CS183C Session 3: Michael Dearing

Michael Dearing | LinkedIn

Harrison Metal

Michael Dearing (@mcgd) | Twitter

Our guest for this class was investor and Stanford lecturer Michael Dearing. Michael delivered a guest lecture and was interviewed by Reid Hoffman. You can watch the recording here.

• Teaches entrepreneurship at the d.School
• Runs Harrison Metal
• Reid tried 2 or three times to recruit him to LinkedIn, and he said no each time.
• Heroes of Capitalism (from beyond the grave)
• Over the past 1,000 years, real World GDP per capita has changed significantly
• In the 13th century, GDP collapsed due to the Black Death
• In the late 18th century, GDP began to grow exponentially
• Other than that, GDP was pretty much flat
• “You ever live through a low-growth situation? Imagine doing that for 30 generations.”
• What changed during the Industrial Revolution? Coffee shops, insurance, America.
• Joseph Schumpeter on Capitalism: The opening up of new markets, the development of industrial organization. “Creative Destruction” is the essential fact of development. Entrepreneurship.
• Plentiful sources of cheap energy became available.
• “Humans didn’t suddenly become more creative in the 18th century, they just got bigger levers to move the machines they built.”
• Alfred Chandler: Founded the discipline of business history at Harvard Business School. Felt that Schumpeter was right; entrepreneurs played an important role, but that managers also played an important role.
• The managerial revolution scaled with the companies that technology enabled. “The invention of managerial capitalism.”
• “We now have an engine that can pay the bill to fix the bad things about life on earth — war, hunger, etc.”
• “The money that comes to Silicon Valley to fund the creative destruction of today doesn’t come from the wealthy fat cats. Some of it does, but most of it comes from universities and hospitals, the institutions that defend civilization.”
• “No pressure, but it’s your turn to drive this train. Civilization depends on you.” Celebrate Schumpeter’s entrepreneurs, scale genius with a visible hand (management), fund health, freedom, art, opportunity, justice.
• Three periods of industrialization 1) The mechanization of cotton 2) The transportation revolution (e.g. railroads) 3) The technology revolution (e.g. Silicon Valley). Today, we’ll focus on the railroads.
• “Railroads were startups once.”
• Daniel McCallum, Hero of Capitalism.
• https://en.wikipedia.org/wiki/Daniel_McCallum
• Born in Scotland, came to America (upstate NY) in 1822. His father was a tailor, and McCallum wanted to do something different. He began woodworking as a child, and became a self-taught architect and bridge maker. His Susquehanna bridge was patented. He was rapidly promoted (every 24 months or so) until he became CEO of the New York and Erie railroad by the age of 43, stretching from Maine to Kansas.
• McCallum wrote about how easy and fun it was to run a small railroad, but how hard and painful it was to run a massive railroad. His letter is available online.
• “The joy of running that 50-mile railroad was that I could get the right people to work on the right stuff at the right time. I had a personal connection to them.”
• McCallum posed 5 key questions
• 1) How do you get a group of people to work together to common goals?
• 2) How do you give people the right amount of responsibility?
• 3) How do you make sure the job gets done?
• 4) How do you know how things are going?
• 5) How do you do all this with respect for others?
• Notice: Still relevant today, still unsolved today, not focused on financials, emphasis on respect
• McCallum had answers to these questions. For example, he had the branches report status via telegraph every 30 minutes using a set format.
• About two or three years after he wrote this letter, the railroad failed.
• He became the Master of Railroads for the Union Army, and was a hero of the Civil War.
• “Things As They Are In America”: http://www.amazon.com/Things-as-they-are-America/dp/B006EISYT6
• “The wealth that was created by the Industrial Revolution paid for the destruction of the disgusting institution of slavery. That’s why entrepreneurship matters.”

