Monthly Archives: October 2012

Why venture capital hasn’t solved humanity’s most important problems

There has been a lot of recent discussion about the lack of tech startups attempting to solve humanity’s most important problems. While it’s true that Facebook has changed our social lives, Airbnb is making it cheaper to find a place to stay while also connecting people, and Square is changing the way we make payments at bricks-and-mortar stores, these startups fall short of addressing humanity’s most important needs. Although these startups certainly improve our lives, they do not tackle big problems like malnutrition or political oppression, reduce deaths from illnesses like cancer or malaria, or lower our dependence on the fossil fuels behind global warming. Since venture capital is the traditional financier of tech startups, the lack of progress in applying technology to resolve humanity’s most pressing concerns has led to criticisms that venture capitalists simply aren’t doing their jobs properly.

This criticism is incorrect, and we don’t need to travel far to see why. A venture capitalist’s primary obligation is towards the limited partners who provide the capital to invest in startups. These limited partners, which include pension funds, endowments, and wealthy individuals, have a single objective. This is to generate a financial return on their capital. As a result of this obligation, venture capitalists need to invest in those startups that have a relatively high probability of becoming sizable commercial successes. 
Unfortunately, humanity’s most important problems are very, very difficult to solve. Investing in startups is already a risky business, but this risk pales in comparison to the risk of backing a startup attempting to address one of humanity’s most pressing problems. A marketplace connecting buyers and sellers of a particular product is a much safer bet than a potential cure for a cancer that has yet to be defeated. Not only is the probability of success significantly lower than what a venture capitalist can reasonably justify to limited partners, but there may also not be a clear path to achieving a financial return. What if a startup discovers a way to prevent malaria but is required to make it available free of charge due to the treatment’s life-saving characteristics?
A startup attempting to solve one of humanity’s biggest problems has a very low probability of success even when measured on the scale of startups. In addition, a startup’s ability to monetize its solution to one of humanity’s most pressing problems is far from being assured. As a result of these two factors, venture capitalists find it very challenging to justify backing these types of startups. If venture capitalists cannot support such startups because of their obligation to generate a financial return, then who can? 
The answer is those groups whose primary obligation is not financial, but human development. The key groups which meet this requirement are governments and philanthropists. It was NASA, supported by the US government, that landed the first man on the moon. And it is philanthropists like Bill Gates and George Soros who are using their private capital to respectively prevent deadly illnesses and fight political oppression. If these sources of capital which do not have a financial return as their objective are able to bring a startup they back to a point where it has a sufficiently high probability of becoming a sizable commercial success, then venture capitalists can do their job by helping the startup complete the journey.

Revolutionary ideas come from identifying and solving your daily problems

Tech entrepreneurship is sexy these days. The likes of Facebook, Apple, Google, and Twitter are now part of the daily lives of billions of people. Personally, I spend over 3 hours each day using the products and services of these four companies. While most people are happy to be users of technology, an increasing number are asking themselves whether they can also be producers. Can’t they build the next Facebook or Apple? The simple answer is yes.

However, this is not an unequivocal yes. In fact, it comes with many qualifications. It takes the unique combination of a revolutionary idea, relentless execution, and luck to build the next tech industry leader. Let’s work our way backwards through each of these. Although some people claim that you create your own luck, which I believe is facilitated by relentless execution, luck is a very difficult skill to teach. I like to think of it as a catch-all for the fit between your abilities and the market realities which prevail during a particular period of time. Relentless execution, on the other hand, is possible to teach. It’s a lengthy topic which covers everything from your sales and marketing strategy to the value of performing rapid iterations and dealing with failures. I’ve touched on some of these topics in previous posts and plan to write about other strategies for successful execution in the future. What I’d like to write about today is the first leg of the stool: how to come up with a revolutionary idea.

