Innovation Footprints

What if . . . ?

Economic Moat

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

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.
You can find Alibaba’s SEC Form F-1 here. Accessed online; Sept. 12, 2014.
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.
Heather Brilliant, Elizabeth Collins, et al. Why Moats Matter: The Morningstar Approach to Stock Investing. Wiley. Hoboken, NJ. 2014; p. 1
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.
Network effect is often colloquially referred to as network externality. However, the two are not precisely the same.
Ibid; p. 27
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.
Ibid.
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.
This is based on the work of Prof. Arun Sundararajan. Accessed at http://oz.stern.nyu.edu/io/network.html on Sept. 12, 2014.
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
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.
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.
Based on Prof. John M. Gallaugher’s Understanding Network Effects. Accessed at http://www.gallaugher.com/Network%20Effects%20Chapter.pdf on Sept. 12, 2014.

Why Tech Startups Can Gain Competitive Advantage from Operations

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Hunter Walk’s blog post serves as the inspiration for this one. He points out that operations is key for startups operating in the on-demand economy. I want to pick up where he left off, and attempt to connect the dots. This post will answer the question “Why is operations important for tech startups?”

All else equal, and I know that is rarely true, operations marks the difference between an unsustainable competitive advantage and a sustainable competitive advantage. 1Any errors in appropriately citing my sources is 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. In order to understand the role of operations in determining the success or failure of a startup we must start with some definitions.

Definition #1: What is a startup? When I think of a startup I prefer to paraphrase the definition provided by Steve Blank and Bob Dorf in their book The Startup Owner’s Manual; 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. The defining characteristic of a startup is that of experimentation – to have a chance at survival every startup has to be good at performing the experiments that are necessary for the discovery of a successful business model.

Definition #2: What is a company? A company is what a startup becomes once its search for a repeatable, scalable and profitable business model is complete. The inflection point between startup and company is characterized by the creation of the kind of infrastructure that we typically associate with large companies. For example, it becomes essential to have an HR organization where one was previously unnecessary. It become necessary to have a marketing and sales organization where that would have been hard to justify during the startup phase. Finally, it might also become necessary to build a sophisticated finance and accounting organization where previously there was not much to monitor or report, and someone with an unsophisticated understanding of accounting was adequate for the startup’s requirements, or the role might have been filled by someone working on a part-time basis. Basically, a startup becomes a company when its continued existence depends nearly equally on having the right organizational structures in place to ensure that the business is well managed as it does on having the right product or service to sell.

Definition #3: What is strategy? According to Fred Nickols, strategy is the accumulation of perspectives, positions, plans, patterns, tactics, choices, policies, concrete actions, decisions, thoughts, ideas, insights, experiences, goals, memories, perceptions and expectations that enable a company bridge the gap between the factors of production that the company controls and the output that it wishes to create and deliver to its customers. 2Fred Nickols, Strategy: Definitions & Meanings, 5/24/2012. Accessed online on Aug. 10th, 2014 More succinctly, strategy is the qualitative essence of how a company does what it says it will do for its current and prospective customers. At a high level, strategy gives broad, abstract and general answers to the question; In what direction should we travel?

Definition#4: What is marketing? Marketing is the process by which the producer of a product or service creates demand for its output. It involves various modes of communication aimed at helping consumers interpret the value that the producer hopes to deliver to each consumer that buys the product or service. Marketing includes sales, advertising, public relations, and any other practice or activity whose ultimate goal is to build awareness in order to directly or indirectly facilitate sales. Marketing is what makes operations necessary. Without marketing, there would be no demand to satisfy.

Definition #5: What is operations? Operations is the set of activities in a startup or a company that takes inputs and turns them into the final product or service through which the value proposition is delivered to the market. Operations is focused on the process of transformation – transforming tangible and intangible inputs into something that the market is willing to pay for, at a cost level that enables the producer to earn a profit consistent with the accompanying strategy. Operations seeks to answer the question; How do we implement strategy?

