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Archive for the ‘soapbox’ tag

Speaking the Same Language

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For thousands of years, cultures were separated by communication difficulties enforced by language barriers. But today, communication barriers have little to do with native tongue, as English has become the common language of international business, academia and government. Rather, the communication barriers of the 21st century are our differing familiarities with communication technologies. As technologies evolve, these “cultural” differences will become just as powerful as language barriers.

Just this week, I was speaking with a New York State employee who had called me in an attempt to get a corporate issue resolved. I had a complete a form, and part of the conversation went something like this:

Me: How do I find the form?
Her: Are you near a pen and paper?
Me: No, I’m walking. Can you email me the URL?
Her: We can’t use email. I have to spell it out to you.
Me: Okay, but I’m not near a computer or a pen. Can I call you later today?
Her: I don’t have a direct number. I’ll call you.
Me: Okay, so then I mail you the form? What’s your address?
Her: We prefer fax.

I’ve discussed the government technology gap before — clearly, there is a disconnect in native communication platforms between my company and New York State and likely a comparable disparity between myself and this employee. But this is not simply a hierarchy of tech savvy. For instance, while both an average American teenager and I are technologically competent, we live on different platforms — I live on email and Skype and am occasionally annoyed whenever someone sends me an important note via Facebook or over a text message. We communicate in a different technological language.

As communication evolves at an ever-increasing rate, my native platforms will continue to diverge from both the teenager’s and the NY state government employee’s. By the time New York State, for instance, adopts email, I will probably have moved on to a totally different communication platform. But at the same time, new technology quickly yet unevenly spreads across our society, leaving us in the position of being unable to communicate effectively — not across cultural or linguistic barriers, but across technological ones.

On a related note, I have seen several examples of employers making hiring decisions based on a potential employee’s presence on the social web — not in the negative sense that you hear about in the news, but rather to ensure that a new team member participates in the same communication platforms as the rest of the team: Facebook, Twitter et al. This has become a big piece of the “cultural fit” that so many companies — especially startups — talk about.

Communication barriers tend to amplify over time. This is how species are created and languages are formed. If it is difficult for Group A to understand Group B due to a slight language difference, they are less likely to communicate. But with less direct communication between the groups comes a continued divergence of language, which can eventually lead to an entirely new language being created — and the groups totally unable to understand each other. While the opposite process has been happening for the world’s languages, I worry that divergence will begin again on top of technological barriers.

I’m not sure there is an effective solution here. “Education” is one answer, but in reality the problem is rarely an unfamiliarity with technology in general — it is either a lack of comfort with particular platforms or regulatory barriers that prevent its effective use.

Written by Brad Hargreaves

May 1st, 2011 at 11:18 am

The Long Game

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I was having drinks with a few entrepreneurs last week, and the topic of business plan competitions came up. I ran Yale’s competition for a year while I was a student there — a sobering experience. Ostensibly, the winners of the contest were the best potential entrepreneurs. In reality, the top awards were often swept by Yale MBA candidates who spent the entire year perfecting a 30-40 page business plan with little intention of starting a real business. They’d take the award money alongside their McKinsey or Goldman signing bonus.

Most experienced entrepreneurs — or at least most of us around the table that night — agree that business plan competitions suck. But is there a way to improve them? One CEO in attendance suggested that business plan competitions be revised to focus on the real tools of a VC pitch — that is, a slide deck and in-person presentation. It’s certainly a better basis than a business plan, but I don’t think it solves the problem. Rather, it still perpetuates a false and harmful archetype of how venture money is raised.

In reality, raising capital is a long game — a process to be measured across years and companies, not weeks and pitches. The people who “win” the real venture capital game are those entrepreneurs who spend years — if not decades — building their reputation and their relationships with investors. This doesn’t mean that first-time entrepreneurs can’t raise money, but that they’re far better off spending their time setting metrics-driven goals and hitting those goals in order to build trust in the investor community than writing a business plan or shopping a deck.

Business plan competitions can’t build a comparable experience, so they’ve created a generation of first-time entrepreneurs who falsely believe that money is raised in front of a Powerpoint rather than series of coffees and beers.

