Startup Paths To Take And To Avoid

May 18, 2022

Hong Kong Island from aerial view in sunrise

“A startup is the largest endeavor over which you can have definite mastery.” - Peter Thiel

Introduction

I am looking to start a company. What I am looking for most in any business idea is whether it would be avoiding any common pitfalls of stagnation. One such a company type by its nature would be a startup.

A startup is not just an early stage company or any tech company, but is instead characterized by focusing heavily on growth. It can have some revenue coming in, but this in general should be a concern for later times as the focus should be on growing the user base instead. So any company that starts out by trying to make the most money out of the gate is probably unfit to be a startup as any business that can make money this quickly is likely not scalable (e.g., a consultancy). A startup is in essence a larval stage business that is in the process of unusually rapidly growing into a large enterprise.

Even then, I still love business that’s just good business. I am enamoured by simpler businesses build on schemes such as buying property in a strategic location and setting up a laundromat, American-style. But unless during this process you stumble upon a stroke of a genius, it is unlikely to become a billion dollar business. The income is possibly quite good, but it is tad uninspiring to be in and the pursuit of changing the world here is missing. If becoming wealthy and living off of my investments were my goal, I would much rather focus on value investing Buffet-style. But startups have more soul!

I will be going through common forms of building a business, moving closer to startups and then dissecting some nuances.

The Old Way

An Iranian Shepherd

The Shepherd

The main way businesses are created are through gradual building through lean operations or through small amounts of debt. Let’s take a shepherd for example. The shepherd starts with a few sheep, but has way more wool than he would use for his own use. So he sells the wool on the market, gets some money for it, and is able to buy other goods for it that he needs. Since herding sheep is what the shepherd is best at, he sees value in that cycle of herding sheep, but getting also other things for it other than sheep products. So he gets more sheep, to produce more wool. Also, once he has dozens of sheep, the sheep get old enough for him to take their meat. But again, he does not have the need for a full sheep amount of meat. So he sells the meat on the market as well. Also, with this amount of wool, the needs of the local village market are fulfilled, so the shepherd figures what to do with this extra wool. He find there’s still a demand for processed wool products, so with the proceeds of the goods sold earlier he hires an employee that continuously creates other products from the wool, such as duvets, extending the product offering as a result.

In terms of competition, of course the shepherd competes with the guy with the ducks in the market of duvets, not just other shepherds.

So the shepherd here is essentially a businessman. Simply by doing what he knows how to do well and what other people value, he could expand his offering over time and become more wealthy through this work.

This sort of an approach has a great advantage: you know the market values your supply. Once the market has ample supply, you can expand vertically. This approach minimizes many risks in building a business and is likely the most stable way to bring money in through entrepreneurship.

Race To The Bottom

But naturally, there is another side to this coin. Due to this process of gradually building up a business directly from what you do best is so commonplace, there is also a lot of supply for it on the market. With this you get both intense competition, driving prices down, but also has simultaneously limited value to the society if the hole you are filling could be filled quickly by another business. So the value provided is something so common that if you do not do it, someone else will, and no one cares. It’s like choosing between restaurants. So what if the one pizza place disappears. It’s not as if there’s any scarcity.

Where the traditional trade-to-business approach might still be a good one to take would be in markets that even with ample supply, there is still more demand for it that’s not completely met. In such a case, the returns are not as marginal and these could in turn be used to expand the business to something greater. One such industry would be the software industry, where automation and digital systems are still underutilized. Although software is extremely cost-saving, it also tends to have a high upfront cost due to the expertise required to build such systems.

The Wantrepeneur Way

Young Entrepreneur

There’s a lot of people around me that have the dream of living a good life, and being proud of being an entrepreneur. So the first idea they get tends to be something they personally see that there is a need for, or it is something that is easy to build.

