Efficient Startup Hypothesis

If we entirely ignore theory, we can make big mistakes. We can fool ourselves into thinking it’s possible to know more than everyone else and regularly beat heavily populated markets. . . . But swallowing theory whole can make us turn the process over to a computer and miss out on the contribution skillful individuals can make
– Howard Marks in his 2014 memo, “Getting Lucky”

Lately I’ve been kicking around the idea of an efficient-market hypothesis as it relates to startups. EMH is a well-known theory in finance that states (definition from Investopedia) “it is impossible to ‘beat the market’ because stock market efficiency causes existing share prices to always incorporate and reflect all relevant information”. Efficient Startup Hypothesis or ESH is a theory I came up with, in which today it is incredibly difficult to invest in and build truly great companies because the crowdsourcing of information and ideas efficiently surfaces so many of the biggest opportunities and therefore competition increases before a sustainable competitive advantage can be built.

The Internet has democratized distribution and information sharing. The economy of scale experienced by incumbents via traditional media channels is rapidly disappearing as our mindshare moves to the smartphone and OTT content. At the same time, with 2 billion smartphone users, information is exchanged rapidly and ubiquitously in both small topic-based communities and large-scale, broad platforms. No longer can big corporations remain complacent by leveraging economies of scale with their advertising dollars or media companies monopolize the content we all consume effectively.

Consider the fact that any given idea can quickly be discussed with over 307 million Twitter users or 36 million Reddit users around the world. Product Hunt has done an excellent job of this as well, crowdsourcing demand and feedback for products and services in a matter of a few hours. As a result, there are a lot of startups that look quite similar and more companies searching for value by offering solutions to narrower audiences and niche markets.

For example, take a look at the adtech market. With the advent of the smartphone, adtech companies found great success in years past. As a result, entrepreneurs began starting companies that continued vying for the attention of marketers’ budgets in differentiated ways but the market quickly became oversaturated, with more look-a-like ad networks, product offerings that began to look all the more similar, and limited data sets dependent on the big platforms. As a result, you wind up with an overabundance of companies in an industry based on limited campaigns which makes revenues unpredictable and the public markets weary.

Today, most investors completely shun adtech, preventing the possibility for innovative companies to come along that are actually onto something big. We saw this in the daily deals category, in social gaming, dating, and are beginning to see signs of the same in messaging and the “uber for x” category. As market penetration occurs, more verticals are tackled, and more niche industries become the focus for the founders of tomorrow. This is a poor strategy for founders and investors alike but it also doesn’t mean that great companies can’t be built in these categories either.

The prevailing assumption has been that tech companies should be venture-backed, attempt to get to $100M in revenue within 7 years and create massive value for the company’s founders, investors, and employees. Given the ubiquity of the Internet, this may no longer be the case. There are a lot of great markets to go after and product to be built that will never reach that kind of scale and as a result go out of business or try to find an acquirer. While not the key idea behind this blog post, I’d argue that these businesses would be better served finding profitability early on and building very good businesses generating free cash flow vs. the status quo venture-backed model. Bryce Roberts from OATV had this very thesis while creating Indie.vc.

This isn’t the dream so many envisioned after seeing The Social Network, but as niche market segments continue to emerge and more functions of businesses are unbundled, it’s a viable alternative and a good way to create value and wealth in the process.

Getting back to the Efficient Startup Hypothesis, a popular joke associated with EMH goes something like this:

A passionate college professor who teaches efficient-market hypothesis and a friend are walking around campus one day. The friend says to the professor, “hey look it’s a $20 bill on the ground”. The professor then turns to the friend and says, “that’s impossible. If there were a $20 bill on the ground it would’ve been picked up already”.

So the question then is, how do we find the $20 bills or put more bluntly, the big hairy audacious ideas out there that aren’t being built or even discussed yet?

Given the number of 2016 predictions I’ve seen from investors, journalists, entrepreneurs and other members of the tech community I thought this was a good time to discuss this. While I’m not criticizing anyone for writing down their ideas, being transparent and in the process opening themselves up for criticism, hindsight, etc., it does in many ways perpetuate the problem that plagues today’s ecosystem. Consider this quote taken from Duncan Watts’ 2007 article in the New York Times entitled, Is Justin Timberlake a Product of Cumulative Advantage?:

The reason is that when people tend to like what other people like, differences in popularity are subject to what is called “cumulative advantage,” or the “rich get richer” effect. This means that if one object happens to be slightly more popular than another at just the right point, it will tend to become more popular still. As a result, even tiny, random fluctuations can blow up, generating potentially enormous long-run differences among even indistinguishable competitors — a phenomenon that is similar in some ways to the famous “butterfly effect” from chaos theory.

The formula for success is rather simple. Founders, operators and investors need to take risks, make predictions about the future, and be right in doing so.

However, just because you are well-read and make predictions about what the future will look like (even if you’re right), there will be hundreds or maybe even thousands of others onto the same ideas. This is where the tech community’s tendency to operate as “inside baseball” (even if the league is continually expanding), plagues itself.

As Peter Thiel would say, you need to have a “secret” and be “contrarian and right”. This becomes harder as the competitive advantage period becomes shorter and finding inefficiencies and big opportunities become more difficult. Combine this with the rapid decline in the cost of technology and the myriad of ways to reach users and customers and suddenly the idea of starting a company for the sake of starting a company isn’t quite as sexy as it was leaving the movie theater after seeing The Social Network.

