REID HOFFMAN IS AN entrepreneur and a partner at the venture capital firm Greylock Partners. A New Yorker profile describes his early career:
His first job was at a short-lived online service at Apple called eWorld. Then he worked at WorldsAway, a “virtual chat” community, owned by Fujitsu, where users interacted through fictionalized graphic representations of themselves. In 1997, Hoffman started his own company, called SocialNet, which created a way for people to connect with each other for various purposes, mainly dating, using pseudonyms.
Hoffman joined the payments provider PayPal in 1999, after selling SocialNet. He was a cofounder and executive chair of LinkedIn before its sale to Microsoft. He serves on the boards of Airbnb, Edmodo, Microsoft, Mozilla, Shopkick, and Wrapp. Hoffman is a coauthor of The Start-Up of You and The Alliance. His passion about issues such as the economic and social impacts of automation, the skills gap, shifting educational and career patterns, and socioeconomic stratification make his views on business and venture capital particularly interesting. The increasing importance of data and networks to competitive advantage is a topic that few know more about than Hoffman.
1. “The top investment is worth the total amount of all the other projects and more. You’re looking for the one high-water mark, not the average. People don’t come to you looking for singles.”
In an excellent essay on venture capital economics, Andy Rachleff notes,
The industry rule of thumb has been to look for deals that have the chance to return 10X your money in five years…. If 20 percent of a fund is invested in deals that return 10X in five years and everything else results in no value, then the fund would have an annual return of approximately 15 percent.
Due to the attention lavished on a few massive startup successes some people fail to understand that there are many businesses one can start that do not require venture capital. On this point, Bill Gurley has said, “If you want to get to fifty to one hundred employees, unless you’ve discovered the next Google AdWords, you’re going to need outside funding, but that doesn’t mean that venture capital investment is right for everyone.” Non-venture capital–backed companies can generate attractive financial returns and can, when selected correctly, have a substantially lower probability of failure. This should not be a surprise since you simply cannot have the failure rate of venture capital–backed businesses and have the winners return only two to five times the capital invested over a similar period.
2. “At a startup or early-stage project, the only massive early-stage projects are where you’re contrarian and right. The projects where everyone agrees often end up having less overall success than the projects where there was some disagreement amongst the board. Where’s the contrarian thinking that, if they turn out to be right, could be really, really big? Consensus indicates it’s probably not a total breakout project. If your thinking isn’t truly contrarian, there’s a dog pile of competitors thinking the same thing, and that will limit your total success.”
Being contrarian is essential to outperforming a market. It is impossible to beat the crowd if you are the crowd. The crowd is usually right, so the tricky part is being able to predict when it is wrong. Just being contrarian for its own sake is a losing strategy. Moreover, of course, the bet must be convex. If you are contrarian, you do not want the upside to be a small return relative to what you put at risk. The best opportunities for a convex bet tend to be in places where other people are not looking. Michael Mauboussin explains this tendency with a simple example:
Being a contrarian for the sake of being a contrarian is not a good idea. In other words, when the movie theater is on fire, run out the door, right? Don’t run in the door…. Successful contrarian investing is not about going against the grain per se; it is about exploiting expectations gaps. If this assertion is true, it leads to an obvious question: How do these expectations gaps arise? Or, more basically, how and why are markets inefficient?
3. “A great founding strategy is contrarian and right. That ensures that, at least for an important initial time, no one is coming after you. Eventually, people will come after you if you’re on to something good.”
It’s so important for early-stage companies to avoid competition because you can’t isolate it to one front. Competition affects you on the customer front, hiring front, and financing and business development fronts—on all of them. When you’re one of n, your job becomes much harder, and it’s hard enough already. Difficult competition with no edge makes for a war of attrition. People may be sucked into ruthlessly competitive situations by the allure of the pot of gold to be had. It’s like rushing the Cornucopia in The Hunger Games instead of running away into the forest.
Having a barrier to entry against competitors (a moat) is essential. Hoffman is saying here that avoiding competition during a startup’s formation period greatly enables moat creation. In other words, it is helpful to have a business operating in a portion of the market that is not a “dog-eat-dog” competition from the beginning. In this sense, being contrarian as an investor has a double benefit: It allows for greater market-beating returns to be found, and it allows the business to grow in a less competitive environment.
4. “People also underestimate how much of an edge you need. It really should be a compounding competitive edge. If your technology is a little better or you execute a little better, you’re screwed. Marginal improvements are rarely decisive.”
Unless your product is 100X better, usually your average consumer will use what they encounter. If others are much more successful at distribution, they have much better viral spread, and they have a better index and SEO, it doesn’t matter if your product is 10X better; the folks don’t encounter it.