In a fine dining restaurant operations is the process of transforming the knowledge and experience of every member of the restaurant’s staff into a consistently enjoyable and memorable dining experience. This process has to deliver results in tangible and intangible ways. Dishes have to be executed to a high degree of excellence, and the atmosphere, decor and service have to evoke emotions of pleasure, satisfaction and joy that meet or exceed diners’ expectations and cause them to dine at the restaurant as frequently as the restaurant’s operators wish. Each time a diner has a meal at the restaurant it must be memorable, in a good way.

In a general aviation company operations is the process that begins with finding out the traveler’s needs, matching those needs with a specific aircraft, and then safely transporting the traveler from the point of departure to the desired destination within a period of time acceptable to the traveler. Each time a traveler is transported from one place to another, that passenger must arrive safely. Also, the passenger should have enjoyed the trip enough to choose that charter company as frequently as its operators wish.

In a software startup operations is the process that begins with designing and creating the software, delivering it to users, and then ensuring that it is available whenever users or customers wish to use it. The experience of using the software has to be such that it is the first choice that users think of when they consider using software to facilitate that specific set of activities.

Once a strategic choice has been made, the process of transforming inputs into outputs is accomplished through capabilities within the organization. The diagram below shows the connection.

What is the connection between strategy, capabilities, and operations?
What is the connection between strategy, capabilities, and operations?

Strategy is concerned with answering the question; Where should we go? Operations is concerned with answering the question; How will we get there? The question around capabilities is; What do we have to be good at to get there? While all this is happening, processes that determine how a startup does its work are being developed. Processes matter because eventually a set of processes will lead to the development of a certain set of capabilities. As a result, it is essential to think about which capabilities are most critical to the startup’s survival before adopting one process over another. Eventually, as the startup matures it builds up a legacy of past choices that may limit or enhance the strategic options it can pursue in the future. Faced with a period of dramatic change in consumer or customer preferences, market structure, technological innovation, or regulations, flexibility is what separates winners from losers. The key attributes of a successful operations organization are:

    1. It must work hand in hand with strategy, marketing, finance, human resources, and every other area within the company.
    2. It must implement procedures and processes that lead to the right blend of capabilities within the company – for exploiting current opportunities, or resolving future threats.
    3. It must make infrastructure choices that protect the startup’s strategic flexibility to deal with current and unforeseen developments in the market.

Here are a few examples of how strategic and operational flexibility made the difference between startups that otherwise were neck-and-neck at some point in time – Friendster, Myspace, and Facebook.

What do you do when your users adopt your product for uses you did not intend or foresee? Facebook and Friendster were founded roughly around the same time. Friendster was founded in 2002, Facebook in 2004. Friendster reportedly grew to 3 million users within 3 months after it became generally available to the public in the United States. It soon became obvious that users were using Friendster for purposes its creators did not intend. For example they started creating various types of profile pages that were not tied to a real person – these became known as Fakesters. Friendster’s founders decided to prevent users from creating such profiles. Facebook experienced a similar behavior from its users. However, it took a different approach. It observed such behavior, learned from it and eventually enabled the behavior it observed. For example, users’ habit of creating profile pages for parties on college campuses eventually led to the development of the events feature on Facebook. In effect;

Facebook continuously watched how users used, and of course misused, their products by gathering usage data. These data guided their product development roadmap and helped ensure they were building features or making changes to their services that would encourage users to recommend the service to others (fan-out) and continue using it themselves (retention). 3Fisher, Michael; Abbott, Martin; Lyytinen, Kalle (2013-11-01). The Power of Customer Misbehavior: Drive Growth and Innovation by Learning from Your Customers (p. 103). Palgrave Macmillan. Kindle Edition.

While we can not say precisely what motivations drove the opposite reactions Friendster and Facebook had to observed user behavior, we can guess that a need for operational simplicity motivated Friendster’s response. Locking down and restricting the number of ways in which its users could engage with its product made operations easier to manage. On the other hand, Facebook’s approach seems to reflect a philosophy that is more outward looking and user-centric. In other words, operations would adapt to ensure that Facebook’s product evolved to reflect the desires and wants expressed by its users in their day to day interaction with the product. In the process, Facebook developed capabilities that strengthened its strategy and so on and so forth. 4Twitter and Zynga are two more examples of cases in which product features, and operations have been adapted and modified on the basis of observed user behavior. Pinterest just updated its web and mobile apps with a messaging feature. From the outside it appears this update is a response to the observed behavior of its users.