For the engineers among us who thought I would be giving you a step-by-step instruction manual to come up with the next game-changing idea, I’m sorry to disappoint you. If I had such a recipe, I would have already built each of the tech products you will be using in your daily lives ten years from now. What I can offer, however, is a simple way to greatly increase your chances of changing the world through technology. It all starts by asking the right question. In particular, identify a problem that you experience in your daily life, and ask yourself how you would change the status quo to produce an optimal outcome. Then think about how close you can get to this optimal outcome through technology.
Let me give a few examples to illustrate how this approach works in practice. In the past, you needed to go to the library to learn because that was the central location where the majority of the world’s information was found. Frustrated by the need to go to the library whenever you wanted to research something, the invention of the internet made it possible to imagine a readily accessible website containing as detailed information on as wide a range of topics as the library. Enter Wikipedia. Since the internet also produced many other websites beyond Wikipedia, there was a need to index and search the content of all these websites to produce the most relevant and reliable information. Enter Google. Too shy to ask someone out in person, you could think of a world where it’s possible to make such introductions without a face-to-face interaction. Enter Too short on time to visit many different travel agencies or online booking websites to find the best flight fare, you would seek to have all this information aggregated and easily comparable on the web. Enter Kayak.
Wherever you look in your life, it’s very likely that you’ll be able to identify a suboptimal status quo. What you need to do is imagine what this area of your life would look like in a utopic world without constraints. Then try to get as close to creating this utopia as possible. Due to the constraints and the incremental nature of innovation, you’ll likely fall short, even very short. But it might be just enough to revolutionize the lives of billions of people.

Retaining your startup’s authenticity while scaling

As startups grow, they begin to encounter tradeoffs between scaling and retaining the authenticity which contributed to their success so far. This tradeoff can express itself in many forms. For example, a startup may have the opportunity to scale faster by automating manual processes. While this increases output and efficiency, it often comes at the cost of difficult layoffs. Another example is when a startup grows beyond its core team. The addition of new team members makes it increasingly difficult to rely on informal dialogues for decision making. Successful coordination requires the creation of operating units and hierarchies. Employees who thrived in an informal setting can find it difficult to adjust to the more formal structure and processes required to drive future growth.

Change is a constant for startups, so entrepreneurs should embrace these transitions as a natural part of their startup’s growth path. However, they should be careful to balance these requirements for growth with an equal sensitivity for the startup’s traditional way of doing things. The startup’s authentic culture which has made it a fun place to work for the team behind the startup’s success should remain intact.

If founding team members traditionally take long walks to reflect and debate before finalizing important decisions, they should share this unique approach to decision making with their direct reports once they are executives in the larger organization. If they usually take time off early in the evening to have dinner with their family or exercise before returning to work, they should give this same option to their future employees. If they need to replace early team members who were crucial to the startup’s initial successes but no longer fit the pieces of the puzzle because their role can be automated or they work better in small team settings, they should fairly reward these employees through accelerated vesting of their stock options. If they would gather at the local pub on Friday nights, they should extend the same invitation to their new employees.

These are just a few examples of how entrepreneurs can preserve the traditional culture of their startup while taking the at times painful decisions which are necessary to grow. Just as individuals benefit from staying grounded, growing startups benefit from preserving the distinct characteristics which have made them a great place to work for the founders. When transferred to new employees, the authenticity which contributed to the success of the founding team can also facilitate the success of the new larger organization.

Products don’t sell themselves

Products don’t sell themselves. Although Apple sold 5 million of its latest smartphone model, the iPhone 5, in the first three days following its launch, this is the result of years of product development followed by careful strategic branding. Even after several iPhone iterations with each successive model blowing the previous model’s sales record out of the water, the company continues to complement its product development efforts with an even greater emphasis on sales and marketing. The theatrical launch events and the unique Apple store experience, where customers are encouraged to actively use products and participate in demonstrations, are all part of Apple’s sales strategy. This is what has allowed Apple to shape public perception like I’ve rarely seen before. In a recent experiment where iPhone 4 users were told that they were being handed the new iPhone 5, but were instead given an iPhone 4, they actually believed that the phone they were holding was lighter, slimmer, and faster!

Industry leading tech companies have a relentless focus on their go-to-market strategy to transform their products into selling brands. It’s therefore surprising to see that so many seed stage startups which take these companies as role models don’t have a coherent sales strategy. In a recent discussion with a startup selling a mobile service to enterprises, all was smooth sailing for the first 15 minutes of our conversation. We established the significant improvement which the service represents over the current way of doing things, talked about the pricing strategy, and discussed the barriers to entry for potential competitors. We then started talking about the startup’s sales activities.

