Notes Essays—Peter Thiel’s CS183: Startup—Stanford, Spring 2012
Companies exist because they optimally address internal and external coordination costs. In general, as an entity grows, so do its internal coordination costs. But its external coordination costs fall. Totalitarian government is entity writ large; external coordination is easy, since those costs are zero. But internal coordination, as Hayek and the Austrians showed, is hard and costly; central planning doesn’t work.
The path from 0 to 1 might start with asking and answering three questions. First, what is valuable? Second, what can I do? And third, what is nobody else doing?
The intellectual rephrasing of these questions is: What important truth do very few people agree with you on? The business version is:_ What valuable company is nobody building_?
You know you’re on the right track when your answer takes the following form: “Most people believe in X. But the truth is !X." Make no mistake; it’s a hard question. Knowing what 0 to 1 endeavor is worth pursuing is incredibly rare, unique, and tricky. But the process, if not the result, can also be richly rewarding.
And over ice cream, the PayPal team reached an important conclusion: BD didn’t work. They needed organic, viral growth. They needed to give people money. So that’s what they did. New customers got $10 for signing up, and existing ones got $10 for referrals. Growth went exponential, and PayPal wound up paying $20 for each new customer. It felt like things were working and not working at the same time; 7 to 10% daily growth and 100 million users was good. No revenues and an exponentially growing cost structure were not. Things felt a little unstable. PayPal needed buzz so it could raise more capital and continue on.
Great companies do three things. First, they create value. Second, they are lasting or permanent in a meaningful way. Finally, they capture at least some of the value they create.
People often talk about “first mover advantage.” But focusing on that may be problematic; you might move first and then fade away. The danger there is that you simply aren’t around to succeed, even if you do end up creating value. More important than being the first mover is being the last mover. You have to be durable. In this one particular at least, business is like chess. Grandmaster José Raúl Capablanca put it well: to succeed, “you must study the endgame before everything else.”
The really valuable businesses are monopoly businesses. They are the last movers who create value that can be sustained over time instead of being eroded away by competitive forces.
It’s just that the bigger the class, the harder it is to be number one. Well-defined, well-understood markets are simply harder to master.
So if we decide that Google as a tech company, we must view it in a different context entirely. It’s not surprising that this is Google’s narrative. Monopolies and companies worried about being perceived as such tell a union story. Defining their market as a union of a whole bunch of markets makes them a rhetorical small fish in a big pond. In practice, the narrative sounds like this quotation from Eric Schmidt: “The Internet is incredibly competitive, and new forms of accessing information are being utilized every day.” The subtext is: we have to run hard to stay in the same place. We aren’t that big. We may get defeated or destroyed at any time. In this sense we’re no different than the pizzeria in downtown Palo Alto.
There are three steps to creating a truly valuable tech company. First, you want to find, create, or discover a new market. Second, you monopolize that market. Then you figure out how to expand that monopoly over time.
Finding the right market is not a rhetorical exercise. We are no longer talking about tweaking words to trick ourselves or persuade investors. Creating your market has nothing to do with framing stories about intersections or unions. What is essential is to figure out the objective truth of the market.
If there is no compelling narrative of what the market is and how it can scale, you haven’t yet found or created the right market. A plan to scale is crucial.
The best kind of business is thus one where you can tell a compelling story about the future. The stories will all be different, but they take the same form: find a small target market, become the best in the world at serving it, take over immediately adjacent markets, widen the aperture of what you’re doing, and capture more and more. Once the operation is quite large, some combination of network effects, technology, scale advantages, or even brand should make it very hard for others to follow. That is the recipe for building valuable businesses.
The big question about Twitter is whether it will ever make any money. That’s not an easy question to answer. But if you ask the future tech questions—Do you have a technological advantage? Do you have a moat? Can people replicate this?—Twitter seems safe. If Twitter’s market is the market for sending messages of 140 characters or less, it would be incredibly hard to replicate it. Sure, you can copy it. But you can’t replicate it. Indeed, it’s almost impossible to imagine a technological future where you can compete with Twitter. Move to 141 characters and you break SMS compatibility. Go down to 139 and you’re just missing a character. So while monetization is an open question, Twitter’s robustness and durability are hard to beat.
