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The Pmarca Guide to Startups, part 6: How much funding is too little? Too much?

In this post, I answer these questions:

How much funding for a startup is too little?

How much funding for a startup is too much?

And how can you know, and what can you do about it?

The first question to ask is, what is the correct, or appropriate, amount of funding for a startup?

The answer to that question, in my view, is based my theory that a startup's life can be divided into two parts -- Before Product/Market Fit, and After Product/Market Fit.

Before Product/Market Fit, a startup should ideally raise at least enough money to get to Product/Market Fit.

After Product/Market Fit, a startup should ideally raise at least enough money to fully exploit the opportunity in front of it, and then to get to profitability while still fully exploiting that opportunity.

I will further argue that the definition of "at least enough money" in each case should include a substantial amount of extra money beyond your default plan, so that you can withstand bad surprises. In other words, insurance. This is particularly true for startups that have not yet achieved Product/Market Fit, since you have no real idea how long that will take.

These answers all sound obvious, but in my experience, a surprising number of startups go out to raise funding and do not have an underlying theory of how much money they are raising and for precisely what purpose they are raising it.

What if you can't raise that much money at once?

Obviously, many startups find that they cannot raise enough money at one time to accomplish these objectives -- but I believe this is still the correct underlying theory for how much money a startup should raise and around which you should orient your thinking.

If you are Before Product/Market Fit and you can't raise enough money in one shot to get to Product/Market Fit, then you will need get as far as you can on each round and demonstrate progress towards Product/Market Fit when you raise each new round.

If you are After Product/Market Fit and you can't raise enough money in one shot to fully exploit your opportunity, you have a high-class problem and will probably -- but not definitely -- find that it gets continually easier to raise new money as you need it.

What if you don't want to raise that much money at once?

You can argue you should raise a smaller amount of money at a time, because if you are making progress -- either BPMF or APMF -- you can raise the rest of the money you need later, at a higher valuation, and give away less of the company.

This is the reason some entrepreneurs who can raise a lot of money choose to hold back.

Here's why you shouldn't do that:

What are the consequences of not raising enough money?

Not raising enough money risks the survival of your company, for the following reasons:

First, you may have -- and probably will have -- unanticipated setbacks within your business.

Maybe a new product release slips, or you have unexpected quality issues, or one of your major customers goes bankrupt, or a challenging new competitor emerges, or you get sued by a big company for patent infringement, or you lose a key engineer.

Second, the funding window may not be open when you need more money.

Sometimes investors are highly enthusiastic about funding new businesses, and sometimes they're just not.

When they're not -- when the "window is shut", as the saying goes -- it is very hard to convince them otherwise, even though those are many of the best times to invest in startups because of the prevailing atmosphere of fear and dread that is holding everyone else back.

Those of us who were in startups that lived through 2001-2003 know exactly what this can be like.

Third, something completely unanticipated, and bad, might happen.

Another major terrorist attack is the one that I frankly worry about the most. A superbug. All-out war in the Middle East. North Korea demonstrating the ability to launch a true nuclear-tipped ICBM. Giant flaming meteorites. Such worst-case scenarios will not only close the funding window, they might keep it closed for a long time.

Funny story: it turns out that a lot of Internet business models from the late 90's that looked silly at the time actually work really well -- either in their original form or with some tweaking.

And there are quite a few startups from the late 90's that are doing just great today -- examples being OpenTable (which is about to go public) and TellMe (which recently sold itself to Microsoft for $800 million), and my own company Opsware -- which would be bankrupt today if we hadn't raised a ton of money when we could, and instead just did its first $100 million revenue year and has a roughly $1 billion public market value.

I'll go so far as to say that the big difference between the startups from that era that are doing well today versus the ones that no longer exist, is that the former group raised a ton of money when they could, and the latter did not.

So how much money should I raise?

In general, as much as you can.

Without giving away control of your company, and without being insane.

Entrepreneurs who try to play it too aggressive and hold back on raising money when they can because they think they can raise it later occasionally do very well, but are gambling their whole company on that strategy in addition to all the normal startup risks.

Suppose you raise a lot of money and you do really well. You'll be really happy and make a lot of money, even if you don't make quite as much money as if you had rolled the dice and raised less money up front.

Suppose you don't raise a lot of money when you can and it backfires. You lose your company, and you'll be really, really sad.

Is it really worth that risk?

There is one additional consequence to raising a lot of money that you should bear in mind, although it is more important for some companies than others.

That is liquidation preference. In the scenario where your company ultimately gets acquired: the more money you raise from outside investors, the higher the acquisition price has to be for the founders and employees to make money on top of the initial payout to the investors.

In other words, raising a lot of money can make it much harder to effectively sell your company for less than a very high price, which you may not be able to get when the time comes.

If you are convinced that your company is going to get bought, and you don't think the purchase price will be that high, then raising less money is a good idea purely in terms of optimizing for your own financial outcome. However, that strategy has lots of other risks and will be addressed in another entertaining post, to be entitled "Why building to flip is a bad idea".

Taking these factors into account, though, in a normal scenario, raising more money rather than less usually makes sense, since you are buying yourself insurance against both internal and external potential bad events -- and that is more important than worrying too much about dilution or liquidation preference.

How much money is too much?

There are downside consequences to raising too much money.

I already discussed two of them -- possibly incremental dilution (which I dismissed as a real concern in most situations), and possibly excessively high liquidation preference (which should be monitored but not obsessed over).

The big downside consequence to too much money, though, is cultural corrosion.

You don't have to be in this industry very long before you run into the startup that has raised a ton of money and has become infected with a culture of complacency, laziness, and arrogance.

Raising a ton of money feels really good -- you feel like you've done something, that you've accomplished something, that you're successful when a lot of other people weren't.

And of course, none of those things are true.

Raising money is never an accomplishment in and of itself -- it just raises the stakes for all the hard work you would have had to do anyway: actually building your business.

Some signs of cultural corrosion caused by raising too much money:

• Hiring too many people -- slows everything down and makes it much harder for you to react and change. You are almost certainly setting yourself up for layoffs in the future, even if you are successful, because you probably won't accurately allocate the hiring among functions for what you will really need as your business grows.
• Lazy management culture -- it is easy for a management culture to get set where the manager's job is simply to hire people, and then every other aspect of management suffers, with potentially disastrous long-term consequences to morale and effectiveness.
• Engineering team bloat -- another side effect of hiring too many people; it's very easy for engineering teams to get too large, and it happens very fast. And then the "Mythical Man Month" effect kicks in and everything slows to a crawl, your best people get frustrated and quit, and you're in huge trouble.
• Lack of focus on product and customers -- it's a lot easier to not be completely obsessed with your product and your customers when you have a lot of money in the bank and don't have to worry about your doors closing imminently.
• Too many salespeople too soon -- out selling a product that isn't quite ready yet, hasn't yet achieved Product/Market Fit -- alienating early adopters and making it much harder to go back when the product does get right.
• Product schedule slippage -- what's the urgency? We have all this cash! Creating a golden opportunity for a smaller, scrappier startup to come along and kick your rear.

So what should you do if you do raise a lot of money?

As my old boss Jim Barksdale used to say, the main thing is to keep the main thing the main thing -- be just as focused on product and customers when you raise a lot of money as you would be if you hadn't raised a lot of money.

Easy to say, hard to do, but worth it.

Continue to run as lean as you can, bank as much of the money as possible, and save it for a rainy day -- or a nuclear winter.

Tell everyone inside the company, over and over and over, until they can't stand it anymore, and then tell them some more, that raising money does not count as an accomplishment and that you haven't actually done anything yet other than raise the stakes and increase the pressure.

Illustrate that point by staying as scrappy as possible on material items -- office space, furniture, etc. The two areas to splurge, in my opinion, are big-screen monitors and ergonomic office chairs. Other than that, it should be Ikea all the way.

The easiest way to lose control of your spending when you raise too much money is to hire too many people. The second easiest way is to pay people too much. Worry more about the first one than the second one; more people multiply spending a lot faster than a few raises.

Generally speaking, act like you haven't raised nearly as much money as you actually have -- in how you talk, act, and spend.

In particular, pay close attention to deadlines. The easiest thing to go wrong when you raise a lot of money is that suddenly things don't seem so urgent anymore. Oh, they are. Competitors still lurk behind every bush and every tree, metaphorically speaking. Keeping moving fast if you want to survive.

There are certain startups that raised an excessive amount of money, proceeded to spend it like drunken sailors, and went on to become hugely successful. Odds are, you're not them. Don't bet your company on it.

There are a lot more startups that raised an excessive amount of money, burned through it, and went under.

Remember Geocast? General Magic? Microunity? HAL? Trilogy Systems?

Exactly.

Now playing: Silicon Valley short attention span theater

Oh, this is so exciting!

Five weeks after the launch of Facebook's new platform, certain Internet commentators (whom you can find in my "Guilty Pleasures" blogroll, directly to your right -- and no, I'm not talking about Rosie) have declared Facebook's new initiative to be passe, so over, no longer groovy, kicked out of the in club, and a "pricked bubble".

That was fast.

Five f______ weeks!

If the backlash against Facebook's platform has begun, then let me now start the backlash against the backlash.

Silicon Valley -- and the tech industry generally -- suffers from a particularly acute form of "short attention span theater".

This has always been the case -- there has always been an "inside baseball" effect within our industry where new trends are adopted and dissected at a hyperactive pace by those of us who care a lot about new technology.

The topics of focus used to be new chip architectures, new disk drives, new database architectures, new operating systems, new networking protocols -- and have now moved on to new consumer Internet services, new forms of messaging, new ways to deploy video, new ways to do scripting and embedding, new approaches to ecommerce.

More recently, aided and abetted by new communications technologies such as blogging and instant messaging, the inside baseball effect has become particularly acute and short-sighted among the group Josh Kopelman famously dubbed the Techcrunch 50,000 -- the core group of Internet industry aficionados and early adopters, including myself and many of my friends, who live, sleep, and breathe this stuff.

It works like this: A new technology hits the market in its earliest form -- social networking, or peer-to-peer video streaming, or voice over IP, or widget-style embedding, or now the Facebook platform. Said technology is rapidly adopted by the Techcrunch 50,000, who jump all over it, enthuse about it, dissect it, analyze it, write about it, use it some more, find some limitations in it, tire of it, cynically dismiss it, and then move on to the next thing, almost overnight.

Sometimes the new thing then proceeds to fall over and die, starved of attention and press coverage, and forever confined to life in a tiny niche of die-hards. And the Techcrunch 50,000 say, yep, called it.

But sometimes, the new thing goes on its merry way, ignored and dismissed by the in crowd, and grows, and grows, and grows, and grows, and grows, and grows -- and is ultimately discovered by millions, tens of millions, hundreds of millions, or even billions of people all around the world who incorporate it into their daily lives and don't have the foggiest idea that there was ever a group of insiders who dismissed it a few weeks into its pre-adolescence.

Let's take a look at the points made by our friends in my Guilty Pleasures blogroll:

• "Unimpressive apps" -- "for users, the novelty has worn off" the first set of Facebook apps. My response: five f______ weeks! We haven't even begun to see the interesting apps on Facebook yet.
• "Illusory popularity" -- "it's not clear" that "users" will "stick" with apps. My response: five f______ weeks! We don't have the slightest idea yet how Facebook users six months from now, a year from now, two years from now are going to react to, adopt, stick with, and/or abandon apps. How can we -- we don't even know what those apps will be yet!
• "Disappointing numbers" -- "most of the attention is hogged by the most popular apps, and those tend to be the ones present at launch". My response: five f______ weeks! Any new app on Facebook that wasn't present at launch by definition can have only been in market for a max of about five weeks -- that isn't enough time to draw any conclusions about numbers.

  An anonymous commentator made the observation that, of the last 500 apps to be approved by Facebook, only five have more than 100,000 members. The last 500 apps, logically, have to all have been approved within the last three or four f______ weeks!

  Further, how many new apps on any platform in the whole history of computing are you aware of that acquired more than 100,000 members in their first three or four weeks, before this? Approximately none.

• "Change in the rules" -- Facebook is tweaking the invitation algorithms, reducing the rate at which users can invite their quote-unquote friends to new apps -- which, I would imagine, is the first of many such changes that Facebook will do to both their virality features and limitations, as Facebook does the sensible thing and attempts to balance the goals of preserving a clean user experience with enabling proliferation of lots of applications.

  Again, my response: five f______ weeks! You have to expect this will continue to change, and that some of the changes will accelerate app adoption while some will reduce it, as Facebook, its developers, and its users learn how this new world is going to work at scale.

• "Natural saturation point" where "people stop inviting their friends" and "trying out every new triviality". First up, if you're developing a triviality, don't expect anyone to use it. That's no surprise.

  However, that said, if you're developing a real app, you can conclude absolutely nothing from some theory that we've already hit a "natural saturation point" five f______ weeks in, and the rest of this post will talk about why.

General theory time:

In any given year, a ton of new technologies will hit the market. Most of them will fail to achieve product/market fit, and will fade from view and never be heard from again. That is how it has always been and will always be. This stuff is not easy.

However, every once in a while, you get a new technology that will march, more or less predictably, through the following stages: alpha; beta; pre-adolescent general release where it is adopted, picked apart by, and then dismissed by the inside baseball crowd; silence while it's tweaked and tuned and enhanced to have broader appeal; adoption by a new wave of pragmatic early adopters who have a real use for it in their daily lives; adoption by those early adopters' friends and relatives and colleagues based on enthusiastic word of mouth; and then a gradual spiralling of uptake into the mass market, ultimately resulting in whatever level of millions, tens of millions, hundreds of millions, or billions of users for whom the technology is truly appropriate.

This, also predictably, takes years. Even when it happens really fast.

This is how things go mainstream.

This is what happened with:

• The PC -- 1+ billion users and growing
• The web browser -- 1+ billion users and growing
• SMS -- 2+ billion users and growing
• Ecommerce -- hundreds of millions of users and growing
• Instant messaging -- hundreds of millions of users and growing
• VOIP -- 100+ million users and growing
• The MP3 player -- at least tens of millions of users and growing
• Internet video -- niche/marginal at best until sudden takeoff a couple years ago with Youtube and now exploding in about a hundred different forms for tens of millions of users and growing fast.
• Social networking! The in crowd first wrote off social networking post-Friendster, then again post-Orkut. Then social networking started to get traction in the mainstream market -- four years later! -- in 2005-2006 with MySpace and now Facebook.

Yes, these are the exceptions. But here's what they all have in common: they all got to a point where they had 10 or 20 million users and were still growing fast, and then they just kept on growing. You almost never see a new technology that reaches 10 or 20 million users and is still growing fast, that then falls over and dies.

Call it escape velocity or whatever you want, but social networking now has it, Facebook now has it, and the best prediction you can make is that you are seeing the beginning of widespread mainstream adoption at a scale that the original early adopters can barely imagine.

Remember, people love this stuff. People love the Internet, they love technology, they love new things, and in particular they love new ways to connect, new ways to share, new ways to communicate -- new ways to be part of the network, part of the world. That's why you get more than a billion normal, regular people to adopt the Internet in about 12 years from a nearly standing start, and that's a powerful predictor for what the next decade is going to be like.

