Weekly Reading #4: Zero to One (Part 2)

Notes on Startups, or How to Build the Future by Peter Thiel

“Every moment in business happens only once. The next Bill Gates will not build an operating system. The next Larry Page or Segrey Bin won’t make a search engine. And the next Mark Zuckerberg won’t create a social network. If you are copying these guys, you aren’t learning from them.”

It’s easier to copy than to create something new. Copying takes the world from 1 to n, adding more of something similar. Creating takes us from 0 to 1. Innovation is what makes American businesses successful. We will fail if we stop searching for new paths.

Zero to One is about how to build companies that create new things.

Read Part 1 (Chapter 1–2–3) here:

Chapter 4: The Ideology of Competition

Creative monopoly means new products that benefit everyone and sustainable profit for the creator. Competition means no profits, no meaningful differentiation and a struggle for survival. So why do people believe that competition is healthy? The answer is that competition is an ideology that has been preached and idolized.

The education system has trained us to ignore the truth about competition: the more we compete, the less we gain. Grades are the precise measurement of each student’s competitiveness, although not everyone learn the same way. Students who don’t learn well by sitting as desk are considered inferior. Those who do well in the conventional measures like tests and assignments go to college, and fight more fiercely over conventional careers like management consulting or investment banking. Why are we doing this to ourselves?

Thiel lived a conventional student life until he went to Stanford Law School. After clerking for federal appeals court for a year, he went to an interview for clerkships at the Supreme Court, the dream of thousands of law students. He was so close to winning “the last competition”, but he didn’t get the job and was devastated. He went to build, and later sold PayPal.

Thiel said, ” Had I actually clerked on the Supreme Court, I probably would have spent my entire career taking depositions or drafting other people’s business deals instead of creating anything new. It’s hard to say how much would be different, but the opportunity cost were enormous.”

Why do people compete with each other? Marx and Shakespeare provided two models to understand every kind of conflict.

According to Marx, people fight because they are different. They have different ideas and goals. According to Shakespeare, people fight because they are alike. Thiel draws example from the first line of Romeo and Juliet: “Two households, both alike in dignity.” The two families, don’t know why, fight until they lost sights of why they started fighting in the first place.

To Thiel, Shakespeare proves the superior guide in the business world. Firms become obsessed with their competitors in the marketplace. They lose sight of what matters and focus on their rivals instead.

Google vs. Microsoft

In the beginning, Google built a search engine, Microsoft built operating systems. As they grew, they began to focus on each other. The result? Windows vs. Chrome OS, Bing vs. Google Search, Internet Explorer vs. Chrome, Office vs. Docs, and Surface vs. Nexus. Because of the fight, both lost their dominance to Apple. In January 2013, Apple's market capitalization was $500 billion, while Google and Microsoft combined were worth $467 billion. Three years before, Microsoft and Google were each more valuable than Apple. War is costly business.

Pet.com vs. PetStore.com vs. Petopia.com

Each company was obsessed with defeating it rivals, because there was no difference among them. They lost sight of the wider question of whether the question of whether the online pet supply market was the right space to be in. When Pet.com folded after the dot-com crash, $300 million of investment capital disappeared with it.

PayPayl and X.com

If you can't beat a rival, it may be better to merge. PayPal and X.com had the same products and features. By late 1999, they were in all-out war. The focus was to defeat each other. But in February 2000, Thiel and Elon Musk, X.com founder, were more scared about the rapid inflating tech bubble than they were about each other. They merged on a 50-50 deal and together ride out the dot-com crash.

Sometimes you do have to fight. Where that’s true, you should fight and win. There is no middle ground: either don’t thrown any punches, or strike hard and end it quickly. But you should only fight for what matters.

Chapter 5: Last Mover Advantage

Escaping the competition will give you monopoly, but even a monopoly is only a great business if it can endure the future.

Comparing Twitter and the New York Times Company. In 2013, Twitter has more than 12 times the Time’s value, even the Times earned $133 million in 2012 while Twitter lost money. The difference is infuture cash flow — the sum of money a company will make in the future. Investors expect Twitter to capture monopoly profits over the next decade, while the days of newspaper are over.

Unlike traditional low-growth businesses, which have most of its value in near term then fade away, technologies companies follow the opposite trajectory. They often lose money for the first few years, then gain value at least 10 to 15 years in the future.

However, for a company to be valuable it must grow and endure. Many entrepreneurs focus on short-term grown because growth is easy to measure, but durability is not. So, they may overlook the deeper, harder-to-measure problems that threaten the durability of the business. An example is Zynga and Groupon, which had rapid short-term growth but failed in long term. Zynga scored with Farmville, but faced a problem of every Hollywood studio: how can you reliably produce a constant stream of popular entertainment for a fickle audience? Groupon once had hundreds of thousands of businesses to try their products, but failed to turned those businesses into repeat customers.

If you focus on near-term growth above all else, you miss the most important question you should be asking: will this business still be around a decade from now?

Characteristics of MONOPOLY

1. Proprietary Technology

Proprietary technology is the most substantive advantage a company can have because it makes your product difficult or impossible to replicate. An example is Google’s search algorithms, which returns results better than anyone’s else.