If you made me redesign the business plan competition, I’d do something pretty nontraditional: a unit economics competition. The contest would be in-person and just takes five minutes per contestant: explain your business concept in 1-2 minutes and walk through one Excel worksheet presenting the unit economics in the next 2-3 minutes. No long-form writing or slides, just the basic math that explains the core cost and revenue drivers and assumptions of your company. And no 3-5 year projections, either. While it might be beneficial for entrepreneurs to fully think through their company by spending 150 hours writing a business plan, modeling out your unit economics will provide 90% of the value at a fraction of the time.

Furthermore, the winners of a unit economics contest would be more likely to build successful companies. Unlike a business plan, with a 3-5 year projection at its core, a unit economic model tends to focus the entrepreneur on the near-term opportunities with the highest likelihood of success: the kind of things that will create grounded and focused businesses rather than speculative, multi-threaded companies. And if you’re a broke student hoping to start a business straight out of a university-sponsored competition, which would you rather have?

Written by Brad Hargreaves

February 12th, 2011 at 3:19 pm

The Peril of Dominance, or why we don’t need a new Google

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There was an interesting New Year’s Day post on TechCrunch about something we’ve all noticed: for certain keyword phrases, Google is entirely spam. A search for a high-value keyword like “online degrees”, for instance, turns up little more than affiliate directories run by spammers with a solid grasp of SEO. So many people are gaming Google that it has lost much of its value.

But — contrary to Wadhwa’s implication — this isn’t a special failure on the part of Google’s engineers. Rather, it’s a fundamental characteristic of dominant technologies. Through market dominance, a technology can become the sole target of those who wish to exploit: an easy ROI for scammers, marketers and anyone else out to make a buck. Rather than building and optimizing for multiple competitive technologies, system gamers must only target one.

This is of particular concern for monopoly technologies, or borderline monopolies. Microsoft ran into the same problems fifteen years ago and continues to suffer the fallout. Hackers and virus creators knew that they only had to optimize for one operating system — Windows — and could target a massive share of the market. They ignored Unix and Mac OSes, giving those systems a reputation of relative security and safety against viruses and hackers. But have no doubt that if, say, Mac OS gained sufficient market share and corporate adoption, malware creators would see a new opportunity and begin writing viruses and malware for Macs. Suddenly, finding exploits in OS X would become orders of magnitude more important than it is today.

And thus Wadhwa’s conculsion (“We need a new Google”), makes no sense. We don’t need a new Google, an overwhelming search monopoly. We need a diversity of competitive search engines. Blekko’s engineers are no better than Google’s. And even if they were better, creating a search engine that is immune to gaming is fundamentally impossible, with increasing difficulty as the search engine’s market share increases. Blekko is simply not spammed because it’s not worth the spammers’ time to figure it out.

Display advertising is a great counter-example of a market with diverse technologies, protocols and big players. While display isn’t totally immune to gaming — click arb and ads that launch malware, for instance — it doesn’t fundamentally challenge the value of the technology as overzealous SEO does to search.

When a technology is in a constant arms race with competitors, users win. When it is a black box inside a giant monopoly, the internet’s underbelly rolls up its sleeves and gets to work.

Written by Brad Hargreaves

January 2nd, 2011 at 3:23 pm

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The Nonprofit Model is Broken

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When someone at a tech event pitches me on a nonprofit, I have a tendency to tune out. It’s not because I’m a terrible person. It’s because small nonprofits often combine the professionalism and scale of early-stage startups with the stakeholder motivation and agility of Fortune 500 companies.

The nonprofit model has its place. The structure works for charities, for instance, where the entity doesn’t need to do much beyond raising and distributing money. But it’s a poor fit for entrepreneurs who are trying to scalably effect social change by building a socially-motivated enterprise.

It shouldn’t be this way — after all, most founders who structure their companies as 501(c)(3) nonprofits are simply trying to change the way something works for the better. Usually they have backgrounds in large corporations or academia rather than startups. Thus, they don’t necessarily think about economic incentive — one of the most critical aspects of starting a successful company. The 501(c)(3) model removes economic incentives by eliminating stock and setting market-driven salary caps for employees and board members, preventing anyone associated with the organization from earning meaningful returns.