Digging into social networking a little bit more: Facebook has something like 20 or 30 million users. MySpace has perhaps 40 or 50 million; it's hard to say exactly. These are big numbers, but the latest estimates from credible sources are that there are more than a billion Internet users already, and that number is growing fast too. The obvious conclusion is that most Internet users have not yet even heard of social networking, much less adopted it, much less decided that it has hit some kind of "natural saturation point".

One billion plus Internet users -- all interconnected, all one click away from the next mainstream service -- is a huge market.

Betting against a market that big, and betting against things that have reached escape velocity at 20+ million users and are growing fast into that market, is a sucker's game.

This stuff is just getting started.

Those of you who were around in the mid 90's, when the Internet was first emerging into its own as a consumer medium, may remember that a certain New York-based newspaper of record had a well-regarded technology reporter who decided to enhance his reputation by writing a series of front-page articles about how the Internet was a fad, about how all the estimated Internet user numbers were inflated, about how the whole thing was overblown, and about how the Internet would most likely never develop into a true consumer medium.

I sure wish I could remember his name.

I'll close with a prediction on Facebook and Facebook apps:

We're now in the summer slump, when all the kids are outside playing and going to the movies (well, at least watching movies of questionable provenance on their laptops), and necking in the bushes.

We'll see three months of experimentation and development of new apps on Facebook, including many false starts and many duds, but also a whole series of innovative new apps that we haven't even thought of yet.

Come September, with the resumption of the school year and a whole crop of new freshpeople, Facebook traffic will once again go vertical, as will adoption of the best of the new apps.

You heard it here first.

The Pmarca Guide to Startups, part 5: The Moby Dick theory of big companies

"There she blows," was sung out from the mast-head.

"Where away?" demanded the captain.

"Three points off the lee bow, sir."

"Raise up your wheel. Steady!" "Steady, sir."

"Mast-head ahoy! Do you see that whale now?"

"Ay ay, sir! A shoal of Sperm Whales! There she blows! There she breaches!"

"Sing out! sing out every time!"

"Ay Ay, sir! There she blows! there -- there -- THAR she blows -- bowes -- bo-o-os!"

"How far off?"

"Two miles and a half."

"Thunder and lightning! so near! Call all hands."

-- J. Ross Browne's Etchings of a Whaling Cruize, 1846

There are times in the life of a startup when you have to deal with big companies.

Maybe you're looking for a partnership or distribution deal. Perhaps you want an investment. Sometimes you want a marketing or sales alliance. From time to time you need a big company's permission to do something. Or maybe a big company has approached you and says it wants to buy your startup.

The most important thing you need to know going into any discussion or interaction with a big company is that you're Captain Ahab, and the big company is Moby Dick.

"Scarcely had we proceeded two days on the sea, when about sunrise a great many Whales and other monsters of the sea, appeared. Among the former, one was of a most monstrous size. ... This came towards us, open-mouthed, raising the waves on all sides, and beating the sea before him into a foam."

-- Tooke's Lucian, "The True History"

When Captain Ahab went in search of the great white whale Moby Dick, he had absolutely no idea whether he would find Moby Dick, whether Moby Dick would allow himself to be found, whether Moby Dick would try to immediately capsize the ship or instead play cat and mouse, or whether Moby Dick was off mating with his giant whale girlfriend.

What happened was entirely up to Moby Dick.

And Captain Ahab would never be able explain to himself or anyone else why Moby Dick would do whatever it was he'd do.

You're Captain Ahab, and the big company is Moby Dick.

"Clap eye on Captain Ahab, young man, and thou wilt find that he has only one leg."

"What do you mean, sir? Was the other one lost by a whale?"

"Lost by a whale! Young man, come nearer to me: it was devoured, chewed up, crunched by the monstrousest parmacetty that ever chipped a boat! -- ah, ah!"

-- Moby Dick

Here's why:

The behavior of any big company is largely inexplicable when viewed from the outside.

I always laugh when someone says, "Microsoft is going to do X", or "Google is going to do Y", or "Yahoo is going to do Z".

Odds are, nobody inside Microsoft, Google, or Yahoo knows what Microsoft, Google, or Yahoo is going to do in any given circumstance on any given issue.

Sure, maybe the CEO knows, if the issue is really big, but you're probably not dealing at the CEO level, and so that doesn't matter.

The inside of any big company is a very, very complex system consisting of many thousands of people, of whom at least hundreds and probably thousands are executives who think they have some level of decision-making authority.

On any given issue, many people inside the company are going to get some kind of vote on what happens -- maybe 8 people, maybe 10, 15, 20, sometimes many more.

When I was at IBM in the early 90's, they had a formal decision making process called "concurrence" -- on any given issue, a written list of the 50 or so executives from all over the company who would be affected by the decision in any way, no matter how minor, would be assembled, and any one of those executives could "nonconcur" and veto the decision. That's an extreme case, but even a non-extreme version of this process -- and all big companies have one; they have to -- is mind-bendingly complex to try to understand, even from the inside, let alone the outside.

"... and the breath of the whale is frequently attended with such an insupportable smell, as to bring on a disorder of the brain."

-- Ulloa's South America

You can count on there being a whole host of impinging forces that will affect the dynamic of decision-making on any issue at a big company.

The consensus building process, trade-offs, quids pro quo, politics, rivalries, arguments, mentorships, revenge for past wrongs, turf-building, engineering groups, product managers, product marketers, sales, corporate marketing, finance, HR, legal, channels, business development, the strategy team, the international divisions, investors, Wall Street analysts, industry analysts, good press, bad press, press articles being written that you don't know about, customers, prospects, lost sales, prospects on the fence, partners, this quarter's sales numbers, this quarter's margins, the bond rating, the planning meeting that happened last week, the planning meeting that got cancelled this week, bonus programs, people joining the company, people leaving the company, people getting fired by the company, people getting promoted, people getting sidelined, people getting demoted, who's sleeping with whom, which dinner party the CEO went to last night, the guy who prepares the Powerpoint presentation for the staff meeting accidentally putting your startup's name in too small a font to be read from the back of the conference room...

You can't possibly even identify all the factors that will come to bear on a big company's decision, much less try to understand them, much less try to influence them very much at all.

"The larger whales, whalers seldom venture to attack. They stand in so great dread of some of them, that when out at sea they are afraid to mention even their names, and carry dung, lime-stone, juniper-wood, and some other articles of the same nature in their boats, in order to terrify and prevent their too near approach."

-- Uno Von Troil's Letters on Banks's and Solander's Voyage to Iceland In 1772

Back to Moby Dick.

Moby Dick might stalk you for three months, then jump out of the water and raise a huge ruckus, then vanish for six months, then come back and beach your whole boat, or alternately give you the clear shot you need to harpoon his giant butt.

And you're never going to know why.

A big company might study you for three months, then approach you and tell you they want to invest in you or partner with you or buy you, then vanish for six months, then come out with a directly competitive product that kills you, or alternately acquire you and make you and your whole team rich.

And you're never going to know why.

The upside of dealing with a big company is that there's potentially a ton of whale meat in it for you.

Sorry, mixing my metaphors. The right deal with the right big company can have a huge impact on a startup's success.

"And what thing soever besides cometh within the chaos of this monster's mouth, be it beast, boat, or stone, down it goes all incontinently that foul great swallow of his, and perisheth in the bottomless gulf of his paunch."

-- Holland's Plutarch's Morals

The downside of dealing with a big company is that he can capsize you -- maybe by stepping on you in one way or another and killing you, but more likely by wrapping you up in a bad partnership that ends up holding you back, or just making you waste a huge amount of time in meetings and get distracted from your core mission.

So what to do?

First, don't do startups that require deals with big companies to make them successful.

The risk of never getting those deals is way too high, no matter how hard you are willing to work at it.

And even if you get the deals, they probably won't work out the way you hoped.

"'Stern all!' exclaimed the mate, as upon turning his head, he saw the distended jaws of a large Sperm Whale close to the head of the boat, threatening it with instant destruction; -- 'Stern all, for your lives!'"

-- Wharton the Whale Killer

Second, never assume that a deal with a big company is closed until the ink hits the paper and/or the cash hits the company bank account.

There is always something that can cause a deal that looks like it's closed, to suddenly get blown to smithereens -- or vanish without a trace.

At day-break, the three mast-heads were punctually manned afresh.

"D'ye see him?" cried Ahab after allowing a little space for the light to spread.

"See nothing, sir."

-- Moby Dick

Third, be extremely patient.

Big companies play "hurry up and wait" all the time. In the last few years I've dealt with one big East Coast technology company in particular that has played "hurry up and wait" with me at least four separate times -- including a mandatory immediate cross-country flight just to have dinner with the #2 executive -- and has never followed through on anything.

If you want a deal with a big company, it is probably going to take a lot longer to put together than you think.

"My God! Mr. Chace, what is the matter?" I answered, "we have been stove by a whale."

-- "Narrative of the Shipwreck of the Whale Ship Essex of Nantucket, Which Was Attacked and Finally Destroyed by a Large Sperm Whale in the Pacific Ocean" by Owen Chace of Nantucket, First Mate of Said Vessel, New York, 1821

Fourth, beware bad deals.

I am thinking of one high-profile Internet startup in San Francisco right now that is extremely promising, has great technology and a unique offering, that did two big deals early with high-profile big company partners, and has become completely hamstrung in its ability to execute on its core business as a result.

Fifth, never, ever assume a big company will do the obvious thing.

What is obvious to you -- or any outsider -- is probably not obvious on the inside, once all the other factors that are involved are taken into account.

Sixth, be aware that big companies care a lot more about what other big companies are doing than what any startup is doing.

Hell, big companies often care a lot more about what other big companies are doing than they care about what their customers are doing.

Moby Dick cared a lot more about what the other giant white whales were doing than those annoying little people in that flimsy boat.

"The Whale is harpooned to be sure; but bethink you, how you would manage a powerful unbroken colt, with the mere appliance of a rope tied to the root of his tail."

-- A Chapter on Whaling in Ribs and Trucks

Seventh, if doing deals with big companies is going to be a key part of your strategy, be sure to hire a real pro who has done it before.

Only the best and most experienced whalers had a chance at taking down Moby Dick.

This is why senior sales and business development people get paid a lot of money. They're worth it.

"Oh! Ahab," cried Starbuck, "not too late is it, even now, the third day, to desist. See! Moby Dick seeks thee not. It is thou, thou, that madly seekest him!"

-- Moby Dick

Eighth, don't get obsessed.

Don't turn into Captain Ahab.

By all means, talk to big companies about all kinds of things, but always be ready to have the conversation just drop and to return to your core business.

Rare is the startup where a deal with a big company leads to success, or lack thereof leads to huge failure.

(However, see also Microsoft and Digital Research circa 1981. Talk about a huge whale.)

Closing thought:

Diving beneath the settling ship, the whale ran quivering along its keel; but turning under water, swiftly shot to the surface again, far off the other bow, but within a few yards of Ahab's boat, where, for a time, the whale lay quiescent.

"...Towards thee I roll, thou all-destroying but unconquering whale; to the last I grapple with thee; from hell's heart I stab at thee; for hate's sake I spit my last breath at thee. Sink all coffins and all hearses to one common pool! and since neither can be mine, let me then tow to pieces, while still chasing thee, though tied to thee, thou damned whale! THUS, I give up the spear!"

The harpoon was darted; the stricken whale flew forward; with igniting velocity the line ran through the grooves; -- ran foul. Ahab stooped to clear it; he did clear it; but the flying turn caught him round the neck, and voicelessly as Turkish mutes bowstring their victim, he was shot out of the boat, ere the crew knew he was gone.

-- Moby Dick

The Pmarca Guide to Startups, part 4: The only thing that matters

This post is all about the only thing that matters for a new startup.

But first, some theory:

If you look at a broad cross-section of startups -- say, 30 or 40 or more; enough to screen out the pure flukes and look for patterns -- two obvious facts will jump out at you.

First obvious fact: there is an incredibly wide divergence of success -- some of those startups are insanely successful, some highly successful, many somewhat successful, and quite a few of course outright fail.

Second obvious fact: there is an incredibly wide divergence of caliber and quality for the three core elements of each startup -- team, product, and market.

At any given startup, the team will range from outstanding to remarkably flawed; the product will range from a masterpiece of engineering to barely functional; and the market will range from booming to comatose.

And so you start to wonder -- what correlates the most to success -- team, product, or market? Or, more bluntly, what causes success? And, for those of us who are students of startup failure -- what's most dangerous: a bad team, a weak product, or a poor market?

Let's start by defining terms.

The caliber of a startup team can be defined as the suitability of the CEO, senior staff, engineers, and other key staff relative to the opportunity in front of them.

You look at a startup and ask, will this team be able to optimally execute against their opportunity? I focus on effectiveness as opposed to experience, since the history of the tech industry is full of highly successful startups that were staffed primarily by people who had never "done it before".

The quality of a startup's product can be defined as how impressive the product is to one customer or user who actually uses it: How easy is the product to use? How feature rich is it? How fast is it? How extensible is it? How polished is it? How many (or rather, how few) bugs does it have?

The size of a startup's market is the the number, and growth rate, of those customers or users for that product.

(Let's assume for this discussion that you can make money at scale -- that the cost of acquiring a customer isn't higher than the revenue that customer will generate.)

Some people have been objecting to my classification as follows: "How great can a product be if nobody wants it?" In other words, isn't the quality of a product defined by how appealing it is to lots of customers?

No. Product quality and market size are completely different.

Here's the classic scenario: the world's best software application for an operating system nobody runs. Just ask any software developer targeting the market for BeOS, Amiga, OS/2, or NeXT applications what the difference is between great product and big market.

So:

If you ask entrepreneurs or VCs which of team, product, or market is most important, many will say team. This is the obvious answer, in part because in the beginning of a startup, you know a lot more about the team than you do the product, which hasn't been built yet, or the market, which hasn't been explored yet.

Plus, we've all been raised on slogans like "people are our most important asset" -- at least in the US, pro-people sentiments permeate our culture, ranging from high school self-esteem programs to the Declaration of Independence's inalienable rights to life, liberty, and the pursuit of happiness -- so the answer that team is the most important feels right.

And who wants to take the position that people don't matter?

On the other hand, if you ask engineers, many will say product. This is a product business, startups invent products, customers buy and use the products. Apple and Google are the best companies in the industry today because they build the best products. Without the product there is no company. Just try having a great team and no product, or a great market and no product. What's wrong with you? Now let me get back to work on the product.

Personally, I'll take the third position -- I'll assert that market is the most important factor in a startup's success or failure.

Why?

In a great market -- a market with lots of real potential customers -- the market pulls product out of the startup.

The market needs to be fulfilled and the market will be fulfilled, by the first viable product that comes along.

The product doesn't need to be great; it just has to basically work. And, the market doesn't care how good the team is, as long as the team can produce that viable product.

In short, customers are knocking down your door to get the product; the main goal is to actually answer the phone and respond to all the emails from people who want to buy.

And when you have a great market, the team is remarkably easy to upgrade on the fly.

This is the story of search keyword advertising, and Internet auctions, and TCP/IP routers.

