supply chain innovation acts as an economic multiplier. Every dollar of innovation in supply chain innovation leads to more than a dollar of total economic output. It is not a coincidence that countries ranked highest on the Worldbank’s Logistics Performance Index tend to have the most developed economies, while those ranked lowest tend to have the least developed economies. 

Supply chains are to human civilization what oxygen is to life; When they work well, no one notices them. It is only when they start to fail that we realize there’s a problem. It is easy to assume that there’s no room for innovation in global supply chains and trade, but this is simply not true. Here are four examples. 

  • As governments and people around the world awaken to the issues posed by climate change, there’s a growing social, regulatory, and economic push for innovations in supply chain logistics that will significantly reduce the amount of pollution created by the transportation industry. Some of these innovations involve the application of machine learning to the analysis of data obtained from connected devices in transportation and supply chain networks in order to make the operation of such networks more efficient and optimized. This needs to be done in a way that ensures that the transportation of people and merchandise does not destroy the environment. 
  • There is an ongoing shift away from linear supply chains in which the materials that remain after consumption has taken place are discarded, and more towards circular and regenerative supply chains that place an emphasis on using post-consumption waste as raw materials for new products. This shift relies on advances in materials science – both in the creation of new materials that did not exist before, and in the processing of materials that we have become accustomed to, but which we now recognize pose a growing threat to the environment as waste accumulates in quantities that the world can no longer sustain. In order to reduce or eliminate waste and pollution, the focus here is on developing supply chains around the repair, renewal, regeneration, and recycling of materials and products.
  • Manufacturing is undergoing a transformation of its own, one which will make the changes happening in transportation and materials that much more impactful. With the recent shift in political attitudes towards global trade, more companies are beginning to consider regionalized and localized manufacturing as a path towards avoiding costly tariffs. Such a transformation will rely on a mix of emerging and mature manufacturing techniques in order to keep costs within a manageable range. These advances in manufacturing will rely heavily on manufacturing goods to fulfill actual demand, rather than manufacturing goods in anticipation of future demand.
  • Invariably, software is being used more than ever to create new methods of collecting, storing, and analyzing data to augment human decision making in every industry. These technologies are being applied in industrial supply chains as distinct as: Pharmaceuticals and industrial chemicals – to simulate new compounds and test them more quickly and inexpensively; They’re also used in agriculture – to manage the production, storage and distribution of food and other agricultural produce in order to minimize food loss and food waste; And in energy – to aid in the production, storage, and distribution of energy from increasingly complex power grids that incorporate renewable and non-renewable sources of electrical power. 

The way we make things, the way we consume things, the way we move things, and the power that is required to make all that possible is changing dramatically thanks to advances in software and hardware technologies. Solving the foundational problems that plague global supply chains is a daunting task. Moreover, global GDP, most recently estimated at about $88 trillion, rests on our ability to solve these problems. 

Technological Transformation of Supply Chains: An Economic Problem, An Economic Opportunity

In our conversations with other people, we are often asked the question; “Wouldn’t this be easier if the transformation of supply chains were driven more by economic forces and consumer needs?”

In The Supply Chain Economy: A New Framework for Understanding Innovation and Services, Mercedes Delgado and Karen Mills state that; “The U.S. supply chain contains 37% of all jobs, employing 44 million people. These jobs have significantly higher than average wages, and account for much of the innovative activity in the economy.” 

Similar conclusions hold true in every other region of the world, and there is ample evidence to support that belief thanks to work by a number of global. Multilateral organizations like the World Economic Forum, The World Bank, The International Monetary Fund, various agencies of the United Nations, and others.

For example;

  • According to Growing Better: Ten Critical Transitions to Transform Food and Land Use, a September 2019 report by the Food and Land Use Coalition;  “The hidden costs of global food and land use systems sum to $12 trillion, compared to a market value of the global food system of $10 trillion.”
  • According to Long-Term Macroeconomic Effects of Climate Change: A Cross-Country Analysis, a July 2019 paper by researchers at the University of Southern California (USA), the University of Cambridge (UK), Trinity College (UK), the International Monetary Fund (Washington DC, USA), and National Tsing Hua University (Taiwan); “Our counterfactual analysis suggests that a persistent increase in average global temperature by 0.04C per year, in the absence of mitigation policies, reduces world real GDP per capita by 7.22 percent by 2100.” Furthermore the authors state; “We also provide supplementary evidence using data on a sample of 48 U.S. states between 1963 and 2016, and show that climate change has a long-lasting adverse impact on real output in various states and economic sectors, and on labour productivity and employment.”
  • According to Impact of the Fourth Industrial Revolution on Supply Chains, an October 2017 report published by the World Economic Forum; “Disruptive technologies are transforming all end-to-end steps in production and business models in most sectors of the economy. The products that consumers demand, factory processes and footprints, and the management of global supply chains are being re-shaped to an unprecedented degree and at unprecedented pace. Industry leaders who were consulted believe that new technological solutions heralded by the Fourth Industrial Revolution – such as advanced robotics, autonomous systems and additive manufacturing – will revolutionize traditional ways of creating value. As the costs of deploying technology continue to fall, international differentials in labour costs will no longer be a decisive factor in choosing the location of production.” 

Other examples are not difficult to find. 

A company’s supply chain is an integral part of that company’s customer experience, and consumers all over the world will continue to become more demanding, not less. The supply chains of the future will become a reality precisely because the refashioning of global and local trade infrastructure is an economic issue that is driven by consumer preferences.

That being said, it is important to recognize why conversations about the transformation of supply chains are less straightforward than one might hope.

In Disaster Mitigation is Cost Effective, a world development background note by Ilan Kelman, he states that it is easier for politicians who tend to seek visibility for themselves to pursue after-the-fact measures rather than pursue prospective and preventative measures related to disaster risk reduction. After-the-fact measures are more visible, while prevention is intangible and difficult to quantify, resulting in less of a boost for the personal ambitions and ego of individual politicians.

We observe a similar pattern of behavior among corporate executives, who tend to pursue highly visible, customer facing, short-term, tactical initiatives at the expense of long-term strategic initiatives that will help their companies develop and gain mastery over their backend supply chain operations. On the other hand, we observe that the companies that have become globally dominant are also those that have developed superior supply chain mastery within their respective markets and industries. We believe that companies with inferior supply chain operations will continue to fall victim to a degraded customer experience. We also believe that companies with inferior supply chains will lose market share to established, and new, competitors with superior supply chain capabilities.

Early-Stage Technology Venture Capital Will Play An Important Role

Surprisingly, the men and women who set out to tackle these problems usually find a lack of sufficient early-stage venture capital to support their efforts at the earliest and riskiest stages of their work – as they take that work out of academic research labs, or small apartments and houses, and start the often arduous process of commercialization. 

That is when there is the greatest need for venture capitalists who understand the nature of the problems, who recognize the potential commercial opportunities, who have a willingness to do the necessary hard work required to help these entrepreneurs succeed, and who have developed relationships with prospective commercial partners willing to investigate new technological innovations for long-standing supply chain problems.

This is changing, but it is not changing fast enough. The world needs much more risk-seeking capital to fund these entrepreneurs – the market opportunity is enormous. As we have already pointed out, global GDP rests on a foundation built entirely on physical and digital supply chains.

For these innovations to succeed, governments and traditional industry must become more open to partnering with venture capitalists and technology startups. Unlike innovations in information technology, the technological innovations that will transform global supply chains and trade interact with the real world. As a result, it is not enough for policies and regulations to lag innovation by years. Instead, regulators and policy makers must work hard to create regulatory frameworks that help to nurture innovation rather than assist in suffocating it. Correspondingly, venture capitalists and entrepreneurs must partner with community organizations, politicians, and regulators to help them keep up with advances in technology and innovation. 

One might ask: “Are there really enough opportunities for early-stage investments in supply chain?” Yet, once one understands what a supply chain is, a few minutes spent thinking about that question illuminates the misconception. 

The recent success of funds like Lux Capital – which announced that it raised a billion dollars distributed across two funds, and DCVC – which announced a $725 million fund, suggests that there are significant financial returns to be harvested by limited partners who have the foresight to invest in the small handful of venture funds that are now choosing to focus on funding early-stage startups solving the sorts of problems we have already described. 

The longevity of Supply Chain Ventures, established in 2001 by Dave Anderson, also suggests that this is a market that is ready for more early-stage venture capital, not less. This is assertion is based on how many advances in computational and information technologies have occurred since 2001, and how much easier it is now for such technologies to be implemented in physical supply chains. That observation is also based on the rising interest, relatively speaking, in issues surrounding supply chains within the general population.

Our conversations with corporate executives responsible for meeting demand from customers suggests that there is a growing appetite for new technology to enable companies to meet the expectations of an ever more impatient and demanding customer base. Also, our conversations with government officials point to a growing desire by public servants to seek new innovations geared at solving the problems that plague large and growing urban communities, and the suburban communities that surround them. 

What Can You Do?

There is a lot that one can do to participate in the coming transformation of supply chains;

  • Individual Consumers: As individual consumers we can all continue to become more active and engaged about understanding how our consumption affects the finite world around us. Social media and information technology makes it easy for attitudes and beliefs about consumption, production, sustainability, the environment, and climate change to spread. In Consumer attitudes towards sustainability and sustainable business: An exploratory study of New Zealand consumers., a 2015 master’s thesis by David Anthony Thompson at Lincoln University in New Zealand, he states; “From a purely pragmatic perspective, this study has indicated that consumers are generally likely to be supportive of not just purchasing sustainably produced goods and services, but that they feel positively towards companies that demonstrate sustainable social and environmental behaviour. This has implications for reputation building for organisations and in turn hints at benefits when it comes to securing supply contracts, recruiting staff and relationships with their physical communities. The study also suggests that understanding and knowledge play a – 56 – contributory role in forming these attitudes, therefore supporting the value in education and information strategies for sustainably run businesses.”
  • Sources of Private Capital: As we have already discussed previously, investing in early-stage innovations in supply chain transformation is an opportunity that remains largely under-resourced in terms of risk-seeking capital relative to the size of the opportunity. It is an area that is ripe for increased allocations of capital within the private equity asset allocation targets of family offices, endowments, foundations, and pension funds.
  • Governments: During #SCIT2019, The Worldwide Supply Chain Federation’s inaugural global summit on supply chain, innovation, and technology held in NYC on June 19 – 20, 2019, Samuel Chan, Regional Vice President, Americas, at the Singapore Economic Development Board provided attendees with a sense of how the Government of Singapore is thinking about the role that supply chain, innovation, and technology can play in Singapore’s economic development. Supply chain occupies a central position in Smart Nation Singapore, and specifically in its Smart Logistics initiative. As we have stated previously; It is not a coincidence that countries ranked highest on the Worldbank’s Logistics Performance Index tend to have the most developed economies, while those ranked lowest tend to have the least developed economies. Increasingly, the countries and regions of the world that will continue to experience the strongest economic growth will be those that are quickest to embrace and deploy the still nascent and emerging engineered systems that reflect a tight integration of computation and physical supply chains, in every area of economic activity.