Sure, people are motivated by things other than money — such as the potential to do good in the world. But successful businesses are able to quantify success, and most measures of social good are difficult to quantify. The social enterprises I have seen accomplish the most are able to align their profitability with social good, which gives them a far more tangible target. They can also give their employees financial incentives for hitting targets that are aligned with the organization’s social goals, a double whammy of motivation to get things done.

Combine all this, and the nonprofit model makes it difficult for companies to recruit top-tier talent. Unlike top-quartile workers ten years ago, employees today understand equity, options and other incentives. They know the value of their time. An all-star developer might volunteer on the weekends for a nonprofit but is unlikely to choose it as a full-time job over a position at a startup or big company. The inability to score top talent is a positive feedback cycle, as a new potential hire is unlikely to want to join an organization filled with mediocre, unmotivated people.

Ultimately, companies are measured by the social good they accomplish, not their tax structure. It makes no sense for a social enterprise to let the latter limit the former.

Written by Brad Hargreaves

December 19th, 2010 at 12:02 pm

Bosslessness

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There’s a common misconception about why people become entrepreneurs. In my chats with founders, I’ve seen that the most common driver — ahead of earning fantastic returns, working flexible hours or learning new things — is simply getting away from a bad boss, or bosses at all.

To those on the outside looking in, the world of startups looks like a boss-free paradise. After all, you can name yourself the CEO, or at the very least have control of a menagerie of roles in your business. Unfortunately, it’s usually not. That’s because someone — perhaps an investor, a customer or a partner — is almost always playing the boss role.

Truly bossless businesses are tough to find; they have to follow a few major constraints. First, they need to hit cash flow positive almost immediately. Without that, you’ll either need to keep your day job (and your boss) or take investment (and investors, which are a different kind of boss). With cash flow, you’re only responsible to yourself and your business. Second, they need to have tons of customers, even at an early stage. That way, each customer isn’t important enough to justify appeasing them. Ideally, each customer is spending such a small amount that their process of dealing with you is automated (in B2B) or your business supports high churn (in B2C). Finally, executing the concept shouldn’t require more than perhaps one or two trusted partners.

There are a few broad categories of businesses that meet these constraints, and I’m fascinated by each of them:

Affiliate Marketing / Lead Gen: This is probably the easiest vertical to get into, as it doesn’t necessarily require any technical skills. Anyone with some marketing smarts and a WordPress install can start generating affiliate revenue, and it doesn’t really come with any obligation to anyone — affiliate program managers are often at least one level removed from the publisher (you), and it’s trivially easy to switch from one affiliate program to another.

One of the beautiful things about many affiliate businesses is that the entrepreneur is also building long-term value — typically, in a targeted email list or site that ranks high in search engines on certain keywords. In that way, affiliate and lead gen businesses are also fundamentally different from (say) consulting, in which it’s tough to argue that the consultant is building long-term value in their business.

Arbitrage: An extremely broad category, “Arb” is big umbrella that could include online advertising arbitrage, proprietary equity trading or perhaps even certain types of e-commerce. But it’s probably the most common of all bossless trades, with a huge number of independent prop traders making essentially bossless livelihoods. The downside of any arbitrage-based business, of course, is that the opportunity can (and will) disappear — of all the businesses discussed here, arbs are building the least long-term value in their enterprise.

Software Sales: To fit the criteria listed above, software business require some engineering skills. But if you’re a hacker, there are few better bossless businesses. This is especially true on the B2C side, with gaming as a prime example.

Note that in some of these businesses — especially B2B software sales — there’s a fine line that prevents customers from becoming bosses, and many entrepreneurs accidentally cross over that line by doing custom work, failing to automate sales processes or relying too much on a few large buyers.

This stuff isn’t for everyone, but I think there is some inherent (particularly American) desire for freedom from people looking over you shoulder, setting deadlines and making demands. And to many of us, that freedom is being a founder. Just be careful what you choose to found.