Conversely, in a terrible market, you can have the best product in the world and an absolutely killer team, and it doesn't matter -- you're going to fail.

You'll break your pick for years trying to find customers who don't exist for your marvelous product, and your wonderful team will eventually get demoralized and quit, and your startup will die.

This is the story of videoconferencing, and workflow software, and micropayments.

In honor of Andy Rachleff, formerly of Benchmark Capital, who crystallized this formulation for me, let me present Rachleff's Law of Startup Success:

The #1 company-killer is lack of market.

Andy puts it this way:

• When a great team meets a lousy market, market wins.
• When a lousy team meets a great market, market wins.
• When a great team meets a great market, something special happens.

You can obviously screw up a great market -- and that has been done, and not infrequently -- but assuming the team is baseline competent and the product is fundamentally acceptable, a great market will tend to equal success and a poor market will tend to equal failure. Market matters most.

And neither a stellar team nor a fantastic product will redeem a bad market.

OK, so what?

Well, first question: Since team is the thing you have the most control over at the start, and everyone wants to have a great team, what does a great team actually get you?

Hopefully a great team gets you at least an OK product, and ideally a great product.

However, I can name you a bunch of examples of great teams that totally screwed up their products. Great products are really, really hard to build.

Hopefully a great team also gets you a great market -- but I can also name you lots of examples of great teams that executed brilliantly against terrible markets and failed. Markets that don't exist don't care how smart you are.

In my experience, the most frequent case of great team paired with bad product and/or terrible market is the second- or third-time entrepreneur whose first company was a huge success. People get cocky, and slip up. There is one high-profile, highly successful software entrepreneur right now who is burning through something like $80 million in venture funding in his latest startup and has practically nothing to show for it except for some great press clippings and a couple of beta customers -- because there is virtually no market for what he is building.

Conversely, I can name you any number of weak teams whose startups were highly successful due to explosively large markets for what they were doing.

Finally, to quote Tim Shephard: "A great team is a team that will always beat a mediocre team, given the same market and product."

Second question: Can't great products sometimes create huge new markets?

Absolutely.

This is a best case scenario, though.

VMWare is the most recent company to have done it -- VMWare's product was so profoundly transformative out of the gate that it catalyzed a whole new movement toward operating system virtualization, which turns out to be a monster market.

And of course, in this scenario, it also doesn't really matter how good your team is, as long as the team is good enough to develop the product to the baseline level of quality the market requires and get it fundamentally to market.

Understand I'm not saying that you should shoot low in terms of quality of team, or that VMWare's team was not incredibly strong -- it was, and is. I'm saying, bring a product as transformative as VMWare's to market and you're going to succeed, full stop.

Short of that, I wouldn't count on your product creating a new market from scratch.

Third question: as a startup founder, what should I do about all this?

Let's introduce Rachleff's Corollary of Startup Success:

The only thing that matters is getting to product/market fit.

Product/market fit means being in a good market with a product that can satisfy that market.

You can always feel when product/market fit isn't happening. The customers aren't quite getting value out of the product, word of mouth isn't spreading, usage isn't growing that fast, press reviews are kind of "blah", the sales cycle takes too long, and lots of deals never close.

And you can always feel product/market fit when it's happening. The customers are buying the product just as fast as you can make it -- or usage is growing just as fast as you can add more servers. Money from customers is piling up in your company checking account. You're hiring sales and customer support staff as fast as you can. Reporters are calling because they've heard about your hot new thing and they want to talk to you about it. You start getting entrepreneur of the year awards from Harvard Business School. Investment bankers are staking out your house. You could eat free for a year at Buck's.

Lots of startups fail before product/market fit ever happens.

My contention, in fact, is that they fail because they never get to product/market fit.

Carried a step further, I believe that the life of any startup can be divided into two parts: before product/market fit (call this "BPMF") and after product/market fit ("APMF").

When you are BPMF, focus obsessively on getting to product/market fit.

Do whatever is required to get to product/market fit. Including changing out people, rewriting your product, moving into a different market, telling customers no when you don't want to, telling customers yes when you don't want to, raising that fourth round of highly dilutive venture capital -- whatever is required.

When you get right down to it, you can ignore almost everything else.

I'm not suggesting that you do ignore everything else -- just that judging from what I've seen in successful startups, you can.

Whenever you see a successful startup, you see one that has reached product/market fit -- and usually along the way screwed up all kinds of other things, from channel model to pipeline development strategy to marketing plan to press relations to compensation policies to the CEO sleeping with the venture capitalist. And the startup is still successful.

Conversely, you see a surprising number of really well-run startups that have all aspects of operations completely buttoned down, HR policies in place, great sales model, thoroughly thought-through marketing plan, great interview processes, outstanding catered food, 30" monitors for all the programmers, top tier VCs on the board -- heading straight off a cliff due to not ever finding product/market fit.

Ironically, once a startup is successful, and you ask the founders what made it successful, they will usually cite all kinds of things that had nothing to do with it. People are terrible at understanding causation. But in almost every case, the cause was actually product/market fit.

Because, really, what else could it possibly be?

[Editorial note: this post obviously raises way more questions than it answers. How exactly do you go about getting to product/market fit if you don't hit it right out of the gate? How do you evaluate markets for size and quality, especially before they're fully formed? What actually makes a product "fit" a market? What role does timing play? How do you know when to change strategy and go after a different market or build a different product? When do you need to change out some or all of your team? And why can't you count on on a great team to build the right product and find the right market? All these topics will be discussed in future posts in this series.]

The Pmarca Guide to Startups, part 3: "But I don't know any VCs!"

In my last post in this series, When the VCs say "no", I discussed what to do once you have been turned down for venture funding for the first time.

However, this presupposes you've been able to pitch VCs in the first place. What if you have a startup for which you'd like to raise venture funding, but you don't know any VCs?

I can certainly sympathize with this problem -- when I was in college working on Mosaic at the University of Illinois, the term "venture capital" might as well have been "klaatu barada nikto" for all I knew. I had never met a venture capitalist, no venture capitalist had ever talked to me, and I wouldn't have recognized one if I'd stumbled over his checkbook on the sidewalk. Without Jim Clark, I'm not at all certain I would have been able to raise money to start a company like Netscape, had it even occured to me to start a company in the first place.

The starting point for raising money from VCs when you don't know any VCs is to realize that VCs work mostly through referrals -- they hear about a promising startup or entrepreneur from someone they have worked with before, like another entrepreneur, an executive or engineer at one of the startups they have funded, or an angel investor with whom they have previously co-invested.

The reason for this is simply the math: any individual VC can only fund a few companies per year, and for every one she funds, she probably meets with 15 or 20, and there are hundreds more that would like to meet with her that she doesn't possibly have time to meet with. She has to rely on her network to help her screen the hundreds down to 15 or 20, so she can spend her time finding the right one out of the 15 or 20.

Therefore, submitting a business plan "over the transom", or unsolicited, to a venture firm is likely to amount to just as much as submitting a screenplay "over the transom" to a Hollywood talent agency -- that is, precisely nothing.

So the primary trick becomes getting yourself into a position where you're one of the 15 or 20 a particular venture capitalist is meeting with based on referrals from her network, not one of the hundreds of people who don't come recommended by anyone and whom she has no intention of meeting.

But before you think about doing that, the first order of business is to (paraphrasing for a family audience) "have your stuff together" -- create and develop your plan, your presentation, and your supporting materials so that when you do meet with a VC, you impress her right out of the gate as bringing her a fundable startup founded by someone who knows what he -- that's you -- is doing.

My recommendation is to read up on all the things you should do to put together a really effective business plan and presentation, and then pretend you have already been turned down once -- then go back to my last post and go through all the different things you should anticipate and fix before you actually do walk through the door.

One of the reason VCs only meet with startups through their networks is because too many of the hundreds of other startups that they could meet with come across as amateurish and uninformed, and therefore not fundable, when they do take meetings with them. So you have a big opportunity to cut through the noise by making a great first impression -- which requires really thinking things through ahead of time and doing all the hard work up front to really make your pitch and plan a masterpiece.

Working backwards from that, the best thing you can walk in with is a working product. Or, if you can't get to a working product without raising venture funding, then at least a beta or prototype of some form -- a web site that works but hasn't launched, or a software mockup with partial functionality, or something. And of course it's even better if you walk in with existing "traction" of some form -- customers, beta customers, some evidence of adoption by Internet users, whatever is appropriate for your particular startup.

With a working product that could be the foundation of a fundable startup, you have a much better chance of getting funded once you do get in the door. Back to my rule of thumb from the last post: when in doubt, work on the product.

Failing a working product and ideally customers or users, be sure to have as fleshed out a presentation as you possibly can -- including mockups, screenshots, market analyses, customer research such as interviews with real prospects, and the like.

Don't bother with a long detailed written business plan. Most VCs will either fund a startup based on a fleshed out Powerpoint presentation of about 20 slides, or they won't fund it at all. Corollary: any VC who requires a long detailed written business plan is probably not the right VC to be working with.

Next: qualify, qualify, qualify. Do extensive research on venture capitalists and find the ones who focus on the sector relevant to your startup. It is completely counterproductive to everyone involved for you to pitch a health care VC on a consumer Internet startup, or vice versa. Individual VCs are usually quite focused in the kinds of companies they are looking for, and identifying those VCs and screening out all the others is absolutely key.

Now, on to developing contacts:

The best way to develop contacts with VCs, in my opinion, is to work at a venture-backed startup, kick butt, get promoted, and network the whole way.

If you can't get hired by a venture-backed startup right now, work at a well-regarded large tech company that employs a lot of people like Google or Apple, gain experience, and then go to work at a venture-backed startup, kick butt, get promoted, and network the whole way.

And if you can't get hired by a well-regarded large tech company, go get a bachelor's or master's degree at a major research university from which well-regarded large tech companies regularly recruit, then work at a well-regarded large tech company that employs a lot of people like Google or Apple, gain experience, and then go to work at a venture-backed startup, kick butt, get promoted, and network the whole way.

I sound like I'm joking, but I'm completely serious -- this is the path taken by many venture-backed entrepreneurs I know.

Some alternate techniques that don't take quite as long:

If you're still in school, immediately transfer to, or plan on going to graduate school at, a large research university with well-known connections to the venture capital community, like Stanford or MIT.

Graduate students at Stanford are directly responsible for such companies as Sun, Cisco, Yahoo, and Google, so needless to say, Silicon Valley VCs are continually on the prowl on the Stanford engineering campus for the next Jerry Yang or Larry Page.

(In contrast, the University of Illinois, where I went to school, is mostly prowled by mutant cold-weather cows.)

Alternately, jump all over Y Combinator. This program, created by entrepreneur Paul Graham and his partners, funds early-stage startups in an organized program in Silicon Valley and Boston and then makes sure the good ones get in front of venture capitalists for follow-on funding. It's a great idea and a huge opportunity for the people who participate in it.

Read VC blogs -- read them all, and read them very very carefully. VCs who blog are doing entrepreneurs a huge service both in conveying highly useful information as well as frequently putting themselves out there to be contacted by entrepreneurs in various ways including email, comments, and even uploaded podcasts. Each VC is different in terms of how she wants to engage with people online, but by all means read as many VC blogs as you can and interact with as many of them as you can in appropriate ways.

See the list of VC bloggers on my home page, as well as on the home pages of various of those bloggers.

At the very least you will start to get a really good sense of which VCs who blog are interested in which kinds of companies.

At best, a VC blogger may encourage her readers to communicate with her in various ways, including soliciting email pitches in certain startup categories of interest to her.

Fred Wilson of Union Square Ventures has even gone so far as to encourage entrepreneurs to record and upload audio pitches for new ventures so he can listen to them on his IPod. I don't know if he's still doing that, but it's worth reading his blog and finding out.

Along those lines, some VCs are aggressive early adopters of new forms of communication and interaction -- current examples being Facebook and Twitter. Observationally, when a VC is exploring a new communiation medium like Facebook or Twitter, she can be more interested in interacting with various people over that new medium than she might otherwise be. So, when such a new thing comes out -- like, hint hint, Facebook or Twitter -- jump all over it, see which VCs are using it, and interact with them that way -- sensibly, of course.

More generally, it's a good idea for entrepreneurs who are looking for funding to blog -- about their startup, about interesting things going on, about their point of view. This puts an entrepreneur in the flow of conversation, which can lead to interaction with VCs through the normal medium of blogging. And, when a VC does decide to take a look at you and your company, she can read your blog to get a sense of who you are and how you think. It's another great opportunity to put forward a fantastic first impression.

Finally, if you are a programmer, I highly encourage you, if you have time, to create or contribute to a meaningful open source project. The open source movement is an amazing opportunity for programmers all over the world to not only build useful software that lots of people can use, but also build their own reputations completely apart from whatever day jobs they happen to have. Being able to email a VC and say, "I'm the creator of open source program X which has 50,000 users worldwide, and I want to tell you about my new startup" is a lot more effective than your normal pitch.

If you engage in a set of these techniques over time, you should be able to interact with at least a few VCs in ways that they find useful and that might lead to further conversations about funding, or even introductions to other VCs.

I'm personally hoping that the next Google comes out of a VC being sent an email pitch after the entrepreneur read that VC's blog. Then every VC on the planet will suddenly start blogging, overnight.

If none of those ideas work for you:

Your alternatives in reverse (declining) order of preference for funding are, in my view: angel funding, bootstrapping via consulting contracts or early customers, keeping your day job and working on your startup in your spare time, and credit card debt.

Angel funding -- funding from individuals who like to invest small amounts of money in early-stage startups, often before VCs come in -- can be a great way to go since good angels know good VCs and will be eager to introduce you to them so that your company goes on to be successful for the angel as well as for you.

This of course begs the question of how to raise angel money, which is another topic altogether!

I am not encouraging the other three alternatives -- bootstrapping, working on it part time, or credit card debt. Each has serious problems. But, it is easy to name highly successful entrepreneurs who have followed each of those paths, so they are worth noting.

Closing link:

Finally, be sure to read this page on Sequoia Capital's web site.

Sequoia is one of the very best venture firms in the world, and has funded many companies that you have heard of including Oracle, Apple, Yahoo, and Google.

On that page, Sequoia does entrepreneurs everywhere a huge service by first listing the criteria that they look for in a startup, then the recommended structure for your pitch presentation, and then finally actually asks for pitches "over the transom".

I have not done a thorough review of other VC web sites to see who else is being this open, but for Sequoia to be offering this to the world at large is a huge opportunity for the right startup. Don't let it pass by.

[Editorial note: This will be the last VC-related post in this series for a while. From now on I plan to focus much more on how to make a startup successful.]

The Pmarca Guide to Startups, part 2: When the VCs say "no"

This post is about what to do between when the VCs say "no" to funding your startup, and when you either change their minds or find some other path.

I'm going to assume that you've done all the basics: developed a plan and a pitch, decided that venture financing is right for you and you are right for venture financing, lined up meetings with properly qualified VCs, and made your pitch.

And the answer has come back and it's "no".

