Before you start a company, find this kind of secret – an insight that will help you maximize leverage against your competitors and that doesn’t oppose strength with strength.

How do you do that?

I think about it like Judo. There are two basic tenets of judo:

First: never to oppose strength with strength.

Second: maximize leverage.

You can’t compete with Google by building a better search engine. Google will put 100x the engineering team, leverage their 1,000x greater click data and out spend you on marketing by 10,000x. Don’t oppose strength with strength. Startups shouldn’t rely on more manpower, bigger ad budgets or data access advantages in fields where there is a large incumbent. During its infancy, Google won with distribution. Most internet companies believed search wasn’t valuable. Google thought differently. They offered to power all the major portals’ search engines and eventually dethroned them. This was Google’s secret.

The question, then, is what to leverage. Startups’ advantage is speed which means they can explore new technologies (mobile apps, Node, Meteor, Cassandra) which build better products, new distribution channels (mobile and tv app stores, viral, OpenGraph) which reach customers more cost effectively or novel product designs (Path, Dropbox, Expensify).

Many companies are now using distribution as their secret – mobile app stores and Facebook Open Graph enable startups to access hundreds of millions of users in ways that incumbents simply aren’t prepared to leverage. Expensify uses mobile app stores to acquire hundreds of thousands of SMBs in ways that their market’s incumbent, Concur (market cap $3B), simply can’t copy. Branchout is building a massive job network on top of Facebook to compete with LinkedIn. If LinkedIn were to copy Branchout, they would marginalize the value of their existing network because LinkedIn would cede their graph to Facebook – an example the classical innovator’s dilemma.

Find your secret and you’ll be well on your way to disrupting a huge market.

NB: Thiel does mention other kinds of secrets. For example, PayPal’s financial losses due to fraud which are secrets in the traditional sense. It’s important to think about the judo principles when deciding whether to keep these secret. Simply put, if a competitor can gain leverage by using the secrets you disclose, keep them closely held.

Thanks to Jarek who inspired this post with his comment on How to Pick Your Startup’s Market.

First, I learned both Zynga and LinkedIn plan products the way I described.

Jack Chou, a great friend who was head of monetization at LinkedIn, commented:

When I started at LinkedIn, the team framed everything through a lens of (essentially) the same pillars: Growth, Engagement, Monetization.

Alan Wells, game producer for the iPhone version of Live Poker, said:

At Zynga, we called it the 3R’s: Reach, Retention, Revenue. Same idea – all initiatives and features on the roadmap had to be considered through the lens of how it would impact one or more of those things.

Of course,  Zynga and LinkedIn are freemium businesses though they serve very different markets: consumer gaming vs recruiters. In the HackerNews comments, mberning asked a great follow-up question:

Seems focused on ad-based or freemium business models. Would like to know his thoughts on top 3 priorities for a company selling product directly.

I work with 2 companies who sell directly, one in ecommerce and one selling paid subscription services through a telesales team. Both companies also think about their business strategy in the Distribution, Engagement, Monetization framework. I don’t think the sales model impacts priorities. The goal of a company is to product, fill the funnel of users, drive user engagement and then ask their customers to pay. Some may defer the last point for a while, but from Path to MapR, the priorities of the companies are the same.

However, the tactics to achieve that strategy vary widely. For example, distribution might come through direct sales teams, SEM/SEO, channel partners, mobile applications, TV/mass media ads, viral growth and so on.

Next, there was a debate about the relative importance of the three priorities. Yoseph wrote:

You don’t really get a sense for engagement until your product is being used on a large scale. That’s the true test for engagement. That’s why distribution should come first.

I agree completely. Of course every product will have a small beta or pilot in which you should be measuring engagement and evaluating whether the product works before building distribution. But after that, increasing the user base is priority #1. Those users will provide you the data to refine the product to better serve the needs of the customers and eventually reduce churn.

A few asked whether I consider managing churn as part of engagement. Yes, they go hand in hand.

Lastly, brunohq opined:

It seems an interesting exercise to do, and keeps you aware of your long-term achievements. Focused and aware. I’ll definitely try that

That’s the goal: inform and inspire everyone to pursue the same clear goals, monitor and gauge your performance, fix what didn’t work, and move to the next target. Lather. Rinse. Repeat. The timing of board meetings should match this cycle.

Thanks to everyone who participated in the conversation and read the article. And in particular, thanks to Bill Ferrell, founder of Embark, who inspired my to change the way I blog. Thanks, Bill!

At board meetings, I’ve started categorizing each portfolio company’s roadmap items into these three buckets. It’s a beautiful simplification that immediately reveals the priorities of the company at any stage. Is most of the product development focused on growth or new product features that drive engagement? How have those priorities changed over time? Where are most of our people allocated? Are these priorities the right ones given the stage of the company?