Written by Brad Hargreaves

December 13th, 2010 at 9:19 am

The Uncertainty Plague

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I had the opportunity to spend Thanksgiving week in Costa Rica, which was a welcome change in scenery from Manhattan. I’m not much for hanging out at the beach, so I found some time to talk to a few people involved in Costa Rican real estate and finance while I was traveling around the country. I was particularly curious about the startup community, which seemed to be totally absent throughout the country.

The difficulty I heard from everyone in Costa Rica was the same: while the country is one of the world’s oldest democracies and most stable Latin American nations, its legal system is frustratingly unfair and unpredictable. Property laws are Byzantine, and squatters have powerful — albeit vague — rights. Costa Rican citizens are explicitly favored in all legal disputes. Tax law is complicated and seems to be made up as you go along. Despite Costa Rica being the most developed country in Latin America, the uncertainty injected into the system by needless legal complications has made technology innovation extremely difficult.

Reports of the United States’ death as the startup capital of the world are greatly exaggerated. Our embarrassing lack of startup visas, bureaucratic burdens and high cost of labor are small inconveniences in comparison to the quality of the States’s legal system, which is largely fair and — most importantly — consistent. In the United States, I have a pretty good idea of what will happen in almost any legal situation. If my company goes bankrupt, there are centuries of precedent governing what creditors can and cannot do. If I want to sue someone, I know the costs and risks. Insurance is available for everything imaginable — mostly because our legal system is so sound.

Consistency is the most underappreciated driver of success in a product or service. This isn’t just about legal structures. Great brands are built through the delivery of consistent and predictable experiences as much as PR, pricing and growth strategy. As a consumer, Apple, Starbucks, Wal-Mart, McDonald’s and dozens of other successful brands will each give me exactly what I’m expecting to get from them. I simply don’t have to worry about the risk of getting something different or unexpected. Humans are naturally risk-averse creatures, and we’d much rather take something guaranteed than something that might be 25% better or 25% worse.

By removing the uncertainty around business law, the state of Delaware has prospered, generating over $750 million in revenue in 2009 from corporate services alone. The majority of entrepreneurs I know send Delaware a sizable check every year for doing nothing other than having less uncertainty around corporate law than other states — and anywhere else in the world. If this isn’t an example of a brilliant hack, I’m not sure what is. For doing something without any fundamental cost — providing a consistent legal framework — Delaware has created a massively successful business.

Ironically, having a stable, un-disruptable legal system around our entrepreneurs gives them the power to disrupt industries and aging business models. Until other countries develop the kind of legal infrastructure that will give innovators the certainty to know that their creations and profits are protected from corrupt officials, greedy politicians, populists and nativists, the United States will continue to produce and host the vast majority of innovative, billion-dollar companies and entrepreneurs.

Written by Brad Hargreaves

November 28th, 2010 at 6:43 pm

Martyrs, or How to be Miserable and Inefficient

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Most of the truly miserable people you meet in life aren’t stupid or unambitious, traits we’ve been taught to associate with an unhappy life. Rather, the unhappiest people I know are also some of the smartest and hardest-working. But they’re also martyrs, a dangerous and under-appreciated workplace pathology.

Approximately every tenth highly intelligent person I meet is a martyr. Martyrs have an addiction to making themselves miserable for the sake of others. It’s not necessary for this misery to be for anyone’s benefit — it simply needs to be understood by the martyr that they are performing a sacrifice at the feet of another person or group.Many smart people are martyrs, like these guys

Paul Graham’s How to Lose Time and Money makes a great corollary point — specifically, that driven people rarely waste time by sitting on the couch watching TV, but by doing useless work. I’d like to take that a step further. A number of smart people are Martyrs, who draw their willpower from Sisyphean quests, enjoying difficult and painful situations for the sake of the pain endured. Their equivalent of praise is the feeling of deep guilt they can inspire in others.