One "no" doesn't mean anything -- the VC could just be having a bad day, or she had a bad experience with another company in your category, or she had a bad experience with another company with a similar name, or she had a bad experience with another founder who kind of looks like you, or her Mercedes SLR McLaren's engine could have blown up on the freeway that morning -- it could be anything. Go meet with more VCs.

If you meet with three VCs and they all say "no", it could just be a big coincidence. Go meet with more VCs.

If you meet with five, or six, or eight VCs and they all say no, it's not a coincidence.

There is something wrong with your plan.

Or, even if there isn't, there might as well be, because you're still not getting funded.

Meeting with more VCs after a bunch have said no is probably a waste of time. Instead, retool your plan -- which is what this post is about.

But first, lay the groundwork to go back in later.

It's an old -- and true -- cliche that VCs rarely actually say "no" -- more often they say "maybe", or "not right now", or "my partners aren't sure", or "that's interesting, let me think about it".

They do that because they don't want to invest in your company given the current facts, but they want to keep the door open in case the facts change.

And that's exactly what you want -- you want to be able to go back to them with a new set of facts, and change their minds, and get to "yes".

So be sure to take "no" gracefully -- politely ask them for feedback (which they probably won't give you, at least not completely honestly -- nobody likes calling someone else's baby ugly -- believe me, I've done it), thank them for their time, and ask if you can call them again if things change.

Trust me -- they'd much rather be saying "yes" than "no" -- they need all the good investments they can get.

Second, consider the environment.

Being told "no" by VCs in 1999 is a lot different than being told "no" in 2002.

If you were told "no" in 1999, I'm sure you're a wonderful person and you have huge potential and your mother loves you very much, but your plan really was seriously flawed.

If you were told "no" in 2002, you probably actually were the next Google, but most of the VCs were hiding under their desks and they just missed it.

In my opinion, we're now in a much more rational environment than either of those extremes -- a lot of good plans are being funded, along with some bad ones, but not all the bad ones.

I'll proceed under the assumption that we're in normal times. But if things get truly euphoric or truly funereal again, the rest of this post will probably not be very helpful -- in either case.

Third, retool your plan.

This is the hard part -- changing the facts of your plan and what you are trying to do, to make your company more fundable.

To describe the dimensions that you should consider as you contemplate retooling your plan, let me introduce the onion theory of risk.

If you're an investor, you look at the risk around an investment as if it's an onion. Just like you peel an onion and remove each layer in turn, risk in a startup investment comes in layers that get peeled away -- reduced -- one by one.

Your challenge as an entrepreneur trying to raise venture capital is to keep peeling layers of risk off of your particular onion until the VCs say "yes" -- until the risk in your startup is reduced to the point where investing in your startup doesn't look terrifying and merely looks risky.

What are the layers of risk for a high-tech startup?

It depends on the startup, but here are some of the common ones:

Founder risk -- does the startup have the right founding team? A common founding team might include a great technologist, plus someone who can run the company, at least to start. Is the technologist really all that? Is the business person capable of running the company? Is the business person missing from the team altogether? Is it a business person or business people with no technologist, and therefore virtually unfundable?

Market risk -- is there a market for the product (using the term product and service interchangeably)? Will anyone want it? Will they pay for it? How much will they pay? How do we know?

Competition risk -- are there too many other startups already doing this? Is this startup sufficiently differentiated from the other startups, and also differentiated from any large incumbents?

Timing risk -- is it too early? Is it too late?

Financing risk -- after we invest in this round, how many additional rounds of financing will be required for the company to become profitable, and what will the dollar total be? How certain are we about these estimates? How do we know?

Marketing risk -- will this startup be able to cut through the noise? How much will marketing cost? Do the economics of customer acquisition -- the cost to acquire a customer, and the revenue that customer will generate -- work?

Distribution risk -- does this startup need certain distribution partners to succeed? Will it be able to get them? How? (For example, this is a common problem with mobile startups that need deals with major mobile carriers to succeed.)

Technology risk -- can the product be built? Does it involve rocket science -- or an equivalent, like artificial intelligence or natural language processing? Are there fundamental breakthroughs that need to happen? If so, how certain are we that they will happen, or that this team will be able to make them?

Product risk -- even assuming the product can in theory be built, can this team build it?

Hiring risk -- what positions does the startup need to hire for in order to execute its plan? E.g. a startup planning to build a high-scale web service will need a VP of Operations -- will the founding team be able to hire a good one?

Location risk -- where is the startup located? Can it hire the right talent in that location? And will I as the VC need to drive more than 20 minutes in my Mercedes SLR McLaren to get there?

You know, when you stack up all these layers and look at the full onion, you realize it's amazing that any venture investments ever get made.

What you need to do is take a hard-headed look at each of these risks -- and any others that are specific to your startup and its category -- and put yourself in the VC's shoes: what could this startup do to minimize or eliminate enough of these risks to make the company fundable?

Then do those things.

This isn't very much fun, since it will probably involve making significant changes to your plan, but look on the bright side: it's excellent practice for when your company ultimately goes public and has to file an S1 registration statement with the SEC, in which you have to itemize in huge detail every conceivable risk and bad thing that could ever possibly happen to you, up to and including global warming.

Some ideas on reducing risk:

Founder risk -- the tough one. If you're the technologist on a founding team with a business person, you have to consider the possibility that the VCs don't think the business person is strong enough to be the founding CEO. Or vice versa, maybe they think the technologist isn't strong enough to build the product. You may have to swap out one or more founders, and/or add one or more founders.

I put this one right up front because it can be a huge issue and the odds of someone being honest with you about it in the specific are not that high.

Market risk -- you probably need to validate the market, at a practical level. Sometimes more detailed and analytical market research will solve the problem, but more often you actually need to go get some customers to demonstrate that the market exists. Preferably, paying customers. Or at least credible prospects who will talk to VCs to validate the market hypothesis.

Competition risk -- is your differentiation really sharp enough? Rethink this one from the ground up. Lots of startups do not have strong enough differentiation out of the gate, even after they get funded. If you don't have a really solid idea as to how you're dramatically different from or advantaged over known and unknown competitors, you might not want to start a company in the first place.

Two additional points on competition risk that founders routinely screw up in VC pitches:

Never, ever say that you have no competitors. That signals naivete. Great markets draw competitors, and so if you really have no competition, you must not be in a great market. Even if you really believe you have no competitors, create a competitive landscape slide with adjacent companies in related market segments and be ready to talk crisply about how you are like and unlike those adjacent companies.

And never, ever say your market projections indicate you're going to be hugely successful if you get only 2% of your (extremely large) market. That also signals naivete. If you're going after 2% of a large market, that means the presumably larger companies that are going to take the other 98% are going to kill you. You have to have a theory for how you're going to get a significantly higher market share than 2%. (I pick 2% because that's the cliche, but if you're a VC, you've probably heard someone use it.)

Timing risk -- the only thing to do here is to make more progress, and demonstrate that you're not too early or too late. Getting customers in the bag is the most valuable thing you can do on this one.

Financing risk -- rethink very carefully how much money you will need to raise after this round of financing, and try to change the plan in plausible ways to require less money. For example, only serve Cristal at your launch party, and not Remy Martin "Black Pearl" Louis XIII cognac.

Marketing risk -- first, make sure your differentiation is super-sharp, because without that, you probably won't be able to stand out from the noise.

Then, model out your customer acquisition economics in detail and make sure that you can show how you'll get more revenue from a customer than it will cost in sales and marketing expense to acquire that customer. This is a common problem for startups pursuing the small business market, for example.

If it turns out you need a lot of money in absolute terms for marketing, look for alternate approaches -- perhaps guerilla marketing, or some form of virality.

Distribution risk -- this is a very tough one -- if your plan has distribution risk, which is to say you need a key distribution partner to make it work, personally I'd recommend shelving the plan and doing something else. Otherwise, you may need to go get the distribution deal before you can raise money, which is almost impossible.

Technology risk -- there's only one way around this, which is to build the product, or at least get it to beta, and then raise money.

Product risk -- same answer -- build it.

Hiring risk -- the best way to address this is to figure out which position/positions the VCs are worried about, and add it/them to the founding team. This will mean additional dilution for you, but it's probably the only way to solve the problem.

Location risk -- this is the one you're really not going to like. If you're not in a major center of entrepreneurialism and you're having trouble raising money, you probably need to move. There's a reason why most films get made in Los Angeles, and there's a reason most venture-backed US tech startups happen in Silicon Valley and handful of other places -- that's where the money is. You can start a company wherever you want, but you may not be able to get it funded there.

You'll notice that a lot of what you may need to do is kick the ball further down the road -- make more progress against your plan before you raise venture capital.

This obviously raises the issue of how you're supposed to do that before you've raised money.

Try to raise angel money, or bootstrap off of initial customers or consulting contracts, or work on it after hours while keeping your current job, or quit your job and live off of credit cards for a while.

Lots of entrepreneurs have done these things and succeeded -- and of course, many have failed.

Nobody said this would be easy.

The most valuable thing you can do is actually build your product. When in doubt, focus on that.

The next most valuable thing you can do is get customers -- or, for a consumer Internet service, establish a pattern of page view growth.

The whole theory of venture capital is that VCs are investing in risk -- another term for venture capital is "risk capital" -- but the reality is that VCs will only take on so much risk, and the best thing you can do to optimize your chances of raising money is to take out risk.

Peel away at the onion.

Then, once you've done that, recraft the pitch around the new facts. Go do the pitches again. And repeat as necessary.

And to end on a happy note, remember that "yes" can turn into "no" at any point up until the cash hits your company's bank account.

So keep your options open all the way to the end.

The Pmarca Guide to Startups, part 1: Why not to do a startup

In this series of posts I will walk through some of my accumulated knowledge and experience in building high-tech startups.

My specific experience is from three companies I have co-founded: Netscape, sold to America Online in 1998 for $4.2 billion; Opsware (formerly Loudcloud), a public software company with an approximately $1 billion market cap; and now Ning, a new, private consumer Internet company.

But more generally, I've been fortunate enough to be involved in and exposed to a broad range of other startups -- maybe 40 or 50 in enough detail to know what I'm talking about -- since arriving in Silicon Valley in 1994: as a board member, as an angel investor, as an advisor, as a friend of various founders, and as a participant in various venture capital funds.

This series will focus on lessons learned from this entire cross-section of Silicon Valley startups -- so don't think that anything I am talking about is referring to one of my own companies: most likely when I talk about a scenario I have seen or something I have experienced, it is from some other startup that I am not naming but was involved with some other way than as a founder.

Finally, much of my perspective is based on Silicon Valley and the environment that we have here -- the culture, the people, the venture capital base, and so on. Some of it will travel well to other regions and countries, some probably will not. Caveat emptor.

With all that out of the way, let's start at the beginning: why not to do a startup.

Startups, even in the wake of the crash of 2000, have become imbued with a real mystique -- you read a lot about how great it is to do a startup, how much fun it is, what with the getting to invent the future, all the free meals, foosball tables, and all the rest.

Now, it is true that there are a lot of great things about doing a startup. They include, in my experience:

Most fundamentally, the opportunity to be in control of your own destiny -- you get to succeed or fail on your own, and you don't have some bozo telling you what to do. For a certain kind of personality, this alone is reason enough to do a startup.

The opportunity to create something new -- the proverbial blank sheet of paper. You have the ability -- actually, the obligation -- to imagine a product that does not yet exist and bring it into existence, without any of the constraints normally faced by larger companies.

The opportunity to have an impact on the world -- to give people a new way to communicate, a new way to share information, a new way to work together, or anything else you can think of that would make the world a better place. Think it should be easier for low-income people to borrow money? Start Prosper. Think television should be opened up to an infinite number of channels? Start Joost. Think that computers should be based on Unix and open standards and not proprietary technology? Start Sun.

The ability to create your ideal culture and work with a dream team of people you get to assemble yourself. Want your culture to be based on people who have fun every day and enjoy working together? Or, are hyper-competitive both in work and play? Or, are super-focused on creating innovative new rocket science technologies? Or, are global in perspective from day one? You get to choose, and to build your culture and team to suit.

And finally, money -- startups done right can of course be highly lucrative. This is not just an issue of personal greed -- when things go right, your team and employees will themselves do very well and will be able to support their families, send their kids to college, and realize their dreams, and that's really cool. And if you're really lucky, you as the entrepreneur can ultimately make profound philanthropic gifts that change society for the better.

However, there are many more reasons to not do a startup.

First, and most importantly, realize that a startup puts you on an emotional rollercoaster unlike anything you have ever experienced.

You will flip rapidly from a day in which you are euphorically convinced you are going to own the world, to a day in which doom seems only weeks away and you feel completely ruined, and back again.

Over and over and over.

And I'm talking about what happens to stable entrepreneurs.

There is so much uncertainty and so much risk around practically everything you are doing. Will the product ship on time? Will it be fast enough? Will it have too many bugs? Will it be easy to use? Will anyone use it? Will your competitor beat you to market? Will you get any press coverage? Will anyone invest in the company? Will that key new engineer join? Will your key user interface designer quit and go to Google? And on and on and on...

Some days things will go really well and some things will go really poorly. And the level of stress that you're under generally will magnify those transient data points into incredible highs and unbelievable lows at whiplash speed and huge magnitude.

Sound like fun?

Second, in a startup, absolutely nothing happens unless you make it happen.

This one throws both founders and employees new to startups.

In an established company -- no matter how poorly run or demoralized -- things happen. They just happen. People come in to work. Code gets written. User interfaces get designed. Servers get provisioned. Markets get analyzed. Pricing gets studied and determined. Sales calls get made. The wastebaskets get emptied. And so on.

A startup has none of the established systems, rhythms, infrastructure that any established company has.

In a startup it is very easy for the code to not get written, for the user interfaces to not get designed... for people to not come into work... and for the wastebaskets to not get emptied.

You as the founder have to put all of these systems and routines and habits in place and get everyone actually rowing -- forget even about rowing in the right direction: just rowing at all is hard enough at the start.

And until you do, absolutely nothing happens.

Unless, of course, you do it yourself.

Have fun emptying those wastebaskets.

Third, you get told no -- a lot.

Unless you've spent time in sales, you are probably not familiar with being told no a lot.

It's not so much fun.

Go watch Death of a Salesman and then Glengarry Glen Ross.

That's roughly what it's like.

You're going to get told no by potential employees, potential investors, potential customers, potential partners, reporters, analysts...

Over and over and over.

And when you do get a "yes", half the time you'll get a call two days later and it'll turn out the answer has morphed into "no".

Better start working on your fake smile.

Fourth, hiring is a huge pain in the ass.

You will be amazed how many windowshoppers you'll deal with.

A lot of people think they want to be part of a startup, but when the time comes to leave their cushy job at HP or Apple, they flinch -- and stay.

Going through the recruiting process and being seduced by a startup is heady stuff for your typical engineer or midlevel manager at a big company -- you get to participate vicariously in the thrill of a startup without actually having to join or do any of the hard work.

As a founder of a startup trying to hire your team, you'll run into this again and again.

When Jim Clark decided to start a new company in 1994, I was one of about a dozen people at various Silicon Valley companies he was talking to about joining him in what became Netscape.

I was the only one who went all the way to saying "yes" (largely because I was 22 and had no reason not to do it).