What do you do when your technology infrastructure appears to be unable to keep up with growth, and the accompanying demands? 5I am assuming here that initially the startup relies on outside service providers for technology that is not core to its business model. Sometimes things change in a really big way as a startup makes the transition from searching for a business model to scaling. Maybe its marketing and its product are so successful that existing infrastructure proves to be inadequate to meet the demands that the startup’s customers and users place on it. The startups that thrive and go on to become transformative companies adapt operations to deal with this reality. To do so they call on new capabilities that they have developed over the course of time. Google 6Jeff Dean(2008 Google I/O Session Videos and Slides); Underneath The Covers at Google: Current Systems and Future Directions. Accessed online, Aug. 15th 2014. and Facebook 7Jonathan Helliger; Building Efficient Data Centers with The Open Compute Project, Apr. 7th, 2011. Accessed online, Aug. 15th, 2014. provide examples. They both realized that the off-the-shelf server hardware that they were relying on to run their operations were not necessarily designed to handle the massive amounts of data that their unique business models require them to each deliver to their users and customers daily. As a result they have modified their operations so that they now develop, design and build their own server infrastructure. 8Jon Brodkin; Who Needs HP and Dell. Facebook Now Designs All Its Own Servers, Feb. 14, 2013. Accessed online, Aug. 16, 2014. There are many benefits to be derived from this. For example; First, this practice saves them money by optimizing energy usage. Second, it ensures that their business runs smoothly and efficiently so that users and customers have an experience that is commensurate with the value propositions that Facebook and Google have made and the experience users and customers have come to expect. Third, this makes it more difficult for new competitors to compete directly with Facebook or Google in the core areas of their business. As a testament to the soundness of this approach, many other companies that rely on technology as a cornerstone of their business operations are moving towards the practice of building their own custom server and networking hardware and software. 9Netflix, Amazon and RackSpace are each reported to have adapted their operations to rely on custom designed server hardware. I assume there are others we do not yet know about. At one point SingTel, the huge Asian telecommunications company was thinking of building its own CDN instead of relying on providers like Akamai.

Contrast the fate of Facebook with that of Myspace and Friendster. Remember that Friendster, Myspace and Facebook were founded in 2002, 2003, and 2004 respectively. At one point Myspace was the most visited social networking site in the world. It briefly overtook Google as the most visited website in the world. So What happened to Friendster and Myspace? I am certain there is more than one reason for their failure. However, reports in the press suggest that their inability to adapt the technology that was core to running their business played an important role in their loss of market leadership to Facebook, and their subsequent failure – they continued to rely on server hardware and software from original equipment manufacturers who build off-the shelf servers. Friendster reportedly slowed down as traffic to its website grew. 10Gary Rivlin; Wallflower at The Web Party, Oct. 15th, 2006. Accessed online, Aug. 16th, 2014. Similar observations are made about Myspace. 11Abel Avram; Debate: What’s The Reason for MySpace’s Decline?, Mar. 30, 2011. Accessed online, Aug. 16th, 2014. While we do not know the full details, we can deduce that operations at Friendster and Myspace did not mature to the the same extent that operations at Facebook had matured.

As these examples suggest, operations is critical to the survival of any entity that intends to grow to any substantial size by satisfying demand from a large number of customers or users. To succeed technology startups cannot make the mistake of treating operations like an unwanted orphan stepchild. Rather, operations must have a seat at the table, and it must participate in a healthy exchange of ideas, information and opinions with strategy, marketing, finance and accounting, and HR about how each of those functions can work, individually and in concert, to accomplish the goal that the startup wishes to set for itself. Tech startups can ill afford to have operations start from the bottom.