Going up against an entrenched competitor with loads of cash, experience, and sales, marketing, and distribution channels is so difficult that you need a significant edge to win. Convincing a customer to move to a new product or service is hard work if the new offering is only slightly better. In other words, the cost of customer acquisition drops as the value premium over the competitor’s product or service rises. When thinking about whether a product or service has core product value, Andy Johns suggests that it’s important to ask two key questions: Is the problem your product is solving painful to and important for your customers, and is there a sizable market behind this problem? He adds, “Some firms create new, meaningful experiences, rather than solving an existing, painful problem. One could count Facebook, Twitter, Snapchat, Instagram, and others in this group.”
5. “You want to start building a company one to four years, maybe five years, in advance. This means that when the technology converges with the world you see coming you’re positioned to capitalize. You have to be right about a set of things, including what your competitors are going to do.”
The great hockey player Wayne Gretzky is famous for saying “I skate to where the puck is going to be, not where it has been.” One way to find “where the puck is going to be” is to profit from the inability of people to understand the exponential phenomenon. Bill Gates said once, “When things are improving so rapidly, how do you create a model in your head? Computers are doubling in power, relative to the price, about every eighteen months. Most humans don’t have a situation where something doubles in its power every two years.” The difficulty that most people have in understanding some phenomena creates mispriced opportunities for investors.
Being genuinely contrarian as an investor means being uncomfortable sometimes. Some people are good at being uncomfortable, and some are not. Peter Lynch has said, “To make money, you must find something that nobody else knows, or do something that others won’t do because they have rigid mindsets.” Successful investing is the search for the mistakes of other people that may create a mispriced asset, says Howard Marks. In other words, one person’s mistake about the value of an asset is what can create an opportunity for another investor to outperform the market. People who are curious and hardworking are best at doing this kind of searching. Great investors hustle, have a huge scuttlebutt network, and read constantly. They are constantly trying to learn more about more things, and they know that the more they know, the more they will know that there is even more they do not know. If you are not getting more humble over time, you have a flawed system.
Mr. Market’s irrationality creates opportunity for investors. Markets are often wise but not always. The best returns accrue to investors who are patient yet aggressive when they are offered an attractive price for an asset. Seth Klarman says, “Successful investing is the marriage of a calculator and a contrarian streak.”
6. “Silicon Valley … should now be called Software Valley.”
Software delivered over networks drives financial returns in the venture capital business because the hardware is relatively ubiquitous. You can purchase it on demand and in many cases is already in place—most notably in smartphones. Advances in silicon drive the exponential phenomenon, but the companies that surf this wave are primarily software driven. Yes, there are important and successful hardware startups and, yes, 3D printers and such. In most cases, when you look at a company that has achieved a grand-slam financial return, it is software or software-enabled cloud-based services driving the innovation and new customer value. There are also inevitably many vitally important software engineers working in what some people would call a hardware business.
7. “Having a great product is important, but having great product distribution is more important. I meet many entrepreneurs who think the best product is the most important thing and that the best product should always win. What many people fail to realize is that without great distribution, the product dies. How will you get your product in the hands of millions or hundreds of millions of people?”
Excellent product distribution is not optional. Customers do not magically appear at a company’s doorway holding stacks of hundred-dollar bills ready to buy whatever a business is selling. An entrepreneur must either learn how to create great product distribution or find someone who knows how to do so.
8. “In tech, if you’re not continually thinking about catching the next curve, one of the next curves will get you. Yahoo owned the front end of the Internet in 2000. It had the perfect strategy. However, it did not adapt; it failed at social and other trends; and that didn’t go so perfectly. Just over a decade later, having missed some very key tech curves, it’s in a very different position.”
Because significant phenomena can emerge from complex adaptive systems with essentially no warning, you can find yourself in deep trouble for a mistake you made several years before. Looking back at the cause of what is killing a business now, the outcome may seem obvious, but that is the nature of complex adaptive systems. What is understandable retroactively is not predictable prospectively. “Missing a curve” can send a business flying over a precipice. The inverse is also true: If you can catch the next curve, it can propel your business in a nonlinear manner.
9. “If you are not embarrassed by the first version of your product, you’ve launched too late.”
Product and market fit requires you to figure out the earliest tells. How do you bring in as much networked intelligence into that process as possible? In Silicon Valley, you bring in new advisers, employees, customers. What you are trying to figure out is, is the path I’m trying to build the company around accurate? Most people begin with the financing process as a series of hoops to get a degree of money in the bank. Nevertheless, the most interesting thing about the investment process is getting network intelligence on the critical questions of, “Is this a good plan?” “What is the piece of common intelligence about my project?” “What are the risks in their investment?”