Let’s say they discover that there aren’t enough sunny looking clothes on the market. Everyone seems to be dressing very drab and conservative, but there isn’t anything that simply shines bright, like a neon yellow raincoat. So they build up a webstore (because a brick and mortar store would have a way too high of an upfront cost), find a few fitting raincoats from Aliexpress to resell, and up it goes. Once a standard ad campaign for these are done and a few orders have been fulfilled, it sort of feels like work. And it seems like the ad spend is more than the margin earned from these raincoats. So it is demotivating to keep pushing your own money into the business, just to lose it in the process. The dream dies with every month, and there does not seem to be a rush for these joy-sparking clothes after all.

It seems like this is one of the worst ways of building a business as it expects too much, you get a bad experience out of it, and thus you are less likely to try again. The mistakes done in this approach is following your instincts without ensuring there is a market for it, having no strategy, and not choosing what you do more carefully. I think all of this is soul destroying, despite the hopefully learned lessons.

Another extremely misleading proverb is “if you build it, they will come”. Even though it is mostly meant to tell you to put your heart into your work, it misses a major point: with any business you must have a distribution strategy.

The Silicon Valley Way

Video depicting HBO’s Silicon Valley

The Gist Of It

When it comes to startups, there is no better authority on it than Silicon Valley itself with a whopping 12T of market capitalization of its companies. I especially like Y Combinator’s approach to venture capital and I think I might have quite a good grasp on what it’s about thanks to Hacker News. The overall steps seem to be:

  1. Find a novel problem to solve
  2. Have an idea how to solve the problem, preferrably with at least one cofounder
  3. Be super likable and get funding from investors
  4. Build the product, grow the user base, and get more funding, rinse and repeat
  5. Exit by selling the company to a bigger fish or start monetizing the business

What Makes It Hard

The problem with this approach is that you actually have to be where the investors are in most cases. Or if you are not where they are, you move. Luckily there are some hotspots across the world for it, not just San Francisco’s Silicon Valley. It is essential to move to any of them, for example, London. But moving to a startuppy hotspot is most likely a good idea even if you don’t intend on involving investors and going the startup route. This helps connect with other founders, find people for your company, and also to be closest to the market itself.

The other big issue is finding a cofounder that you believe will know how to work 80-hour workweeks with you. Unsurprisingly, that is problem with any business, really, not just a Silicon Valley style sytartup. You want someone you know that will commit properly. Without this sort of a good dynamic between cofounders getting funding from Y Combinator is extremely unlikely as this is the main thing they’re looking for. Even across the world in Tallinn, I asked the local VC fund Startup Wise Guys’ representative about it and got the same attitude: it’s 60% about the team and 40% everything else. I am pretty sure Y Combinator evaluates investments based on this even to a more extreme extent.

Lastly, it needs to be an idea that is either completely insane, as in the case of Airbnb - letting other people use your rooms for money. Or it would need to be two worlds better than anything else on the market like Stripe. This is usually achieved by having inside knowledge to a problem field, or by being positioned very favourably either through people or experience. Being approached by the Winkelvoss brothers to test an idea while being in Harvard while having the perfect launch environment for your product certainly helps. Oddly enough, having the right idea at the right time and at the right place is probably the most limiting aspect of it all. And if you’re missing that magic combination and you are a fisherman with a law degree trying to change the way ice cream is made, investors are probably not flocking to you.

The Peter Thiel Way

Peter Thiel

Image from The New Yorker

Zero To One

In Zero To One, Peter Thiel’s approach is even a more extreme version of the Silicon Valley model, or it could also be seen as a complement. But there are some keys to the difference here.

Thiel emphasizes the importance of choosing a problem domain, as small as the market may be, where you actually have a shot at completely dominating the market. He argues that only in this position you can start properly providing extraordinary value to your shareholders, your customers, and the society at large. There is no situation where you have to compete head-on for the profits, scraping for marginal returns. I cannot do his reasoning proper justice, but in essence it is the reverse of perfect competition - a benevolent monopoly. I think a good example of one would be Google that has a monopoly on search, and this enables provide so much more value in adjacent domains in turn. If they had to focus on competing on prices and marginal differences in product offering with, say, Microsoft, the value Google provided us would be so much less.