The rest flinched and didn't do it.

And this was Jim Clark, a legend in the industry who was coming off of the most successful company in Silicon Valley in 1994 -- Silicon Graphics Inc.

How easy do you think it's going to be for you?

Then, once you do get through the windowshoppers and actually hire some people, your success rate on hiring is probably not going to be higher than 50%, and that's if you're good at it.

By that I mean that half or more of the people you hire aren't going to work out. They're going to be too lazy, too slow, easily rattled, political, bipolar, or psychotic.

And then you have to either live with them, or fire them.

Which ones of those sounds like fun?

Fifth, God help you, at some point you're going to have to hire executives.

You think hiring employees is hard and risky -- wait until you start hiring for VP Engineering, VP Marketing, VP Sales, VP HR, General Counsel, and CFO.

Sixth, the hours.

There's been a lot of talk in Silicon Valley lately about work/life balance -- about how you should be able to do a startup and simultaneously live a full and fulfilling outside life.

Now, personally, I have a lot of sympathy for that point of view.

And I try hard in my companies (well, at least my last two companies) to do whatever I can to help make sure that people aren't ground down to little tiny spots on the floor by the workload and the hours.

But, it's really difficult.

The fact is that startups are incredibly intense experiences and take a lot out of people in the best of circumstances.

And just because you want people to have work/life balance, it's not so easy when you're close to running out of cash, your product hasn't shipped yet, your VC is mad at you, and your Kleiner Perkins-backed competitor in Menlo Park -- you know, the one whose employees' average age seems to be about 19 -- is kicking your butt.

Which is what it's going to be like most of the time.

And even if you can help your employees have proper work/life balance, as a founder you certainly won't.

(In case you were wondering, by the way, the hours do compound the stress.)

Seventh, it's really easy for the culture of a startup to go sideways.

This combines the first and second items above.

This is the emotional rollercoaster wreaking havoc on not just you but your whole company.

It takes time for the culture of any company to become "set" -- for the team of people who have come together for the first time to decide collectively what they're all about, what they value -- and how they look at challenge and adversity.

In the best case, you get an amazing dynamic of people really pulling together, supporting one another, and working their collective tails off in pursuit of a dream.

In the worst case, you end up with widespread, self-reinforcing bitterness, disillusionment, cynicism, bad morale, contempt for management, and depression.

And you as the founder have much less influence over this than you'll think you do.

Guess which way it usually goes.

Eighth, there are lots of X factors that can come along and whup you right upside the head, and there's absolutely nothing you can do about them.

Stock market crashes.

Terrorist attacks.

Natural disasters.

A better funded startup with a more experienced team that's been hard at work longer than you have, in stealth mode, that unexpectedly releases a product that swiftly comes to dominate your market, completely closing off your opportunity, and you had no idea they were even working on it.

At best, any given X factor might slam shut the fundraising window, cause customers to delay or cancel purchases -- or, at worst, shut down your whole company.

Russian mobsters laundering millions of dollars of dirty money through your service, resulting in the credit card companies closing you down.

You think I'm joking about that one?

OK, now here's the best part:

I haven't even talked about figuring out what product to build, building it, taking it to market, and standing out from the crowd.

All the risks in the core activities of what your company actually does are yet to come, and to be discussed in future posts in this series.

Closing metaphor:

Analyzing the Facebook Platform, three weeks in

On May 24, Facebook launched the newest version of the Facebook Platform, a set of application programming interfaces (APIs) and services that allow outside developers to inject new features and content into the Facebook user experience.

In this post, I provide an overview and analysis of the Facebook Plaform and what we have learned about it in the three weeks since it launched.

To start, my personal opinion is that the new Facebook Platform is a dramatic leap forward for the Internet industry.

Here's why:

Veterans of the software industry have, hardcoded into their DNA, the assumption that in any fight between a platform and an application, the platform will always win.

Definitionally, a "platform" is a system that can be reprogrammed and therefore customized by outside developers -- users -- and in that way, adapted to countless needs and niches that the platform's original developers could not have possibly contemplated, much less had time to accommodate.

In contrast, an "application" is a system that cannot be reprogrammed by outside developers. It is a closed environment that does whatever its original developers intended it to do, and nothing more.

The classic example of an application being vanquished by a platform was the Wang word processor versus Microsoft DOS-based personal computers.

Wang word processors -- the application, in this case -- were highly evolved, fantastically successful dedicated word processing systems that owned their market, until the general-purpose PC came along. While the PC at first was inferior at word processing, within a few years of its launch the fact that outside developers had built thousands of applications for it -- like spreadsheets -- that closed Wang word processors could not match, coupled with steadily improving PC-based word processing software like Wordstar, had all but killed the Wang word processor. Wang -- one of the most succcessful technology companies of the 1970's -- went bankrupt not long after.

This is a story whose moral has historically not been embraced by the web industry to nearly the extent one would have thought.

The web, after all, vanquished proprietary online services like America Online, Prodigy, and Compuserve -- the so-called "walled gardens" -- in large part because the web is a platform and the walled gardens were not. No single closed service, no matter how good, and no matter how big, could compete with the diversity of thousands and then millions of web sites that were customized to every conceivable user interest and need.

Yet most major web busineses have not themselves sought to become platforms.

Sure, some have released APIs -- some have even released very sophisticated APIs -- but such APIs have mostly been for interacting with a web system from the outside. Those APIs have been a far cry from the programmability and customizability enabled by a true platform in the sense that the software industry has come to understand it.

Instead, most major web businesses have sailed along without the added lift from platform-style programmability that they could have had at any point.

Until now.

In a nutshell, the Facebook API enables outside web developers to inject new features and content into the Facebook environment.

After signing up for a developer account on Facebook, the developer writes a web application (in the simplest case, a piece of web content; in the most advanced case, a full fledge web application with deep functionality) and hosts it on her own servers. The developer then registers her application with Facebook, and then users can add that application to their Facebook user experience in several different ways, including within their Facebook profile pages.

Viewed simply, this is a variant on the "embedding" phenomenon that swept MySpace over the last two years, and which Facebook prohibited.

However, what Facebook is now doing is a lot more sophisticated than simply MySpace-style embedding: Facebook is providing a full suite of APIs -- including a network protocol, a database query language, and a text markup language -- that allow third party applications to integrate tightly with the Facebook user experience and database of user and activity information.

And then, on top of that, Facebook is providing a highly viral distribution engine for applications that plug into its platform. As a user, you get notified when your friends start using an application; you can then start using that same application with one click. At which point, all of your friends become aware that you have started using that application, and the cycle continues. The result is that a successful application on Facebook can grow to a million users or more within a couple of weeks of creation.

Finally, Facebook is promising economic freedom -- third-party applications can run ads and sell goods and services to their hearts' content.

Metaphorically, Facebook is providing the ease and user attraction of MySpace-style embedding, coupled with the kind of integration you see with Firefox extensions, plus the added rocket fuel of automated viral distribution to a huge number of potential users, and the prospect of keeping 100% of any revenue your application can generate.

The leadership that the Facebook team is showing here rivals anything that the large and established software and web companies have done in this decade.

You may also notice the irony of Facebook leapfrogging MySpace on embedding at the same time that MySpace seems to be getting substantially more restrictive, in some cases even shutting down third-party widgets.

Let's look at some of the key aspects of the Facebook Platform in more detail.

First, perhaps the most architecturally interesting aspect of the Facebook platform is the fact that everything routes through Facebook's servers.

This is known as a "proxy" model -- you interact with a third-party Facebook application by interacting with Facebook's servers which turn interact with the application's servers.

There are very sharp pros and cons to this approach, contrasted with the MySpace model where third-party content is pulled directly from third-party servers.

Pros:

Facebook retains much tighter control of the overall user experience. Applications must conform to Facebook guidelines for appearance and content or they are disallowed.

Facebook can provide third-party pages with integral access to Facebook user and activity information -- the application can easily be aware of who your Facebook friends are, for example. This allows the applications to be considerably more powerful in the context of a social network than a simple piece of embedded content.

Facebook can cache static content such as images and videos and thereby serve them up faster, improving the overall user experience.

Cons:

Facebook retains much tighter control of the overall user experience. Applications must conform to Facebook guidelines for appearance and content or they are disallowed. Yes, this is also listed above under "Pros".

Performance will generall be slower than a non-proxy model. There are additional network hops for each access of a third-party application, which causes additional latency. Plus, Facebook's servers do a lot of processing of the third-party content that they are passing back and forth: they essentially rewrite every page on the fly to implement the added features (e.g. FBML) and restrictions (e.g. no Javascript; div's are rewritten) that they provide. This processing inevitably takes time.

On balance, of course, this is a fine set of tradeoffs that accommodate Facebook's dual goals of opening up their environment but in carefully controlled ways, and may well serve as a powerful precedent for how other web businesses will open themselves in the future.

Second, Facebook has really thought through the API suite it provides to developers.

You get a REST web services API that lets your application programmatically interact with Facebook's systems and data in very interesting ways. Developers who understand web services can pick it up in about five minutes.

You get a database query language called FQL -- a variant of SQL -- that lets you interact with Facebook's databases directly. Developers who are experienced with relational databases and SQL will be right at home.

And, you get a text markup language called FBML -- a variant of HTML. FBML strips out some features of HTML, such as Javascript, and adds a new set of features that enable a third-party application page to access Facebook features, data, and look and feel elements in a variety of interesting ways. Anyone who knows HTML can take advantage of it immediately.

This is a very sophisticated yet easy to adopt suite of APIs for a brand new platform, and demonstrates real seriousness of purpose.

Third, there are three very powerful potential aspects of being a platform in the web era that Facebook does not embrace.

The first is that Facebook itself is not reprogrammable -- Facebook's own code and functionality remains closed and proprietary. You can layer new code and functionality on top of what Facebook's own programmers have built, but you cannot change the Facebook system itself at any level.

The second is that all third-party code that uses the Facebook APIs has to run on third-party servers -- servers that you, as the developer provide. On the one hand, this is obviously fair and reasonable, given the value that Facebook developers are getting. On the other hand, this is a much higher hurdle for development than if code could be uploaded and run directly within the Facebook environment -- on the Facebook servers.

The third is that you cannot create your own world -- your own social network -- using the Facebook platform. You cannot build another Facebook with it.

I won't dwell on these three factors too much right now. Those of you familiar with Ning may, however, expect me to revisit them in the future, and I will :-).

These factors are, however, very reflective of the fact that while the Facebook Platform gives developers a lot of capabilities that they never had before, and access to a huge base of enthusiastic users, as a Facebook developer you're very much living in Facebook's world -- you're not creating your own world. And you have to be serious enough about living in that world that you are willing to hit the fairly high barrier of being willing to run your own servers and infrastructure for any applications you build.

Which takes us to...

Fourth, and perhaps most significantly, when your application takes off on Facebook, you are very happy because you have lots of users, and you are very sad because your servers blow up.

Let me explain.

I already described Facebook's viral distribution mechanism by which users became instantly aware of which applications their friends are using, can with one click start using those applications, and automatically spread them to their friends.

This is happening in an environment with 24 million active users -- active users defined as users active on the site in the last 30 days. 50% of active users return to the site daily. 100,000 new users join per day. 45 billion page views per month and growing. 50 million users, and a lot more page views, predicted by the end of 2007.

An application that takes off on Facebook is very quickly adopted by hundreds of thousands, and then millions -- in days! -- and then ultimately tens of millions of users.

Unless you're already operating your own systems at Facebook levels of scale, your servers will promptly explode from all the traffic and you will shortly be sending out an email like this.

ILike was the first third-party application to get serious lift-off on Facebook. Quoting from ILike's blog shortly after their launch:

In our first 20 hours of opening doors we had 50,000 users sign up, and it is only accelerating. (10,000 users joined in the first 12 hrs. 10,000 more users in the next 3 hrs. 30,000 more users in the next 5 hrs!!)

We started the system not knowing what to expect, with only 2 servers, but ready with backup. Facebook's rabid userbase chewed up our 2 servers almost instantly. We doubled our capacity to catch up. And then we doubled it again. And again. And again. Oh crap - we ran out of servers!! Although iLike.com has a very healthy level of Web traffic, and even though about half of all the servers in our datacenter were sitting unused, idle, as backup capacity, we are now completely maxed out.

We just emailed everybody we know across over a dozen Bay Area startups, corporations, and venture firms in a desperate plea to find spare servers so we can triple our capacity for the continued onslaught. Tomorrow we are picking up over 100 servers from different companies to have them installed just to handle the weekend's traffic. (For those who responded to our late night pleas, thank you!)

Yesterday, about two weeks later, ILike announced that they have passed 3 million users on Facebook and are still growing -- at a rate of 300,000 users per day.

They didn't say how many servers they're running, but if you do the math, it has to be in the hundreds and heading into the thousands.

Translation: unless you already have, or are prepared to quickly procure, a 100-500+ server infrastructure and everything associated with it -- networking gear, storage gear, ISP interconnetions, monitoring systems, firewalls, load balancers, provisioning systems, etc. -- and a killer operations team, launching a successful Facebook application may well be a self-defeating proposition.

This is a "success kills" scenario -- the good news is you're successful, the bad news is you're flat on your back from what amounts to a self-inflicted denial of service attack, unless you have the money and time and knowledge to tackle the resulting scale challenges.

Will every Facebook application go through this?

No, of course not. The ones that nobody uses will not have this problem.

But the successful ones all will.

The implication is, in my view, quite clear -- the Facebook Platform is primarily for use by either big companies, or venture-backed startups with the funding and capability to handle the slightly insane scale requirements. Individual developers are going to have a very hard time taking advantage of it in useful ways.

Fifth, there's the fascinating issue of the Facebook application directory -- the page from which users can pick which applications they want to use.

When you develop a new Facebook application, you submit it to the directory and someone at Facebook Inc. approves it -- or not.

If your application is not approved for any reason -- or if it's just taking too long -- you apparently have the option of letting your application go out "underground".

This means that you need to start your application's proliferation some other way than listing it in the directory -- by promoting it somewhere else on the web, or getting your friends to use it.

But then it can apparently proliferate virally across Facebook just like an approved application.

There is already long list of underground apps that you can use -- and proliferate.

It will be fascinating to see how Facebook deals with this -- will they embrace underground apps, or move to shut them down?

The answer will go a long way towards understanding the true level of freedom that developers have on the Facebook Platform.

In closing:

Congratulations to the Facebook team -- big time! -- for an amazing leap forward in what the Internet can do for real users and for opening up whole new vistas of opportunities for third-party developers.

This is an amazing achievement -- one of the most significant milestones in the technology industry in this decade.

Clarifications and expansions:

In conversations with the folks at Facebook, there are a few clarifications and expansions I'd like to note:

First, my statement that "applications must conform to Facebook guidelines for appearance and content or they are disallowed" is partially but not entirely true. Boxes that contain content from an application on a user's Facebook profile page must be rendered via FBML and have tight controls over what can be included, particularly the no-Javascript limitation. On the other hand, so-called "canvas" pages -- the pages dedicated completely to a specific application, and accessible via the left-hand-side app navigation area, can be rendered either via FBML (which is restrictive), an iframe that can include arbitrary content, or a combination of the two. From an iframe you do pretty much whatever you want, but you don't get the FBML features.