Martyrdom is chronic and can impact someone’s strategic decisions. I’ve seen martyrs join organizations doomed to fail simply to have a steady stream of martyr-ready situations. Playing the martyr role is addictive, and situations in which a martryr can work extreme hours, take the blame for far-reaching problems, and prostrate themselves at the feet of bosses are their crack cocaine.

Martyrs paralyze organizations. I’ve written about the huge influence guilt has on communication, but it deserves restating. The guilt that martyrs inspire among their peers and superiors destroy organizational structure and productivity. When a colleague is going to fall on any sword within eyesight, there’s a natural disincentive within a team to hide the swords — that is, to cover up the issues and problems that arise in any organization. Martyrs inspire guilt, and guilt is a terrible emotion to inspire in a group. Guilt saps enthusiasm, sweeps problems under the rug and eliminates any willingness to take risks.

Everyone avoids the dull, the lazy and the untrustworthy. By their very definition, martyrs are none of these things — yet they should be avoided to the same degree. Martyrdom is at best saddening and at worst contagious and destructive.

Written by Brad Hargreaves

October 3rd, 2010 at 1:31 pm

Journalism : 2010 :: Food : 1910

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There is a certain watershed moment in the evolution of most consumer web entrepreneurs. In this moment, entrepreneurs recognize that they do not understand the way most people think about and interact with the internet. They recognize that if you are going to market to “Normals“, you have to leave your intuition of user behavior on the web behind.

People who are successful at marketing and serving content to Normals recognize that most internet users can’t distinguish between platform and app, content and ad, “good” content and “bad” content. Normals need a different level of clarity than savvier users, and if something isn’t immediately apparent, they’ll leave. Normals type URLs into Google, Microsoft Word or their email search bar. Each Normal is unique, and there are many different categories of Normals, but they all interact with the web in different ways than us (“early adopters”, “techies”, “bleeding edge”, etc), ways that may or may not be predictable to even the most seasoned designers and entrepreneurs.

Take journalism, for instance.

Old-line journalists regularly equate newspapers with journalism and blogs with something lesser and dirtier. In truth, there are a significant number of blogs that do far better journalism than newspapers have ever done. But there are many, many more that are simply content factories that benefit from a deep understanding of Google’s ranking algorithm that smaller (and journalistically superior) players don’t have. Demand Media, for instance, built a massive business by understanding that Normals have difficulty distinguishing quality, well-researched content from content that was generated by an Indian freelancer paid half a penny per word.

So what does any of this have to do with food? Well, the core problem with American food production in the early 20th century was informational: normal people didn’t have sufficient knowledge of their food’s origins and quality and were thus unable to distinguish between “good” food (e.g., meat processed in a clean environment) and “bad” food (e.g., meat processed in filthy sweatshop-slaughterhouses). In an economic environment in which buyers cannot distinguish between high quality and low quality products, all producers will move to solely creating low-quality products. High-quality producers will simply be priced out of the market.

Today’s content production industry is in the midst of that phase shift. As the vast majority of consumers cannot distinguish between good and bad content, mass-produced low-quality content is slowly pushing high-quality, journalistic online content deeper and deeper into niches.

Created in 1906, the FDA set out to solve this informational asymmetry in the food production industry by introducing basic hygiene standards coupled with labeling, inspections and reporting. This is analogous to what Google claims to be doing today for content — decreasing our informational asymmetries around content by calculating the “authority” of various content sources and offering content to users accordingly.

But I don’t think Google is doing a particularly good job. Google’s inability to effectively determine and communicate the value of content is, after all, why Demand Media and its kin can exist as businesses. It is why searches for high-value keywords (“online degrees“, for instance) return a bunch of affiliate honeypots and garbage content size wholly focused on acquiring users via SEO. And if you’ve ever ranked well for a particular search term, you know well that those are low-value users as opposed to users acquired via other channels. Web search has become a dramatically inferior way to discover anything online.

But unlike the FDA, Google is not a government agency. It’s a private company with private competitors. Competitors that may — no, will — eventually unseat Google as the king of search.

So who is going to write The Jungle of content?