Breaking strategy into these three parts makes it easy – you now have a template, a stencil for describing your strategy. Make a table that looks like this:

Fill it in with the top 2 to 3 initiatives per quarter. You have just built a board-level roadmap that describes your strategy. Explain it to your board, solicit feedback, then hold a town hall and describe it to your team. Then get back to building your company!

Update: I’ve written a follow up post after some great conversations/comments and the amazing distribution this post has received.

Private capital markets lack a single common platform. As a result of information asymmetry and market fragmentation, private companies suffer enormous costs and miss key strategic opportunities.

AxialMarket levels the playing field for bootstrapped entrepreneurs and the advisors who help them finance and exit their business. AxialMarket enables entrepreneurs and their advisors to access private equity and debt capital sources that include family offices and strategic buyers – ultimately increasing efficiency in the market place. The company has amassed a network of thousands of deal professionals, data on private company profiles and strategies, developed deal marketing tools and deal pipeline software. It’s clear why these deal professionals use AxialMarket: the network makes them more successful.

We believe AxialMarket will be a dominant platform in the private markets. Headed by Peter Lehrman, who was instrumental in the growth of Gerson Lehrman Group, AxialMarket has grown dramatically, helping 8,800 companies execute financial transactions. In the words of their customers, every day on AxialMarket is “the biggest conference of the year in the private markets.”

We’re thrilled to welcome AxialMarket and the Axialites into the Redpoint family and we can’t wait to see how AxialMarket will grow and transform the private capital markets.

Electric Imp will soon release the Imp, an inexpensive WiFi enabled computer the size of an SD card, designed to allow almost any electrical product to communicate with users and services on the web. Imps enable device manufacturers to easily connect their devices to the Internet and empower consumers to control their homes from just about anywhere using just a phone or computer. Electric Imp builds the Internet service that communicates with these devices.

At Redpoint, we believe the connected age is just beginning and that most devices will be internet enabled. Today, the technology platforms to enable these kinds of connections and communications aren’t yet in place. Electric Imp will build this infrastructure. We believe that by providing low cost, simple and immensely flexible Imps, the company will become the networking and software layer for the connected home and office.

We welcome the Electric Imp team into the Redpoint family and are excited to help them achieve their vision.

When I’m meeting a startup for the first time, my goal is to understand as much about the business and team as I can.

• Founders/Team: How do the founders know each other? How do they interact with each other? Are they passionate? How qualified are they? What would it be like to work with them?
• Business: In some form, I walk through the Business Model Generation framework: value proposition, key activities, key partners, major assets, channels of distribution, customer segments, cost structure and revenue streams.
• Basics: Can the company simply articulate their value proposition? Can the team explain how they will go to market? Do they have a good understanding of the competition?

After the first meeting

After a startup has left and I’m “doing diligence”, I want to test some of the assertions made by the company.

• Market Size Validation: The first thing is to verify market size and whether it foots with the data the company presented. Then, I try to dig deeper into the nuances of the market. How concentrated is the market? What kinds of moves are the incumbents making and how they change the market?
• Pitch-it-myself test: I stop a few partners in the office and give them the pitch to test their reactions. I do the same with my wife. In a sense, I’m getting their cursory opinions and some skewed market feedback, but I’m also testing the pitch, the go-to-market and the top level attractiveness of the company. It helps me think through a lot of the business.
• Six degrees of separation. I look up the founders on LinkedIn, send a few emails for references and then wait to hear back on some initial thoughts.

Second and third meetings

Follow up meetings are dedicated to metrics and the future.

• Pipeline: Let’s get to brass tacks and some numbers. How many customers/users? How often are they using it? What are CAQ, LTV and churn metrics? How do those compare with industry benchmarks?
• Product roadmap: I know it’s early and hard to forecast, but I’m looking to be convinced the founder have a good sense of where the company is going and why.
• Financing plan: What are your major buckets of expenditures? How do they change over time? Is your revenue plan reasonable? What are the key metrics for the business?
• Industry: I’ll call a few friends in the industry who can help me better understand the dynamics in the sector.

Additional meetings

At this point, I’m really interested and I’m trying to understand the investment risks better.

• Key issues analysis: After a founder has met several partners, I gather questions and dig deeper to answer them as best I can. If I don’t have the material to answer the questions, I diligence some more: data, reference calls, and more meetings.

After the term sheet:

After the term sheet is signed, the lawyers step in.

• Legal diligence:  I’m interested in learning how well formed the company is, if there are skeletons in the closet like fired co-founders or large debts or consultants who are owed shares or pending lawsuits. I’m also curious to see how a founder negotiates (though this comes through after the term sheet has been issued).