At this point it quickly became clear that the team consisted of five product people of which one allocated half his time to developing, pitching, and attempting to close sales leads. In addition to the unbalanced team composition, the startup’s target customers were in a different geography than the core team. This meant that the person in charge of sales had to travel several hours to meet with potential customers. Being in physical proximity to your customers is of crucial importance for seed stage startups which depend on rapid customer feedback to iterate and improve their product. This becomes even more important for companies performing enterprise sales since the customer has more specific needs and is often being courted by several companies at once.

Unfortunately, the example I demonstrated above is not the exception, but closer to the rule. When faced with a seed stage startup without a go-to-market strategy, the investor has two options. The first is to not move forward with the discussion. When the other pieces of the puzzle, like product-market fit, don’t fit together, this is the preferred approach. However, when a startup has clear product-market fit, there can be an opportunity to guide the startup in the right direction by recommending that they revisit their sales strategy and bring on new team members with the skills required to fill this gap. Since the startup in this example had a great product meeting a clear market need, I decided to take the second approach.

In addition to suggesting that the startup address the unbalanced team composition by bringing on two dedicated sales people operating in the company’s target geography, I offered to assist in the identification and recruitment of these individuals. Although some team members appeared to acknowledge the need to revisit their go-to-market strategy, they ultimately decided that this should not be their core focus. Not only had the startup not properly thought through how they were going to sell, it also wasn’t willing to make this investment in the future.

While a strong product focus is essential to build an industry leading tech company, it only becomes valuable when complemented with a coherent go-to-market strategy. Since the engineers who often launch tech startups naturally tend to focus on product, I encourage them to think about their sales strategy and build the skills around them to complement their product expertise before they begin to scale. Having a coherent sales strategy will make your business more attractive for investors, but this is just a side benefit. Whether you decide to take outside funding or not, a clear go-to-market strategy will make you more likely to build the next tech industry leader.

Identify better entrepreneurs by asking for neutral or negative references

I want to share with investors a tried and tested way to get a complete picture of the entrepreneurs who they’re backing. Reference checks are a very important part of the research process before making an investment because they help investors who haven’t worked with an entrepreneur before understand how the entrepreneur dealt with business and life challenges in the past. And unlike the stock market, I’ve discovered that the past behavior of people is often a pretty good indicator of their future behavior. Since a founder’s future behavior will determine the fate of their startup, investors benefit from knowing what to expect.

The problem with reference checks is that the references are traditionally provided by entrepreneurs. Since entrepreneurs have a clear incentive to portray themselves favorably, they guide investors to those references who they know will vouch for them. A potential solution to the resulting positivity bias which references show is to explicitly ask the reference to describe an area in which the entrepreneur can improve. This usually takes the form of a personal attribute which is supported by an example of when the entrepreneur displayed the attribute. However, this rarely solves the problem of the positivity bias. Since the reference remains favorably disposed to the entrepreneur, they describe an attribute which may have a negative connotation but support it with an example of the behavior which had positive consequences. 

A classic example is that the entrepreneur is a perfectionist. Perfectionism can lead to a willingness to do everything very well and hence an inability to prioritize what’s truly important. This can have disastrous consequences in the hectic environment of a startup. However, the example provided by the reference is rarely along these lines. Instead, it tends to showcase how the entrepreneur stayed up until 6 AM one morning to deliver a product to a customer’s front porch, and how that customer later became the company’s biggest revenue source. In other words, the perfectionism almost always has a positive consequence.

A better solution to the positivity bias inherent in the traditional model of reference checking is to speak to those people who have a neutral or even negative view of the entrepreneur. There are two ways to do this. You can either find these people yourself, for example by searching for prior colleagues on the web or requesting the names of other people who the entrepreneur worked with from the original references. Since this approach sidesteps the entrepreneur, it can result in a breach of trust if the entrepreneur discovers that you’ve contacted their prior colleagues without their permission. And it’s usually not a question of if, but when.

My preferred approach is to be transparent and directly ask the entrepreneur to provide references who will portray them in a neutral or negative light. Everyone has people with whom they didn’t click, or situations where they wish they had behaved differently. As a result, if an entrepreneur refuses to provide neutral or negative references, or does provide them but the references are also invariably positive, investors get a pretty good signal that the entrepreneur is hiding something. On the other hand, if the entrepreneur does provide the references and they do indeed help paint a more balanced picture, investors get a pretty good signal that the entrepreneur is comfortable with their past and open to criticism. As an investor, these are the entrepreneurs who you want to consider backing.