Fair warning: Kindda long…. Read at your own risk.
I have watched the action in Silicon valley very closely for the last 17 years and wondered why the valley seems like a place with irrational, crazy people that seem to be fueling large hype cycles and betting on young entrepreneurs to “change the world”.
When I was graduating from University in 1995, I had the choice of working for Netscape in the valley and Oracle (one was just getting started and the other was hmmm, well, getting started), I chose Oracle over Netscape as I felt that Netscape would get crushed by Microsoft and that is exactly what happend a few years later. For me Oracle was an incredible journey and built a lot of my character but looking back and connecting the dots I feel like I missed something cool like Netscape. Imagine what it would have felt like working in a hyper-growth company that was “changing the world”. I then chose to go work at a company that was “changing the world” and found openwave which was largely Mobile Web 1.0. Openwave browsers were embedded in over a billion phones and the company was valued at $10B with revenues of $400M. People were really betting that Openwave would own this space. Then dot bomb and Sept 11th 2001 happened and markets went back to the basics and started looking at the real fundamentals of companies and re-adjusted the price basis. Openwave was suddenly a $1B company and revenues dropped significantly. I was there for 7 years to see the company go from 30 employees to 2000 and re-adjusting to less than 1000 after the bust.
So, in tech we have had one large hype cycle (web 1.0) and I believe the second hype cycle (web 2.0 – the social web) is well underway. So, what are the lessons entrepreneurs and startups can learn from the past and make sure that whatever they are doing is grounded in reality to help them build lasting companies and be successful.
Most young and old’errr entrepreneurs in India seem to want to be a Google or Facebook. Ambition is great but when it is not grounded in reality then it can be foolish.
Let us understand what really happened in Web 1.0 and the types of companies that rode this hype cycle. Web 1.0 was largely a new medium of publishing and commerce. If we look back at 1995 when the web started up until now there are only 2 big things that have happened namely Google and Amazon. Yeah, a few other billion $$ companies may have been created along the way but undeniably, Google and Amazon are those two companies that will go down in the history books as companies that made a lasting impact on society. Google realized that the web is simply a new medium of publishing, that advertisers would use this new medium and that search was the only way in which discovery of content would work for end users. They connected these three dots and were able to build one of the greatest properties on the web. In economic terms, pre-web the total size of the traditional advertising industry (print, tv and radio) was about 2% of the US GDP. 
(Source: http://www.theeconomicsofadvertising.com)
When Google’s ad platform started to work in 2005, the advertising market expanded. In macro-economic views of the world when an Industry like advertising is re-invented, it is assumed that the new medium will replace the old mediums and in traditional industries that is likely the case and as a % of the GDP the spend remains constant (also called the principle of relative constancy in economics). However, let us see what happened when the organized Internet advertising industry was born:
(Source: http://www.theeconomicsofadvertising.com)
The way to read the above chart is as follows:
1. The green line is the traditional (print, tv, radio) ad spend teetering along near 2% of GDP
2. The red line is the non-traditional advertising ad spend which until about 1995 was mostly the direct mail, coupon and the tele-calling industry.
3. With the Internet this market which was basically around 1.5% to 2% of the GDP suddenly expanded by another 1 to 1.5% of the GDP. What is interesting to see on this chart is that towards 2000 there is classic signal that shows the birth of Google and that there is a hockey stick in the non-traditional ad spend and a decline in the traditional medium. It is hard to discern this from these charts as GDP percent growth is so small relatively that it is hard to quickly spot a trend.
So, in essence technology does not disrupt traditional businesses as quickly as techcrunch or other valley trade journals may want you to believe. Technology and Internet have expanded markets as they essentially increase ACCESS and REACH to markets that were traditionally closed.