Note that you are incented to use FBML because that's the easiest way to achieve integration between your application and Facebook -- e.g. to let your app have access to information about the user and her friends. FBML is clearly a good thing; it's just that when you're using it, you can't do certain other things that you're used to. And, as noted, you are required to use it for content that shows up on users' profile pages.

Second, my point that "success kills" -- that a successful, widely used application will require a large number of servers to run, at best, and will fall over and die, at worst -- is true, but the Facebook folks point out that as an app developer you have a lot of control over how fast your application grows. You don't have to light up all the viral spread features all at once, for example.

I would counter-argue that deliberately tamping down the growth rate doesn't do you any favors either -- then you don't get widely used, which for most apps is the whole reason to exist.

My larger point is that if your app succeeds on Facebook, expect to have to do a lot of heavy lifting on your back end and to spend a lot of money on hardware and bandwidth -- just like if you built a web app that succeeded outside Facebook, of course.

Some commenters have proposed that Amazon's EC2 service would be a way to easily scale a Facebook app (or a non-Facebook web app). I think EC2 is a great service and have no desire to say anything negative about it. So I will just say two things: it isn't as easy as that, and EC2 is not free either. Bonus points to commenters who want to go into more detail on these topics than I have here!

Appendix -- some interesting links:

• Techcrunch's Facebook Platform launch coverage
• VentureBeat's launch coverage
• Dare Obasanjo's launch coverage
• Paul Allen's (no, the other one) launch coverage
• David Kirkpatrick's first Fortune article
• David Kirkpatrick's second Fortune article
• Josh Kopelman on MySpace vs Facebook
• David Sacks on Facebook vs portals
• VentureBeat interview with ILike CEO Ali Partovi shortly after ILike's launch on Facebook
• Needham report on Facebook from April 2007
• Inside Facebook -- a blog on all things Facebook
• Inside Facebook's review of 25 Facebook applications
• Mashable's review of 30 Facebook applications
• Webware's review of 5 Facebook applications
• Mashable's 10 awesome things built on the original Facebook API

The truth about venture capitalists, Part 3

Bonus chapter!

(This will be the last post on venture capital for a while, if I can help it.)

The current venture capital environment in the United States is characterized by a very large number of venture firms (866, according to the National Venture Capital Association), investing an extraordinarily large amount of capital (over $7 billion in the first quarter of 2007 alone, according to Price Waterhouse).

Traditionally the venture capital industry was said to experience a "seven fat years, seven lean years" model -- seven years of boom, followed by seven years of bust.

Following that pattern, the late 60's/early 70's were great (the "-tronics" boom -- this is when Intel was funded by Arthur Rock), the mid-70's were terrible, 1978-1985 was great (the PC!), '86-92 was terrible, '93-99 was fantastic, and '00-06 was not so good.

As you'd expect, inflows of capital to venture firms during the lean years typically shrank dramatically -- venture capital returns are terrible during the lean years, and who in their right mind wants to put more money into an investment vehicle with terrible returns?

This capital inflow shrinkage would then lead to a significant percentage of venture firms closing their doors (technically, not raising new funds -- the venture capital firm equivalent of going under) -- especially the newer, less proven ones.

Ultimately, capital inflows would shrink to the point where the remaining venture firms were managing a much smaller base of cash, which primed the pump for dramatic investment returns over the next seven fat years: less capital + a new wave of high-growth startups = explosive investment returns.

That is the cycle that has played out every time -- except this time.

Let's examine that $7 billion invested by venture firms in the first quarter of 2007.

Annualized, that is an annual investment rate of about $28 billion per year.

Pulling the data on venture capital investing by year over the last 10 years, we see that this is, as you might expect, substantially lower than 1999's $54 billion and 2000's $105 billion (what a year!)...

...but, higher than 1997's $15 billion and 1998's $21 billion.

And that rate of investment has been broadly consistent for the last several years -- in fact, it's been trending up.

Even when you adjust for inflation, venture capital funding is flowing into venture firms and out to startups at a higher rate in 2007 than in 1997 and 1998.

Those of you remember 1997 and 1998 will remember that those were true boom times for venture capital. The returns on funds from '93-95 were extraordinary -- some of the best ever -- and limited partners were shoveling money into venture firms, leading VCs to fund new companies as fast as they possibly could.

Yet, despite disastrous venture returns on average from 2000-2006, the cash spigot from investors in venture capital firms continues to be wide open to a level where VCs can be more active in 2007 than they were in 1998.

While some older, stale venture firms have recently shut down -- Sevin Rosen and Yankee come to mind -- the rate of venture firm death has not been anywhere close to what you'd expect, and in fact many new funds have been formed and raised money in the last few years.

And the cash just keeps on coming.

Somehow we've ended up in a paradox: venture capital returns, on average, have been terrible, but contrary to historical precedent, the money keeps flooding in, venture firms keep going, and you have more money chasing deals than you did in the middle of the dot com boom.

How can we explain this?

In a nutshell:

Institutional investors who invest in venture funds -- large university endowments, philanthropic foundations, and pension funds -- began radically shifting their investment strategies in the early to mid 1990's, and that shift has led to private equity generally, and venture capital specifically, becoming a permanent "asset class" for those investors.

I call this the "asset-classization" of venture capital.

Here's how it works:

A large institutional investor like a university endowment runs its investment strategy with a top-down approach that says, we'll put x% in stocks, y% in bonds, and so on -- this is called asset allocation.

The actual details of which stocks, which bonds, etc. are less important -- the big decision is what percentage of the total capital to put in which asset classes, because when you run a huge pool of capital, that's what mathematically drives your returns. (You can't put enough money into any single investment to really move the needle, at least not without being irresponsible, so you have to think in broad strokes -- in terms of asset classes.)

Traditionally, such large institutional investors were quite conservative. An asset allocation that was perhaps 60% US equities, 30% US bonds, and 10% cash would not have been unreasonable.

Really daring institutional investors might have allocated some percentage to non-US equities, or (gasp) high-yield "junk" bonds.

This all started to change in the late 80's and early 90's when a group of advanced thinkers, such as David Swensen, then and now head of the Yale University endowment, crunched the numbers and realized that if they had a long-term time horizon (which they did -- Yale and its peers are expected to be around for some time), they could generate higher returns by allocating more of their capital to so-called "alternative asset classes" -- basically, anything other than public stocks, bonds, and cash.

This meant hedge funds, real estate partnerships, commodities, timber, leveraged buyout firms -- and venture capital.

To read about this new strategy -- and it is a fascinating strategy -- pick up a copy of David Swensen's excellent book Pioneering Portfolio Management, which describes his approach in detail. (Be sure to also pick up a copy of his book for individual investors -- Unconventional Success -- which explains why you can't pursue this strategy without getting your clock cleaned.)

The institutions such as Yale and its peers that adopted a Swensen-style strategy did fantastically well in the 1990's, and outperformed (technically, "kicked the ass of") any institution that had an older, more conservative investment policy.

This predictably led a significant number of institutions to shift massively into alternative investments and venture capital in the late 90's, just in time to get hammered by the crash of 2000-2002.

Here's the interesting part: that hammering -- by people who, say, only started investing in venture funds in 1999 -- has not resulted in a significant pullback on the part of institutional investors from venture capital.

Instead, venture capital has become an apparently permanent asset class of many large institutional investors -- and increasingly, smaller institutional investors.

Those institutional investors are managing so much money -- literally trillions of dollars -- that even a very small asset allocation to venture capital represents an enormous amount of cash -- tens of billions of dollars per year.

An organization called NACUBO (don't ask) tracks asset allocation behavior of university endowments, and tells us that the average large ($1+ billion) university endowment had a 3.5% asset allocation to venture capital in 2006.

3.5% of a ginormous amount of money is a lot of money.

But it's a small percentage of the total base, so apparently what's been happening is that although returns on venture capital have been poor (technically, "sucking") for the last several years, institutions that invest in venture capital are not taking that much actual pain on their overall asset bases, and they don't see that many better alternatives, and so they're sticking with their overall asset allocations and therefore sticking with venture capital.

You can argue that this is smart -- that such institutions are very well set up for the next venture capital boom, and that they will do very well over the next 10-20 years with this strategy -- versus the old approach of pulling out just before the sector was set to boom again.

You can also argue that this is not smart -- that this is leading to more venture dollars chasing few good deals and long-run terrible returns for everyone. Particularly since historically, most of the positive returns for venture capital have gone to the top 10% of venture firms -- or maybe even the top 10 venture firms -- and most of the money going into venture capital as an asset class by definition is going into the other 90% of venture firms.

But regardless, it does seem to be the case.

And that's why, from where I sit in Silicon Valley, there are probably 200 venture capital firms within 20 miles with likely over $20 billion of capital at their disposal chasing a very small number of good potential investments, despite terrible average returns for the asset class over the last seven years.

I love this country.

The truth about venture capitalists, Part 2

As promised:

Comparing venture firms, and comparing partners within firms:

When raising venture capital, remember that venture firms vary wildly in style and quality.

For example, some venture firms are very entrepreneur-friendly. Others are notoriously brutal.

Interestingly, financial success in the venture capital profession does not seem to be correlated to entrepreneur-friendliness.

Individuals (partners) within each venture firm vary wildly in style, personality, knowledge, experience, ability to be helpful, drive, and ethics.

Personally I'd recommend being more focused on picking the right partner than picking the right firm.

This is slightly counterintuitive advice -- and firm quality does matter -- but the partner is the person you're going to be working with. The other people at the firm you will see probably twice in the whole lifespan of your company.

Best of both worlds is to pick a strong partner at a strong firm, but be aware going in that even strong firms have weak partners.

Venture capital professionals arguably used to be a more homogeneous group: the founders and pioneers of the business, and their hand-picked proteges who had grown up as venture capitalists under close supervision and with rigorous training.

The explosion of venture capital in the late 90's has led to a much broader range of people becoming partners in venture capital firms.

Many partners today have little venture capital experience but come out of an operating background (an executive role at a big company, or experience as an entrepreneur with their own startup), or come out of some other background (corporate attorney or executive recruiter), or come straight out of business school with no meaningful experience whatsoever.

There are pros and cons to working with any of these kinds of partners.

For example, VCs with operating experience are great when it comes to sitting down and talking about how to run a business, but sometimes they have less perspective (because their career was probably focused on one or two companies, whereas a professional VC has probably invested in 30+ companies), and they may have trouble keeping their hands off the steering wheel.

A VC with an executive recruiting background can be incredibly helpful at recruiting -- one of the main areas in which a VC can add value (see below).

And a VC who used to be an attorney can be very helpful when you need to get a parking ticket fixed.

But there's probably still no substitute for the VC who has been a VC for 20 years and has seen more strange startup situations up close and personal than you can imagine.

A venture capitalist's ideal investment:

A venture capitalist's ideal investment is the one that would be a huge success without her.

How much help, and what kinds of help, you can expect from your VC:

Assuming your startup does not fall in the category of a VC's ideal investment, what kinds of help can you hope for from your VC?

First, it's important to really internalize that the founders of a startup are the ones who have to make a startup succeed.

Odds are, nothing your VC does, no matter how helpful or well-intentioned, is going to tip the balance between success and failure.

In addition, VCs are -- usually -- incredibly busy people. Sitting on as many as a dozen boards, sourcing new investments, tracking the fast-moving technology industry, raising money and managing their LPs, and pitching in on their partners' companies and their problems takes up a lot of time.

(Although every once in a while you will run into a VC who is lazy as sin -- but that's a topic for another post, when I've had more to drink.)

The best assumption to make is that your VC's primary value add is the cash they are investing.

Then you'll always be surprised on the upside.

Additional areas in which a VC can help include: recruiting, strategy, partner introductions, customer introductions, additional fundraising, and generally being a good sounding board and source of advice and industry knowledge.

Some firms run incredibly helpful programs such as forums in which new consumer Internet startups can interact with major advertisers, for example.

The only real way to find out how much help you can really expect from your new VC is to ask the founders of other companies funded by that same partner.

Finally, never expect the help to just happen unsolicited. If you want it, ask for it proactively.

You actually don't want a VC who provides too much help without being asked. I leave the why as an exercise for the reader.

How VCs spend an awful lot of their time, and why you should feel sorry for them:

My friends who are VCs seem to spend a surprising amount of their time working with their failing companies.

The reason goes right back to the definition of a VC's ideal investment: their winners are succeeding -- they don't need very much help.

Some of the best VCs in the industry spend most of their time on their successes, helping to boost them to higher and higher levels of success.

But generally, life in the VC trenches seems to consist of trying to jumpstart or otherwise fix fatally flawed startups.

Can you imagine how un-fun that would be?

Venture capitalists: soulless and rapacious capitalists, or surprisingly generous philanthropists? Or both?

Here's something surprising about venture capitalists: their primary job is often helping very worthwhile nonprofits build larger and larger endowments to be able to continually make the world a better place.

The largest investors in many top-tier venture capital firms are nonprofits -- particularly universities and large philanthropic foundations.

This is partially because such institutions are very patient investors and have very long time horizons. But this is also partially because many of the top venture capitalists feel a real sense of obligation and mission to help such vital organizations grow and flourish.

Traditionally this has been hard to see because venture capital firms have wrapped the identities of their investors (limited partners, in the lingo) in confidentiality agreements. But more recently, via certain SEC filings and disclosures by public universities, it has become possible to get a glimpse into the investor bases of some of the world's best venture capital firms.

For example, it has been previously well publicized that you can see who Sequoia's investors are by reading the SEC disclosure on the Google/Youtube acquisition.

You can see in that filing that Sequoia's major investors include such universities as Amherst, Brown, Colby, Columbia, and Dartmouth -- and that's just into the D's. Similarly, philanthropic foundations invested in Sequoia include the Ford Foundation, the Moore Foundation, the Irvine Foundation, the Rockefeller Foundation, and the Hewlett Foundation.

This is not unusual.

The best VCs get to improve society in two ways: by helping new companies take shape and contribute new technologies and medical cures into the world, and by helping universities and foundations execute their missions to educate and improve people's lives.

Why we should be thankful that we live in a world in which VCs exist, even if they yell at us during board meetings, assuming they'll fund our companies at all:

Imagine living in a world in which professional venture capital didn't exist.

There's no question that fewer new high-potential companies would be funded, fewer new technologies would be brought to market, and fewer medical cures would be invented.

We should not only be thankful that we live in a world in which VCs exist, we should hope that VCs succeed and flourish for decades and centuries to come, because the companies they fund can do so much good in the world -- and as we have seen, a lot of the financial gains that result flow into the coffers of nonprofit institutions that themselves do huge good in the world.

Remember, professional venture capital has only existed in its modern form for about the last 40 years. In that time the world has seen its most amazing flowering of technological and medical progress, ever. That is not a coincidence.

How to make a VC's head explode, in one easy step:

Point out to her that her compensation from carried interest should be taxed as ordinary income, not capital gains, since she's receiving a fee for service and it's not her capital at risk.

