Class 3 Notes Essay — Reid Hoffman, John Lilly, Chris Yeh, and Allen Blue’s CS183C Technology-enabled Blitzscaling course

Here is an essay version of my class notes from Class 3 of Stanford University’s CS183C — Technology-enabled Blitzscaling — taught by Reid Hoffman, John Lilly, Chris Yeh, and Allen Blue. Errors and omissions are my own. Credit for good stuff is Reid, John, Chris Yeh, and Allen’s entirely.

This class was taught by Michael Dearing — of Harrison Metal and formerly early team member of eBay — accompanied with a Q&A by Reid Hoffman afterwards.

Video of the course (Notes are below)

I. 1,000 Year Historical Context on Scale

This chart shows the GDP per capita (total output per person) over 1,000 years (based on a constant dollar in log scale). Longer explanation about the data sources are here.

Between 1,000–1,800 there was basically no growth in GDP per capita. Since then there has been an incredible rise in productivity and output on a global scale. The inflection point on this curve was the Industrial Revolution.

Why did this period of high growth happen at this point in time vs. other earlier periods of time? A few theories suggest the Industrial Revolution happened when it did because of:

  • Density of the population — more and more people living in cities closer to one another
  • Cheap energy — primarily in the form of coal.
  • Mobility — because of the cheap energy and most notably the creation of railroad systems, it gave people the opportunity to move around.
  • Exchange of ideas — This mobility led to the increased cross-pollination of ideas.

II. Creative Destruction and the Managerial Revolution.

One of the philosophical thinkers about this time period in history is Joseph Schumpeter who wrote Capitalism, Socialism and Democracy. In this book he introduced the concept of “creative destruction” which is:

innovative entry by entrepreneurs was the force that sustained long-term economic growth, even as it destroyed the value of established companies that enjoyed some degree of monopoly power.

Put simply, entrepreneurs create products which completely change how people do things, and put the existing systems out of business. Examples include: typewriters vs. computers, CD’s vs the iPod, and movie rentals vs. Netflix on-demand.

Because of all of the above forces (cheaper energy, greater movement, density of population) the entrepreneurs during this time period had much more leverage and the scale of the companies created during this time period were much larger than ever before in history. Examples include: Carnegie Steel, Standard Oil, New York Central Railroad System, and J.P. Morgan.

Another major thinker of this time period was Alfred D. Chandler who wrote — The Visible Hand: The Managerial Revolution in American Business. Chandler agreed with Schumpeter in that entrepreneurs played a big role in creating new companies but also argued that managers played an equal role in amplifying those entrepreneurs’ ideas.

Along with the Industrial Revolution and capitalism also came the birth of a new science — management.

III. Using Capitalism to Solve our Societal Challenges

One key theme Michael Dearing put forth during the class was this growth and wealth creation through the entrepreneurial process gives entrepreneurs the means to solve our societal problems.

Although the Industrial Revolution brought problems of unequal wealth creation, pollution, environmental damage; at the same time, it gave us the means to create widespread education, improve health, increased life expectancy, and also the means to solve our other problems. All this to say is growth (even with its issues) is better than no growth.

We should celebrate Schumpeter’s entrepreneurialism, embrace managerial capitalism, and use the proceeds to make humanity’s situation better.

IV. Zooming in on the Transportation Revolution

Going back to the timeline of GDP per capita growth we zoomed in on the 1820's during the creation and growth of the railroad industry.

One entrepreneur of this time period.

The railroads were the hot startups of this time period and entrepreneurs were creating and growing these railroad companies to massive scales. One such individual was named Daniel McCallum who worked on the New York and Erie Railroad Company line.

Daniel McCallum started off as a self taught woodworker, specialized in building railroad bridges, became in charge of all bridges, patented his own type of bridge, became Superintendent of the whole company — all this in the span of 10+ years.

One of his key insights was while he was working on a small railroad line, the work was fun, joyful, and he was at ease. However when he was managing the whole operation, all he experienced was pain and suffering of trying to manage a long railroad line.