Written by Brad Hargreaves

August 22nd, 2010 at 4:20 pm

Learning from Failure is Hard, Learning from Success is Harder

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Unqualified lessons are hard to wring from startups. It’s difficult to really understand something without doing it, and no two people who do it have identical experiences. That said, I’ve seen two schools of thought on how to learn from others’ startup experiences:

1) It’s best to learn from success. Stories of failures have no prescriptive advice on how to accomplish something. Stories of success, on the other hand, offer models to copy.

2) It’s best to learn from failure. Success is fairly random, whereas failure usually happens for distinct reasons.

First, anyone thinking of starting a company should take lessons from wherever they’re available — successes, failures or those yet to be determined. But given a choice, the best lessons come from failure.

I’ve stopped thinking of a startup as a discrete success or failure. Rather, a company is a series of small (or big) successes and failures, one side of which eventually overwhelms the other. Some failures are singular and crushing — taking on a bad co-founder, for instance. Others are subtle and can sit under the radar for years, even in companies that are otherwise successful. Poor initial equity distribution or choice of corporate structure, for instance.

That said, most companies aren’t killed by one overwhelmingly bad decision. They’re killed by dozens of bad decisions that pile up and stick the company in an unrecoverable morass. These small, could’ve-gone-better decisions offer the best startup learnings, are the exact lessons covered up by success.

Take one of the greatest entrepreneurial success stories of our generation — Facebook. Clearly, Facebook did some things right. But they also did a whole lot of things wrong, and it’s hard for anyone to determine how much more Facebook could’ve screwed up before they would have doomed their chances to win the social networking wars. It’s entirely reasonable that they could’ve blown any number of decisions and still come out on top.

On the flip side, copying success is tricky. Let’s look at Facebook again. The most difficult thing about copying Facebook’s success (or any company’s success) is not deriving the factors that led to their success, but figuring out the level on which they should be copied. For instance:

Level 1: Facebook was successful, so I should copy what they created: a new social network. Good luck with that one.

Level 2: Facebook was successful, so I should copy their operational or strategic decisions for my own idea. As I pointed out above, it’s not obvious that Facebook made great operational or strategic decisions.

Level 3: Facebook was successful, so I should copy their methodology of thinking about ideas or products. This sounds high-level enough, but how does one execute on it? Does anyone know what goes on inside Zuckerberg’s brain? More practically, are those thoughts relevant to your product as opposed to a walled garden social network?

On the theme of translating theory into practice, I helped create Founders at FAIL, a forum for entrepreneurs to talk about their failures. Think Founders at Work, but all the stories have unhappy endings. I’ll be speaking there (along with GoCrossCampus founder Matthew Brimer) on August 18th.

Written by Brad Hargreaves

August 9th, 2010 at 6:22 am

In Defense of Lifestyle

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You don’t have a company. You have a job.

- Yale prof and Honest Tea founder Barry Nalebuff, to me, September 2006

I was in college at the time, running a small antique furniture reseller called Aloysius Properties on the side. Aloysius was a fun business. We realized that Ivy League schools, especially our own Yale, were selling their turn-of-the-century-era wood furniture at fire sale prices as they renovated libraries and classrooms. Aloysius bought as much as we could get our hands on and sold it online at significant markups — a 20x multiple wasn’t uncommon in addition to a 15% shipping and handling fee. And our customers (almost exclusively wealthy southern women) were thrilled to have these pieces of academic history.

It was very much a lifestyle business in every sense of the term. Specifically, the founders (Matt Brimer and I) wanted a business that threw off a decent amount of cash with minimal hourly involvement — that is, a business to support our lifestyles as college students. And it was a total break from our college lives spent staring at books and screens — buying furniture out of university warehouses, physically moving inventory, talking to customers and coordinating shipping was different and exciting.

But this kind of business went over with the pre-Lehman Yale crowd like selling crack in New Haven grade schools. It was gross, physical labor — a waste of our precious mental resources that would surely be better spent pricing derivatives or being flown around the world by McKinsey. In more precise terms, Aloysius would not get one laid.