The truth about venture capitalists, Part 1

A lot of people have opinions about venture capital -- the pros and cons of VC, whether or not to take VC, which venture capitalists to take money from, how to get VCs to invest in your company, whether VCs are seasoned risk-taking professional investors or psychotic entrepreneur-hating sociopaths, etc.

Often these opinions are based on one individual's specific personal experience with venture capital, and often based on someone's negative experience -- as is often the case, people who have negative experiences are more motivated to tell others than people who have positive experiences.

With that in mind, I will try to provide my hopefully broad perspective on the topic.

I'll just say up front that I don't think my point of view on this is any more valid than that of any of my fellow entrepreneurs -- everyone's experience is different, and this is definitely a topic where reasonable people disagree.

My experience with venture capital includes: being the cofounder of two VC-backed startups that later went public (Kleiner Perkins-backed Netscape and Benchmark-backed Opsware); cofounder of a third startup that hasn't raised professional venture capital (Ning); participant as angel investor or board member or friend to dozens of entrepreneurs who have raised venture capital; and an investor (limited partner) in a significant number of venture funds, ranging from some of the best performing funds ever (1995 vintage) to some of the worst performing funds ever (1999). And all of this over a time period ranging from the recovery of the early 90's bust to the late 90's boom to the early 00's bust to the late 00's whatever you want to call it.

I'm starting to understand why I don't have any hair left.

The most important thing to understand about venture capitalists is that they are in business to do a very specific thing.

They raise a large amount of money -- often $100 million or more -- today, in order to invest in a series of high-risk startups over the next small number of years -- usually 3 to 4 years.

The legal lifespan of the fund is usually 10 years, so that's the absolute outer limit on their investment horizon.

They generally intend, and their investors generally expect, to have the returns from those startups flow back within the next 4 to 6 years -- that's their realistic investment horizon.

Within that structure, they generally operate according to the baseball model (quoting some guy):

"Out of ten swings at the bat, you get maybe seven strikeouts, two base hits, and if you are lucky, one home run. The base hits and the home runs pay for all the strikeouts."

They don't get seven strikeouts because they're stupid; they get seven strikeouts because most startups fail, most startups have always failed, and most startups will always fail.

So logically their investment selection strategy has to be, and is, to require a credible potential of a 10x gain within 4 to 6 years on any individual investment -- so that the winners will pay for the losers and in the timeframe that their investors expect.

From this, you can answer the question of which startups should raise venture capital and which ones shouldn't.

Startups that have a credible potential to be sold or go public for a 10x gain on invested capital within 4 to 6 years of the date of funding should consider raising venture capital.

Most other startups should not raise venture capital. This includes: startups where the founders want to stay private and independent for a long time; startups where there's no inherent leverage in the business model that could result in a 10x gain in 4 to 6 years; and startups working on projects with a longer fuse than 4 to 6 years.

Notably, there are many fine businesses in the world -- many of them highly profitable, and very satisfying to run -- that do not have leverage in their model that makes them suitable for venture capital investment.

By leverage in this context, I mean: the ability to make something once (a piece of software, a chip design, a web site) and sell it (directly or indirectly) to a lot of people (1,000 business customers or 10 million consumers) -- which leads to the classic "hockey stick" revenue projection.

Venture capitalists shouldn't, and can't, invest in companies that don't hit these criteria -- not because they're not good businesses but because their own investors wouldn't stand for it.

There are also many fine entrepreneurs in the world who want their companies to stay small, or who don't want to sell their companies or take them public. That is also well and good, and those entrepreneurs should not raise venture capital.

On the other hand, a business that is built for leverage that could be sold or go public in 4 to 6 years should strongly consider raising professional venture capital, for three reasons:

First, you get the cash to invest in the business and grow it at the speed required to realize its full potential.

It's satisfying to say you don't want to deal with VCs and you want to do it on your own, but if your business has the potential to get big, in my view you should take the cash to invest to make it as big as you can, and that usually requires more capital than you can raise from bootstrapping or from angels.

Second, you get that cash from a professional investor who invests in this kind of business as her full-time job and reason for existence in the world.

Most other possible investors in a high-growth startup will be much more difficult to deal with than a professional venture capitalist.

Third, in the best case, you will get help building your high-growth business from the venture capital partner you take money from (but see more on this in Part 2).

When a venture capitalist turns you down, it isn't personal and it isn't (usually) because she's stupid. Instead, it's often for one of these reasons:

One, she can't see the leverage -- she can't see you getting to a sale or IPO with a credible prospect of a 10x return within 4 to 6 years. If she can't see this, and 10 of her peers at other firms can't see it, then you may want to revisit your fundamental business model assumptions and try to understand what's missing.

Remember, it's in her best interest to see the full potential in your business -- she is looking for high-potential startups in which to invest.

Two, she thinks that what you're doing is too early or unproven.

This is the one that drives entrepreneurs nuts. Isn't the whole point of venture capital to make risky investments in unproven technologies and markets?

Unfortunately, that's life -- sometimes things are simply too early for venture capital. In that case, develop your idea further with bootstrap or angel funding and then take it back to the VCs later with more proof points.

Three, she isn't convinced that you've assembled the right team to go after the opportunity. This usually means she doesn't think your technical founder(s) are strong enough, or she doesn't think your founding CEO is strong enough. Again, it's in her best interest to see the potential in the team if it's there -- so if she and 10 of her peers pass on your startup because of concerns about the team, then you may want to rethink your team.

There are many other reasons in addition to these that a VC may pass on your investment that have nothing to do with you:

She loves it but she can't talk her partners into it -- which happens.

She's fully committed and doesn't have time to take on a new opportunity.

It would require travelling and she can't or won't do that.

You're in a market she doesn't know much about.

Or, she had a bad experience with a similar investment in the past.

The frustrating part is that she won't always tell you why she's passing -- in large part because she wants to keep the door open to investing at a later date if things change (i.e. if it becomes clearer that you have a home run on your hands).

For that reason, whenever a VC passes and explains why, no matter how mean or unfair they sound, the best response is to thank them for their honesty.

I'm trying to keep these posts from getting too long, so I'll stop here, but tantalize you with the topics to be covered in Part 2:

• Comparing venture firms, and comparing partners within firms.
• The VC's ideal investment.
• How much help, and what kinds of help, you can expect from your VC.
• How VC's spend an awful lot of their time, and why you should feel sorry for them.
• VCs: soulless and rapacious capitalists, or surprisingly generous philanthropists? Or both?
• Why we should be thankful that we live in a world in which VCs exist, even if they yell at us during board meetings, assuming they'll fund our companies at all.
• And, how to make a VC's head explode.

How to hire the best people you've ever worked with

There are many aspects to hiring great people, and various people smarter than me have written extensively on the topic.

So I'm not going to try to be comprehensive.

But I am going to relay some lessons learned through hard experience on how to hire the best people you've ever worked with -- particularly for a startup.

I'm going to cover two key areas in this post:

Criteria: what to value when evaluating candidates.

And process: how to actually run the hiring process, and if necessary the aftermath of making a mistake.

Criteria first.

Lots of people will tell you to hire for intelligence.

Especially in this industry.

You will read, hire the smartest people out there and your company's success is all but guaranteed.

I think intelligence, per se, is highly overrated.

Specifically, I am unaware of any actual data that shows a correlation between raw intelligence, as measured by any of the standard metrics (educational achievement, intelligence tests, or skill at solving logic puzzles) and company success.

Now, clearly you don't want to hire dumb people, and clearly you'd like to work with smart people.

But let's get specific.

Most of the lore in our industry about the role of intelligence in company success comes from two stratospherically successful companies -- Microsoft, and now Google -- that are famous for hiring for intelligence.

Microsoft's metric for intelligence was the ability to solve logic puzzles.

(I don't know if the new, MBA-heavy Microsoft still does this, but I do know this is how Microsoft in its heyday worked.)

For example, a classic Microsoft interview question was: "Why is a manhole cover round?"

The right answer, of course, is, "Who cares? Are we in the manhole business?"

(Followed by twisting in your chair to look all around, getting up, and leaving.)

Google, on the other hand, uses the metric of educational achievement.

Have a PhD? Front of the line. Masters? Next. Bachelor's? Go to the end.

In apparent direct contraction to decades of experience in the computer industry that PhD's are the hardest people to motivate to ship commercially viable products -- with rare exception. (Hi, Tim! Hi, Diego!)

Now, on the one hand, you can't question the level of success of either company.

Maybe they're right.

But maybe, just maybe, their success had a lot to do with other factors -- say, huge markets, extreme aggressiveness, right time/right place, key distribution deals, and at least in one case, great products.

Because here's the problem: I'm not aware of another Microsoft that's been built by hiring based on logic puzzles. And I'm not aware of another Google that's been built by hiring PhD's.

So maybe there are other hiring criteria that are equally, or more, important.

Here's what I think those criteria are.

First, drive.

I define drive as self-motivation -- people who will walk right through brick walls, on their own power, without having to be asked, to achieve whatever goal is in front of them.

People with drive push and push and push and push and push until they succeed.

Winston Churchill after the evacuation of Dunkirk:

"We shall not flag or fail. We shall go on to the end, we shall fight in France, we shall fight on the seas and oceans, we shall fight with growing confidence and growing strength in the air, we shall defend our Island, whatever the cost may be, we shall fight on the beaches, we shall fight on the landing grounds, we shall fight in the fields and in the streets, we shall fight in the hills; we shall never surrender."

That's what you want.

Some people have it and some people don't.

Of the people who have it, with some of them it comes from guilt, often created by family pressure.

With others, it comes from a burning desire to make it big.

With others, it comes from being incredibly Type A.

Whatever... go with it.

Drive is independent of educational experience, grade point averages, and socioeconomic background.

(But Marc, isn't a 4.0 GPA a sure sign of drive? Well, it's a sign that the person is driven to succeed on predefined tests with clear criteria and a grader -- in an environment where the student's parents are often paying a lot of money for the privilege of having their child take the tests. That may or may not be the same thing as being driven to succeed in the real world.)

Drive is even independent of prior career success.

Driven people don't tend to stay long at places where they can't succeed, and just because they haven't succeeded in the wrong companies doesn't mean they won't succeed at your company -- if they're driven.

I think you can see drive in a candidate's eyes, and in a candidate's background.

For the background part, I like to see what someone has done.

Not been involved in, or been part of, or watched happen, or was hanging around when it happened.

I look for something you've done, either in a job or (often better yet) outside of a job.

The business you started and ran in high school.

The nonprofit you started and ran in college.

If you're a programmer: the open source project to which you've made major contributions.

Something.

If you can't find anything -- if a candidate has just followed the rules their whole lives, showed up for the right classes and the right tests and the right career opportunities without achieving something distinct and notable, relative to their starting point -- then they probably aren't driven.

And you're not going to change them.

Motivating people who are fundamentally unmotivated is not easy.

But motivating people who are self-motivated is wind at your back.

I like specifically looking for someone for which this job is their big chance to really succeed.

For this reason, I like hiring people who haven't done the specific job before, but are determined to ace it regardless.

I also like specifically looking for someone who comes from some kind of challenging background -- a difficult family situation, say, or someone who had to work his/her way through school -- who is nevertheless on par with his/her more fortunate peers in skills and knowledge.

Finally, beware in particular people who have been at highly successful companies.

People used to say, back when IBM owned the industry: never hire someone straight out of IBM. First, let them go somewhere else and fail. Then, once they've realized the real world is not like IBM, hire them and they'll be great.

And remember, an awful lot of people who have been at hugely successful companies were just along for the ride.

Career success is great to look for -- but it's critical to verify that the candidates out of hugely successful companies actually did what they claim in their roles at those companies. And that they really get it, that the real world is a lot tougher than being IBM in the 80's, or Microsoft in the 90's, or Google today.

Second criterion: curiosity.

Curiosity is a proxy for, do you love what you do?

Anyone who loves what they do is inherently intensely curious about their field, their profession, their craft.

They read about it, study it, talk to other people about it... immerse themselves in it, continuously.

And work like hell to stay current in it.

Not because they have to.

But because they love to.

Anyone who isn't curious doesn't love what they do.

And you should be hiring people who love what they do.

As an example, programmers.

Sit a programmer candidate for an Internet company down and ask them about the ten most interesting things happening in Internet software.

REST vs SOAP, the new Facebook API, whether Ruby on Rails is scalable, what do you think of Sun's new Java-based scripting language, Google's widgets API, Amazon S3, etc.

If the candidate loves their field, they'll have informed opinions on many of these topics.

That's what you want.

Now, you might say, Marc, that's great for a young kid who has a lot of spare time to stay current, but what about the guy who has a family and only has time for a day job and can't spend nights and weekends reading blogs and staying that current?

Well, when you run into a person like that who isn't current in their field, the other implication is that their day job isn't keeping them current.

If they've been in that job for a while, then ask yourself, is the kind of person you're looking for really going to have tolerated staying in a day job where their skills and knowledge get stale, for very long?

Really?

Remember -- because of the Internet, staying current in any field no longer costs any money.

In my experience, drive and curiosity seem to coincide pretty frequently.

The easiest way to be driven is to be in a field that you love, and you'll automatically be curious.

Third and final criterion: ethics.

Ethics are hard to test for.

But watch for any whiff of less than stellar ethics in any candidate's background or references.

And avoid, avoid, avoid.

Unethical people are unethical by nature, and the odds of a metaphorical jailhouse conversion are quite low.

Priests, rabbis, and ministers should give people a second chance on ethics -- not hiring managers at startups.

'Nuff said.

One way to test for an aspect of ethics -- honesty -- is to test for how someone reacts when they don't know something.

Pick a topic you know intimately and ask the candidate increasingly esoteric questions until they don't know the answer.

They'll either say they don't know, or they'll try to bullshit you.

Guess what. If they bullshit you during the hiring process, they'll bullshit you once they're onboard.

A candidate who is confident in his own capabilities and ethical -- the kind you want -- will say "I don't know" because they know that the rest of the interview will demonstrate their knowledge, and they know that you won't react well to being bullshitted -- because they wouldn't react well either.

Second topic: process -- how to run the hiring process.

First, have a written hiring process.

Whatever your hiring process is -- write it down, and make sure everyone has a copy of it, on paper.

It's continually shocking how many startups have a random hiring process, and as a result hire apparently randomly.

Second, do basic skills tests.

It's amazing how many people come in and interview for jobs where their resume says they're qualified, but ask them basic questions about how to do things in their domain, and they flail.

For example, test programmers on basic algorithms -- linked lists, binary searches.

Just in pseudocode -- it doesn't matter if they know the relevant Java library calls.

It does matter if they are unable to go up to the whiteboard and work their way through something that was covered in their first algorithms course.

A lot of people come in and interview for programming jobs who, at their core, can't program.

And it's such a breath of fresh air when you get someone who just goes, oh yeah, a linked list, sure, let me show you.

The same principle applies to other fields.

For a sales rep -- have them sell you on your product all the way to a closed deal.

For a marketing person -- have them whiteboard out a launch for your new product.

Third, plan out and write down interview questions ahead of time.

I'm assuming that you know the right interview questions for the role -- and frankly, if you don't, you probably shouldn't be the hiring manager for that position.

The problem I'm addressing is: most people don't know how to interview a candidate.