McCallum’s biggest problem was cost-per-mile. As fast as the railroad grew in size, operating costs grew faster. Where the company should have seen productivity improvement (declining cost per mile), it saw the opposite. Communication, coordination, operations, sales — all became more difficult, not less so, as the railroad grew.
McCallum was at the height of his career, still prototyping how to manage. Remember, there were no business schools or how-to books in 1855. No general manager apprenticeships. McCallum had been taught to engineer and build bridges, not to manage thousands of people across half a continent.

V. Key Management Challenges at Scale

The things McCallum loved about managing a small railroad line were:

  • Having personal connections with his direct reports and workers
  • The ability to make sure things were getting done — by using his own eyes
  • The ability to see the trains moving and know how the system was performing
  • The ability to have respect for one another through the personal interactions

While trying to manage a 5,000 mile railroad line, all of these items went away. What McCallum was trying to do was bring back what he loved about the small railroad line, to the big railroad line.

He experimented by using the telegraph systems to share information, creating the first ever modern organization chart, and creating various management principles from lessons learned.

What is interesting is while these questions were being asked in 1855 — all of these questions are still highly relevant today and none of these core challenges of managing large scale companies have actually been solved.

VI. Question and Answers with Reid Hoffman

Reid Hoffman: Did you get the sense that McCallum was a micro-manager?

Michael Dearing: Absolutely. McCallum came up with an excruciatingly detailed operating model and made people report their status to him every single hour through the telegraph system. He was trying to re-create the intimacy of being there in person without having to be physically next to them.

Reid Hoffman: It sounds like McCallum was the first person to try to systematically attack the scale up problem.

Going back to the 1,000 year curve line it’s clear that one curve is capitalism and another curve is the invention of technology, but the correlation is unclear. How much do you attribute to the incentive system vs. technology system?

Michael Dearing: I think that both incentives and technology are mutually reinforcing. We tried an experiment of this and when you take one away, both would collapse.

Another aspect of this is the set of people who happen to have money, who happen to have great ideas, who happen to have managerial ambitions — is a very small subset of people. When you realize the investor can be different than the inventor can be different than the manager — this allows for a multitude of connections that wouldn't have happened otherwise.

Reid Hoffman: While you were doing your research did you look into the invention of Venture Capital — which was invented very late on this curve post-WW2?

Michael Dearing: The thing you have to look at is the substitutes for venture capital which are rich families.

One example of this was Slater Mill which was funded by Moses Brown — who created Brown University — who owned textile operations but had no idea how to mechanize their spinning operations. Slater had the technical skill and inventiveness and they were able to pair together.

Reid Hoffman: In fact many of the elite Venture Capital funds started with wealthy families and have since moved on to institutions.

Shifting gears a bit. Your talk was a call to arms to capitalism, creativity, and creative destructions — when should someone consider doing a startup?

Michael Dearing: After 8 years of exclusively focused on early stage investing I’ve noticed two things:

  1. Entrepreneurs can’t keep it inside them and the idea just bursts out. The founder starts to irrationally allocate time and resources to this new idea because they literally just can’t stop thinking about it. While they are working on the idea, if time just disappears and you miss two meals because you are so engrossed in your work — it’s a good sign it’s an idea you have to get out of your system.
  2. The other characteristic I see when founders are ready is when the founder accidentally gets their friends fired up too. The friends keep thinking about the idea as well and want to work with you on it. I’m not mystical about these things but this is the market talking to you.

If you have these two signals it’s an indicator that you should do something about it.

Reid Hoffman: What are the cross checks that you think people should do to make sure it’s the right thing to work on?

Michael Dearing: I’d suggest two things:

  1. One is to give a chunk of time in your schedule to devil’s advocacy. I learned this from Michael Eisner — the former CEO of Disney — is that every good idea is going to be subjected to a devil’s advocate at some point in time. I’d suggest finding the smartest person you can find, have them destroy your idea, find everything wrong with your idea, be a huge asshole, and have the permission to do this.
  2. Secondly the other technique I like is to do a pre-mortem. Pretend that you started the idea and failed already — forecast what went wrong and try to identify all of the deadly risks early. We may decide to bail or keep going but if we keep going we can put in shock absorbers for those key risks.

Reid Hoffman: Along those lines, one thing I say to do while talking to smart people you know, is to ask them — what is wrong with your idea. Most people want reassurance (your idea is great!) but this has negative value — ask what is broken. People need that permission from you so that they can be negative.