If by now, the reader is beginning to conclude that the future of supply chains will be driven largely by supply chain enthusiasts, we agree.

We Will All Be Supply Chain Enthusiasts

So who is today’s supply chain enthusiast? A supply chain enthusiast is;

  • Someone who recognizes that the world is a mechanism for providing humanity with the resources it needs to survive. 
  • Someone who recognizes that each of us has a responsibility for ensuring that this supply chain that we are part of is managed in a way that ensures that humans continue to thrive. 
  • Someone who understands that collectively, we must summon the political will to begin the effort of arresting, and then reversing, the harm that we have caused to the environment. 

We will all become supply chain enthusiasts, not because it is the fashionable thing to do, but because with every year that passes it will become an issue of increasing and critical necessity. As more people become aware of, and start to understand that how we produce, store, transport, and consume things has a profound impact on our environment, enthusiasm about supply chain, innovation, and technology will become more socially and culturally mainstream. 

At that point, “The world is a supply chain.” will become a rallying cry everyone innately understands.

Note: “The world is a supply chain.” is a trademark owned by The New York Supply  Chain Meetup.

About The Authors: Brian Laung Aoaeh (@brianlaungaoaeh) and Lisa Morales-Hellebo (@lisahellebo) are co-founders of REFASHIOND Ventures, an early-stage venture capital fund that is being built to invest in startups creating innovations to refashion global supply chain networks. They are also co-founders of The Worldwide Supply Chain Federation, a growing network of grassroots-driven communities focused on supply chain, innovation, and technology.

#NotesOnStrategy | Seed-stage Venture Capital Portfolio Construction

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Note: Although I have not used quotation marks, much of this blog post quotes the people to whom I have ascribed comments almost verbatim. I made slight stylistic and mechanical edits to account for the fact that presented in this format, I do not have the constraints that Twitter imposes on users. Where meaning is unclear or erroneous, I bear full blame for the mistake.

The man who grasps principles can successfully select his own methods. The man who tries methods, ignoring principles, is sure to have trouble.
– Ralph Waldo Emerson

Background: I joined a single family office in December 2008 as the second employee on the team, and as the first employee on what would become the direct investing team. In January 2011 we started building a venture fund from the ground up, KEC Ventures. It grew to $98M of assets under management distributed across a $35M 2011 fund and a $63M 2014 fund, with 51 investments in aggregate. I left KEC Ventures in September 2018. You can read my reflections on my time at KEC Ventures here: #ProofPoints.

I have now teamed up with Lisa Morales-Hellebo to build an early stage fund to invest in startups building innovations to refashion global supply chains. We’re in the early stages of raising the fund, so I am thinking through the issues that every emerging fund manager grapples with. We are simultaneously building The New York Supply Chain Meetup, and The Worldwide Supply Chain Federation – more about that at the end of this article.

This blog post is a qualitative examination of issues pertaining to portfolio construction and portfolio management, from the perspective of a seed-stage manager who is managing a Fund I portfolio that falls somewhere between $10M and $25M of AUM. It is based on a discussion that occured on Twitter in early February 2019.

Before I go much further, some philosophical housekeeping;

  1. It is my belief that the seed-stage technology venture capitalist’s only goal is to benefit disproportionately from uncertainty. To do this the best seed-stage venture capitalists seek startups that fit an investment thesis, and make investments before other investors would normally invest.
  2. When I think of uncertainty, I am thinking of a state of affairs in which I have limited information and knowledge, and must make a decision whose outcome I can’t predict because the future is unknown and unknowable. I do not think one can measure uncertainty quantitatively.
  3. When I think of risk, I am thinking of undesirable future outcomes some of which I can enumerate quantitatively.

A startup is a temporary organization built to search for the solution to a problem, and in the process to find a repeatable, scalable and profitable business model that is designed for incredibly fast growth. The defining characteristic of a startup is that of experimentation – in order to have a chance of survival every startup has to be good at performing the experiments that are necessary for the discovery of a successful business model.

This is the definition I have in mind when I speak of a startup. Early stage venture capitalists will typically invest before search and discovery is complete. This definition is based on a definition by Steve Blank, to which I have added the characteristic of fast growth based on Paul Graham’s observations.

In the remainder of this post, I try to synthesize and organize the comments that arose from my original question on Twitter. I add some commentary of my own where I feel it will be helpful. I am always thinking about this topic so if there is other material you think I should read please send it to me. The easiest way to do so is via Twitter: @brianlaungaoaeh.

I assume that the reader is already familiar with the basics of VC and how a venture fund is structured. If not, here’s a decent introduction from the Harvard Business Review: How Venture Capital Works.

Note: When I make references to modeling portfolio construction for REFASHIOND Ventures’ first fund – which we are in the early days of raising, I am using a spreadsheet model template developed by Taylor Davidson at Foresight. I have known Taylor since 2013 and I couldn’t recommend his work highly enough.

The data below from Correlation Ventures, and CBInsights is pretty self-explanatory.

Correlation Ventures’ data looks at individual financings rather than at individual companies – one company can have multiple financings. The data from CBInsights looks at individual startups, where, similarly, one startup can have multiple financings.

My conclusion, based on these two pieces of analysis, is that an early stage VC should expect that at least 50% of the startups in any given fund portfolio will lose all the money that the VC invests in them. The data from Correlation Ventures suggests an even more grim outlook – though as you’ll see later it is somewhat less categorically conclusive. However one looks at the data, the conclusion is sobering.

To put the data in context, for a while the rule of thumb was that 33% of the startups in a VC portfolio would go to zero, another 33% would return invested capital, and the remaining 33% would do significantly better – resulting in the 3x net return that limited partners expect.

According to this historical distribution of returns data compiled by Correlation Ventures, 10% of financings provide over 5x return while 65% are partial or complete write-offs.
In this analysis by CBInsights, less than 50% of startups that raised a seed round in the United States between 2008 and 2010 were able to raise a subsequent round of capital.
In this analysis by CBInsights, less than 50% of startups that raised a seed round in the United States between 2008 and 2010 were able to raise a subsequent round of capital.

Given this state of affairs, how do different VCs think about portfolio construction and portfolio management? If you are a family office, an individual, or a corporation getting into venture capital as an asset class for the first time, and if you are investing in a manager who is raising their first fund, what should you be on the lookout for? I hope this helps frame the issues worth considering. Note that the discussion documented below centered around the data from Correlation Ventures only. I have not included every response to my tweet, only those I feel contribute directly to the topic. It is possible I have missed a few replies because the thread started branching off in several directions after a while.

Eliot Durbin (@etdurbin) from Boldstart Ventures: Two nuggets of advice I got on our early funds . . . expect 20% of portfolio to drive 80% of returns. Pay attention to founders that get those 1x – 3x returns on their first rodeo, because the next will be better. Also, third, plan your percentage reserves for follow-on investments because ownership in your winners matters most.

Jerry Neumann (@ganeumann) from Neu Venture Capital: It means you have to make enough investments so that you have a decent shot at being in some of the outliers. The expected value here is at least 1.2x.

Hadley Harris (@Hadley) + Nihal Mehta (@nihalmehta) from ENIAC Ventures: The key is to build out two models. The first is a fund model with number of companies and projections about how broad/deep you follow. The second is a liquidity model to project when money will come back for recycling, and the triggers for investing past initial investable capital. Note: The process of recycling capital allows the fund to gain leverage without exposing limited partners to additional risk beyond their capital commitment.

Albert Wenger (@albertwenger) from Union Square Ventures has blogged about uncertainty for some time, and he discusses this topic in this installment – arguing that because this distribution is now well understood, valuations are being bid up significantly. This puts small funds at a disadvantage, and contributes to the phenomenon whereby VCs raise larger and larger subsequent funds. It’s a brief post. You should read it.

Chris Douvos (@cdouvos) from AHOY Capital: Here’s a thought:

  • VC has always been a power law business, so big hits drive portfolio returns . . . and the big hits are getting bigger, but on the other hand, pricing going up is going to cut returns, not only of the big winners, but also of the middle OK part of the portfolio.
  • Remember: Opportunity = Value – Perception, and the industry is so good at blowing up perception, but true Value is more fleeting – and, if we’re being pedantic, Value is the discounted present value of future (positive) cash flows. [My comment; The dichotomy between Value and Perception that Chris is referring to explains why the data from Correlation Ventures seems so jarring at first glance.]
  • But everyone’s bought into the power law dogma, so unicorns are getting bid up, often with pricing for perfect execution, following winds, and fair seas . . . any hiccup (systematic or idiosyncratic) will lead to a lot of stranded unicorns, or as Bryce (of Indie.VC) calls them, “donkeys in party hats” . . . Speaking of which, I think his efforts over at Indie.VC have been a creative and thoughtful search for Opportunity in the context of Value – remember, Opportunity = Value – Perception.
  • At the end of the day all that matters is Moolah in da Coolah – the distributed to paid-in-capital multiple that a fund ultimately achieves. Here was my effort at thinking about some of these portfolio construction issues in the context of valuation environment: All About the Benjamins.
  • But I remain really nervous about the environment. As Henry McCance at Greylock told me in 2001, VC works well when time is cheap and capital expensive. When that relationship is reversed, trouble ensues.

Dave McClure (@davemcclure), formerly of 500 Startups:

  • This means you should do a LOT more deals, unless you pick better than Sequoia. Of course depends on dealflow, selection, and stage, but if you start investing at seed-stage, most GPs with portfolios with N < 50 companies are playing Russian roulette. If large outliers of > 20x happen only 1% – 2% of the time, basic math would suggest a portfolio size of N > 100 is more rational.
  • [My comment; Yes, The basic math certainly supports that conclusion. Though, I wonder if there are nuances the basic math doesn’t capture. Do you think there are conditions under which one might justify deviating from that prescription?] Well if you’re a subject matter expert and/or have excellent access to dealflow or an established brand, you might choose to build a concentrated portfolio – but again you’d have to convince yourself, hopefully based on data, that you’ll generate a higher percentage of outliers than the average VC.
  • [My comment; Got it . . . Though, one has to wonder if there’s such a thing as a subject matter expert when it comes to predicting how the future will unfold. But, I see why that approach would make sense – in some rare cases. Who would you say does that really well? Anyone? CVCs?] Well for specific IP-related areas, people who are scientists/PhDs/professors might have an advantage. For industry verticals, maybe experienced business or technical folks. Famous people and/or famous VC firms might also have an advantage. Not sure about CVCs, unless specific IP perhaps.
  • [My comment; That reminds me of one of the points Richard Zeckhauser makes in Investing in the Unknown and Unknowable; collaborate with other investors with superior knowledge of specific industry verticals, among other things.]