 

 

References

Any errors in appropriately citing my sources is 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.
Fred Nickols, Strategy: Definitions & Meanings, 5/24/2012. Accessed online on Aug. 10th, 2014
Fisher, Michael; Abbott, Martin; Lyytinen, Kalle (2013-11-01). The Power of Customer Misbehavior: Drive Growth and Innovation by Learning from Your Customers (p. 103). Palgrave Macmillan. Kindle Edition.
Twitter and Zynga are two more examples of cases in which product features, and operations have been adapted and modified on the basis of observed user behavior. Pinterest just updated its web and mobile apps with a messaging feature. From the outside it appears this update is a response to the observed behavior of its users.
I am assuming here that initially the startup relies on outside service providers for technology that is not core to its business model.
Jeff Dean(2008 Google I/O Session Videos and Slides); Underneath The Covers at Google: Current Systems and Future Directions. Accessed online, Aug. 15th 2014.
Jonathan Helliger; Building Efficient Data Centers with The Open Compute Project, Apr. 7th, 2011. Accessed online, Aug. 15th, 2014.
Jon Brodkin; Who Needs HP and Dell. Facebook Now Designs All Its Own Servers, Feb. 14, 2013. Accessed online, Aug. 16, 2014.
Netflix, Amazon and RackSpace are each reported to have adapted their operations to rely on custom designed server hardware. I assume there are others we do not yet know about. At one point SingTel, the huge Asian telecommunications company was thinking of building its own CDN instead of relying on providers like Akamai.
Gary Rivlin; Wallflower at The Web Party, Oct. 15th, 2006. Accessed online, Aug. 16th, 2014.
Abel Avram; Debate: What’s The Reason for MySpace’s Decline?, Mar. 30, 2011. Accessed online, Aug. 16th, 2014.

A Reexamination: Can Venture Capitalists be Value Investors?

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Let’s begin with some disclaimers. I have never actually been a value investor. I have also never made individual picks of stocks traded on the public markets. I was completely oblivious of stock markets until soon after I had graduated college in 2001. Before I arrived in the United States in 1997, I would not have been able to answer the question; What is a stock? During my 4 years of college I stayed narrowly focused on mathematics and physics, in which I completed a double major.

It was not till I began my professional career as an actuarial analyst at Watson Wyatt that I began to read the Wall Street Journal, and also to pay attention to news about the economy and the financial markets. I bought and read a copy of Roger Lowenstein’s Buffett: the Making of an American Capitalist. I bought the book because what I had read about value investing in the popular press at that time seemed made me think it was an investment philosophy that would agree with my temperament.

In business school at New York University’s Stern School of Business, I decided that I should petition the committee on academic standing to let me pursue an independent study on value investing. I drafted the petition, drew up a syllabus, won approval from the school, and then persuaded a professor to act as my course supervisor. My goal for the course was to learn enough about value investing to allow me to apply its precepts in what I hoped would be a career as a buy-side equity investment research analyst, studying publicly traded companies. That was 2008. Things did not work quite as I expected. I did not land at what one would traditionally think of as a securities analysis outfit. Honestly, for a while I did not know if I would land anywhere.

Eventually, I did land somewhere. Initially, my job required me to focus on helping two small companies navigate the treacherous economic climate that was the reality in 2008, 2009 and 2010. For two years that was all I did. Eventually, my responsibilities at work evolved. Now, I primarily spend my time assessing early stage technology-enabled startups for investment consideration by a venture capital fund that makes seed, series A and series B investments.

As you might expect, the shift in my responsibilities has led me back to thinking about value investing. I have asked myself what role it plays in my work. I have also been thinking about how I might apply its main precepts to my work. 1Any mistakes in quoting from my sources are entirely mine.

Jeffrey Bussgang tackled this subject in a piece for Fortune in October 2010, coincidentally this was not too long after I had started my very first seed stage venture capital assignment. 2Jeffrey Bussgang, Can VCs Be Value Investors?, Fortune, October 6, 2010. Accessed at http://finance.fortune.cnn.com/2010/10/06/can-vcs-be-value-investors/ on August 10, 2013. I was knee deep in trying to teach myself the basics of venture capital investing. I still am. I was happy that someone else had already seen the need to tackle that question, and so I read that blog post eagerly. However, I felt a sense of intellectual dissatisfaction after I was done. So I am revisiting the question he raised. I hope I do a good job of adding to the discourse that he started. For the record, I agree with Jeff Bussgang’s conclusion – in general, it is difficult for venture capitalists to apply the concepts of value investing in a straightforward way to their work. That said, I wonder if it is not possible to apply the framework to early stage venture investing, even if the details about that application differ from what one might be accustomed to seeing or doing.