Last thing in terms of starting a startup, what role should considering the competition be — on whether you have a good idea or not?

Michael Dearing: Founders who pause on competition usually pause for the wrong reasons. Big company X is going to launch a product with your exact features is totally irrelevant.

Competition in the early stage is typically the user not caring about your product or putting together their own solution without you. You should be more worried about what is occupying your users’ attention today.

Reid Hoffman: Discounting the large companies (unless you are doing search then you need to pay attention to Google), startups should be aware of what other startups are doing.

Given your presentation what would be your advice for eBay?

Michael Dearing: Keeping in mind I have been gone longer than I was ever there for the unbundling of Paypal (which was a the right thing to do) — to create a more competitive market for ideas.

One of the nice things about having lots of complimentary assets is you can do command and control economy inside — allocate capital by the decision of the CEO. However over time the judgement of any one person is fallible and the market is a much better allocator of capital than one person.

Reid Hoffman: Some of the leading Silicon Valley people think you should organize companies based on markets vs. command and control, do you have this point of view?

Michael Dearing: I do, especially with product development resources. I tried to allocate software development and hardware development time through a competitive market internal to the firm so the competition for resources was very intense. The resources were split up by the economic value of an idea vs. the whim of a senior manager.

Reid Hoffman: Should founders do this?

Michael Dearing: Yes, but with a different pricing model. Startups shouldn’t go through a pricing model a corporation would have to go through but rather the founder should be the editor and chief of the product roadmap.

Reid Hoffman: Shifting topics, there is mainstream view that being contrarian is important — do you think being contrarian is important for the startup idea?

Michael Dearing: It’s not imperative but it’s a nice feature. From the investors perspective it’s the wild enthusiasm for an idea that chase prices higher.

Personally I appreciate contraction thinking because it helps me understand how the founders’ brain works. If the road map from technical insight to product is contrarian then it tends to be more interesting and teaches me more about their thinking process.

Reid Hoffman: I think to get a massive discontinuous result — the idea has to be contrarian to get going.

On the other-hand where contrarian goes too far is — you can have something that is specifically contrarian in one decision but normal in the rest. For example with Workday — people didn’t believe going to the cloud was important — this was there one contrarian idea. Everything else was just good execution — they didn’t say they were contrarian on the UI, etc.

Shifting to more how we do startup questions — How should people think about evaluating themselves as founders?

Michael Dearing: I think about this through the stages of life you will go through as a founder.

  • Have a technical insight which is the basis for the idea
  • Turn the technical insight into a product for consumers
  • Turn the product into a company

These three things have very little in common. As a founder if you are energized by each of these stages the founding process will be satisfying. If you are only in love with the technical insight — this is a problem. Right now there are a lot of science projects which aren’t companies. You need to move fast across these stages and see yourself contributing to each one.

Reid Hoffman: How should you select co-founders?

Michael Dearing: As a founder you should take inventory of your own brain. We published a video on this called the Cognitive Distortion of Founders — aka wacky ways of founders seeing the world.

For example if you are more of a black and white thinker — very judgmental and quick to strongly held opinions — you need to have a co-founder who is more of a grey thinker. The key is to pair your own deadly risks with a co-founder who compliments those as shock absorbers.

Reid Hoffman: As an investor what cognitive traits do you look for founders?

Michael Dearing: A few things come to mind:

  • Personal exceptionalism — the belief that you are not destined for a normal outcome — comes in very handy when founding a company
  • Black and white thinking —which we just mentioned. The error rate on your decisions are higher but the rate of speed of decision making is high. Speed is sometimes all you have in a startup.
  • Schumpeter’s mindset — no matter how much the pain is, the creative destruction is worth the cost.

Reid Hoffman: One other one I have seen is founders need to be more generalists. There is a laundry list of challenges in the beginning, eventually you’ll hire more specialists as you scale.

How do you hire well? Especially for the first 3–5 hires — what is your advice on what to do and not to do?

Michael Dearing: One red flag we see is founders come to us with a shopping list: We want 32 oz of front end developer, 1 lbs of iOS engineer, etc. It doesn’t work this way.