In another parallel, I think the disruption due to to technology has been significant in another segment called Trade and Commerce. Amazon is now the largest online commerce company on the planet and valued at ~$100B. But, let us look closely at the data on how online impacted offline commerce. According to the US Census which published a bunch of great data in 2008:
(Source: http://www.census.gov/econ/estats/, tabulated by: http://home.uchicago.edu/syverson/onlinevsoffline.pdf)
Again in this example, the Internet basically put serious brakes on traditional commerce and helped expand the overall market and over time will become bigger than the traditional market but that is a 50 year game. The Internet simply acted as a medium to dis-intermediate the middle men in traditional commerce (hence making goods and services cheaper) and provide a great user experience by bringing the convenience of a store into your home.
Ok, so why am I rambling and why is this lesson in economics important. Well, to understand what is going on today in the world we live in, we need to understand a few things about the past and the background I provided above is an important history lesson for folks who were not a part of that era. Tech and the Internet generation tends to see things very myopically. Markets tend to take a long time to evolve and eventually traditional mediums will get replaced with new mediums but this is a very slow process.
So, that brings us to Facebook, Instagram, Pinterest, etc, etc, etc and the other $B valued companies and ask ourselves if this is justified and if the valley has gone crazy by investing in these companies. How can a company with 20 employees be valued at a billion $$? The answer is Yes and Yes 
Again let us start with some data:
From the chart above one can clearly see that the big segments are Search Marketing and Display Marketing which are largely Google’s turf today. However, search and email marketing have the lowest CAGR while Mobile and Social have the largest CAGR growth. Display advertising to our surprise seems to have better growth than Search advertising. So, let us come back to the Facebook valuation discussions. Facebook dominates Social advertising and people are betting that Mobile will be largely social as well. Facebook is also proving to be a great platform for brands to do Display advertising. In a nutshell, this means that if you ask investors to place a bet, the most growth in Interactive Advertising will happen in Social, Display and Mobile and Facebook seems poised to own this space. So, from an investment perspective it is where most $$ will flow.
The ~$100B valuation may be great from a market perspective but if I were the CEO of facebook, I would worry a lot about the immense pressure it will put on facebook for growth. If facebook cannot show the numbers that the street expects a company to show in a few quarters of going public, then the street will punish facebook. All the glory days will be forgotten and analyst after analyst will start downgrading the stock and shorting the company which will seriously affect employee morale. This is exactly what happened to companies in the Web 1.0 bubble. Companies that were well poised to dominate specific markets were soon managed by the street. When companies start to get managed by the street, bad things happen. I saw this very closely at Openwave which has turned into a patent troll today. This happened to Yahoo! where they can hire CEO after CEO and the result is the same – things get worse until the companies just die and disappear. Groupon is a great example of a company built largely on hype fueled by investors and secondary markets but the company continues to fumble quarter after quarter and the street which was very bullish about it has started punishing it.
I am not at all suggesting that Facebook will be another groupon. Facebook has the best talent in the valley and they will figure out how to maximize the opportunity of social, mobile and display advertising the best and the valley continues to believe in Facebooks growth story. In a fairly flat down market where the financial markets are teetering along Facebook’s IPO could re-invigorate the investment climate. However at the macro-economic level if the markets see a downturn due to other fundamentals that are beyond the control of anyone (terrorist attacks, wars etc), then I believe the bubble will burst and the companies that will be most affected by it are the ones that were built largely around a hype.
As a startup founder it is important to understand the dynamics of markets and economics. It is also important to know the type of company you want to build. A lot of startups in the valley build features or apps or small companies that can be flipped to a bigger player in a relatively short period of time often riding on a hype train. They do find investors who back this philosophy and are looking for small opportunistic investments and relatively small exits. There are also companies that spend a lot of time to build depth and platforms and play the long game. Both are great ways to build companies. But, it is really important to be clear as a founder about what you are building – a short term “flip” company or a long term “value” company. A short term company needs a different focus than a long term company. A short term company needs a different set of investors than long term investors etc, etc. If you are clear on your goals and the potential outcome then everything else falls in place. Things get really hairy when you say that you want to build a long term company and do things for the short-term.
Filed under: insight, media industry, startup, Technology