To begin the discussion I will lay out some terms that have guided how I think about this question.

When I think of a startup I prefer to use Steve Blank’s definition. According to that definition:

A startup is a temporary organization in search of a scalable, repeatable, profitable business model. 3Steve Blank and Bob Dorf, The Startup Owner’s Manual Vol. 1: The Step-by-Step Guide for Building a Great Company, California, K&S Ranch Press, 2012, page xvii.

I paraphrase that definition very slightly. A startup is a temporary organization established for the purpose of finding the solution to a problem, and to search for a scalable, repeatable, profitable business model. It is important to emphasize the process of finding a solution to a problem because it is not unusual for venture capitalists to encounter startups that have developed a solution that is seeking a problem. I try to avoid such startups. Once the startup has found a scalable, repeatable, profitable business model it begins the process of transforming itself from a startup into a company.

Venture capitalists invest in early stage, high growth startups. Usually the startups that attract the attention of venture capitalists are going into business on the basis of some innovation; technology, business model, or even a completely new invention. Generally venture-backed startups are most concentrated in areas where science, technology, engineering and mathematics play a central role. Venture capitalists typically invest after the startup has already raise some capital from friends and family, and subsequently from angel investors. However, some venture capitalists have begun to invest exclusively in seed stage startups where often the only previous capital raised by the startup is that raised from the founding team’s family and friends. The venture capitalist provides capital in exchange for an equity stake in the startup. Therefore the venture capitalist earns a return when there is an exit – an acquisition by a larger company, or an initial public offering in which shares are sold to the investing public. Venture capitalists tend to speak of themselves as people who know how to build companies. The most sought after venture capitalists tout their prior entrepreneurial experience taking innovations from idea to startup to company, and ultimately to exit. They insist that experience makes them an invaluable source of advice and ideas for entrepreneurs traveling the entrepreneurial path. There is a debate in some quarters as to wether venture capitalists’ returns derive from their ability to pick securities much like is the case for investors in the public markets, or if instead it is in fact the company building activities of venture capitalists that lead to the returns that they have realized. 4I am greatly simplifying things for the sake of brevity, but this covers the basics.

For a succinct description of value investing I turn to J. Dennis Jean-Jacques;

The goal of the value investor is quite simple: To buy solid businesses at exceptional prices in order to achieve adequate after-tax returns over a long period. The mental model is as follows: Good Business + Excellent Price = Adequate Return over Time 5J. Dennis Jean-Jacques, The Five Keys To Value Investing, New York, McGraw-Hill, 2002, page 2.

One of value investing’s most important concepts is the concept of a margin of safety. To emphasize its importance in value investing Benjamin Graham says ” . . . to distill the secret of sound investment into three words, we venture the motto, MARGIN OF SAFETY. This is the thread that runs through all the preceding discussion of investment policy – often explicitly, sometimes in a less direct fashion.” 6Benjamin Graham, The Intelligent Investor, New York, HarperCollins, the 2005 reprint of the original 1949 edition, page 241. Seth Klarman is considered one of the most successful practitioners of value investing. In discussing the concept of margin of safety he says: “A margin of safety is achieved when securities are purchased at prices sufficiently below underlying value to allow for human error, bad luck, or extreme volatility in a complex, unpredictable, and rapidly changing world.” 7Seth Klarman, Margin of Safety: Risk-Averse Value Investing Strategies for The Thoughtful Investor, New York, HarperCollins, 1991, page 92. Generally, margin of safety is analyzed quantitatively – in terms of a discount to intrinsic value, remembering that value investors only buy when a stock’s market price is well below their estimate of its intrinsic value, under the assumption that they understand how the stock price will gradually recover until price approaches intrinsic value.

Another central concept in value investing is the concept of an economic moat. Warren Buffett is credited with coining the term “moat” in relation to investing after he recognized that the companies that yield the most profitable investments over long investment horizons typically possess one or more characteristics that give them a durable competitive advantage. Generally, economic moats are built through some combination of economies of scale, switching costs, network effects, and intangible assets. Some value investors speak of a soft moat as the competitive advantage that a company derives from a unique corporate culture. However one does the analysis, studying the presence and durability of economic moats involves performing a qualitative analysis that is aimed at understanding how competitive advantage may be developed, and maintained.