All these companies are different, but the pattern is the same: start with a small, specific market, scale up, and always have an account of how robust you are going forward. The best way to fail is to invert this recipe by starting big and shrinking. Pets.com, Webvan, and Kozmo.com made this mistake. There are many modes of failure. But not being honest about objective market conditions is a sort of failure paradigm. You can’t succeed by believing your own rhetoric over reality except by luck.
One way to tell whether you’ve found a good frontier is to answer the question “Why should the 20th employee join your company?” If you have a great answer, you’re on the right track. If not, you’re not. The problem is the question is deceptively easy sounding.
“Why would the 20th engineer join your company when they could go to Google instead and get more money and prestige?”
So you have to strike the right balance between nerds and athletes. Neither extreme is optimal. Consider a 2 x 2 matrix. On the y-axis you have zero-sum people and non zero-sum people. On the x-axis you have warring, competitive environments (think Indian food joints on Castro Street or art galleries in Palo Alto) and then you have peaceful, monopoly/capitalist environments. Most startups are run by non-zero sum people. They believe world is cornucopian. That’s good. But even these people tend to pick competitive, warring fields because they don’t know any better. So they get slaughtered. The nerds just don’t realize that they’ve decided to fight a war until it’s all over. The optimal spot on the matrix is monopoly capitalism with some tailored combination of zero-sum and non zero-sum oriented people. You want to pick an environment where you don’t have to fight. But you should bring along some good fighters to protect your non zero-sum people and mission, just in case.
First, a company must have very talented people. Second, they must have a long-term time orientation. Third, there must what might be called a generative spirit, where people are constantly creating. With this framework, hiring is more understandable: you just find people who have or contribute to all three properties. Culture is the super-structure to choose and channel people’s energies in the right direction.
One good hiring maxim is: whenever there’s any doubt, there’s no doubt. It’s a good heuristic. More often than not, any doubt precluded a hire.
Even in best of startups, a lot of chaotic things happen. If disagreements aren’t surfacing, it’s not because there are none. Key things are being covered up. Everyone moving together in lockstep is a big red flag, not an ideal.
Thiel’s law: A startup messed up at its foundation cannot be fixed.
In this calculus, one factor dominates all others. That factor is whether the founders are aligned with each other. This is key both in terms of structure and company culture. If the founders are in sync, you can move on to the rest of the equation. But if they aren’t, it will blow up the company. Nothing will work. This is why investors should and do focus so much on founding teams. Everything matters. How well the founders know each other matters. How they interact and work with each other matters. Whether they have complimentary skillsets and personalities matters. This set of questions is very important. Any fissures in the founding team will be amplified later on.
The question of the founding team is thus the single most important question in assessing an early startup. There are a couple different versions of it. How do the founders split up equity amongst themselves? How well do they work together?
The crucial takeaway is that most measures of equity are irrelevant. The number of shares is irrelevant. Share price is irrelevant. The share of the option pool is irrelevant. Your share relative to other employees’ share should be irrelevant, at least ideally. What matters is your share of the company.
One of the most important things to understand is that, like all people, VCs are different people at different times of day. It helps to pitch as early as possible in the day. This is not a throwaway point. Disregard it at your peril. A study of judges in Israel doing parole hearings showed prisoners had a two-thirds chance of getting parole if their hearing was early in the day. Those odds decreased with time. There was a brief uptick after lunch—presumably because the judges were happily rested. By the end of the day people had virtually no chance of being paroled. Like everyone, VCs make poorer decisions as they get tired. Come afternoon, all they want to do is go home. It does indeed suck to have to wake up early to go pitch. But that is what you must do. Insist that you get on the calendar early.
SpaceX has a great elevator pitch: “Launch costs haven’t come down in decades. We slash them by 90%. The market is $XXbn.” (Contrast this with: “We’re NASA meets Toyota!”)
The equation form of a good short pitch would be problem + solution = money. Get this down, because VCs are floating around everywhere and you never know when or where you’ll be pitching. Don’t be pushy. Don’t pounce on them. Certainly don’t interrupt their dinner. But if you are in a good social context go for it.