A Conversation between Reid Hoffman and Michael Dearing

• How much do you attribute to financial incentives and how much to technological advances? “They go hand in hand, and without one, the other collapses. We ran this experiment for 800 years, and we had zero growth. When the person with the idea had to have the money and the management skill, very few enterprises could succeed. Decoupling these allows much more activity to happen.”
• “Before venture capital, rich families were the source of month. Slater’s Mill was funded by the Brown family.” RGH: And of course, venture capitalists started by investing rich people’s money.
• When should they consider starting a startup? “It kind of bursts out. The founder irrationally allocates time and resources to an idea because he/she can’t stop thinking about it. If you find that you’re working on an idea and you don’t notice that you’ve missed two meals, that’s a good sign that you can’t get it out of your system. Another is when, without even trying, you start getting your friends fired up about the idea as well.”
• What are the indicators you’d use to evaluate an idea? “Give a chunk of time in the schedule for devil’s advocacy. Every big, good idea is going to be subjected to a devil’s advocate, who should be the smartest person you can find, whose job is to try to destroy the idea. Please spend the next two days figuring out everything that’s wrong with this idea.” RGH: Go to every smart person you know and ask them, what’s wrong with this idea. “People need that permission from your as a founder — I need you to be negative right now.”
• John Lilly thought LinkedIn was a bad idea. But his criticism was incredibly valuable because his criticism was that we’d never get to critical mass, which is what we made our primary emphasis.
• “Another practice is the premortem. Assume that we failed. What went wrong to make this happen. We can’t keep going without building shock absorbers for the risk.”
• How should founders think about competition? “Founders often pause for the wrong reason. Isn’t Big Company XYZ going to do this? That’s totally wrong. The substitute for your product is almost always doing nothing, or hacking something together. Big companies are slow and usually bad; instead, focus on what’s occupying your target market’s mind right now.” RGH: Unless you’re doing search, and it’s Google. But do think about other startups.
• How would you re-invent eBay? “I’ve been gone almost 10 years, but I still watch it. They should do more of what they’ve been doing. Unbundling PayPal was a good idea. The market is a better allocator of capital than one CEO or the capital committee. I’d also think about how many people work there. It sure feels like a lot.”
• “Particularly when it comes to product development processes, companies should work like a competitive market, rather than command-and-control. The internal mechanisms for drawing the line should be focused on economic value, not executive whims.” What metric? “Net Present Value. When people are held accountable for predicting the economic value of their ideas, you can get better at making decisions. The problem is that you can end up feeding the beast; feeding the core business always looks better for NPV.” Should startups implement markets? “The founder has to be the guardian and editor-in-chief of the product roadmap. Everyone else should have input, but he or she makes the decision.”
• Who do you think is the most successful company that implements an internal marketplace mechnanism? “I’ve been very impressed with how Airbnb allocates product development resources. This is an outsider’s view. The people I know talk about making investments to improve the customer experience 9–12 months from now. I also think that they do the math on all the investments that they make. It’s not a startup, but it’s still a young company. There’s a company I work with right now, Signal Sciences, which has 10 people. It has about as wide a funnel as you can imagine, but then the founders cull it. Wide open market on the front end, benevolent dictatorship on the roadmap.”
• It’s become a consensus view that being contrarian is imperative. “It’s not imperative. It’s a nice feature. It’s where you find value as an investor. It’s the wild enthusiasm of conventional wisdom that chases prices higher in an investment round. I enjoy the contrarian opinion because it helps me understand how the founder’s mind works.” RGH: To get a massive, discontinuous result, it has to be contrarian or there will be a lot of people competing for the same market. But where the contrarian consensus goes too far is thinking that everything needs to be contrarian. You need one key contrarian decision (e.g. Workday moving to the cloud) but conventional excellence on other matters.
• How do you evaluate yourself as a founder? “The simple answer is the stages of life you go through as a founder: Technical insight, which you turn into a product, which you turn into a business. If you are focused just on the technical insight, you have a science project. If you find yourself continually tinkering with the product, that’s a problem as well. You need to be screaming across these stages. Today we’re in technical insight mode, in a month we should be productizing, and monetizing right after that.”
• How do you find co-founders? “Take an inventory of the brain. The cognitive distortions of founders.” https://www.harrisonmetal.com/library/the-cognitive-distortions-of-founders
• 1) Black and white thinker. Needs to be paired with someone who is more nuanced, so the other members of the team don’t get shut down by the visionary.
• Which ones do you zoom in on? “A sense of personal exceptionalism, that you are destined for greatness. That comes in very handy when founding a company. Black and white thinking proxies for the speed of decision-making, though the error rate can be high. A Schumpeterian mindset — no matter the pain, the creative part of creative destruction is so appealing that I’ll live with the destruction.” RGH: Also, do we have the key skillsets required to reach the market? Part of the role of founders is being generalists — tackling any problem that comes along. One or more of the initial team has to jump on the unexpected problems and pivots. JL: Good founders are drawn to the problems that other members of the team can’t solve.