As a good rule of thumb: proprietary technology must be at least 10 times better than its closest substitute in some important dimensions to lead to a real monopolistic advantages. Anything less than an order of magnitude will probably be perceived as a marginal improvement and will be hard to sell, especially in an already crowded market.

Here are some suggestions to get 10x improvement:

  • Invent something completely new. An example might a drug to cure baldness.
  • Improve an existing solution 10x.
    Before PayPal, buyers needed to mail checks to sellers, which took 7 to 10 days. With PayPal, both can transfer money as soon as the auction ends.
    - Amazon offers 10 times as many books as any other bookstore
  • Improve integrated design. Before iPad, tablets were unusable because of bad usability design. With iPad, tablets are now easy-to-use and widely adopted.

2. Network Effects

Network effects make a product more useful as more people use it. Facebook is an example. If all your friends are on Facebook, it makes sense for you to join Facebook.

However, the network should be valuable to its very first users, when the network is small. In 1960, Xanadu built a technology similar to the Internet but required every computer to connect at the same time. It didn’t work. Facebook started with a small market, with an intention to connect only Harvard students.

This is why successful network business rarely get started by MBA types: the initial markets are so small that they often don’t even appear to be business opportunities.

3. Economies of Scale

A monopoly business gets stronger as it gets bigger. Software startups can enjoy especially dramatic economics of scale because the marginal cost of producing another copy of product is close to zero.

A good startup should have the potential for great scale built into its first design. Twitter has more than 250 million users, but it doesn’t need to add too many customized features in order to acquire more.

4. Branding

A company has a monopoly on its own brand by definition, so creating a strong brand is a powerful way to claim a monopoly. A powerful brand also needs strong underlying substances.

Apple doesn’t only have paid advertising, branded stores, or luxurious materials, it also has a complex suite of proprietary technologies both in hardware and software. It manufactures products at large scales and dominates pricing for the materials it buys. Apple also have a content ecosystem: apps, apps developers and app users. Those advantages are less visible, but they are the fundamentals that let the branding effectively reinforce Apple’s monopoly.

Building a monopoly

Brand, scale, network effects, and technology in some combination define a monopoly, but to get them to work, you need to choose your market carefully and expand deliberately.

Start Small and Monopolize

Every startup is small at the start and every monopoly dominates a large share of its market. It means that startup should start with a very small market, because it’s easier to dominate a small market than a big one. Yet, small doesn’t mean non-exist.

Case: PayPal

PayPal made a mistake on trying to dominate the PalmPilot users market with their money beaming technology. Although no one else did that technology, the users didn't need it. The market for that technology didn't exist. In late 1999, PayPal targeted the small market of  high-volume "PowerSeller" on eBay. After three month, they served 25% of the market.

The perfect target market for a startup is small group of particular people concentrated together and served by few or no competitors. Any big market is a bad choice, and worse is a big market with competing companies. In practice, a large market will either lack a good starting point or it will be open to competition, which mean zero profit.

Scaling Up

Once you create and dominate a niche market, then you should gradually expand into related and slightly broader markets. Amazon started with books, then expanded to CDs, videos, and software. It added categories gradually until it had become the world’s general store.

eBay also started by dominating the Beanie Baby trading market, comprised of a small number of enthusiast. Then it gradually expanded to other small niche markets before ultimately becoming a reliable marketplace for everyone. However, the auction marketplace doesn’t fit well into commodity products, like pencil or Kleenex. eBay is still a valuable monopoly, but it is just smaller than people in 2004 expected it to be.

Don’t Disrupt

“Disruption” has become a buzzword in Silicon Valley. The concept describes threats to incumbent companies, so startups like to describe themselves through older firms’ eyes. However, if your company can be summed up by just its opposition to already existing firms, it can’t be completely new and it’s probably not to become a monopoly.

Disruption also attracts attention; disruptors are people who look for trouble and find it. Think Shawn Fanning and Sean Parker, founders of Napster, who picked fight with the music industry. They made it to the cover of Time magazine, and went bankrupt a year and a half later.

PayPal can be seen as a disruption to the banking business. Yet, you may use PayPal and traditional checking cards for other reasons. The overall dynamic was net positive, unlike Napster’s negative-sum struggle with the U.S. recording industry.

As you craft a plan to expand to adjacent markets, don’t disrupt: avoid competition as much as possible.

The Last Will be First

“First mover advantage” means being the first entrant to the market, capture significant market share while competitors scramble to get started. But what really matter is generating cash flows in the future, so it doesn’t help if someone else comes along and unseats you. It’s much better to be a last mover and make the last great development in a specific market and enjoy decades of monopoly profits. The way to do that is to dominate a small niche and scale up from there, toward your ambitious long-term vision.

To cite chess Grandmaster Jose Raul Capablanca: to succeed, “you must study the endgame before everything else.”

About Weekly Reading

Weekly Reading is a personal project to expand my knowledge by exposing myself to new ideas. Every Saturday, I lock myself in the neighborhood Barnes & Nobles and consume a book in one reading. Then, I share my note with the world.

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