One alternative approach that does _work well is the pre-pitch. Done properly, this can be very effective. It’s basically PR. TechCrunch has to run 20 stories a day. Let one of them be about you. If you do it right, VCs might actually approach you.
To avoid this fate, tell a story – and try to do it first without relying on your deck. People like stories. Our brains are wired to respond them. We recall facts better when they are embedded in narrative. Hollywood is the proof of their value. We pay lots of money for stories. Entertainment is a much bigger industry than venture capital because people like stories. Even a crappy game like Mass Effect 3 sells a million copies because it tells a story. So you should try to tell one, too. Why did you start your company? What do you want to achieve? Then drape the facts around that skeleton.
Fortunately, the framework for a good story has been long established. Aristotle figured out the elements of a perfect pitch thousands of years ago. He identified the principles of logos, ethos, and pathos. Logos is argument based on facts and reason. Ethos is argument based on character—_your _character. This is the credibility piece. Finally, pathos is argument based on listeners’ emotions. Those are what you need to exploit. So think about your pitch in terms of logos, ethos, and pathos. There is 3,000 years of decent evidence that people respond to pitches that get these factors right.
Another trick that smart law students understand is to underline key phrases. Professors never actually fully read exams or bluebooks. And there are only 10-15 important concepts in any given question on a law exam. So if you underline those concepts on the paper, the professor sees them. The professor probably won’t even take the time to see if you correctly embedded those concepts. You’ve made grading easy, and you get an A. Venture Capital isn’t that different. If you underline important stuff, you reduce the amount of effort the VC has to put in. That reduces friction in the decision making process, which is the goal of all this.
Again, organic conversation is much better than talking through your deck. So break from the deck quickly. You start with the vision – what do you ultimately want to accomplish. Explain why you are a company, not just a product/feature? Then get into the business. What is it? Why is it superior? Why is it not likely to be displaced for some time? Be clear and concise. Your pitch will be recapitulated by people inside the firm. Give anyone on your side sufficient ammunition to defend your company to their co-workers. VCs love to poke holes in their partners’ proposed investments— it’s a critical part of the lemon detection process. Anticipate the holes and fill them.
The team is important. This is the ethos part of the presentation—why are you the right people for the task? Why should the VC trust you? Who (and what skills) do you have? Are you missing anyone? How are you going to recruit and convince that 20th employee to join? Also be prepared to talk about your compensation philosophy. Some VCs, you might have heard, have strong views on compensation.
The discussion should then turn to your market, and specifically the size of the “addressable” market and how you are going to grab it. How much of the market are you going to capture? How? What’s your assessment of the competition? Be honest. It’s almost always a mistake to insist that you have no competition. VCs will get that you think you’re (going to be) better than the competition—everyone knows it’s a pitch. But radically underestimating your competition will set off peoples’ BS detectors.
Being able to talk about revenue, sales processes, customer acquisition, and barriers to entry/exit shows your VCs that you’re not that naïve.
You also need to have a clear ask. How much are you looking to raise? What do you need it for? What’s your burn rate? The one question that people don’t seem to want to talk about is valuation, which, of course, is what people really want to know. You should discuss valuation early on—perhaps not in your first pitch, but certainly in your second. It’s a gating factor, so there’s no point in investing many cycles if you’re orders of magnitude apart of price. And yet VCs and entrepreneurs alike tend to dance around it.
There are all sorts of small nuggets of wisdom that are worth remembering. Don’t present data in weird ways. It’s a pitch, not a modern art class. Label your axes. Do not include charts or references to Facebook unless your thing honestly and actually has to do with Facebook. Though even the most out-of-touch VCs get that Facebook is catching on with young people and somehow important, none will be fooled by unrelated logos and clip art.
Predictable things that VCs will want to know: Macro a. Are you a company or just a product/feature? b. Your vision for the company Your product(s) a. What it is b. What problem it solves c. Why it is superior d. Why it is not likely to be displaced for some time Team a. This is the ethos part of the presentation – why are you the right people for the task and why should the VC trust you? b. Are you missing anyone? c. How are you recruiting/convince the 20th employee to join? d. What’s your philosophy on compensation? The Business a. Market size, specifically the “addressable” market b. How much of the market are you are going to capture and how c. Competitive analysis/advantages d. Business model e. How will you generate revenue? 1. Sales process * Customer acquisition cost * Profitability f. Barriers to entry/exit The Ask a. How much do you need and what will you use it for? b. What’s your burn? c. Valuation Funding History/Syndication a. Who else are you talking to? (This is the pathos bit) b. Why do you want to work with this VC? c. What do you want from the VC besides money?
