Monthly Archives: November 2014

Unbroken Markets

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Many startup pitches start off with the 512px-Broken_glasssimple claim that something is broken. “Email is broken.” “Messaging is broken.” “Advertising is broken.” If you hear too many pitches, you might start wondering how anything at all gets done since everything around us is so broken.

It’s a common refrain which you expect from aggressive founders who are eager to change the world. When your vision of the future is powerful and truly innovative, the current state of the world can seem very broken in comparison. However, such powerful vision and dismissal of the status quo overlooks the fact that the status quo exists for a reason.

If something is broken, why are people using it everday?

Activation Energy

In chemistry, changes come through chemical reactions. Reactions don’t just happen on their own, they require some minimum amount of energy to get started. That energy is known as the activation energy of the reaction.

Innovations are similar to chemical reactions. Where chemical reactions transform materials, innovations transform markets. What, then, is the activation energy of innovation? In business, activation energy takes the form of the amount of effort you need to displace existing tools and services with new innovations. That effort is a combination of how radical the innovation is and how much you need to invest to get that innovation adopted in your market.

Depending on the characteristics of a market the activation energy required for innovation can differ greatly. For example, a highly mature and slow moving market with large, entrenched competition such as the taxi industry requires a massive innovation and investment in the form of Uber/Lyft. A young but fast moving market like online messaging requires less innovation and investment in the form of WhatsApp/Snapchat to transform the market.

Your activation energy is not only overcoming the existing market competitors, but the ingrained habits of your customers. Customers who have a regular habit of using a product, even if that product is bad, will resist changing out of sheer momentum. In these cases you need even more activation energy to transform the market.

Unbroken Markets

So, how does chemistry help you start a company? By helping us make good assumptions.

It is dangerous to assume that the activation energy for your market is low, but that is exactly what you are doing when you assert it is “broken.” Instead, assume your market is stable and healthy, so that your innovation needs to be radical to succeed. Also assume that the effort to bring that innovation to market will be significant as well, so you will plan accordingly. Any other assumption will allow you to become complacent.

Your market may, in fact, be broken. Assuming otherwise will ensure that you do not underestimate your challenges.

Image By Jef Poskanzer (originally posted to Flickr as smash) [CC-BY-2.0 (http://creativecommons.org/licenses/by/2.0)%5D, via Wikimedia Commons 

The Founder Spectrum

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Understanding your own weakness is very difficult. Most people have a positive self image, and company founders tend to have an extremely positive self image. That self confidence is what allows us to persevere when everyone else is saying stop, and can carry you through the worst parts of The Struggle. However, it also prevents you from objectively evaluating your own weakness.

Many start up failures can be traced back to founder weaknesses that are either exacerbated under the heavy stress of starting a company or are never compensated for by the rest of the team. No one is perfect, and understanding your weaknesses will allow you to compensate for them before they become risks to your business.

One way to make sure you are objectively evaluating yourself is to find entrepreneurs similar to you and examine their weaknesses. While all founders are created differently, you can group founders together at a very high level. I call these groupings the Founder Spectrum and there are many.  One of my favorite, and most useful, founder spectrums is what I like to call the Scientist, the Expert and the Outsider.

The Scientist

Many of the exciting start up companies you read about in the news are started by university researchers who have been developing new technologies for many years. This is not a coincidence, since pushing the boundaries of what is possible can take a long time and require deep study. These founders have created new technology that was never possible before, and are true innovators in their field. Their companies use this technology as their core asset to build a new business and compete with existing companies. An example Scientist is Tillman Gerngross (GlycoFi, Adimab) who has repeatedly pushed the boundaries of protein synthesis.

Strengths

  • Through their technology, Scientists have a head start on the rest of the industry. It may take many years for competitors to match them.
  • Through their deep expertise, they can maintain that head start by continuing to improve the technology.
  • If they are part of a university, they can spend many years developing the technology without worrying about burn rates and capital requirements.

Weaknesses

  • If the technology fails for any reason, the company will fail. While their expertise is deep, it is not broad and everything is bet on the specific technology.
  • If the technology is too new, it may take a long time to convince customers to buy it. Something truly innovative will be strange to customers who might not have any idea how to value how much it is worth.

How to compensate

  • Test the market value and potential of the technology as much as possible before founding your company. Make sure that companies are willing to pay for the products enabled by the technology starting on day one.

The Expert

Experts are people who have worked in a given industry long enough to understand all of the nuances and details that make it run. While they might lack the deep technical expertise of the Scientist, they make up for it by understanding the business deeply. That understanding brings with it the ability to see opportunities that are not available from the outside, while maintaining a wide perspective that isn’t limited to a single technology. Examples of experts include Lew Cirne (Wily Technologies, New Relic) and Craig Walker (Dialpad, Grand Central, Uber Conference).

Strengths

  • Deep understanding of the industry allows Expers to see opportunities that no one else can see.
  • Able to adjust within their market as things change, staying flexible. In many cases they see changes coming before others.

Weaknesses

  • Can have difficulty getting out of the rut of industry thinking and see things differently than everyone else. This becomes more true the longer they spend in the industry.
  • Limited to their industry of choice, even if that industry is challenged.