The university did have a nascent startup scene. Innovation was encouraged, and traditional jobs in high finance and consulting were held in slightly less regard. But there was a parallel problem in the Yale startup community, one that effectively took the place of the larger university’s fetishization of high finance. There was the palpable sense that unless you raise significant capital, you’re not running a real business.*

This left Aloysius high and dry. Matt and I abandoned the business in early 2007, choosing instead to focus our efforts on raising venture capital for an online gaming startup, GoCrossCampus. Things didn’t turn out badly — my next company, PayoutHub, was acquired earlier this year, albeit not for fuck you money.

Since then, I’ve slowly getting back into “lifestyle-like” cash flow businesses. It’s entirely possible that I’ll see an opportunity in a company to take it to the next level and scale it into a venture-fundable blow-the-doors-off next-coming-of-facebook success. But I don’t have to, and there’s nothing wrong with covering my downside by starting with the goal of building profitable companies and seeing where it goes from there.

As a caveat, scalability of personal involvement is important. This is the difference between a job and a company — and helped spell the doom of Aloysius. Aloysius Properties was not only a personnel-heavy business, but it would’ve been difficult to pass off to an intern with minimal instruction (my litmus test for cash flow businesses). If you can’t pass it on to an intern with fewer than a few hours’ per week involvement, it’s probably a job. As you might imagine — and contrary to our beliefs at Yale — the litmus test has nothing to do with raising venture capital.

* Over the last few years, the Yale Entrepreneurial Institute has done a great job shifting this culture. One of last year’s businesses was a grilled cheese restaurant. Cool.

Written by Brad Hargreaves

July 18th, 2010 at 1:45 pm

Incentives and Carried Interest

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The House recently passed a bill to tax carried interest at the higher income tax – rather than the lower capital gains – rates. This has generated considerable consternation and debate in the venture world and somehow led to Chris Dixon asking Jim Robinson to go fuck himself [1]. In brief, taxing carried interest – the “profit share” that money managers take from any positive returns they make – at income tax rates would increase the tax burden on VCs and possibly lead to changes in the way VC funds are structured. Some smart people think this is a good thing, as it seems a bit silly for money managers to receive a government subsidy at a time when there are so many money managers.

Let me add some thoughts into the mix [2]. First and foremost, I don’t really buy the argument that taxing money managers at a higher rate will directly lead to a decrease in capital flowing into funds. Pension funds, endowments and high net worth individuals still have lots of money, and they’re willing to pay someone to manage it. I may be wrong here, because I don’t pretend to understand all the subtleties of the system, but this is not the argument that speaks to me.

But I do believe that people respond strongly and (fairly) efficiently to financial incentives. Over the past two decades, some of our nation’s smartest people have gone into banking and private equity because you can make great money there. If science and engineering had the same compensation structure and magnitude as high finance, we’d have a lot more scientists and engineers.

Fred Wilson uses this argument as he writes in favor of taxing carried interest at a higher rate. If it were less lucrative to be a money manager – the result of this tax increase – fewer of our best and brightest would become money managers. On the surface, that seems like a good thing. And it may be. But one of the things that makes the American startup scene great is the number of smart VCs out there. Sure, VCs come in many flavors – some are brilliant folks dedicated to supporting entrepreneurs, and others are idiots. But the last thing we need is to turn VCs into mutual fund managers – the bottom of the financial hierarchy with minimal alignment with their investors or incentive to perform. Mutual fund managers don’t take carried interest, just a management fee. Because of this and other factors, mutual fund management is one of the least lucrative executive positions in finance and is staffed accordingly.

I don’t want to see venture capitalists without significant carried interest – timid, risk-averse and totally misaligned with the interests of entrepreneurs and LPs. This will inevitably lead to lower returns – and an eventual decrease in money flowing into venture capital, and by association, startups.

Money managers are given the task of allocating the free world’s capital. Their decisions of where to put that capital to work have an overwhelming effect on our nation’s growth, development and standard of living. There’s a strong argument to be made that they’ve been doing a terrible job of late – rather than investing the past decade’s excess wealth in infrastructure, science and technology, they decided to build houses in suburbia that now lie vacant, rotting in the Sun Belt summer. There’s a growing body of research showing that this choice will have a significant impact in our nation’s economic growth and competitiveness for decades to come.