Josh Wolfe (@wolfejosh) from Lux Capital:

Huge wins are rare / Mostly luck / Claimed as skill / But huge wins beget halos / And halos beget better reputation / And better rep begets better opps / And better opps up the odds / That you get lucky / With a rare huge win [My comment; Josh typed this like a poem. I just couldn’t figure out how to get that layout using this new UI on WordPress. I have spent a lot of time thinking about the skill versus luck dichotomy in early stage VC. So one way to think about this discussion is to ask; In relation to portfolio construction, what can a seed-stage VC do to optimize luck?]

Tren Griffin (@trengriffin), author of 25iq – a blog about markets, tech, and everything else:

At the core of almost everything is probability. The future is a probability distribution. The best processes creates favorable odds of a correct decision. A good process can create a bad result and vice versa. Quoting Warren Buffett:

Warren Buffett, on Diversification and Portfolio Construction
Warren Buffett, on Diversification and Portfolio Construction

Fred Destin (@fdestin) of Stride.VC:

  • In my experience the skew is almost systematically massive. With one fund returner – your fund is likely to be fine, with two – it’s likely to be great, etc. The top 2 to 4 exits will likely more than 2x+ the fund, the next 5 to 8 exits together will return 1x the fund, and the rest might lose some money.
  • Hence I’m always thinking – never invest in anything that can’t return the fund – which is, of course, a function of ownership and upside, with upside uncapped if you want to have a shot at a “glimmer of greatness”.

[My comments; Thanks, Fred. “Never invest in anything that can’t return the fund.” How does one figure this out? In one of his books Nassim Nicolas Taleb talks about two forms of analysis; First – Thinking forward to the future state, and then, Second – Thinking backwards to the current state. But, how does one do that without succumbing to magical thinking? Are there other approaches? I created a grid based on a blog by Bill Gurley – All Revenue is Not Created Equal: The Keys to the 10X Revenue Club. But, I’m always wondering how others approach this question. I have to admit, team decision-making then becomes an issue . . . Doesn’t work if rest of the team doesn’t buy into systematically thinking about that question as a group. I used a similar approach to guide my effort to determine if a startup has the potential to develop moats. This also raises an issue that Dave McClure mentioned in our exchange on this same question; A VCs ability to add value – early customer introductions, engineering outcomes to help avoid or minimize the scenarios where a startup doesn’t return invested capital – makes a big difference – I noticed this while I managed a fund of funds portfolio at KEC Holdings between 2008 and 2012. I’m confident using a template or checklist is helpful – Michael Mauboussin discusses that approach in The Success Equation. A question in my mind is how Lisa and I can codify best-practices into decision-making processes as we get REFASHIOND Ventures off the ground. But perhaps as Hadley and Eliot alluded, it’s a question that requires a multi-step solution with at least 2 layers of analysis; First – a fund level macro analysis, and then, second – an analysis of each investment to see how it fits the fund level macro framework. Though, I think in Zero to One, Peter Thiel discusses how at the early-stage one differentiator is a VCs qualitative analysis of how the future will unfold more so than anything else. That does not negate anything that’s been said so far, but it suggests that there’s a lot of room for interpretation.]

  • Tie decision making to absolute rules (eg I need a moat in every investment) and you’re introducing a systematic bias / hard screening criteria. That may be fine – but don’t confuse a disciplined decision-making process and method with fixed decision-making “rules”. The only rule that should be fixed in my opinion is: the potential for unlimited upside exists within the fund’s duration. [My comment; I agree. It’s less about absolute rules, and more about ensuring I have thought about the issues and have consciously decided one way or the other. I think it’s important to do that when things are uncertain and and failing to think through the issues is costly. As you point out, it’s more about process than hard rules . . . Especially – at the stage at which I’m doing this there are no moats yet, but I need to consider the possibility that they can develop over time, and why that may happen if things work out. But, point taken re systematic bias.]

Never invest in anything that can’t return the fund.

Fred Destin, Stride.VC

Note: At this point I shamelessly plugged my work on Economic Moats: Economic Moats for Early-stage Tech Startups (Half a Dozen Blog Posts & A Presentation. Also, note that there’s a philosophical divide about economic moats and startups among VCs. Some think they matter. Others do not. I think they do, and I think a careful analysis of the issue leads to that conclusion for startups that will go on to return an entire fund, for example. However, I also agree with the observation that at the the earliest stage of a startups existence the thing that matters most is the startup’s ability to make its customers happy as it conducts the search for a scaleable, repeatable, and profitable business model.

An economic moat is a structural feature of a startup’s business model that protects it from competition in the present but enhances its competitive position in the future.

This is the definition of an economic moat I have settled on, based on my work thinking about the topic from my specific vantage point as an early stage VC.

Ed Sim (@etdurbin) from Boldstart Ventures: Great questions but don’t overthink it; First, every investment has to have opportunity to return fund. Second, ownership matters. Third, reserves matter. A related question; What is your return the fund exit (RFE) for each investment assuming dilution? That analysis will show that ownership and reserves matter, and so does capital efficiency. [My comment – I have known Ed and his partner, Eliot since 2012; Ed! I am trying to find the Goldilocks Zone; not too much thinking, but not so little that we get taken by surprise . . . I agree working through these points will cover most, if not all the necessary ground.]

What is your return the fund exit (RFE) for each investment assuming dilution?

Ed Sim, Boldstart Ventures

Sean Glass (@SeanGlass), Founder and CEO – Advantia Health. Founding Partner – Acceleprise; What was the return on that meta portfolio? I think the role of vc as investor is to generate alpha, and you do that by taking an approach that gives your portfolio asymmetric risk. Just like with public equity investing there are a different approaches to doing that.

Sean’s comment raises an observation first made by, Arjun Sethi (@arjunsethi), who is Co-Founder of Tribe Capital, and formerly of Social Capital, Yahoo, and MessageMe, and LoLApps – about the graph from Correlation Ventures; The graph is a poor illustration of what defines a venture round, fund and timeline of investment. [Jerry Neumann’s comment; Agree. The data is fairly useless. If you take the bottom end of each bucket it’s 1.2x, top end (except 50x+) it’s >4x. So, runs the gamut.]

Deepak Gupta (@DeepakG606) from WEH Ventures; The Correlation Ventures data refers to financings and not number of companies. It’s possible a VC made an overall 10x+ in aggregate in one company but would still be hitting 2x or 1x fund in this data. So overall percentage of multibagger companies will be higher than suggested by this analysis. [My comment; This is true, given the modeling I have been working on. There are scenarios in which the fund would fail to meet LP expectation of a 3x+ net distributed to paid-in-capital ratio even though the percentage of big winners is non-zero. It’s quite trivial to see how this might happen if the general partners’ capital allocation decisions do not ultimately work in the fund’s favor.]

  • I wouldn’t go as far as to say the data is completely useless, though I see the argument Arjun and Jerry are making. If one assumes that the two sets of data suggest possible probability distributions, then I think the interpretation should be that; First, any portfolio construction that assumes less than 50% of the portfolio going to zero is almost certainly naively over-optimistic. Second; assumptions about big winners should be scrutinized closely because they are rare – so fund managers should be able to explain how they will attract dealflow that will include more than their fair share of potential fund-returning startups AND the processes they have developed to maximize the chance that they actually select those startups for inclusion in the fund’s portfolio.
  • In my work on modeling portfolio outcome scenarios for REFASHIOND Ventures’ first fund, I have gone as far as assuming 90% of the portfolio goes to zero. I have not modelled 100% of the portfolio going to zero because that’s obviously the trivial case – if that happens we’ll most certainly have bigger problems to worry about. Most of the time spent in discussions between prospective limited partners and the venture fund’s general partners should be in arriving at underlying assumptions that reflect reality and can be justified by how the general partners have said they will run the fund, with enough flexibility to allow the fund to exploit unforeseen and unexpected opportunities as they arise in real-time – remember that optimizing luck is an important aspect of all this.
  • Correlation Ventures has not made public a version of this analysis that presents the results in a manner similar to that done by CBInsights. It is likely that they were unable to get to that level of granularity given the source data, or they may prefer to keep that specific version of the analysis as a trade secret.

Dan Buckstaff (@Buckstaff) shared a link to an article by Morgan Housel (@morganhousel) from Collaborative Fund – Tails, You Win; It’s a short article and you should read it if you want to learn more about how prevalent power laws are around us. I like this quote from Benedict Evans – I have paraphrased it to refer to Early-stage Venture Capital rather than Silicon Valley: Early-stage Venture Capital is a system for running experiments. It’s the nature of experiments that some fail – the key is for the ones that work to really really work. [My comment; Once you read the article you should notice that it echoes themes from the comment Josh Wolfe made earlier.]

Early-stage Venture Capital is a system for running experiments. It’s the nature of experiments that some fail – the key is for the ones that work to really really work.

Paraphrasing, Benedict Evans, Andreessen Horowitz

Baris Guzel (@BarisGSF), of BMWi Ventures, pointed me to a blog post by Seth Levine (@sether) from Foundry Group – Seth’s contribution to the discussion is below;

  • To your specific question; Given skewed outcomes what’s the right strategy for a small fund? in general smaller funds will have less opportunity to consolidate ownership in outperforming companies. Thus I think the right strategy is to seek more exposure – place more bets. [My comment; Thanks, Seth. There seems to be a tension between seeking more exposure AND getting as much ownership % as early as possible, and reserving capital to follow on in later rounds. Especially, in the context of a fund 1 with say $10M – $20M of AUM. Thoughts? If you had to choose?]
  • There’s definitely that tension. In an ideal world you’d have enough capital and enough early, but predictive, data to consolidate into your best companies. Larger “Series A” funds do that regularly, but with a seed fund you have challenges with both capital and information.
  • You have a small fund and by the time you have to make a follow-on decision, or more ideally preempt a round, you don’t really have that much more data about the opportunity. That’s really the argument for placing as many early bets as possible.
  • The ones that run on you drive value and you’ll have plenty of exposure to the potential for upside. It’s easy to say in hindsight that you “knew” something was going to be great, but how often do you have that reliable insight between Pre-seed, Seed, Seed+, and Series A? [My comment; I know that’s a rhetorical question, but there’s so much pressure to seem prescient, all knowing, and fully certain about the future . . . But yes, it’s generally hard to know. So it seems things point back to the decision-making process, and a bit of luck, as others have alluded. I’ve stopped paying attention when people tell me to “sound more confident about what you’re saying” . . . How can one be confident when decisions are being made under extreme uncertainty? I’ll stop bloviating.]
  • Re: Luck, that reminded me of this ancient post of mine (2005 – I was an associate) about what makes a good venture capitalist and David Cowan’s comment, which has always stuck with me. [My comment; I couldn’t find the blog post Seth is referring to, but I found a discussion thread elsewhere in which David Cowan, of Bessemer Venture Partners says the correct answer to the question “What do you think is the most common trait among successful venture capitalists?” is “Luck.” This reminded me of a blog post I wrote about Fab.com around the time I was studying economic moats; Vcs often rail about startups raising too much money at valuations that are too high to sustain, but VCs too sometimes make investments that assume perfect knowledge, perfect execution by the team, perfect market adoption . . . etc, to the point Chris Douvos made earlier. I wonder how the early stage venture funds that invested in Fab.com have fared. I have not looked that up yet.]