There has been one idea that I’ve been thinking about for a few days after I read it. From the fourth class entitled “Last Mover Advantage”, the idea discusses the right types of markets for startups to pursue:

The Goldilocks principle is key in choosing the initial market; that market should not be too small or too large. It should be just right. Too small a market means no customers, which is a problem. This was the problem with PayPal’s original idea of beaming money on palm pilots. No one else was doing it, which was good. But no one really needed it done, which was bad.

Markets that are too big are bad for all the reasons discussed above; it’s hard to get a handle on them and they are usually too competitive to make money.

Combining this idea with the notion that the last-mover in a market has an advantage, I can explain many of the biggest Internet successes:

• Google – last mover in search and search ads. The search ads market was roughly half of the $8B market – not too big, not too small.
• Facebook – last mover (at least for now) in social media. Social media ad market was less than $1B when the company started.
• Dropbox – near last mover in consumer storage. The industry was considered unprofitable by investors given Mozy and Carbonite’s trajectories and was at most $2B at the time the company started.
• Apple – near last mover in portable music players and computers. What a turnaround we’ve seen.

Common across all these examples is significant market growth driven by one company who brought much better product design, strategic management and effective sales processes. It’s easy to point to the product differentiation – later founders used previous product generations and built something significantly better. But it’s also easy to overlook the importance that sales had on most of these companies.

• Google had a team which mechanized closing and on-boarding large search partners growing the revenue base dramatically.
• Dropbox focused significant fractions of their engineering team on optimizing conversion-to-paid funnels. And they maxed out the refer-a-friend program.
• Apple built the best retail experiences which today drive a huge, but undisclosed fraction of sales.

All of this ties back to another one of the classes: distribution. More than building great products, the last movers who won knew or figured out how to distribute their products the best. They could see which strategies had worked and which had struggled.

These last movers also had the advantage that they were selling to an educated market. Their end customers were already aware of the problems these companies sought to solve. Online advertising had gained some scale. Online backup was early in its market development. Social networks had been through a few iterations and users were familiar with the concept. And Rio had brought bulky MP3 players to market. This implied some latent market demand for better products and ultimately faster sales cycles.

My take away: When picking your market, make sure it’s not too big, not too small. Make sure you know why your product is better. Then focus on the most effective path of distribution. Lastly, try t o sell to the previously educated customer.

I’m curious also to find counter-examples – companies who were first to market with a product that were eventually massively successful. Do you have any?

50% of US mobile subscribers use smart phones according to a March Nielsen study. Android has 48% share to Apple’s 32%. Smartphone use skews toward the 25 to 34 user base with 66% penetration. link

According to a study by FreeWheel, the XBox 360 and the iPad each generate about 28% of professional web video views on non-PC/Mac devices, underscoring the strength the gaming consoles have on the living room.  link

The FTC has imposed a 20 year privacy assessment on MySpace after the regulatory body found the company in breach of its privacy policy. MySpace was actively providing advertisers with personally identifiable information among other user data which the company actively provided to advertisers. link

A recent report found 452 crowdfunding platforms are in operation. In the past year, $1.5B has been raised on these platforms across 1M campaigns (about $1500 per campaign). There  are three different types of platforms: equity, debt and donation. Donation platforms are the largest with $680M raised. Debt platforms are in second place at $550M. Equity raises totaled $270M but had the highest average yield with 80% of campaigns raising more than $25k.   link

The Chinese venture capital market is contracting rapidly. Deal volume fell 40% y/y and dollars invested fell 56%, as the broader Chinese economy slows. link

Kindle sales are slowing according to the E-Ink supplier to Amazon’s black and white Kindle. Some financial models forecast a 75% drop in q/q sales from 7M to 1.8M. link

Forrester forecasts tablets will grow at a 48% CAGR and reach 375M sold by 2016. The average life of a tablet is 3 years in their model. link

Video game sales fell 42% y/y according to NPD, after falling 35% in March and 20% in February. link

Product Releases

Facebook announced App Center, a cross platform HTML5 application store that will feature free and paid applications, in a move that will position the company to compete directly with Apple and Google. Facebook Credits will be the major payment mechanism. link

Adobe launched Creative Cloud, a SaaS version of their immensely successful Creative Suite. For between $30 to $75 per month, users may access any of the CS toos.  link

Google has begun to integrate Google Plus into GMail in its continued effort to drive activity on its young social network. In addition the company released a new iOS application to wide design acclaim. link

Mobile payments company Dwolla has released a settlements platform to compete with ACH. The new platform doesn’t charge fees for clearing payments and the company has 12 financial institutions using the platform. link