I want the smartest people in the world deciding which companies have a chance to succeed or fail. There’s a problem in money management, but I’m not sure increasing taxes on the managers’ incentive to succeed is the right answer.

[1] Matt Mireles’s post on this exchange is totally worth reading.

[2] I don’t really have a dog in this fight. Tipping Point doesn’t manage a fund of outside capital, and thus we don’t make any money from carried interest. I don’t personally invest in venture-fundable companies, so I’m not secretly hoping that VCs get weaker so I have access to better deals. I really just want to see a thriving startup ecosystem that leverages technology to drive fundamental change.

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June 13th, 2010 at 10:13 am

Facebook and the Extra-National Currency

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The creation of an extra-national currency has long been a libertarian dream. Fiat currency, after all, ties our assets to the wills and whims of a central government. At times — and many people argue that now is such a time — poor government decisions can dramatically debase the value of our income and savings. Thus, the need for a widely-accepted currency uncoupled from the politicized decisions of a national government.Facebook Coin logo filed with the trademark office

While we haven’t lacked for attempts to create a new currency, pretty much all have fallen by the wayside. The biggest selling proposition of these currencies — freedom from backing by government fiat — is way too obscure for most people, and the logistics of backing issued currency with precious metals is daunting and expensive.

Could Facebook coins be the first successful extra-national currency? There are several factors going for it:

– Facebook’s huge audience and deep presence across the web
– The audience’s clear need for a standardized and trusted currency
– The ability for people to (often inadvertently) “socially endorse” the new currency to their friends
– A pool of merchants — e.g., Zynga — poised to accept Facebook currency
– Simple and seamless integration and exchange with mainstream currencies via the web and mobile makes switching between currencies less of a hassle

To be clear, there have been other virtual extra-national currencies. WoW gold and Linden Dollars are two examples. But these haven’t even touched the mainstream, even in online purchases — try paying for a book on Amazon in WoW gold. These currencies’ value is dependent on an ability to exchange them for dollars — not terribly different from the “regional currencies” that pervaded America in the early 19th century. If you were traveling in South Carolina with paper dollars backed by a bank in Massachusetts, you had to find someone who would exchange them (likely at a steep discount) for a local currency.

But Facebook coins seem fundamentally different. The audience is huge and hundreds of millions of Americans have experience using virtual currencies on Facebook. Right now we’re buying virtual cows and guns, but is it much of a leap to use virtual currency to buy online goods with real-world impact, such as subscriptions to digital content? And once we’re there, it’s a natural step to move that digital subscription into the real world — and even expand into necessities like gas and groceries. They already sell virtual currency cards in grocery stores. The relationships are there. Soon we’ll be using those cards to buy groceries.

So what could this all mean? First, it’s important to draw a distinction between the libertarian fantasy and the reality of Facebook’s extra-national currency. Most libertarians desire a value-backed currency — as in, gold- or silver-denominated – rather than fiat currency. Facebook coins are still a fiat currency. It’s just a corporate fiat rather than a federal one. Facebook coins are only valuable if it can convince buyers of the coins’ utility as a medium of exchange and (possibly) a store of value. But I don’t see any issues with Facebook making this happen: at least initially, there will be a large and defined pool of merchants ready to accept coins via Facebook apps, and exchange with mainstream currencies will be simple.

Of course, this is assuming that Facebook doesn’t throw up barriers to prevent this from happening — namely, if they forbid any part of the buying, selling and transferring ecosystem that makes a currency market successful. The market won’t work if they (for instance) prevent an app developer from exchanging Facebook coins directly with the user or p2p transactions using coins. This doesn’t mean that they have to float the Facebook coin against the dollar — although that would certainly be a fascinating turn of events for economists and currency traders alike.

If Facebook can create a true extra-national currency, it will make more money than any other company in modern American history. Entrepreneurs and VCs often talk about successful companies “printing money”. But Facebook has the opportunity to literally print money within the next five years.

Written by Brad Hargreaves

May 23rd, 2010 at 2:21 pm