This also calls to mind a quote from Andy Rachlef, formerly of Benchmark Capital; Investment can be explained with a 2×2 matrix. On one axis you can be right or wrong. And on the other axis you can be consensus or non-consensus. Now obviously if you’re wrong you don’t make money. The only way as an investor and as an entrepreneur to make outsized returns is by being right and non-consensus.

The 2×2 Matrix of Investing Outcomes

This article by Tren Griffin delves deeper into the topic: Why Investors Must Be Contrarians to Outperform The Market.

Investment can be explained with a 2×2 matrix. On one axis you can be right or wrong. And on the other axis you can be consensus or non-consensus. Now obviously if you’re wrong you don’t make money. The only way as an investor and as an entrepreneur to make outsized returns is by being right and non-consensus.

Andy Rachlef, formerly Benchmark Capital, now at Wealthfront

Note: At a certain point in the discussion on Twitter a side-bar discussion developed about how much help seed-stage venture capitalists should provide to startups in which they have made an investment as those startups search for product-market-fit. I am not including those here as that is a separate topic worth exploring on its own.

Chinedu Enekwe (@Cope84) from Affiniti VC; Very true – risk in the winner and finding ways to coach the laggards into favorable exits. [My comment; He highlighted this blog post by Fred Wilson (@fredwilson). It’s worth reading, if you’re an emerging manager coming to grips with how to manage your portfolio. The primary uptake from Fred’s blog post is that the best early-stage VCs spend more time with startups in the second and third quartile of portfolio returns than with startups in the top quartile. This is keeping with my beliefs on the topic; The very best investments in an early-stage VC portfolio will do fine, those founders are pretty self-directed and resourceful. They will succeed with or without anyone’s help. Also, they are very proactive about letting investors know what assistance will be most beneficial to them, in advance. So where a VC can really move the needle with regard to portfolio returns is with the startups and founders that really need some help to avoid returning 0x the invested capital. I saw this play out in a fair amount of detail when I was also responsible for performance monitoring and reporting on a sizeable fund of funds portfolio between 2008 and 2012 – it included early stage VC funds, growth funds, buyout funds, hedge funds, and some public equity active funds.]

Note: The following discussions were not part of the thread that formed from my question on Twitter, but they are relevant, and so I am including them here.

Samir Kaji (@Samirkaji) from First Republic Bank; Shared an article by Clint Korver of ULU Ventures: Picking winners is a myth, but the Power Law is not. It is worth reading Clint’s article because he introduces some added dimensions to the discussion. Here’s additional advice from Samir, some of which I got over email, and then during a call with him when Lisa and I told him about REFASHIOND Ventures. I have also cherry picked comments from some blog posts he’s written on the topic.

  • To maximize the probability of success, fund GPs raising a first fund should perform the portfolio construction exercise based on their investment thesis, their knowledge of the market in which they plan to operate, and how much capital they need to prove that they can execute the thesis. Although, macro considerations are always a concern for managers raising their very first fund, this exercise should be performed independent of considerations from prospective LPs who make comments such as “You should not raise more than $X for your first fund.” In other words the dog should wag its tail, not the other way around. He discusses that topic here: Is there ideal portfolio construction for seed funds?
  • Although many will pejoratively speak of large portfolios as “spray and pray”, doing so ignores years of probability and statistics, and likely over-weights skill versus luck.
  • That said, larger portfolios do come with some challenges: Scaling value-add to portfolio companies. Requiring larger exits (given smaller initial checks/ownership vs. concentrated portfolios) for definition of outlier (fund returner). Tougher to make follow-on decisions.
  • When pitching LPs, at a minimum expect to discuss
    • Target Fund Size,
    • The stage at which the fund will make its initial investments; Pre-seed, Seed, Series A, Series B . . . or later,
    • Average Initial Check Size,
    • Average Initial Ownership Target – which establishes the valuation bands within which the fund should invest,
    • Total Number of Startups in the Portfolio – a range is the norm,
    • The fund’s Follow on Reserve Percentage, and
    • The Fund’s Investment Period.
  • As conversations progress, more sophisticated LPs may want to discuss the key assumptions driving the sort of scenario analysis I described earlier. Clint performed a simulation to arrive at the conclusions in his article.

Conclusion: The goal of this article was to develop a qualitative understanding of how other VCs think about portfolio construction and portfolio management from the perspective of an emerging early-stage VC raising an initial fund of between $10M and $25M of AUM. Limited Partners in a new manager raising a first fund face the same questions about making an investment that venture capitalists encounter when they seek to first deploy capital into a startup they have just met. For most LPs the easier decision is “wait and see” rather than to take on the uncertainty, risk, and hard work necessary to make a decision to invest in a new VC fund manager. One way to get LPs comfortable making a commitment is to;

  • Demonstrate that the new manager has a unique investment thesis based on knowledge about a market that is under-appreciated by other investors,
  • Demonstrate an ability to source deal-flow in a manner that is both efficient and proprietary – given the rule of thumb that the best VCs see 100 startups for every 1 investment they make,
  • Demonstrate the ability to pick startups that have a high probability of returning the portfolio within the duration of the fund,
  • Demonstrate an ability to manage the portfolio’s losses in a way that maximizes the likelihood that the fund will meet LPs’ expectations, and
  • Demonstrate an ability to execute the fund’s stated portfolio thesis, portfolio construction and portfolio management strategy under real world scenarios.

This is by no means an easy task, and it is only one of the many issues an emerging manager raising a first fund must worry about. As has been reiterated more than once previously, it requires hard work, smarts, keeping one’s wits about oneself, and a fair bit of luck.

Additional Reading:

About The Worldwide Supply Chain Federation

The Worldwide Supply Chain Federation is the collaborative, and mutually supportive coalition of open and multidisciplinary grassroots communities focused on technology and innovation in the global supply chain industry. Founded in August, 2017, The New York Supply Chain Meetup is its founding chapter. The New York Supply Chain Meetup is the world’s largest, fastest growing, and most active community on Meetup.com – with well over 1700 members. The Worldwide Supply Chain Federation is the first community of its kind to focus on supply chain, innovation, and technology. It seeks to bring together BUYERS and BUILDERS of the technology innovations that will refashion global supply chains.

About REFASHIOND Ventures

REFASHIOND Ventures is an emerging early stage venture capital firm that is being built to invest in early-stage startups creating innovations to refashion global supply chain networks. REFASHIOND Ventures is based in New York City. The Worldwide Supply Chain Federation and The New York Supply Chain Meetup are initiatives of REFASHIOND Ventures.

Update: March 23, 2019 at 08:32 to fix some mechanical errors, typos, grammar. Also added definition of a startup, and definition of an economic moat, and highlighted some quotes.

#CountDown: 11 Days To #TNYSCM06: Convergence Across the New Apparel Supply Chain

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A cross-section of the audience at #TNYSCM #02, January 2018.

We’re now just a little over a week away from The New York Supply Chain Meetup’s sixth gathering. The purpose of this post is to outline our plans for that event, and preview what we expect to do in June. We’re still in the early days of building this community, so much of this is subject to change, especially as we go through the process of recruiting sponsors.

#WorkInProgress: Before the preview, however, some news by way of an update; In the 8 months or so since I decided I wanted to hang out with “my people” at a meetup in NYC that focuses on supply chain, technology, and innovation, The New York Supply Chain Meetup (#TNYSCM) has grown to more than 1,000 members. #TNYSCM is the originating chapter of The Worldwide Supply Chain Federation – a global network of meetups focused on supply chain, technology, and innovation. We are currently in the process of establishing The Singapore Supply Chain Meetup (#TSGSCM) and The Vancouver Supply Chain Meetup (#TVRSCM). We are exploring chapters in Australia and Europe. It’s early days for The Worldwide Supply Chain Federation . . . so there isn’t much to report, except; We’re working on it.

Our Mission

To nurture and grow the world’s foremost open, global, multidisciplinary community of people devoted to building the supply chain networks of the future – starting in NYC.

Our Mantra

The past ran on supply chains. The present runs on supply chains. The future will run on supply chains. The world is a supply chain.™

We are actively recruiting corporate sponsors with ambitions that match ours. If you’d like to hear more, please reach us through our website or another social channel.

The New York Supply Chain Meetup is powered by Particle Ventures, a seed-stage fund in New York City that invests in Supply Chain & Industrial Intelligence. Particle is built by the same team that launched KEC Ventures.

#TNYSCM06 is sponsored by SAP.iO, a venture studio, a venture fund, and a startup foundry that helps innovators inside and outside of SAP build products, find customers, and change industries.

Join The New York Supply Chain Meetup

Logistical Details: #TNYSCM06

  • Date: Thursday, May 24, 2018
  • Time: 17:30 – 21:00
  • Location: SAP America, 10 Hudson Yards, 48th Floor, New York, NY. Please register by following the link above.

#TNYSCM06 will feature a showcase and a panel discussion.

Agenda

5:30 PM – 5:55 PM: Pre-event Networking
5:55 PM – 6:00 PM: Welcome Remarks (#TNYSCM, SAP.iO)
6:00 PM – 7:15 PM: Showcase (85 minutes / 10 minutes + 4 minutes Q&A each)
7:15 PM – 7:20 PM: Bio Break
7:20 PM – 8:25 PM: Panel Discussion (50 minutes), Q&A (10 minutes) 8:25 PM – 8:30 PM Closing Remarks

MC: Christian McKenzie (@Xian_Mckenzie)

Startup Showcase

Our showcase presenters are;

  1. Trendalytics
  2. Case Equity Partners
  3. Sewbo
  4. Fuse Inventory
  5. Bolt Threads
  6. Loomia

Panel

The panel will be moderated by Lisa Morales-Hellebo. Lisa is #TNYSCM’s co-founder, she is also building REFASHIOND, a fund that will play a pioneering role in reinventing the global fashion and apparel retail industry.