Apple will deploy OpenSteetMap in its iOS6 release, replacing Google’s mapping tools. link

Company Announcements

GroupOn announced 170M GroupOns sold, 33M active customers and 250,000 merchants. 30% of GroupOn transactions now occur on mobile devices, up from 25% 4 months ago.  link

Box announced 11M users of its enterprise storage platform. link

78M US Facebook users spent on average 441 minutes per month on the mobile site, compared to 391 minutes on the web in April, according to comScore, marking the first time mobile usage exceeded web. link

Google Play has surpassed 15B downloads on its app store compared to 25B for the iTunes store. link

Storm8, the mobile gaming company, announced 300M downloads across 100M unique devices. link

More video is uploaded to YouTube in one month than the 3 major US TV networks created in 60 years. link

Pandora announced 150M US users, 100M of which use the service on mobile devices. Pandora has recorded an 87% increase in hours of music y/y.  link

Talent

Scott Thompson will resign his CEO post at Yahoo after an activist shareholder revealed Thompson had misrepresented his academic credentials. link

Liquidity

LegalZoom filed for an IPO with $156M in ttm revenue (+37% y/y) and $12M in net income. The company has served 2M customers. link

Financings

Google and Facebook are the only active buyers in the market place. Google dominates search and contextual ads in addition to video ads. Facebook owns 28% of display ad inventory. Other players like Aol and Yahoo are riding into the sunset and Microsoft has all but given up acquiring or building, favoring investment. As ad networks migrated to exchanges, power concentrated further. After all, market places are winner take all.

In my view, only an antitrust ruling against Google (right or wrong) would have enough disruptive power to change these dynamics. Perhaps an AppNexus IPO will impact the market, too, but to a much smaller extent.

But this market dynamic isn’t just constrained to ad tech. In fact, the mechanics of social networks and data based businesses reinforce initially small data advantages or user base advantage that soon compound to magnificent power differentials. Google’s search became significantly better over time because they had more clicks. More data led to better algorithms and so on. More users and activity on LinkedIn built the user base – same for Facebook and Zynga. Successful iOS applications convinced new developers to build atop Apple’s platform.  Amazon’s expertise in operating at scale has been rewarded with eCommerce dominance (and subsequent pricing power in acquisitions) as well as infrastructure dominance (AWS).  Instagram and Branchout both have seen compounding growth for the same reasons.

Despite the record amount of cash tech companies carry on their balance sheet (somewhere close to $250B for the top 6), it’s more important than ever for startups to build sustainable standalone businesses. Why? There is no reward for second place in these markets because there are so few buyers in most of these consumer markets.

I have no doubt that market winners will find tremendous exit valuations (Instagram) because the disruptive risk is so great. Chris Dixon points out that it was rational for Facebook to buy a big potential threat for just 1% of their expected market cap. But second place companies won’t find these premiums often because the buyer set is limited and the second place competitor is often much smaller than the winner (because of the social network and data network power compounding effects).

With these kinds of winner take all market place dynamics, your business has to be able to stand on its own as a valuable company. And if you reach the scale that interests one of these big buyers, I’d advise you to go all in. It’s time to get some more competition in these sectors.

Most share trading is now conducted between big banks and hedge funds by high-speed computer programs, and is thus an imperfect guide to market sentiment.

NY Times

And contrasted it with this research:

The emotional roller coaster captured on Twitter can predict the ups and downs of the stock market, a new study finds. Measuring how calm the Twitterverse is on a given day can foretell the direction of changes to the Dow Jones Industrial Average three days later with an accuracy of 86.7 percent.

Wired

It used to be that the market was used as a predictor of consumer sentiment, particularly after the boom of retail brokers with eTrade. Anywhere from 51% to 64% of Americans have owned stock in the past decade. When a stock declined in price, it was assumed shareholders had dimmed their outlook of a security. But high speed trading has changed that – the majority of traded shares are done by computers and are held for fractions of a second. Stock movements now represent the conclusions of trading programs, and over-represent the views of hedge funds and institutional traders.

As a result, social media mining has become, in my view, incredibly important – it’s the only census driven report of American sentiment on any issue that reacts to the news in real time. In 2011, 63% of Americans used social media - more than those who purchased stock. And social media mining for political, economic and market research insight will inexorably increase.

I know the signal exists. I’ve seen its applications first hand. At Google, we increased revenue on social networks by greater than 10x using social media data to inform ad targeting. We see the same results in understanding the effectiveness of TV advertising at Bluefin Labs.

Over the next few years, I’m certain there are many founders who will succeed by (i) leveraging social media to understand their market better (ii) developing products based on the needs of social media users or (iii) transforming insights from social media into concrete actions for their customers to take to improve their businesses. And I’ll be looking for them.