How to compensate

  • Change your environment as much as possible (office, people, places) to encourage new ways of thinking. Bring in advisors from outside the industry to challenge your thinking and open up new avenues of exploration.

The Outsider

Sometimes, it takes someone from outside of an industry to see opportunities and create new innovations.  While an outsider might lack the deep expertise of the Scientist or the Expert, they are also free of any preconceived notions of what is possible. That freedom can allow them to approach problems in novel ways that change the way the business works. Examples of outsiders who have changed industries where they had no previous experience include Elon Musk (Tesla, SpaceX) and Palmer Luckey (Oculus Rift).

Strengths:

  • Fresh perspective on the industry which allows them to find new solutions to existing problems.
  • Lacks any preconceived notions of what is possible or what might have been tried before.

Weaknesses: 

  • Prone to making a large number of mistakes as they learn the nuances of the industry.
  • At the start they have a disadvantage against existing companies due to their lack of relationships, experience and reputation in the industry.

How to compensate

  • Constant customer development and market validation of ideas while developing the first product. The more customer feedback you get, the less likely you will veer off in directions that prove fruitless.

The best founding teams (See 5 Rules for Choosing a Co-Founder) are made up of many different types of people. In fact, some of the best founding teams have a Scientist, an Expert and an Outsider. Having such a diverse team compensates for the weaknesses of any given member while building up a wider array of strengths.

If you read those descriptions and found one that matches you, then you are very self-aware and ahead of the game. If not, don’t worry. Remember, this is a spectrum so there are many people that fall in between these categories.

This is one way to think about the spectrum of founders, but there are many more. The most important thing is to understand your strengths and weaknesses and how they compare to those of your competitors. If you do, you can recruit the kinds of co-founders that will make you stronger.

Why You Don’t Want to Be Acquired

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All founders dream of building everlasting public companies that will live on long after they are gone. However, after a few years of struggling and working for free the idea of being acquired for a nice payday can seem very attractive. In fact, if you read TechCrunch too much, you might believe that an easy way to get rich is to start a company and sell it for $100M in two years.

While getting acquired is a great exit for any company, planning for it is a very bad idea. Even worse, starting a company with the goal of being acquired will set you up for failure before you even begin. To understand why, let’s think about how potential acquiring companies look at acquisition targets.

Goals for Acquisitions

Large companies acquire smaller companies to gain assets they don’t have access to any cheaper way. Acquisitions, even small ones, are expensive ways to gain assets so acquirers are highly motivated by what is necessary to improve their own business.

While you might think about your company as a living, growing organism with many dimensions and nuances, acquiring companies will look at it like a butcher looks at a cow. Your company is made up of one or more assets and those are what they consider acquiring. Those assets may include:

  • People. All of the employees, including the founders, and the expertise they have developed working at your company. If everyone works together extremely well, that teamwork chemistry can also be considered an asset by acquirers looking for productive teams.
  • Product. The product(s) you have built, whether or not they have been released to customers yet or not.
  • Technology. Any unique algorithms, mathematical models or processes you have developed even if they aren’t patented.
  • Customers. Everyone using your products, whether or not they are paying you for them or not. In some cases, you may only have one customer but that customer is a very large customer who pays you a lot of money over a long term.
  • Profit. If your business is profitable, that positive cash flow is a huge asset since it produces a return for whoever owns the business. The same can be true of having a lot of liquid assets as the result of being profitable.

Not all of the assets are created equal. Below is an illustrative example of the comparative values of assets based on the acquisitions I have been involved with (both as the acquirer and the acquired companies).

Example of how corporate assets compare in terms of value to acquirer. Technology is 10 times more valuable than people or products, while customers are 100 times more valuable. Profit can be infinitely more valuable, depending on how much of it you have. Note that these are just illustrative.

Why are assets valued so differently? For the simple reason that the value of your assets are entirely dependent on how they apply to the acquirer’s business. For example, the value an acquirer assigns to your technology is not the value they would get from selling it themselves on the open market, but how much value it will add to their business. It is not enough that your technology is new and ground breaking, it needs to help the acquiring company make money.

It’s not a coincidence that the assets that have the highest value are developed later in the life of a company (customers, profit, etc.). Those assets are the hardest to build and therefor will carry the most value. That is one of the many reasons that companies become more valuable the longer they exist and why it’s so rare to see a big acquisition of a young company.

The Exception Proves the Rule

It is almost impossible to make generalizations about acquisitions because each acquisition depends so much on the companies involved. One acquirer may value your company at $5M while another values it at $20M, because the second company believes they can use your assets to increase their own profits by $40M. So, remember that the previous example is only illustrative.

But that is exactly the reason you should never focus on being acquired! You have no way to control how potential acquirers will value the assets you are creating. Successful acquisitions require the right acquirer to value your company at the right price, at a point where you would consider selling. That combination of factors is rare and definitely not something you can plan.

So what does that mean? The best strategy, in fact your only strategy, is to focus on building a successful and highly profitable business. As long as you do that, you will control your own destiny and decide if and when you get acquired on terms you decide.

Or, maybe you’ll go public! Then you can buy some companies yourself.