When you have an idea for a startup, consult your network. Ask people what they think. Don’t look for flattery. If most people get it right away and call you a genius, you’re probably screwed; it likely means your idea is obvious and won’t work. What you’re looking for is a genuinely thoughtful response.
An idea that is not exposed to feedback from a robust and diverse network of trustworthy, smart individuals is not going to get better or attract the people needed to translate it into a success. Your competitors will be doing this if you do not. The winners in today’s economy are the businesses that adapt best to change, and you cannot change effectively without great sources of feedback.
10. “So many entrepreneurs are worried about protecting their precious ideas, but the truly valuable thing is that you’re in motion, you have momentum, and you are gathering all the necessary resources to make it happen.”
We’re moving from an information age to a network age. Part of that is how do you increase the possibility of a positive outcome from serendipity? There’s still luck, but you can increase the probability of the right decisions made. When you have a problem connecting challenges and solutions, that involves connections in a human network.
An idea without execution is not going to get anyone very far in business. Everyone has ideas for businesses and may think, “I thought of that first,” when they see success. Winning in the market requires doing things, not just generating new ideas. Scott Belsky agrees with Hoffman:
Ideas are worthless if you can’t make them happen. Generating new ideas is easy. Executing is hard. Whether it’s an everyday problem or a bold new concept, you must transform vision into reality for an idea to have value…. All great inventions emerge from a long sequence of small sparks; the first idea often isn’t all that good, but thanks to collaboration it later sparks another idea, or it’s reinterpreted in an unexpected way. Collaboration brings small sparks together to generate breakthrough innovation…. The hyperconnectivity made possible by the Internet has acted as a massive accelerator for the ‘small sparks’ that fuel the refinement of ideas.
11. “Entrepreneurs are often given two pieces of contradictory advice: persistence and flexibility. Have a vision and pursue it through years of people telling you you’re out of your mind. Alternatively, be flexible: Look at data, iterate, and change based on the signals you’re getting. There isn’t an actual algorithm. You have an investment thesis about why this project is likely to work and have some outside result, and usually, that’s expressed in a set of statements and hypotheses, that if you’re right about, adds up like a logical proof and gives you the output you’re looking for. Moreover, you can have varying levels of confidence in how these pieces are adding up and supporting your theses. The challenge is to follow them both, but know which advice is most appropriate for which situation. You must know how to maintain flexible persistence.”
This is an example of a contradiction that Scott Belsky describes in the foreword to this book. There is no substitute for good judgment in determining the right mix of flexibility and persistence. Good judgment comes from making bad judgments but learning from the experience. Some people learn from mistakes better than others and make mostly new mistakes rather than repeating old ones. If you learn from mistakes, you will have a better life. Being a learning machine pays big dividends. It is wise to be a learn it-all-rather than a know-it-all.
12. “It’s not that everyone should start a company, it’s the fact that a career ladder is no longer a strong model for how you do your work and pursue your career. The good grades to good university to good career path model has been broken for years, by globalization and technology’s disruption of the industry. The model for how to think about your life, career, and work is different. How entrepreneurs think about product–market fit, product differentiation, creative risks, all apply to how you, as an individual, live your life.”
The network of people around you is what extends your ability to be effective regarding expertise and reaching your goals. Put yourself out there and get feedback. Don’t be afraid to take a risk.
The notion of a career has changed. Whereas we used to have a career ladder, now we have a career jungle gym. Success in a career is no longer a simple ascension on a path of steps. You need to climb sideways and sometimes down; sometimes you need to swing and jump from one set of bars to the next. In addition, to extend the metaphor, sometimes you need to spring from the jungle gym and establish your turf somewhere else on the playground. In addition, if we want the playground metaphor to describe the modern world, neither the playground nor the jungle gym is fixed. They are always changing—new structures emerge, old structures are in constant change and sometimes collapse, and the playground constantly moves the structure around.
Another huge thing to emphasize is the importance of your network. Get to know smart people. Talk to them. Stay current on what’s happening. People see things that other people don’t. If you try to analyze it all yourself, you miss things. Talk with people about what’s going on. Theoretically, startups should be distributed evenly throughout all countries and all states. They’re not. Silicon Valley is the heart of it all. Why? The network. People are talking to each other.
Networks of all kinds are of increasing importance. However, many of these modern networks are different from the networks people had in mind when they repeated the adage “It’s not what you know, but who you know that matters.” Old-school networks were about webs of “influence,” and while that still exists, the types of networks that are important now are more varied. Many systems today involve being able to generate the information and feedback needed to be agile and better informed. As an example, why do some venture capitalists create so much more of the financial returns in the venture capital industry? Simply put, they have the best networks, defined in the broadest possible sense, and the quality of their networks is feeding back on itself to generate even more quality. This is the Matthew effect at work in just one dimension: Better networks get even better as success feeds back on itself.