Our panelists are;

  1. Joe Sartre, Partner, Bleu Capital
  2. Leslie Harwell, Managing Partner, Alante Capital
  3. Nathan Cray, VP, Integrations & Operations, ALDO Group
  4. John Silverstein, VP, Operations, CGS (Computer Generated Solutions)

Preview — #TNYSCM  in June

Here is what our team of organizers is working on for June.

  • June 21: A Sourcing 101 workshop for startups building physical products. More details coming soon via our meetup page. So sign up there in order to be among the first to know when we announce the details. We are working on an event title, but all the other details are complete.

Other Upcoming Supply Chain Events

  • Transparency18: This is the flagship event series started by the founders of the Blockchain in Transport Alliance. It follows BiTA’s Spring Symposium, a members only event that occurs on May 21, 2018. I will attend both days of Transparency 18 on May 22 and May 23.

Join The New York Supply Chain Meetup

 

How Studying Bankruptcy And Working On Two Turnaround Assignments Prepared Me To Become An Early Stage Venture Capitalist

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The Chinese Character for Crisis; Danger + Opportunity (From The Ten Strategies For Leading At The Edge)
The Chinese Character for Crisis; Danger + Opportunity (From The Ten Strategies For Leading At The Edge)

 

When I started business school at NYU Stern in the fall of 2005 my plan centered on taking every class in Bankruptcy & Reorganization, and Distressed Investing that I could. I took 3 elective classes in that area; Bankruptcy & Reorganization with Prof. Ed Altman, Case Studies in Bankruptcy & Reorganization with Prof. Max Holmes, and Investment Strategies: Distressed Investing with Prof. Allan Brown.

By my logic, if I learned how to assess and invest in dying companies, and then nurse them back to health, analysing, valuing and investing in healthy companies would seem easy by comparison. I was so sure of this that I also tried to turn my Equity Valuation elective into a pseudo Bankruptcy & Reorganization course too, by opting to value a bankrupt company for my final group-project. I do not recommend trying that.

I was still in business school when the economy began to falter. I moved from UBS to Lehman Brothers in late March 2007. A few days later New Century Financial Corp. filed for Bankruptcy. I was let go from Lehman Brothers a year later, on March 12, 2008. Bear Stearns collapsed and was acquired by JP Morgan Chase on March 16, 2008. I graduated from Stern in May, 2008. On September 7, 2008 Fannie Mae and Freddie Mac were taken over by the federal government. Lehman Brothers collapsed on September 15, 2008. On September 16, 2008 the Fed bailed out AIG.

The rest of 2008 was a bloodbath.

It was in that environment that I joined KEC Holdings, KEC Ventures parent company, in December 2008. I was employee #2. I had been hired into a new role that had not existed before at the company. My responsibilities encompassed any direct and indirect investments the company had made, or might make in the future.

Most notably, the company had already made 2 private equity investments; one in a private jet charter company and another in a fine-dining restaurant group – they were struggling to stay afloat given the economic environment. My first order of duty was to “make sure they don’t die” and “help them come out of this mess stronger than they were going into it.” There would be no financial engineering gimmickry. No tried and true business school textbook “indiscriminate” cost-cutting shortcuts. I had to roll up my sleeves and work with each company as intimately as necessary to achieve the objectives.

This post is about how we navigated that period. It is also about what that period between December 2008 and August 2013 has taught me about the challenges startups face, and my role as a venture capitalist.

Every day is a journey, and the journey itself is home. - Matsuo Basho
Every day is a journey, and the journey itself is home.
– Matsuo Basho

Further Background

Both companies were generating top-line revenues in the range of $20,000,000 – $30,000,000 per year. Both had fallen short of budgetary expectations in 2008, but the aviation company had a more prolonged string of losses than the fine-dining restaurant, partly because the restaurant was a more recent investment at that point. I functioned as an “external management consultant”; I was not a full-time employee of either company, but I worked with employees across the hierarchy of both companies. The restaurant company employed between 400 and 500 people while the aviation company had between 30 and 40 employees after several previous rounds of downsizing.

Both companies had watched as some of their competitors ran into strong headwinds, and subsequently shut down operations because the economic environment was so bleak.

Lesson #1: Understand The Business

Once a company is in financial distress investors have to decide if it is worth saving, and they also have to answer the accompanying question; can it be saved given current known constraints? The only way to do this is to develop a deep understanding of the business, and the context within which it is operating.

Between 2008 and 2012, confidence in the economy was very low. People simply were not splurging on expensive meals or luxury jets. An economist would say that private jet charter and fine-dining both have a high elasticity of demand.

I had no prior experience working at, let alone helping to run a restaurant or a private jet charter company. So I decided to spend the first six months in learning mode. I studied everything I could about both markets while I helped the executives and managers at both companies deal with day-to-day nuts-and-bolts issues.

This was important if I was going to build personal credibility, and if I wanted to win buy-in for my ideas from the executives and managers later on. I had to be able to influence them into doing things they probably did not believe in at the outset, and I had to do this with little real influence.

How this applies to early-stage startups: Today, I look for founders who embrace their expertise, and demonstrate a knowledge of their business that surpasses mine. However, the founder also has to demonstrate an ability to assist me learn enough about their industry to make a decision, and act as a useful sounding board for decisions that have to be made in the future.

Lesson #2: Understand The People

During those six months, I also tried to understand the protagonists in each situation. I relied on a technique I had learned in my Literature in English classes during secondary school in Ghana; character analyses.

A character analyses involves performing an in-depth study of the key characters in a drama, and trying to figure out each character’s story; What motivates that person? Why is that person who they are? What is the person afraid of? What drives that person? How does that person communicate? How does that person respond to pressure and stress. What does that person gain the most satisfaction from? What’s the state of that person’s family life? How does that person perceive me? How do I perceive that person? Does that person buy into the need for a turnaround? Is that person willing to commit to the turnaround? What biases does the person exhibit that I can identify? How does that affect things?

I had to be honest, and to contend with the pleasant and the unpleasant, especially around the perceptions other people had of me at the outset.

I took copious notes, and added to them until I felt I had a decent understanding of each of the people with decision-making authority that I would be dealing with most often; executives, managers, and front-line employees.

Perhaps an important, but often overlooked insight is that an investor should strive to understand the people within the context of the business. For example, is this person a leader or a manager? The distinction matters because it can spell the difference between beating about the bush with no results to show, or getting to the heart of the matter and fixing the problems that need to be solved at a tactical and granular level. Fred Wilson writes about this problem in: Leaders and Executives.

How this applies to early-stage startups: We make seed stage and series A investments. That early in a startup’s life, the people make all the difference. The market is important, so is the product. However, at this stage the future is still so nebulous and difficult to envision that the team that has decided to embark on that journey matters more than anything else. So, I have learned to focus on questions like; How did this team come together? Do the founders take responsibility for outcomes, or do they have a habit of passing blame? Do they have the intestinal fortitude to withstand the difficulties they are bound to face as individuals, and as a team on this difficult path they have chosen or will they wilt under pressure? What evidence do I have to support my answer to this question. What is their approach to learning, as individuals and as a team? Have they faced crises together? How did they fare when the going got tough? I will not ask most of these questions directly, but I will be processing every interaction, every bit of information I get, to determine answers to questions along this line of reasoning.

Lesson #3: Create A Sense of Urgency, But Provide Hope

Unlike a startup, a company in financial distress already has a product that it has sold successfully in the past, it also has a sense of who its customers are and where to find them. It is easy for the people within the company to succumb to status quo bias. This is identifiable by statements such as;

  1. “Everything will be fine, we just need to close this one sale.”
  2. “I feel confident it will happen, we have this sale in the bag.”
  3. “They are not our competitor, they do not do what we do!”

In the face of incontrovertible evidence that “they are up shit’s creek without a paddle” people will still choose to do what feels comfortable.

It was my responsibility to shake them out of that rut. As John P. Kotter says in Leading Change: Why Transformation Efforts Fail; 75% or more of a company’s management has to buy into the need for change, otherwise the chance that the change effort will fail is unacceptably high.

How did I do this? In both cases I did not shy away from asking questions that I expected to generate conflict. Indeed, on several occasions I had to have unpleasant and difficult conversations with the top managers and executives in both companies. I did this even if it appeared that I was “meddling” in areas where I had no business poking around. Of course, the idea that there was a part of either company’s operations that I “had no business” exploring was a fallacy only someone keen on maintaining the status quo would believe.

The message, delivered by the investors and the board, and reiterated by me during my frequent field trips, was simple; “The status quo is unacceptable, and failure for lack of effort is out of the question.” We had one chance to get it right, and we had to make the most of that chance even if it meant discomfort some of the time. We could get there with or without conflict. It was entirely up to us to make that choice.

How this applies to early-stage startups: The time for the whole team to start thinking about the Series A Round of Financing is the night before the Seed Round closes. Some one on the team should always be thinking about what it will take to raise the next round.

The time to start thinking about revenues is yesterday, even if you do not implement those plans immediately. Always have a plan. Always test your plan.

Lesson #4: Investors Have Ideas, But Management Runs The Business

Investors will always have ideas about how a business should be run. Sometimes investors know more about a certain topic than management. It is okay for investors to make suggestions, and to offer ideas to management. However, responsibility for choosing which ideas to accept and which to reject has to rest on the shoulders of management, and management has to accept accountability for the outcomes.

There are a number of ways this aspect of the relationship between investors and management might unfold;

  1. Investors can dictate to management what investors think management should do, or
  2. Investors can teach management how and why things should be done a certain way.

I chose the latter. That approach takes more time, but it is also more likely to lead to permanent change in behavior than the former. Also, once the lessons had taken root that approach allowed me to gradually pull back my involvement without jeopardizing the progress that management was making in improving results. It is an approach that builds self-sufficiency.

As part of the process, we cultivated the practice of communicating:

  1. Why a certain goal or strategic initiative was important for the company’s near term goals and long term vision.
  2. What had to get done in order for that goal or strategic initiative to be successfully executed.
  3. Who specifically was primarily responsible for seeing that it got done, and which executive they could go to as often as necessary in order to navigate what ever obstacles they might encounter.
  4. How it would get done, not in excruciating detail, but in broad terms. For example; Which teams needed to collaborate with one another in order to make it happen?
  5. When the team expected to be able to report back periodically on their progress, and importantly, when the project needed to be complete.