There are two closely related questions that are worth drilling down on. First is the simple question: how does one actually distribute a product? Second is the meta-level question: why is distribution so poorly understood? When you unpack these, you’ll find that the first question is underestimated or overlooked for the same reason that people fail to understand distribution itself.
Nikola Tesla invented the alternating current electrical supply system. It was, for a variety of reasons, technologically better than the direct current system that Thomas Edison developed. Tesla was the better scientist. But Edison was the better businessman, and he went on to start GE. Interestingly, Tesla later developed the idea of radio transmission. But Marconi took it from him and then won the Nobel Prize. Inspiration isn’t all that counts. The best product may not win.
Customer lifetime value, or CLV Average revenue per user (per month), or ARPU Retention rate (monthly, decay function), or r Average customer lifetime, which is 1 / (1-r) Cost per customer acquisition, or CPA
The big question about sales is whether all salesmen are really just actors of one sort or another. We are culturally biased to think of salespeople as classically untrustworthy, and unreliable. The used car dealer is the archetypical example. Marc Andreessen has noted that most engineers underestimate the sales side of things because they are very truth-oriented people. In engineering, something either works or it doesn’t. The surface appearance is irrelevant. So engineers tend to view attempts to change surface appearance of things—that is, sales—as fundamentally dishonest.
The message is that sales is hidden. Advertising is hidden. It works best that way.
To succeed, every business has to have a powerful, effective way to distribute its product. Great distribution can give you a terminal monopoly, even if your product is undifferentiated. The converse is that product differentiation itself doesn’t get you anywhere. Nikola Tesla went nowhere because he didn’t nail distribution. But understanding the critical importance of distribution is only half the battle; a company’s ideal distribution effort depends on many specific things that are unique to its business. Just like every great tech company has a good, unique product, they’ve all found unique and extremely effective distribution angles too.
Advertising is tricky in the same way that sales is. The main problem is that, historically at least, you never quite know if your ads are working. John Wanamaker, who is billed as the father of advertising, had a line about this: “Half the money I spend on advertising is wasted: the trouble is I don’t know which half.” You may think your ad campaign is good. But is it? Or are the people who made your ad campaign just telling you that it’s good? Distinguishing between fact and sales pitch is hard.
Marketing people can’t do viral marketing. You don’t just build a product and then choose viral marketing. There is no viral marketing add-on. Anyone who advocates viral marketing in this way is wrong and lazy. People romanticize it because, if you do it right, you don’t have to spend money on ads or salespeople. But viral marketing requires that the product’s core use case must be inherently viral. Dropbox, for example, let’s people share files. Implicit is that there’s someone—a potential new user—to share with. Spotify does this with its social music angle. As people use the product, they encourage other people to use it as well. But it’s not just a “tell your friends” button that you can add-on post-product.
Poor distribution—not product—is the number one cause of failure. If you can get even a single distribution channel to work, you have great business. If you try for several but don’t nail one, you’re finished. So it’s worth thinking really hard about finding the single best distribution channel. If you are an enterprise software company with a sales team, your key strategic question is: who are the people who are most likely to buy the product? That will help you close in on a good channel. What you want to avoid is not thinking hard about which customers are going to buy it and just sending your sales team out to talk to everybody.
The questions you must ask are: how big is the distribution problem? And can this business solve it?
Marc Andreessen’s most famous thesis is that software is eating the world. Certainly there are a number of sectors that have already been eaten. Telephone directories, journalism, and accounting brokerages are a few examples. Arguably music has been eaten too, now that distribution has largely gone online. Industry players don’t always see it coming or admit it when it arrives. The New York Times declared in 2002 that the Internet was over and, that distraction aside, we could all go back to enjoying newspapers.