And even people who do know how, aren't necessarily good at coming up with questions on the fly.

So just make sure you have questions planned out and assigned to each interviewer ahead of time.

I do this myself -- always enter the room with a list of questions pre-planned -- because I don't want to count on coming up with them on the fly.

The best part is that you can then iteratively refine the questions with your team as you interview candidates for the position.

This is one of the best ways for an organization to become really good at hiring: by iterating the questions, you're refining what your criteria are -- and how you screen for those criteria.

Fourth, pay attention to the little things during the interview process.

You see little hints of things in the interview process that blow up to disasters of unimaginable proportions once the person is onboard.

Person never laughs? Probably hard to get along with.

Person constantly interrupts? Egomaniac, run for the hills.

Person claims to be good friends with someone you know but then doesn't know what the friend is currently doing? Bullshitter.

Person gives nonlinear answers to simple questions? Complete disorganized and undisciplined on the job.

Person drones on and on? Get ready for hell.

Fifth, pay attention to the little things during the reference calls.

(You are doing reference calls, right?)

Most people softball deficiencies in people they've worked with when they do reference calls.

"He's great, super-smart, blah blah blah, but..."

"Sometimes wasn't that motivated" -- the person is a slug, you're going to have to kick their rear every morning to get them to do anything.

"Could sometimes be a little hard to get along with" -- hugely unpleasant.

"Had an easier time working with men than women" -- raging sexist.

"Was sometimes a little moody" -- suffering from clinical depression, and unmedicated.

You get the picture.

Sixth, fix your mistakes fast... but not too fast.

If you are super-scrupulous about your hiring process, you'll still have maybe a 70% success rate of a new person really working out -- if you're lucky.

And that's for individual contributors.

If you're hiring executives, you'll probably only have a 50% success rate.

That's life.

Anyone who tells you otherwise is hiring poorly and doesn't realize it.

Most startups in my experience are undisciplined at fixing hiring mistakes -- i.e., firing people who aren't working out.

First, realize that while you're going to hate firing someone, you're going to feel way better after the fact than you can currently imagine.

Second, realize that the great people on your team will be happy that you've done it -- they knew the person wasn't working out, and they want to work with other great people, and so they'll be happy that you've done the right thing and kept the average high.

(The reason I say "not too fast" is because your great people are watching to see how you fire people, and if you do it too fast you'll be viewed as arbitrary and capricious -- but trust me, most startup managers do not have this problem, they have the opposite problem.)

Third, realize that you're usually doing the person you're firing a favor -- you're releasing them from a role where they aren't going to succeed or get promoted or be valued, and you're giving them the opportunity to find a better role in a different company where they very well might be an incredible star.

(And if they can't, were they really the kind of person you wanted to hire in the first place?)

One of the good things about our industry is that there are frequently lots of new jobs being created and so you're almost never pushing someone out onto the street -- so don't feel that you're dooming their families to the poorhouse, because you aren't.

You're not that important in their lives.

I can name a number of people I've fired or participated in firing who have gone on to be quite successful at other companies.

They won't necessarily talk to me anymore, though :-).

Finally, although this goes without saying: value the hell out of the great people you do have on your team. Given all of the above, they are incredibly special people.

Why there's no such thing as Web 2.0

Proposed: There's no such thing as Web 2.0.

Well, that's not actually true.

Let me back up.

Here's what I think happened.

In the beginning, Web 2.0 was a conference.

As conferences go, a good one -- with a great name.

The first Web 2.0 conference was held in the fall of 2004, and coincided with a large number of people in the tech industry (myself included) peeking our heads out from the fallout from the nuclear winter of 2001-2003 and realizing that the Web was not only not dead, it was thriving.

From there, it was easy to conclude that "Web 2.0" was a thing, a noun, something to which you could refer to explain a new generation of Web services and Web companies.

Many people have since pointed out that there is no clear definition of Web 2.0.

Tim O'Reilly, whose organization created the conference (and the term), attempted to define Web 2.0 as follows:

"Web 2.0 is the network as platform, spanning all connected devices; Web 2.0 applications are those that make the most of the intrinsic advantages of that platform: delivering software as a continually-updated service that gets better the more people use it, consuming and remixing data from multiple sources, including individual users, while providing their own data and services in a form that allows remixing by others, creating network effects through an "architecture of participation," and going beyond the page metaphor of Web 1.0 to deliver rich user experiences."

This is, believe it or not, the short definition.

The long one was much, much longer.

Tim's a wonderful guy, a friend, and a true pioneer, but if the creator of the term can't come up with a crisper definition than that, what hope do the rest of us have?

I believe the reality is this: what we have seen over the last several years is the Web itself coming into its own.

After an initial phase of the Web as a medium, in which lots of people attempted to make the Web look like a newspaper, or a magazine, or a TV channel, we as an industry have recently been collectively developing a much clearer idea of what the Web is really like as a medium in and of itself.

This has led to broad realization of a set of design patterns for how Web services and Web companies often get built and used.

Which is great.

And of course, many of those design patterns are described by the sub-bullets of Tim's and others' multifaceted definitions of Web 2.0.

And if it is useful for people to refer to those design patterns collectively with a term, then Web 2.0 maybe makes sense.

Personally, I side with those who say "it's just the Web" -- that's matter of semantics and reasonable people can disagree.

But here's the problem.

Web 2.0 has been picked up as a term by the entrepreneurial community and its corollaries in venture capital, the press, analysts, large media and Internet companies, and Wall Street to describe a theoretical new category of startup companies.

Or a "space", if you will.

As in, "Foobarxango.com is in the Web 2.0 space".

At its simplest level, this is just shorthand to indicate a new Web company.

The technology industry has a long history of creating and naming such "spaces" to use as shorthand.

Before the "Web 2.0 space", you had the "dot com space", the "intranet space", the "B2B space", the "B2C space", the "security space", the "mobile space" (still going strong!)... and before that, the "pen computing" space, the "CD-ROM multimedia space", the "artificial intelligence" space, the "mini-supercomputer space", and going way back, the "personal computer space". And many others.

But there is no such thing as a "space".

There is such a thing as a market -- that's a group of people who will directly or indirectly pay money for something.

There is such a thing as a product -- that's an offering of a new kind of good or service that is brought to a market.

There is such a thing as a company -- that's an organized business entity that brings a product to a market.

But there is no such thing as a "space".

And, as far as startups are concerned, there is no such thing as Web 2.0.

What happens when startups start getting referred to as "Web 2.0 startups" -- or for that matter, "B2B startups" or "mobile startups" or "pen computing startups" -- or as being in the Web 2.0/B2B/mobile/pen computing "space" -- is that trends are getting mistaken for markets and products.

You can't build a company based on a trend.

Trends are obvious, and there's no startup opportunity in the obvious.

You have to build a company based on a new kind of product (or service -- I am using the terms interchangeably) and you have to take that product to a market.

It frankly doesn't really matter which trends, or design patterns, you incorporate into your product.

If the product is compelling to the market, it will succeed.

If the product is not compelling to the market, it will fail.

It's not much more complicated than that.

The hard part is creating that new and compelling product. (This is left as an exercise to the reader.)

Spending too much time thinking about trends and "spaces" is a great way for an entrepreneurial team to go right off the rails and bring another derivative product to market, which the market then promptly ignores.

I can't tell you how many pitches I've seen for startups that are chasing the latest trend and have no chance.

And I can't tell you how few pitches I've seen for new and compelling products.

As a result of the widespread adoption of language like "Web 2.0 companies" and the "Web 2.0 space" -- and startups referring to themselves as such, most of which will fail -- you get a predictably cynical backlash from people who then dismiss the whole category as trendy marketing hype full of me-too wannabes and in the process throw out the baby with the bathwater and dismiss all the legitimately new and exciting products and companies that are being created all around us.

As an entrepeneur, I am frankly torn as to whether or not to even post this piece.

It may be in my best interest to have more of my fellow entrepreneurs off chasing trends and pitching their "Web 2.0 startups" to the latest enterprise software VC who is now "doing Web 2.0 deals" instead of building real products that might compete with one of my companies.

But I think there are so many cool new products and companies being created these days -- many of which have little to do with any conventional wisdom around buzzwords -- and I'm so excited about them, and so proud of them on behalf of my industry, that I can't help myself :-).

Bubbles on the brain

It has become commonplace in Silicon Valley and in the blogosphere to take the position that we are in another bubble -- a Web 2.0 bubble, or a dot com bubble redux.

I don't think this is true.

Let's examine the theory of a new bubble from a few different angles.

First, recall that economist Paul Samuelson once quipped, "Economists have successfully predicted nine of the last five recessions."

One might paraphrase this for our purposes as "Technology industry experts have successfully predicted nine of the last five bubbles"... or perhaps more like five of the last one bubbles.

The human psyche seems to have a powerful underlying need to predict doom and gloom.

I suspect this need was evolved into us way back when.

If there is a nonzero chance that a giant man-eating saber-tooth tiger is going to come over the nearest hill and chomp you, then it's in your evolutionary best interest to predict doom and gloom more frequently than it actually happens.

The cost of hiding from a nonexistent giant man-eating saber-tooth tiger is low, but the cost of not hiding from a real giant man-eating saber-tooth tiger is quite high.

So hiding more often than there are tigers makes a lot of sense, if you're a caveman.

But as with other habits ingrained into us by evolution, the habit of predicting doom and gloom when it isn't in fact right around the corner might no longer make sense.

On Wall Street, investors who have this habit are known as "perma-bears" and generally are predicting the imminent collapse of the stock market. This habit keeps them from being fully invested. Sure, they're well protected during the occasional crash of 1929 or 2000, but by and large they massively underperform their peers who take advantage of the fact that most years, the economy grows, and the market goes up. They have disappointing careers and die unhappy and bitter.

In reality it seems very difficult to predict either a bubble or a crash.

Lots of people predicted a stock market crash... in 1995, 1996, 1997, 1998, and 1999. They were correct in 2000. But as soon as the stock market recovered in 2003 and 2004, they were back at it, and there have been similar predictions from noted pundits ever since -- incorrectly.

Similarly, in the technology industry, there were people calling a bubble starting in 1995 and continuing through to 2000, with a short break for about two years, and then more bubble-calling ever since.

If you're going to listen to people who predict bubbles or crashes, you have to be ready to stay completely out of the market -- the stock market, and the technology industry -- almost every year of your life.

Second, historically, bubbles are very, very rare.

It's significant that in books and papers that talk about bubbles, there are simply not that many examples over the past 500 years of capitalism.

You've got the South Sea bubble, the Dutch tulip bulb bubble, the bubble in Japanese stocks in the 1980's, the dot com bubble, and a few others.

They just don't happen that often, at least in relatively developed economies.

And they don't tend to happen more than once in a generation.

(Perhaps because many of the people who go through one are so traumatized that all they can do is sit around and worry about another one.)

Interestingly, modern economic research is in the process of debunking a number of historical bubbles.

It looks increasingly plausible that had US monetary policy been better run in the early 1930's, our view of what happened in the 1920's would be far more benign.

It also turns out that the Dutch tulip bubble is largely a myth.

So generally speaking, if one is going to seriously call a bubble, one has to be aware that one is calling something that is extremely rare.

Third, in the technology industry, lots of startups being funded with some succeeding and many failing does not equal a bubble.

It equals status quo.

The whole structure of how the technology industry gets funded -- by venture capitalists, angel investors, and Wall Street -- is predicated on the baseball model.

Out of ten swings at the bat, you get maybe seven strikeouts, two base hits, and if you are lucky, one home run.

The base hits and the home runs pay for all the strikeouts.

If you're going to call a bubble on the basis of lots of bad startups getting funded and failing, then you have to conclude that the industry is in a perpetual bubble, and has been for 40 years.

Which may be fun, but isn't very useful.

Lots of people running around starting questionable companies, launching marginal products, pitching third-tier VC's, throwing launch parties, shmoozing at conferences, blogging enthusiastically, and otherwise acting bubbly does not a bubble make.

That's just life in this business.

Note also what you don't see in the theoretical Web 2.0 bubble of 2007.

IPO's.

Lots and lots and lots of IPO's.

For a theoretical bubble, that is just plain odd.

Fourth, getting more specific about Internet businesses -- things have changed a lot since the late 90's.

It is far cheaper to start an Internet business today than it was in the late 90's.

The market for Internet businesses today is much larger than it was in the late 90's.

And business models for Internet businesses today are much more solid than they were in the late 90's.

This is a logical consequence of time passing, technology getting more broadly adopted, and the Internet going mainstream as a consumer phenomenon.

People smarter than me have written about these factors at length elsewhere, so I won't dwell on them, unless there is specific interest.

But my back of the envelope calculation is that it is about 10x cheaper to start an Internet business today than it was in the late 90's -- due to commodity hardware, open source software, modern programming technologies, cheap bandwidth, the rise of third-party ad networks, and other infrastructure factors.

And the market size for a new Internet business today is about 10x bigger than it was in the late 90's -- there are about 10x more people online (really!), and they are far more used to doing things on the Internet today than they were in 1999.

(Want evidence of that last point? Clothing purchases are now bigger than computer hardware and software sales online. I can guarantee you that nobody who was involved in ecommerce in the mid-90's ever would have predicted that.)

The Internet is a fully mainstream medium now, people love it, people are willing to do all kinds of things on it, and it's getting really cheap to offer new services to those people.

Fifth, and finally, there's the simple fact that the Internet businesses that are succeeding in 2007 are for the most part incredibly valuable, compelling services that lots of people like and that are in general either making a lot of money or will be making a lot of money quite quickly.

People laughed when Fox bought MySpace for $580 million, but that's a business that will generate nearly $300 million in revenue in 2007, and more in 2008.

As an independent asset today, MySpace would probably be valued at between $3 billion and $5 billion today -- perhaps higher.

Call that the deal of the decade.

Similarly, Facebook is bringing in a lot more revenue than people think.

And then there's Google.

These companies aren't pulling in all that revenue via some kind of Ponzi scheme.

This is money coming from real advertisers and real users for real services with real value.

Which makes total sense, amid the enormous mass migration of consumer time and attention away from traditional media towards online media.

These same factors apply all the way down the foodchain.

A high-growth online startup that gets bought for $100 million or $200 million by a large Internet or media company isn't getting that kind of acquisition price just for the hell of it, but rather because the acquirer can plug that startup's service into its broader portfolio of services and make real money with it.

These are big numbers, but remember, there are more than a billion people online now. That is a very large market -- a lot of people, spending a lot of time, buying a lot of things, in totally new ways at the same time as they are abandoning older services like newspapers, magazines, television, movie theaters, and print catalogs.

So, my view is that to call a bubble, you have to find evidence of it outside of the mainstream of the kinds of Internet businesses that are being built, sold, and run in 2007.

In closing, I'd be the last person to say that I never roll my eyes at the next startup that's doing online wiki-based popularity-ranked video-podcast mobile social dating widgets for the dog and cat owner market.

But a bubble?

I doubt it.

Postscript: I didn't see this until after I wrote my post, but you have to love the opening line: "Grandpa lived through the Depression, and life thereafter was indelibly shaped by haunting memories of soup kitchens and hobos."