To do this successfully, I had to focus on asking questions and encouraging deeper levels of inquiry than was the custom beforehand. Asking probing questions helped us cut out the “bullshit” of conventional wisdom that is seductively easy to accept.

Each time I heard; “You do not understand, that is not how it is done in our industry.” I would ask; “Why?” That would lead to an examination of the assumptions behind the choices that had been made in the past. Often there was no good reason to refuse to try something different even if it seemed out of step with accepted industry convention.

How this applies to early-stage startups: I am looking for founders at the seed or series A stage whose judgement I can trust enough to feel they do not need me to opine on every decision they ever have to make. That does not mean I am passive. It means I need to trust their decision-making skill and maturity enough to feel confident they will consistently make the right choices for all the startup’s constituents without the need to run everything by investors.

From the investors’ perspective, a policy of “show, don’t tell” goes a long way. To paraphrase the oft quoted saying; “Give a founder a fish and . . . . ” If I feel there’s something a founder ought to learn, I’d rather provide a guide to enable that founder learn the applicable frameworks and how to apply them in day-to-day decision-making situations.

Lesson #5: Create Internal Value By Increasing Organizational Capacity

The way we defined it; Organizational capacity is the harnessing of a company’s human, physical and material, financial, informational, and intellectual property resources in order to enable the company to continually perform above expectations and strengthen its competitive position.

In difficult times especially, it is important that companies do not lose sight of the need to continue to find ways to increase organizational capacity.

One way we did this, in both cases, was to shift both companies off MS Exchange Server and onto Google Docs for Work. This was not easy because of cultural attachments to MS Exchange and fear of having to learn something new. Both companies made the shift, eventually. The immediate benefit they experienced was a dramatic reduction in the costs they incurred for IT assistance. A more important, though less tangible benefit was that both businesses could then afford to give every full-time employee a corporate email address and access to a corporate intranet portal. The benefits were enormous; easier collaboration, easier information transfer and sharing,  and increased security of corporate information and trade secrets. Quicker turnaround on tactical decisions because people could now communicate by chat.

Given the improvements in tools for collaboration, we encouraged the formation of cross-disciplinary teams to tackle some of the problems that each company was dealing with. This allowed people from one area of each business to interact more closely with their colleagues from another area of the business. They developed a better understanding of one another, and of the challenges and constraints that they each faced in trying to execute their day-to-day responsibilities. In turn this fostered a more collaborative relationship across the entire organization. It also enhanced the learning environment for all employees.

How this applies to early-stage startups: It does not take a lot by way of resources to create an environment that is rich in opportunities for cross-functional collaboration and learning. This comes in handy during due diligence because every member of the team will be able to speak knowledgeably about the startup’s immediate and long term plans.

Lesson #6: Direction Must Be Set From The Top, But Engagement Must Begin at The Bottom

We started working on trying to develop a strategic plan for both companies in summer 2009. Before this time, neither company had previously had a coherent strategy.

In consultation with the executives in each company, the board of directors set out the broad areas that the strategic plans ought to cover; Finance, Operations, People, Demand Creation, and Expansion.

Once those had been agreed on, it was my job to meet with front-line employees as well as managers in the field in order to obtain data and insight about how the strategic plan would have to be set up in order to function effectively for them given what each company was trying to accomplish.

That sounds easy. It is not. It took multiple meetings, of several hours each. The restaurant had multiple locations in NYC, one location in NJ and another in CT. I did not visit the location in Chicago, the CFO held discussions with them during his quarterly visits. I had to sift through everything I heard during those meetings, and I had to extract broad themes. Then I had to reconcile that with the strategic framework established by the board. Finally, I had to interpret that information from the perspective of the competitive landscape for each of the two companies. Finally, I had to synthesize it all into digestible chunks for the board, the executives, the managers and rank-and-file employees.

The goal of spending so much time on having these meetings with people across all ranks in each company was to ensure that once the strategy was developed and implemented, there would be complete alignment behind the vision embodied in the strategy, and just as important that every employee would be engaged in and committed to executing the tactical initiatives required to make the strategy succeed.

How this applies to early-stage startups: The founder creates the vision that investors and the startup’s team buys into. The team executes to turn that vision into a living, breathing, growing reality. Investors hopefully act as a positive catalyst to help the process unfold more quickly.

Lesson #7: Do Not Ignore The Soft Issues, Emphasize Both Hard and Soft Issues Simultaneously

My experience might as well be called The Tale of Two Turnarounds. In one company leadership admitted things were awful. They also admitted that they could use whatever help I could offer. They readily admitted their limitations as a team. We had many instances of conflict, but starting from a position of optimism and a willingness to try, the process moved along slowly, but steadily. We created a survey that we administered twice a year to get a sense of how employees were feeling, data that might not be captured in the key performance metrics we monitored weekly, monthly, quarterly, and annually.

We launched the strategic plan in January 2010 after 9 months of work specifically focused on that task. A year later the company made its first ever payments from a new profit-sharing plan that we had created as part of the new strategy. The payments were not huge, but they were evidence that the team’s hard work was paying off. It also created a feedback loop about how actions by employees affect the bottom-line performance of the company.

In the other company the founder, who was also the ceo, was grumpy and relatively uncooperative with investors. To cut a long story short, we launched the strategic plan in April 2010, after about 9 months of work specifically focused on that assignment. Within 6 months 75% of the managers with whom we had worked to develop and launch the strategic plan had left the company or had been fired. It was a classic case in which we would take two steps forward only to take four steps backward.

Morale dipped ever lower. The founders incessant talk about “a vision” and “a mission” became the butt of jokes among rank-and-file employees. It became clear that employees were becoming disillusioned with what the company stood for. While the company fared better than it would have if there had been no attempt at executing a turnaround and developing a strategy, it continued to perform well below its potential.

At a board meeting one day, the founder/ceo went into a vituperous rant about all the areas where the company was falling short. This was in early to mid 2012. I had to burst out in laughter. He might as well have been reciting problems whose solution formed the core of the strategic plan we created in 2010. Implementing that plan would have started the process of solving those problems he was so exercised about that day. We had lost two years for no good reason.

No amount of emphasis on key performance metrics made a difference. Without the founder’s full embrace of the strategic plan, nothing else mattered. I should point out that he had been intimately involved in crafting the strategic plan. This was not a plan that was forced down on him “from on high.” It became clear how badly things had deteriorated when a long time employee quit, this individual was the only employee at the company who had been there as long as the founder.

How this applies to early-stage startups: I am of a firm belief that the team is really important at the seed and series A stage, or at least until uncertainty around product market fit has been largely eliminated. So, I need to develop a sense that a founder is someone I can work with over the long haul . . . Actually, the kind of founder I am happy backing has to be someone I could envision myself working for if circumstances were different. Age, race, gender, religion . . . That is all irrelevant. Early in my process for assessing a startup I focus almost entirely on soft issues.

In one example, I sensed something amiss about the body language between 2 Spanish co-founders pitching a startup to my partner and I in 2013. I decided to tune out what they were saying in order to better observe their body language. There was something about their body language towards one another that did not align with what they wanted us to believe, in my opinion. We passed on their seed round, and decided to watch them till we could get more data about the relationship between the co-founders. That was nearly 3 years ago. I have heard no reports to suggest we made an error in that case.

Let chaos reign, then reign in chaos.

– Andy Grove, Only The Paranoid Survive

Lesson #8: Be Prepared For Chaos; Harness, Focus And Direct It, Empower People

Once employees understood the strategic plan as well as the tactical initiatives that accompanied it, they began developing ideas related to the various functional areas in each company and making suggestions to managers and excutives.

At first this was overwhelming . . . Managers had to do their own work, manage the work of the groups of people that they managed, and now . . . . They also had all these ideas being thrown at them from “left, right, and center.” The initial knee-jerk reaction was to try to “make it stop.”

That would have been a mistake. Among the deluge of ideas were some real gems.

For example, a maintenance department team member at the aviation company noticed that the company could cut down on its electricity usage by changing all the bulbs in its main hangar . . . No one had thought about that over the years, but our discussion about the strategic initiative around improving the product while reducing costs prompted him to take another look at the company’s hangars in search of opportunities to reduce operating costs. Thanks to improvements in technology over the years this was now a measure that could be implemented relatively easily.

In another instance, the team at our restaurant in CT had observed that on certain days of the week large groups of Chinese tourists visited the casino resort in which they are located. They had been thinking of a way to capture some of that business, but had assumed the corporate office would object to the menu changes they thought they had to make in order to execute that plan. As part of our implementation of the strategic initiative around increasing revenues, I suggested they conduct an experiment, analyze the outcome, and then seek assistance from the corporate office if the results looked promising. They did that, and saw a jump in revenues on two days of the week when business would otherwise have been slow. The corporate office gave its blessing, and assisted in making that practice more entrenched by using corporate resources to give it the polish required for company-supported initiatives.

How this applies to early-stage startups: A startup stops being a startup once its search for a repeatable, scalable, and profitable business model is complete. While that search is in process it is important that every member of the team feels empowered to contribute to the discovery of that business model. It can’t be the job of only some members of the team, it has to be part of everyone’s job. The faster a startup gets through the discovery process the better.

Lesson #9: The Turnaround Should Be Its Own Reward; Incentives Should Reinforce Change Not Drive It

It was nice to be able to make payments from the profit-sharing plan that we instituted. The payments were relatively small, yet they were tangible evidence to the employees, managers, and executives that they were collectively well equipped to make it through the ongoing turbulence and correct the mistakes of the past.

The sense of accomplishment employees felt translated into a number of things, among them;

  1. Newfound and increasing pride in being associated with a company that was succeeding where many of its rivals had failed.
  2. High levels of morale and optimism about the future of the company, and their place at the company. Less stress about employment security.
  3. A greater willingness to take the initiative in situations where the possibility of generating business for the company exists.

Basically, every employee was empowered to function as a salesperson on the company’s behalf. We arranged training sessions to equip every employee with the vocabulary they needed to understand in order to do that effectively. We also developed simple tools that they could use. They did not replace the company’s professional salespeople . . . They became an auxiliary sales force.

How this applies to early-stage startups: As startups grow, founders and early team members need to get better at the art and science of “managerial leverage” . . . What is managerial leverage? It is the process by which a manager creates output that far supersedes that manager’s input by using all the resources at the manager’s disposal to influence the work that is done by the group of people whose on-the-job effectiveness and work-output is affected by interactions with the manager.

What is a manager’s output? According to Andy Grove, co-founder and former CEO of Intel “The output of a manager is a result achieved by a group either under his supervision or under his influence.” Great managers create positive output that far exceeds expectations. Below average managers create output that fails to meet expectations given superior resources. Average managers? The team’s output would not be any different if the manager were absent.