• How do you make your first 3 to 5 hires. “I get very worried when I see people come with a shopping list. I need 32 ounces of Front End developer. The early stage should be able finding people who share your passion and who are willing to pick up and do anything. The shopping list is almost always a red flag. The most successful hires come from your network or one degree. The passion has been transmitted in an organic way, rather than through a recruiter and an ad.” RGH: Are they actually committed? Are they a generalist who can pick up something new that you don’t expect? Things that are difficult to measure even with reference checking? “Tell me about a time when you faced a horrible disappointment. Tell me about your greatest victory. Get them to tell you about their lives, and you’ll get a very good view into who they actually are. What did you decide to do with your free time? What did you do when you had perfect freedom?”
• What are the first things you focus on? “It goes back to that McCallum list. Who’s working on what? Is that the most important stuff? How do we know how the work is going along the way? It’s amazing how many 10-person companies don’t realize that something is wrong until the release the code.”
• Is there anything that you’d add to McCallum? “For early stage ventures, I’d go back to financial viability. Is this an actual business? Many things are being backed by VC right now that are not businesses — they are public goods, science experiments, or hobbies.”
• “An opinionated person who wants to start a company ought to know how they intend to go to market. If that doesn’t exist, it reflects a laziness of mind and is a big red flag.”
• “You shouldn’t be able to convince a stranger to give you money without saying, ‘And here’s how we’ll go to market.’”
• What are the things you can ignore? “Every founder should have his or her own list of things they plan to ignore. But if you’re going to ignore the Board of Directors, you need a corporate governance approach. Most of the companies I fund are 5–15 people, and I always set up a board, and I always put myself on it. What I wish was on the list is f — king PR. The idea of founders as brands is a lie. It’s a lie spread by the people who sell ads for pageviews. Many times, PR can tip the outcome in the wrong direction. If you do PR to help recruiting, you’re recruiting the wrong people. People who want to work for companies that get written about are bound to be disappointed.” RGH: This reinforces a point that Sam Altman made last class.
• “If you’ve got no customers and you’ve got no product, but you have a pile of money from investors, you have a civic duty to know how you’re going to spend that money. I think of it as a dress rehearsal for varsity-level company management.”
• What are the key dos and don’ts of financing? “The conventional wisdom today is to punt totally on valuation, and use debt or a SAFE (whatever that means). Nobody came to this company to get great convertible debt terms. When we make a fortune, as a species, we do good things with it. Even the worst people in the world, when they drop dead, their money does some good. This is all nonsense created by the legal professionals and some hucksters. It’s a terrible disservice to teach founders that they don’t deserve shareholders who aren’t tied to the mast with them. You don’t get that when you sell convertible debt or have highly distributed financings where the amount each investor puts in is more or less a generous tip for them. Treat yourself to shareholders. Convertible debt is a terrible poison in our industry. Convertible notes with caps are even worse — lipstick on a pig. It’s still not ownership. You would never ask people to help you, and then give them the price that you got thanks to their help. You should get a price that reflects the value today, not the hypothetical value 12 months down the road.” RGH: If you are selecting a good partner for the business, you want them to benefit from increasing the value of the business. How you navigate the valuation discussion is a good guide to how the partnership will work.
• “If an investor is willing to do convertible note, and says he or she is willing to help you just as much if they had equity, you need to ask yourself, do you believe them?”
• “I help a lot of entrepreneurs with whom I have no business relationship. The number of them that show me polluted cap tables with investors who are useless is outrageous. The shit has hit the fan, and they’re calling investors, and nobody is picking up.”
• “They’re looking at their list of 40–50 investors, and they just can’t get any help.”
• RGH: At every single financing at LinkedIn, we did not choose the highest valuation. I, and many investors have passed on deals because the cap table was too screwed up.
• JL: Reference. There are some investors who add incredible value, and you should add them to any cap table.
• What about Series Seed? “It’s exclusively what I use in my business.”: http://www.seriesseed.com/
• Who picked up the phone with LinkedIn? RGH: Mark Kvamme, David Sze. Nobody got into the round if they weren’t going to be an active investor. Josh Kopelman was an angel investor in LinkedIn, before he started First Round Capital.
• Why is SAFE bad? “I’m deeply suspicious of anything that is named to make me trust it. The Patriot Act comes to mind. Look at the difference between renters and owners and how they treat their homes. Ownership mechanisms ensure the best long-term custodianship of those investments.”
• RGH: The ideal circumstance for a founder is a lead investor who is getting in the foxhole with you. You’re going to have multiple times when you say, “Why did we ever think this was going to succeed?” The lead will help you, and help you raise your next round of financing. Find someone who will be a good partner in good times and bad. Most good funds want 20–30%. If you have a lot of traction, maybe a little less. The VC is like a financial co-founder. But you also want key angel investors who bring something to the table. The ideal configuration is a lead and some key angels.