For the first couple of hires you need to find people who share your passion, will learn anything that is necessary, and will pick up and do everything.

We have always seen these people come from first degree or one degree away from the founder, the passion needs to come from organic sources. Using recruiters or advertising is useful later but not for the first couple of hires.

Reid Hoffman: As an early startup what are the key things you should be focusing on?

Michael Dearing: When I visit companies I walk around with McCallum’s list — Who is working on what? Do they have the authority to keep going? Do you know how things are going along the way?

You would be surprised in a 10 person organization while everyone is literally sitting in the same room — deadlines are missed and schedules are revised.

Reid Hoffman: What do you think about the need to have a go-to market and distribution strategy?

Michael Dearing: I don’t believe a founder needs a full detailed plan on their go-to market strategy but they at least need a hypothesis about it.

Have the founders even thought about go-to-market? It helps me understand how their brain works. If it doesn’t exist then it shows me they are lazy in their thinking.

Reid Hoffman: What are the things startups can ignore?

Michael Dearing: One big thing I have seen startups can ignore is PR.

There is this movement that the founders are the brand and the founders need to be high profile — it’s a complete and total lie made up by the people who sell ads for page views. You may decide to do PR for your own reasons but it never changes the outcome.

For example if you are doing PR because of recruiting — the people who you will attract are the wrong kind of people. Startups will not always be written about in the press, all startups face low points. You need to find people that want to stick with you even through the hard times.

Reid Hoffman: What recommendations do you give just founding teams for financing?

Michael Dearing: The conventional wisdom today is to put off the discussion of valuation by using debt — either convertible notes or SAFE notes. Nobody ever came to this country to have great convertible debt terms — investors want ownership.

I suggest you treat yourself to real shareholders, people who don’t have downside protection. It’s a terrible disservice to teach founders not to have shareholders tied to the boat with you. You don’t get the same level of commitment when you sell convertible debt or highly distributed financing — no one has skin in the game.

It’s important to have the hard conversation about valuation. The math is very simple:

  • How big of a check do you want / ownership percentage = value of company.

Question from the audience — How about convertible notes with caps?

Michael Dearing: It’s lipstick on a pig. Still not ownership. That cap is never the total value of the company— investors should get the price the company is valued at today.

Reid Hoffman: The way I like to look ofthis is to try to find a partner during investment. The way you have these difficult conversations helps you see how good your partner is going to be and if you can solve the problem together.

Question from Audience — How about raising in a competitive market? —What if I am promised the value of the partner and they are still willing to do a convertible note with a cap?

Michael Dearing: If an investor says they are willing to do capped notes and help you — you need to see it to believe it.

60% of the meetings I take are with founders I didn’t even invest in. Many of these founders show me polluted cap tables with lots of investors who promised all of this help — but they never actually help.

This never happens because the investor has ownership and is going to lose real money if your company fails. I’ve seen lots of founders who have 30–40 investors who put in 20K each but can’t get any real help from any of them.

Question from Audience — What do you think about the Fenwick and West Series Seed Docs?

Michael Dearing: This is what we exclusively use, they are great docs.

Question from Audience — Which investors picked up the phone most for you?

Reid Hoffman: For LinkedIn we did our Series A with Mark Kvamme of Sequoia Capital and our Series B with David Sze of Greylock Partners. We took a few selective angels in our A round but no one got in our round unless they were all active.

All of the top tier funds have active participants because that is what helps build great companies. One of our angel investors was Josh Kopelman who invested and helped even before he started First Round Capital.

I think you should have an explicit conversation with your investors on what your alliance will look like and you should call them up if they are not keeping up with their end of the bargain.

Question from Audience — If it’s not in the best interest to do a highly distributed deal, what would an ideal investment round look like?

Reid Hoffman: One, you should have a lead investor who is getting into the foxhole with you. Your startup will have difficult moments and there will be multiple times you need help, you need a real partner during these times. The lead is your partner and will also help with your next round of financing.

Also I would include a few key angel investors who can bring customers/talent/advice which is specific to your business. For example if you are working on a data intensive startup, I would bring on someone who is a data expert.

I’ll post the fourth lecture notes here after our next class. I also started assembling the notes into one collection here.