The art of managerial leverage is in determining; how to apportion time, where to pay more attention, where to pay less attention, who to pay more attention to, who to pay less attention . . . . etc etc. The science of managerial leverage is in determining; what to measure, when to measure it, how often to monitor what is being measured, where bottlenecks are most likely to occur and why, and how to eliminate them . . . . etc etc.

Managerial leverage drives output. Output drives results. Results are measured and reflected in the KPI’s that founders and investors measure. Getting that order right is critical to a startup’s success.

Lesson #10: Learn To Listen, And Communicate Effectively

It is amazing how many problems can be solved relatively quickly if people would communicate more effectively internally and externally. Communication involves two actions; first listening actively in order to understand what is driving the actions of other people. Second, responding to what other people have said in a way that gets to the root cause of the problem being discussed.

During one of my field visits, I spent 8 hours on my first day listening to the executives talk about all the problems they each perceived, and how they felt the issues ought to be tackled. I spent that day with the CEO/President, the CFO, the Head of HR, and the Head of Sales. I encouraged open disagreement and debate.

On my second day I spent about the same amount of time speaking with the middle managers; again we discussed the problems they each perceived, and how they each felt the issues ought to be tackled.

On the third day I brought both groups together, and moderated an all day discussion about the problems the company was facing. Once again, I encouraged open disagreement and debate. Also, I put the inter-personal issues and conflicts that I had uncovered on the table. Things often got heated. It was my job to function as a pressure-release valve during those episodes. It was not pretty.

For example, I explained to the entire group how the CFO who was disliked by a large number of people within the company had made payroll on too many occasions by dipping into his personal 401(K) savings for example. The irony, the folks who disliked him routinely failed to provide the finance team with the data they needed in order to collect on accounts receivable from the company’s customers.

The outcome of this exercise was that;

  1. Everyone felt they had been given a chance to speak and be heard by the rest of the leadership team, and
  2. We discussed expectations in a fair amount of detail, enough so that more work could be done laying them out in adequate specificity rather than vaguely wondering what people could expect from one another, and finally
  3. Created an environment in which each member of the leadership team contributed in creating a communication framework against which they agreed to be held accountable

Our goals for the communication framework were that;

  1. Every employee should know what is expected of them, as individual team members,
  2. Every employee should know what to expect from every other member of the team,
  3. Employees should know what to expect from executives and managers, and lastly
  4. Accountability should be about improving team and company performance, not punishing individuals.

As Rosabeth Moss Kanter says in Four Tips for Building Accountability; “The tools of accountability — data, details, metrics, measurement, analyses, charts, tests, assessments, performance evaluations — are neutral. What matters is their interpretation, the manner of their use, and the culture that surrounds them. In declining organizations, use of these tools signals that people are watched too closely, not trusted, about to be punished. In successful organizations, they are vital tools that high achievers use to understand and improve performance regularly and rapidly.”

How this applies to early-stage startups: Startups typically have to move quickly, especially if they have taken in capital from institutional venture capitalists. A culture of blame, lack of cohesive teamwork, and a lack of organization-wide accountability is an insidious tumor that will eventually lead to failure. The founders who are most successful in the long run are those who do not shift responsibility when things are difficult, but instead serve as a model that other team members can emulate.

Closing Thoughts

Executing a turnaround and getting a startup through the phase of discovering a business model are really just two sides of the same coin. That experience has led me to the belief that it is when things seem bleak that great early stage investors prove their worth.

Further Reading

Blog Posts, Articles, & White Papers

  1. The Psychology of Change Management
  2. Motivating People: Getting Beyond Money
  3. The Irrational Side of Change Management
  4. The CEO’s Role in Leading Transformation
  5. The Role of Networks in Organizational Change
  6. All I Ever Needed To Know About Change Management I Learned at Engineering School
  7. Changing an Organization’s Culture, Without Resistance or Blame

Books

  1. High Output Management
  2. Only The Paranoid Survive
  3. How Did That Happen?
  4. HBR’s 10 Must Reads on Change Management
  5. HBR on Turnarounds

Revisiting What I Know About Network Effects & Startups

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The recently announced IPO of Alibaba got me thinking last week about network effects 1Any errors in appropriately citing my sources are entirely mine. Let me know what you object to, and how I might fix the problem. Any data in this post is only as reliable as the sources from which I obtained them. – what they are, how they develop and evolve, and how network effects can help or hurt a startup. 2You can find Alibaba’s SEC Form F-1 here. Accessed online; Sept. 12, 2014.

That is something I think about a lot, practically every day. In other words each time I am sitting across from a founder listening to that founders’ explanation of a startup’s market, the problem it is solving, and its business model, I am also thinking about the economic moats it might build around itself in order to sustainably fend off competition. One way it might do that is through network effects.

To ensure we are on the same page, let’s start with some definitions. In the rest of this discussion I am primarily focused on early stage technology startups.

Definition #1: What is a startup? A startup is a temporary organization built to search for the solution to a problem, and in the process to find a repeatable, scalable and profitable business model that is designed for incredibly fast growth. The defining characteristic of a startup is that of experimentation – in order to have a chance of survival every startup has to be good at performing the experiments that are necessary for the discovery of a successful business model. 3I am paraphrasing Steve Blank and Bob Dorf, and the definition they provide in their book The Startup Owner’s Manual: The Step-by-Step Guide for Building a Great Company. I have modified their definition with an element from a discussion in which Paul Graham, founder of Y Combinator discusses the startups that Y Combinator supports. As an investor, I hope that each early stage startup in which I have made an investment matures into a company.

Definition #2: What is an economic moat? An economic moat is a structural barrier that protects a company from competition. 4Heather Brilliant, Elizabeth Collins, et al. Why Moats Matter: The Morningstar Approach to Stock Investing. Wiley. Hoboken, NJ. 2014; p. 1 In my case, when I am studying a startup, I am interested in the economic moats that will enable the startup to mature into a great business, and hence a great company – one that can keep competition at bay while earning great returns for its investors. Morningstar identifies 5 moat sources; Intangibles, Cost Advantage, Switching Costs, Network Effect, and Efficient Scale.

Definition #3: What is a network? Any group or system of interconnected people or things. Think; my nuclear family is a network to which I belong. My extended family is a larger network which includes my nuclear family, as well as the nuclear families of each of my relatives. A small business exists in a network that is comprised of its customers, its suppliers, its competitors, its regulators, and so on and so forth. A large network might be formed by a collection of smaller networks. 5I know this seems obvious. However, I was having a discussion via email with Kate Bradley Chernis while writing this. She and her co-founders are building a product to empower SMB’s manage their marketing campaigns. When I told her the topic of this blog post she stated that she finds that many SMB owners have no understanding of the networks that they belong to, or how they can use their networks to enhance their business. I added this definition after that exchange.

Definition #4: What is a Network Effect? A network effect occurs when the value of a good or service increases for both new and existing users as more customers use that good or service. 6Network effect is often colloquially referred to as network externality. However, the two are not precisely the same. The network effect is a virtuous cycle that allows strong companies to become even stronger. 7Ibid; p. 27 Network effects are also known as direct-benefit effects. I think direct-benefit effects makes it easier to remember why network effects can be such a powerful economic moat.

How do network effects develop? Direct-benefit effects develop and become stronger in settings where some form of interaction, or compatibility with others is important. 8David Easley and Jon Kleinberg. Networks, Crowds, and Markets: Reasoning About a Highly Connected World. Cambridge University Press, June 10, 2010 draft version. P. 509. Accessed online on Sept. 12, 2014. In other words, the number of other people using the technology has a direct impact on how valuable that technology is to each individual user. Direct-benefit effects contribute to the strengthening of an economic moat only in so far as they directly contribute to increasing positive externalities for the members of the network. What is an externality? It is “any situation in which the welfare of an individual is affected by the actions of other individuals, without a mutually agreed-upon compensation.” 9Ibid. One can have positive or negative externalities. A positive externality occurs when individual and aggregate welfare increases with the addition of more users to the network. A negative externality occurs when welfare decreases with the addition of more users. 10As an example, think of a website or app that starts to crash and become inaccessible due to capacity constraints as the number of users increases dramatically. Network effects evolve positively for a startup if the members or users of the network derive both inherent value and network value from their use of the product. Inherent value is value that an individual user derives because of that individual user’s consumption of the product or service. For example, even if I were in a network compromising only me, I would derive inherent value from owning one copy of MS Office running on Windows because I could now more easily do word-processing using MS Word or analyze quantitative data using MS Excel. I derive network value from MS Office and Windows because if other people buy and use those products, it becomes easier for me to share my work with them and for them to share their work with me. I derive network value from being able to collaborate with every other person who also uses MS Office and Windows.

Types of Direct-benefit Effects: To fully parse through how a startup I am studying might build an economic moat based on network effects I need to be able to understand the subtle nuances that differentiate one type of network effect from another. 11This is based on the work of Prof. Arun Sundararajan. Accessed at http://oz.stern.nyu.edu/io/network.html on Sept. 12, 2014.

  1. Direct network effects or one-sided network effects occur when increased usage leads explicitly to increased welfare for the members of the network. Think fax machines, telephones, messaging apps.
  2. Indirect network effects occur when the proliferation of network members leads to the proliferation of complementary goods and services such that the welfare of the network’s members increases significantly. Think iOS, Android, smartphones and apps.
  3.  Two-sided network effects are distinct from indirect network effects. A two sided network effect occurs when an increase in usage of the product by one group of network members increases the welfare of a separate and distinct group of other members of the same network. Think marketplaces, platforms that combine hardware and software, and software pairings in which there’s a reader and writer.
  4. Local network effects occur when an individual network member’s welfare increases not because of an increase in the overall network user base, but as a result of growth in the users within a  localized subset of the network’s membership. Think; as a user of Whatsapp, my welfare increases when more people in my cellphone’s contact list join the Whatsapp network. So, while I think it’s great that Whatsapp has 500 Million users, my welfare has no positive correlation to the size of  Whatsapp’s network. However, it does have a positive correlation with how many of my friends, family, colleagues, social and professional acquaintances become members of the Whatsapp network.

This diagram by Ray Stern conveys the power of positive network effects, and the corollary – negative network effects can help erode the competitive position an incumbent occupies. 12Eric Jorgenson, The Power of Network Effects: Why They Make Such Valuable Companies, and How To Harness Them. Accessed on Jun 27, 2015 at https://medium.com/evergreen-business-weekly/the-power-of-network-effects-why-they-make-such-valuable-companies-and-how-to-harness-them-5d3fbc3659f8

The Power of Network Effects (Image Credit: Ray Stern, former CMO of Intuit)
The Power of Network Effects (Image Credit: Ray Stern, former CMO of Intuit)

How might a startup start to experience negative network effects? One of the most exciting things about the Internet is that it has lowered the barriers to competitors entering a space in which they perceive an opportunity to earn economic profits. That is great if I invest in a startup that is earning such profits, but not so great if events unfold such that other startups can launch a credible attack in order to win business away from the startup in which I am an investor.