If it’s true that software is eating the world, the obvious question is what else is getting or will soon get eaten? There are a few compelling candidates. Healthcare has a lot going on. There have been dramatic improvements in EMR technology, healthcare analytics, and overall transparency. But there are lots of regulatory issues and bureaucracy to cut through. Education is another sector that software might consume. People are trying all sorts of ways to computerize and automate learning processes. Then there’s the labor sector, where startups like Uber and Taskrabbit are circumventing the traditional, regulated models. Another promising sector is law. Computers may well end up replacing a lot of legal services currently provided by humans. There’s a sense in which things remain inefficient because people—very oddly—trust lawyers more than computers.
How should one assess industries and opportunities if software is really eating the world? Consider a 2 x 2 matrix. On the vertical axis you have two choices: compete with computers or work with computers. This is essentially anti-technology and pro-technology. On the horizontal axis, your choices are: compete against China or work with China. This essentially corresponds to anti-globalization and pro-globalization.
The strongest form is that, as a consequence of all this, Silicon Valley type software companies will end up eating everything. The kinds of companies we build in the Valley will rule pretty much every industry. These companies have software at their very core. They know how to develop software. They know the economics of software. They make engineering the priority. And that’s why they’ll win.
The companies that will end up dominating most industries are the ones with the same set of management practices and characteristics that you see at Facebook or Google. It will be a rolling process, of course, and the backlash will be intense. Dinosaurs are not in favor or being replaced by birds.
Marc Andreessen: The number one reason that we pass on entrepreneurs we’d otherwise like to back is focusing on product to the exclusion of everything else. We tend to cultivate and glorify this mentality in the Valley. We’re all enamored with lean startup mode. Engineering and product are key. There is a lot of genius to this, and it has helped create higher quality companies. But the dark side is that it seems to give entrepreneurs excuses not to do the hard stuff of sales and marketing. Many entrepreneurs who build great products simply don’t have a good distribution strategy. Even worse is when they insist that they don’t need one, or call no distribution strategy a “viral marketing strategy.”
Marc Andreessen: The core problem with patents is that patent examiners don’t get it anymore. They simply don’t and can’t know what is novel versus what isn’t. So we get far too many patents. As a tech company, you have two extreme choices: you could spend your entire life fighting patents, or you could spend all your money licensing usage. Neither of those extremes is good. You need to find the balance that lets you think about patents least. It’s basically a distracting regulatory tax.
Startups are like sausage factories. People love eating sausage. But no one wants to watch the sausage get made. Even the seemingly glorious startups only seem that way. They’ve had crisis after crises too.
Synthetic biology is one example. That might be the next big thing. It’s basically biology—creating new biological constructs with code. This freaks people out. It’s very scary stuff. But it actually seems to work, and it could be huge.
“Capitalism and competition are antonyms.” That is a secret; it is an important truth, and most people disagree with it. People generally believe that the differences between firms are pretty small. They miss the big monopoly secret because they don’t see through the human secrets behind it.
The distribution secret also has two sides to it. Distribution is much more important than people think. That makes it a business secret. But it’s a human secret too, since the people involved in distribution work very hard to hide what’s going on. Salespeople do best when people do not know they’re dealing with salespeople.
The oceans remain unexplored in a fairly interesting way. The planet is 72% covered by oceans. Some 90% of the inhabited ocean is deep sea. There have been only about 200 hours of human exploration there. So oceans are the last big geographic piece that people aren’t really looking at. But that may be because the default assumption is right; there’s nothing terribly interesting there. Deep sea exploration simply lacks the magic of exploring new lands and continents.
Studying nature becomes the most important thing you could possibly do. This is why physics Ph.D’s are notoriously difficult to work with; because they know fundamental things, they think they know all things.
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 teach other.
There has been a powerful shift toward the idea that statistical ways of thinking are going to drive the future.
The main problem with energy is that production costs are quite variable. Energy is considerably more expensive during peak usage times. But since it's very hard to store power that is produced off-peak, good solutions have been elusive.
People have been interested in predicting the weather for a very long time. It’s sort of amazing that we are still really bad at it. Short-term forecasts are notoriously bad.