Consider this example of an early stage startup. 8While this specific example is entirely fictitious, it is not entirely dissimilar to many of the situations that early stage venture capitalists have to study in order to make an investment decision. An entrepreneur raised $200,000 in seed capital 3 years ago and formed a startup with his co-founder. Working with a small team of in-house developers as well as some contractors, they have a near-final product. The product they have developed is a software product delivered over the Web to the startup’s customers. They won a competitively-bid contract with 1 country office of a large multinational corporation that has operations in more than 200 countries, selling 3,500 different products. That contract earns the startup $50,000 a month. The contract is for 3 years. They are only 3 months in. The customer is already initiating discussions to increase the number of its employees that have access to the product. The customer also wants to act as a sponsor to introduce the startup’s product to the global corporate headquarters in a bid to make the startup’s product a part of the suite of software products made available to all 200+ country offices of the corporation. These talks are in the early stages. In addition to this, the startup is in advanced discussions with other large companies that could benefit greatly from its product. Use of its product would provide these companies with a conduit into markets that they have not yet been able to access due to resource constraints. The co-founders feel they can increase monthly revenues to $100,000 a month very soon after they obtain additional capital. So far it appears that the co-founders have done a remarkable job building the product and gaining customer traction. The startup is starting to reach the point where it needs to expand in order to keep up with demand for its product, and also to access other customer segments that it has not yet been able to pursue in a focused way. The startup is raising $2,000,000 in series A financing. It holds 1 issued patent, and has submitted non-provisional applications for 4 more. All 4 are in patent prosecution. The startup expects to raise a series B financing in 18 months after it closes the series A financing. It has no debt. The post-money valuation from the previous round is not outrageous.

Is it possible to apply the precepts of value investing to this scenario? I think so. However, to do so it is necessary to extend how one applies the traditional approach to value analysis. The difficulty here is that this startup confronts us with a situation in which there is no track record, and no clear sight of the future. 9Tobias Carlisle discusses this in a post from October 7, 2010 entitled Venture Capitalists, Value Investing and Facebook. You can find it here: http://greenbackd.com/2010/10/07/venture-capitalists-value-investing-and-facebook/ Value investing was designed for mature companies with stock trading in the public markets. 10Value investors might be able to adapt their approach to suit mature privately held companies. So, how might a value-oriented venture capitalist analyze this startup?

First, I am assuming that our value-oriented early stage venture capitalist is not considering investing the full $2,000,000 that the startup needs. I am assuming that the venture capitalist will invest a minimum of $750,000 and a maximum of $1,000,000. The startup already has revenues of $50,000 per month. Assuming nothing changes, that revenue stream is locked-in for 3 years. I expect that our venture capitalist will perform some customer calls in order to assess the probability that this revenue stream will be placed at risk anytime soon. Given that the startup is already in talks with that customer to expand the scope of their relationship, I would wager a guess that the probability of that $50,000 per month revenue stream deteriorating is low. I would expect the venture capitalist to focus even more attention on the probability that on-going discussions with other customers will lead to the increase in revenues that the management team has described. Assuming a 24 month investment horizon between the completion of the series A financing and the completion of the series B financing, and assuming that the new revenues do not show up for the first 6 months after the series A financing is completed: 11Since this is a software startup we expect expenses to increase at only a fraction of the increase in revenues, so I will not focus too much on expenses.

Total Revenues = (24)($50,000.00) + (18)($50,000.00) = $2,100,000.00

Remember our definition of a startup? One of the main sources of uncertainty that the venture capitalist faces is that the startup could run out of capital before it concludes its search for a scalable, repeatable, and profitable business model. In this case, I think our value-oriented venture capitalist can take comfort in the fact that the startup has already engaged with one customer, and is in talks with others. 12All customers are not created equal. Moreover, in addition to the capital that it will raise, the startup has significant revenues coming in that will help ensure it has enough cash to complete the most important tasks that lie ahead – growing its base of customers, growing its base of users, growing its revenues, finding its product & market fit, and settling on its business model. If the management team successfully completes each one of these tasks, there’s no reason to believe that the startup will have difficulty raising a series B round at a step-up in valuation.