  1. Lock-in or switching costs occur when a member of one network cannot switch from that network to another without suffering substantial costs. The switching costs could be monetary and non-monetary. Often, the non-monetary switching costs far outweigh the monetary costs. Non-monetary costs might include the loss of massive amounts of information and data, business process disruptions, and so on and so forth. Antitrust regulators do not like to see situations in which such costs bar new competitors from entering a market and create a monopoly for an incumbent – IBM, Microsoft and Apple have all faced antitrust action. Switching costs can also exist in physical goods industries, for example razors and blades, and also printers and printer-cartridges. Switching costs are not an issue as long as users perceive that they derive more value from being within the network than the inconvenience they suffer as a result of lock-in or switching costs.
  2. Network congestion occurs when the experience of each member of the network deteriorates as the network’s membership grows. In other words the network becomes less efficient from the users’ perspective. As a result of this each member of the network derives decreasing inherent and network value from the network. Think; A website, web or mobile app that is consistently unavailable because too many people are trying to access it simultaneously.
  3. Conflicts of interest occur when a network operator behaves in ways that limit or restrict the ability of network members to freely form sub-networks. According to David Reed: 13David Reed. That Sneaky Exponential – Beyond Metcalfe’s Law to the Power of Community Building. Context Magazine. Accessed at http://web.archive.org/web/20080526050751/http://www.contextmag.com/setFrameRedirect.asp?src=/archives/199903/digitalstrategy.asp on Sept. 12, 2014.

But many kinds of value are created within networks. While many kinds of value grow proportionally to network size and some grow proportionally to the square of network size, I’ve discovered that some network structures create total value that can scale even faster than that. Networks that support the construction of communicating groups create value that scales exponentially with network size, i.e. much more rapidly than Metcalfe’s square law. I will call such networks Group-Forming Networks, or GFNs.

That observation might be used to explain the demise of Friendster and Myspace in the face of competition from Facebook. It has also been used to predict the success of Ebay during a time when Yahoo was the most dominant web-portal. 14David Reed. Weapon of Math Destruction: A Simple Formula Explains Why The Internet is Wreaking Havoc on Business Models. Context Magazine. Accessed at http://web.archive.org/web/20080526050751/http://www.contextmag.com/setFrameRedirect.asp?src=/archives/199903/digitalstrategy.asp on Sept. 12, 2014.

What exactly do I mean by conflicts of interest? I love to buy books from Amazon. To save money, I prefer to buy used books if that is at all possible. Amazon has allowed independent merchants to market their goods in its marketplace. many of these merchants sell used books at substantial discounts to the price of a new book offered by Amazon. Let us assume that each time I wanted to make a purchase Amazon compelled me to purchase its own offering of that item, or pay a penalty if I insisted on making the purchase from one of its independent sellers. What effect do you think that might have on my behavior? What effect might that have on the behavior of the independent sellers? What if an Amazon competitor did not impose that penalty? How might that shift the competitive landscape? That is a relatively simple example. It should illustrate the point. When the operator of a network platform starts to compete with its platform partners it is engaging in behavior that will lead to the destruction of the network.

What strategies should a startup that’s competing in a market in which network effects matter employ in order to win? There are a number of strategies that might be employed 15Based on Prof. John M. Gallaugher’s Understanding Network Effects. Accessed at http://www.gallaugher.com/Network%20Effects%20Chapter.pdf on Sept. 12, 2014. independently or in combination with one another by competitors seeking to compete effectively against a rival, or by market leaders seeking to maintain that position.

  1. First mover adoption matters – a lead of a few months can be the difference between winning the market and losing it.
  2. It can pay to subsidize adoption – in order to seed the network it might be worth it to subsidize adoption by providing an in-network benefit of some sort. Dropbox offers free storage to new users, and members who help it acquire new users also get rewarded with free extra storage. However, it is important to strike a balance between subsidizing adoption and maintaining a tight control on costs. Ideally, the marginal cost of subsidizing adoption should be far far less than the marginal benefit of acquiring a new network member.
  3. Viral marketing matters – the success of mobile and web products that benefit from network effects can be greatly enhanced by encouraging viral promotion through social networks like Facebook, Twitter, Pinterest, Instagram, Snapchat, etc etc.
  4. Redefine the market – this has the benefit of bringing in more users who might previously have been inaccessible. It also makes it possible to develop a product or service that envelopes several distinct markets into one. Think; smart phones becoming capable of performing the functions of a media player, a camera, an email editor, an internet browser, a gaming device, a phone, a medical diagnostic tool, a fitness tracker, a notebook, an alarm clock, a GPS navigation system etc. etc.
  5. Form alliances and partnerships – when competing with a powerful incumbent this might make it easier to gain a toehold from which the competitor can then launch an entry into the market. Think; Google’s Android strategy at a time when it appeared Apple’s iOS was an unstoppable force in the smartphone market.
  6. Leverage distribution channels – to pry an opening into a market think of non-obvious ways by which a distribution channel might be created. A popular approach is to bundle a new product with an existing product from the same provider.
  7. Seed the market – one way to do this is to subsidize adoption by making room in the budget for a financial outlay specifically geared towards acquiring new users. For example, a messaging app might pay people in a foreign country to download the app and start using it in hopes that enough of them fall in love with the app and tell their friends about it. Another strategy related to this is to give away product to one group of network participants.
  8. Encourage the development of complementary goods – this is now a widely used strategy through the publication of SDKs and APIs to encourage the development of complementary products and services.
  9. Leverage backward compatibility – to do the opposite would be foolish since that would mean that at the beginning of each upgrade cycle the incumbent has no advantage over a new entrant competitor.
  10. Build-in compatibility with the market leader – this changes users’ options from one in which they have an “either-or” decision to make to one in which they have an “and” decision to make. Who does not like “and”? Every new entrant rival should consider this. For example new social networks ought to build seamless integration with Twitter, Facebook and other leading social networks into the product from the very outset.
  11. Close-off access to new entrants and existing rivals and innovate constantly – this makes it nearly impossible for rivals to steal away business from the incumbent leader in the market.
  12. Pre-announcements – from a large, well known, and well liked producer of a product or service can have the effect of slowing down the adoption of a rival’s competing offering. Some people might want to wait till they can compare the options more directly against one another. Think; when one of Apple’s competitors quickly schedules its product announcement to precede a major product announcement by Apple, but only after after Apple announces an event at which it will discuss a new line of products. The extreme case is when a rival rushes to announce and release its product prior to Apple’s product release date once Apple makes an announcement. 

Understanding networks effects and how they unfold for an early stage startup is critical. Markets in which such effects are present are often characterised by fierce competition and a bandwagon effect tends to take hold thanks to positive-feedback loops. Also, the nature of these markets is that a winner can emerge in remarkably short order and that winner typically garners a commanding market share lead over its competitors. Furthermore, once a winner has been established it is extremely difficult for competitors to win users away from it.

Further Reading

  1. Platform Power – A free book by Sangeet Choudary,  available for download at Platform Thinking Lab’s website.
  2. The Power of Network Effects: Why They Make Such Valuable Companies, and How To Harness Them – blog post by Eric Jorgenson
  3. Exponential Organizations: Why new organizations are ten times better, faster, and cheaper than yours (and what to do about it) – by Salim Ismail, Michael S. malone, and Yuri van Geest

References   [ + ]

1. ↩ Any errors in appropriately citing my sources are entirely mine. Let me know what you object to, and how I might fix the problem. Any data in this post is only as reliable as the sources from which I obtained them.
2. ↩ You can find Alibaba’s SEC Form F-1 here. Accessed online; Sept. 12, 2014.
3. ↩ I am paraphrasing Steve Blank and Bob Dorf, and the definition they provide in their book The Startup Owner’s Manual: The Step-by-Step Guide for Building a Great Company. I have modified their definition with an element from a discussion in which Paul Graham, founder of Y Combinator discusses the startups that Y Combinator supports.
4. ↩ Heather Brilliant, Elizabeth Collins, et al. Why Moats Matter: The Morningstar Approach to Stock Investing. Wiley. Hoboken, NJ. 2014; p. 1
5. ↩ I know this seems obvious. However, I was having a discussion via email with Kate Bradley Chernis while writing this. She and her co-founders are building a product to empower SMB’s manage their marketing campaigns. When I told her the topic of this blog post she stated that she finds that many SMB owners have no understanding of the networks that they belong to, or how they can use their networks to enhance their business. I added this definition after that exchange.
6. ↩ Network effect is often colloquially referred to as network externality. However, the two are not precisely the same.
7. ↩ Ibid; p. 27
8. ↩ David Easley and Jon Kleinberg. Networks, Crowds, and Markets: Reasoning About a Highly Connected World. Cambridge University Press, June 10, 2010 draft version. P. 509. Accessed online on Sept. 12, 2014.
9. ↩ Ibid.
10. ↩ As an example, think of a website or app that starts to crash and become inaccessible due to capacity constraints as the number of users increases dramatically.
11. ↩ This is based on the work of Prof. Arun Sundararajan. Accessed at http://oz.stern.nyu.edu/io/network.html on Sept. 12, 2014.
12. ↩ Eric Jorgenson, The Power of Network Effects: Why They Make Such Valuable Companies, and How To Harness Them. Accessed on Jun 27, 2015 at https://medium.com/evergreen-business-weekly/the-power-of-network-effects-why-they-make-such-valuable-companies-and-how-to-harness-them-5d3fbc3659f8
13. ↩ David Reed. That Sneaky Exponential – Beyond Metcalfe’s Law to the Power of Community Building. Context Magazine. Accessed at http://web.archive.org/web/20080526050751/http://www.contextmag.com/setFrameRedirect.asp?src=/archives/199903/digitalstrategy.asp on Sept. 12, 2014.
14. ↩ David Reed. Weapon of Math Destruction: A Simple Formula Explains Why The Internet is Wreaking Havoc on Business Models. Context Magazine. Accessed at http://web.archive.org/web/20080526050751/http://www.contextmag.com/setFrameRedirect.asp?src=/archives/199903/digitalstrategy.asp on Sept. 12, 2014.
15. ↩ Based on Prof. John M. Gallaugher’s Understanding Network Effects. Accessed at http://www.gallaugher.com/Network%20Effects%20Chapter.pdf on Sept. 12, 2014.