Peter Thiel: A general rule of thumb on distribution is the larger the cost of a product, the slower the process.
Peter Thiel: Remember that sales works best when it’s disguised.
If you want to sell, the best thing to do would be to act like you don’t. The VC version of this is: If you want advice, ask for money. If you want money, ask for advice.
Ricardian trade theory would say that if China can make cheaper cars than can be made in the U.S., it is good for us to buy cars from China. Yes, some people in Detroit lose their jobs. But they can be retrained. And local disturbances notwithstanding, total value can be maximized.
AI, by contrast, is an unregulated frontier. You can launch just as quickly as you can build software. It might cost you $1 million, or millions. But it won’t cost $1 billion. You can work from your basement. If you try to synthesize Ebola or smallpox in your basement, you could get in all sorts of trouble. But if you just want to hack away at AI in your basement, that’s cool. Nobody will come after you. Maybe it’s just that politicians and bureaucrats are weird and have no imagination. Maybe the legislature simply has no mind for AI-kind of things. Whatever the reason, you’re free to work on it.
Intelligence augmentation works because it focuses on conceptual understanding. If there is no existing model for a problem, you have to come up with a concept. Computers are really bad at that. It’d be a terrible idea to build an AI that just finds terrorists. You’d have to make a machine think like a terrorist. We’re probably 20 years away from that. But computers are good at data processing and pattern matching. And people are good at developing conceptual understandings. Put those pieces together and you get the augmentation approach, where gains from trade let you solve problems vertical by vertical.
Network effects could offer a serious advantage. Say you develop great image recognition software. If you’re the first and the best, you can become the AWS of image recognition. You create an entrenching feedback loop; everyone will be on your system, and that system will improve because everyone’s on it.
Bob McGrew: The simple way to do it is to talk about specific problem. Deep Blue beat Kasparov in 1997. Computers can now play better chess than we can. Fine. But what is the best entity that plays chess? It turns out that it’s not a computer. Decent human players paired with computers actually beat humans and computers playing alone. Granted, chess is a weak-AI in that it’s well specified. But if human-computer symbiosis is best in chess, surely it’s applicable in other contexts as well. Data analysis is such a context. So we write programs to help analysts do what computers alone can’t do and what they can’t do without computers. Eric Jonas: And look at mechanical turk. Crowdsourcing intelligent tasks in narrowly restricted domains—even simple filtering tasks, like “this this is spam, this is not”—shows the increasingly blurring line between computers and people. Bob McGrew: In this sense, Crowdflower is Palantir’s dark twin; they’re focusing on how to use humans to make computers better.
The usual narrative is that society should be organized to cater to and reward the people who play by the rules. Things should be as easy as possible for them. But perhaps we should focus more on the people who don’t play by the rules. Maybe they are, in some key way, the most important. Maybe we should let them off the hook.
This course has largely been about going from 0 to 1. We’ve talked a lot about how to create new technology, and how radically better technology may build toward singularity. But we can apply the 0 to 1 framework more broadly than that. There is something importantly singular about each new thing in the world. There is a mini singularity whenever you start a company or make a key life decision. In a very real sense, the life of every person is a singularity. The obvious question is what you should do with your _singularity. The obvious answer, unfortunately, has been to follow the well-trodden path. You are constantly encouraged to play it safe and be conventional. The future, we are told, is just probabilities and statistics. _You are a statistic. But the obvious answer is wrong. That is selling yourself short. Statistical processes, the law of large numbers, and globalization—these things are timeless, probabilistic, and maybe random. But, like technology, your life is a story of one-time events. By their nature, singular events are hard to teach or generalize about. But the big secret is that there are many secrets left to uncover. There are still many large white spaces on the map of human knowledge. You can go discover them. So do it. Get out there and fill in the blank spaces. Every single moment is a possibility to go to these new places and explore them. There is perhaps no specific time that is necessarily right to start your company or start your life. But some times and some moments seem more auspicious than others. Now is such a moment. If we don’t take charge and usher in the future—if you don’t take charge of your life—there is the sense that no one else will. So go find a frontier and go for it. Choose to do something important and different. Don’t be deterred by notions of luck, impossibility, or futility. Use your power to shape your own life and go and do new things.