So, the primary questions for our value-oriented venture capitalist are these: How acute is the problem that this startup is solving for its customers? What alternatives exist today? Does the startup solve the problem in a way that is fundamentally better than the way that problem is solved by the alternatives? Do the startup’s customers think so? What is the relative value of the solution that the startup has developed? Do its customers perceive its solution as high-, medium- or low-value? Does the startup have a culture of continuously observing its customers and improving the product in such a way that the product evolves as the startup’s customers evolve? Or, does it take the approach that its product does not need to evolve?

Looking at earnings 13I am using terms somewhat loosely here; technically revenues are not the same as earnings. in order to make an assessment about margin of safety is not something new in value investing. This is the approach Christopher H. Browne applied in his analysis of American Express after the September 11 terrorist attacks on New York City. In his own words:

Investors who realized that companies of this quality are rarely this cheap and that the income stream from the credit card business offered a margin of safety have been amply rewarded in the years since. 14Christopher H. Browne, The Little Book of Value Investing, New Jersey, John Wiley & Sons, 2007, page 68.

Second, I expect our value oriented venture capitalist to devote some time to studying the prospect that this startup can create an economic moat around itself. To do this, I think there are at least 10 areas that the venture capitalist should study. 15I use a grid that I developed based on Bill Gurley’s post; All Revenue is Not Created Equal: Keys to the 10X Revenue Club. You will find that post here: http://abovethecrowd.com/2011/05/24/all-revenue-is-not-created-equal-the-keys-to-the-10x-revenue-club/ For each area, I rate the startup I am studying as high, medium, or low. These are the areas:

  1. Sustainable competitive advantage; why does it exist, how long is it likely to last?
  2. Network effects; why do they exist, how long are they likely to last?
  3. Revenue; how predictable is revenue, once it is secured?
  4. Switching costs; once a customer is secured, do switching costs exist?
  5. Gross profitability; is gross profitability high, medium, or low? How does gross profitability evolve as the startup grows?
  6. Marginal profitability; is marginal profitability high, medium, or low? How does marginal profitability evolve as the startup grows?
  7. Customer concentration; how profitable is each additional customer? I prefer startups that will quickly evolve to avoid falling victim to buyer power. Many small but highly profitable customers is better than a few powerful and demanding customers.
  8. Partner dependency; is the startup dependent on its partners? What is the nature of that dependency? I prefer the startup not to be so dependent on its partners that an adverse change in the relationship proves fatal for the startup. Several startups have failed after Facebook and Twitter changed the nature of the partnership relationship they had with startups that built products on top of the traffic produced by Facebook and Twitter. 16Alyson Shontell, An Obvious Reason Why Some Startups Fail Shortly After Raising Tons Of Money, August 8, 2013: www.sfgate.com/technology/businessinsider/article/An-Obvious-Reason-Why-Some-Startups-Fail-Shortly-4717874.php
  9. Demand creation; how much will it cost the startup to create additional demand? I prefer startups that do not need to spend large amounts of money in order to create new demand. I spend a lot of my time thinking about this.
  10. Future growth; what are the prospects for future growth? Or, how big is the opportunity that is available to the startup? Bigger is always better in this case – room for more than one player to earn an attractive returns for early investors.

This line of analysis fits well conceptually with a 3-part analysis framework for value investors that is outlined by Bruce Greenwald and Judd Kahn in their book. 17Bruce C. N. Greenwald and Judd Kahn, Value Investing: From Graham to Buffet and Beyond, New Jersey, John Wiley & Sons, paperback edition, 2001, page 35 – 47. The areas of analysis they highlight are asset value, earnings power value, and value of growth. For any startup asset value is none-existent, or almost nil. Allowing for variability, once the startup has found its product & market fit its ability to generate earnings should increase. Lastly, if the startup is solving an important enough problem in a big enough market, there should be enough room for future growth to earn an attractive return for our value-oriented venture capitalist.