It was a16z’s Chris Dixon who wrote the blog post entitled What the smartest people do on the weekend is what everyone else will do during the week in ten years, keying in on the idea that the geekiest garage and basement hobbies become the next major industries.

Some smart VC’s look for markets and companies by looking at Reddit and other communities to see early ideas that show promise in the form of hobbies, tinkering and engagement. Off the top of my head companies like Soylent and industries like bitcoin and nootropics showed early signs that something interesting was brewing there. USV’s Joel Monegro even went so far as to dig into the Deep Web to learn more about what might be on the horizon.

This is certainly an excellent place to start but it’s not comprehensive either. Furthermore, as traditional garage-nerd culture becomes more mainstream and the hobbyists have their own communities, these ideas too will become less contrarian.

This brings me to an interesting discussion I had on Twitter with Julie Fredrickson, the founder and CEO of Stowaway Cosmetics, a Metamorphic Ventures portfolio company in the cosmetics space, one that hasn’t seen much innovation at all in 50+ years. Stowaway’s right-sized cosmetics products are better suited for today’s consumers than the legacy products of yesteryear. Julie responded to my blog post on my theory on the ways in which great venture investors evaluate companies with the idea that while VC’s are looking for outliers, traditional “pattern recognition” often looks like a convergence to the mean. Julie touched on the fact that white male investors end up investing in white male founders and as a result aren’t truly seeking outliers.

We’re in a vastly different era of technology than that which existed when many of the household name VC firms first earned their stripes. Technology has become ubiquitous, influencing (or to use a more overused word disrupting) all traditional industries, demographics and market segments. As Steve Case points out, we’re ushering in a new era where infrastructure or horizontal platforms are already built and now tech is integrating into our lives in a myriad of ways and form factors.

As a result, great companies are being built leveraging new market segments that are big and impactful enough to generate significant value and wealth. Given the structure of management fees, it would be impossible for any venture firm to have experience in all markets and categories, let along age groups, sexes, and races (even if Andreessen Horowitz is giving it their best shot :) ).

Julie’s company, Stowaway Cosmetics is a great example of a company that I believe is an inefficiency in this efficient startup market. While vertically integrated brands have become a hot market for startups ever since Warby Parker burst onto the scene, Stowaway isn’t just seeking to apply the same business model to another product category in the hopes of striking it rich.

Stowaway is founded by women which makes up less than 20% of all VC funded companies (this number has jumped significantly but as recently as 2009 was under 10%). Stowaway’s “secret” is that women never finish their makeup and hoard their products because they feel guilty throwing it away, a secret that most male investors and entrepreneurs undoubtedly know very little about. The founders also have very different backgrounds which contribute to the company’s secret. Julie is an experienced startup founder who knows intimately how to build product and acquire customers. Julie’s cofounder, Chelsa Crowley has spent her entire career in the cosmetics industry. As a result, Chelsa not only understands how to build great cosmetics brands but she knows the inefficiencies that plague the big brands. Chelsa knew that it costs the same amount for high end makeup brands to make smaller-sized products as it does the larger products they sell in stores. Due to brick and mortar margins, economically it has traditionally only made sense for companies to make products that are way too big for women to finish. As a result, you two founders leveraging a secret to build a $20 bill that completely bypasses efficiency of the startup market.

If founders and investors want to find the $20 bills, they’ll need new models to find the outliers. This means more diversity in thinking, team and extended team members. At Metamorphic Ventures, we’ve been building a hands-on network of advisors and partners to assist in both vetting and helping companies because given the structure of management fees, it’s just not possible for any one venture firm to cover so many different demographics and categories. As a result, we lean on our peers and markets/trends/ideas shared within our networks, which leads to a certain form of what is referred to in statistics as a “fallacy of hasty generalization”.

Sean Rose, a member of the product team at Slack alluded to this recently when he tweeted the following:

Tweet #1
Tweet #2

Founders and operators that find the $20 bills will be those that are hell bent on solving a specific problem and/or understand the intricacies of their customer’s needs/wants better than just about anyone else on Earth. My earlier point about companies that needn’t be VC-backed applies to those that will need VC funding to get to scale as well. Building a company that can sustain itself allows for optionality, which that allows companies to continue to build despite which hot markets/companies investors want to invest in during that time. Rafat Ali, founder of Skift nailed it in his post entitled “How We Got off the Addiction to Venture Capital and Created Our Own Way to Profits” when he called these Bootstrap+ companies, which can also be a temporary denomination until investors can’t ignore you any longer.

Starting a company is hard work. Just because the basis of this post is about markets and ideas doesn’t mean I’m minimizing the fact that it takes a ton of hard work, trial and error, a special team, and a little bit of luck to build a great company. This is why investors like to fund “missionaries and not mercenaries” because only those that are hell bent on success will find it (even if not all will).

We’re all human and therefore are subject to our own biases and experiences. Some of the most successful people are those that recognize their own biases and are able to overcome them. The best way to do so is to surround yourself with people who are different and therefore have different biases and experiences. Investors that find these $20 bills will do so by recognizing where their pitfalls exist and overcome them. Hence what makes outliers, outliers because if we all had the same ideas and experiences, progress would be hard to come by or as Chamath Palihapitiya calls “Bros Funding Bros”.