There are numerous pitfalls to the approach I have tried to describe above. First, it is really difficult to estimate intrinsic value for an early stage startup. Second, the approach I have suggested does not change the fact that what our value oriented venture capitalist cannot possibly know far exceeds what is known in relation to the future prospects for this startup. Third, the venture capitalist must spend a considerable amount of time studying the management team of the startup in question. Building an early stage startup is an extremely daunting challenge. Much of our value-oriented venture capitalist’s ability to earn a return rests upon the management team making the right decisions at crucial periods in the startup’s life-cycle. Certain individuals, or combination of individuals, simply lack the temperament to succeed in leading an early stage startup successfully. Last, even after taking all the precautions that one can take, our value-oriented venture capitalist might still wind up making a poor investment – that is true for every value investor, but I expect the frequency of poor results to be higher for a value-oriented venture capitalist than for a traditional value investor.

I have glossed over numerous details by necessity. Fruitful implementation of a value-oriented approach to early stage venture capital investing is all about the details of each specific situation. For instance, I do not know if one can apply a value-oriented approach to startups raising capital at the seed and pre-seed stage. I think this approach only works when the startup has gained some market traction. I have not discussed how investment horizons might factor into this. I default to Warren Buffet’s view that one should invest as if one were buying an ownership stake in a company for the long-haul and not as if one is buying tradable pieces of paper.

I do not know if venture capitalists need to be able to see around corners, but I think they have to do in-depth analysis of the startups in which they invest, and I think they have to spend sometime thinking about the similarities and differences between the early stage startups that they study and the traits of the most successful public companies that were themselves early stage startups at some point in the past.

Early stage venture capitalists can apply the tenets of value investing to what they do, provided they are willing to do some extra work, and are willing to look beyond the most obvious methods that other value investors use.

 

 

References

Any mistakes in quoting from my sources are entirely mine.
Jeffrey Bussgang, Can VCs Be Value Investors?, Fortune, October 6, 2010. Accessed at http://finance.fortune.cnn.com/2010/10/06/can-vcs-be-value-investors/ on August 10, 2013.
Steve Blank and Bob Dorf, The Startup Owner’s Manual Vol. 1: The Step-by-Step Guide for Building a Great Company, California, K&S Ranch Press, 2012, page xvii.
I am greatly simplifying things for the sake of brevity, but this covers the basics.
J. Dennis Jean-Jacques, The Five Keys To Value Investing, New York, McGraw-Hill, 2002, page 2.
Benjamin Graham, The Intelligent Investor, New York, HarperCollins, the 2005 reprint of the original 1949 edition, page 241.
Seth Klarman, Margin of Safety: Risk-Averse Value Investing Strategies for The Thoughtful Investor, New York, HarperCollins, 1991, page 92.
While this specific example is entirely fictitious, it is not entirely dissimilar to many of the situations that early stage venture capitalists have to study in order to make an investment decision.
Tobias Carlisle discusses this in a post from October 7, 2010 entitled Venture Capitalists, Value Investing and Facebook. You can find it here: http://greenbackd.com/2010/10/07/venture-capitalists-value-investing-and-facebook/
Value investors might be able to adapt their approach to suit mature privately held companies.
Since this is a software startup we expect expenses to increase at only a fraction of the increase in revenues, so I will not focus too much on expenses.
All customers are not created equal.
I am using terms somewhat loosely here; technically revenues are not the same as earnings.
Christopher H. Browne, The Little Book of Value Investing, New Jersey, John Wiley & Sons, 2007, page 68.
I use a grid that I developed based on Bill Gurley’s post; All Revenue is Not Created Equal: Keys to the 10X Revenue Club. You will find that post here: http://abovethecrowd.com/2011/05/24/all-revenue-is-not-created-equal-the-keys-to-the-10x-revenue-club/
Alyson Shontell, An Obvious Reason Why Some Startups Fail Shortly After Raising Tons Of Money, August 8, 2013: www.sfgate.com/technology/businessinsider/article/An-Obvious-Reason-Why-Some-Startups-Fail-Shortly-4717874.php
Bruce C. N. Greenwald and Judd Kahn, Value Investing: From Graham to Buffet and Beyond, New Jersey, John Wiley & Sons, paperback edition, 2001, page 35 – 47.