He also argues there are a lot of unique problems still unsolved, waiting to be captured. And that there are undiscovered unintuitive truths about the world. You have to look for them, and once you find them, you should use them, even in the face of others’ disbeliefs. These will become valuable secrets in your business.

His understanding of competitive advantages and the importance of uniqueness is to my understanding quite similar to Michael Porter’s albeit Porter is much more classical to his approach to business than Thiel.

“The best projects are likely to be overlooked, not trumpeted by a crowd; the best problems to work on are often the ones nobody else even tries to solve.” - Peter Thiel

Generating Ideas

Last autumn, I tried the approach of finding problems that nobody is solving. The way I went about it was I imagined how my life would be more the way I wanted it in terms of technology, even if the technology does not exist yet. Whatever I imagined and confirmed was in the realms of actual physics, is basically bound to be our future. Even if not in the exact implementation I was imagining, the problem would be solved nonetheless.

The futuristic list was enormous, but unsurprisingly in hindsight all of the things I imagined tended to be in the realms of ‘needs a research team of 40 people, 50M in funding and 15 years of development’. For example, I researched many current and future hologram technologies. I found that it is possible to draw in normal air with lasers by making the air explode in a tiny blast, however getting that to the stage where we can render 3D objects with that is still super far.

One of the more useful ideas or deep convictions I got in that process was the sheer amount and growth we will be having in battery technology in the next 50 years. Compared to what we will have, the current battery technology is still a toddler. Since it would be unwise to start building another LG Energy Solution, I thought of markets I could get into that are much much smaller (compared to actually developing novel battery technology). Unfortunately, so far I have not found anything that has not already been done very well. As a bonus, I realized I should avoid getting into hardware at this stage, as I would not be building on my expertise that is software.

It feels that even though I did not find any good ideas to pursue at this time, it was still illuminating to the potential this approach has. The idea generation approach probably deserves a second runthrough from a different angle other than predicting the future through extrapolation.

B2C or B2B

Businesses are there to solve problems people have (B2C) or to solve problems businesses have (B2B). In a way, every person’s life is a business of its own, and every business is made up of people, but still there are some general differences. The main difference usually is how big of a price tag you can have on your product or service. And this also usually means that in order to make ends meet, you have to also scale accordingly. Having a profitable business is possible at a lower scale in B2B. Some would say that the problems businesses have are harder and more complex, but I would say that there is much more uncovered ground in B2B whilst trying to find something that customers in a B2C business do not already have or has an unmet demand is much more difficult.

Of course, why B2C businesses tend to be very attractive to new businesspeople is twofold. One, the problems to be solved are much more apparent in our daily lives. Two, you’ll be much more known for it as there’s much more prestige in it as people interact with the brand. Coca-Cola is much more known than Salesforce, even though their scale is both in hundreds of billions in market capitalization. But then there’s companies like Microsoft that has their legs dipped in both B2C and B2B.

The benefit of a B2B business is that you get to talk to other businesses, which tends to be much more civil. The sort of customer service you have to do is also probably less of a hassle. In general, it is much harder to keep 100x more people happy among the common population rather than just 1x among the businessfolk, with the same relative quality offering.

As I am generating ideas, I tend to have my brain approach B2C areas much more often, but then end up realizing the business idea is very hard to pull off. I actively try to avoid thinking too much on consumer solutions and rather focus on the things that amplify businesses. But I am not entirely sure of this approach yet. What I am sure of, however, is that there is value in both. The only question left unanswered is which path is the right one to take for me in this moment of time. It would definitely save me a lot of time if I could just avoid thinking about one of these.

Product or Service

Product

A product business is one where you sell a bundle of features, be it in the form of a physical product or a software product. Selling such a product could even be sold in the form of a subscription, e.g., in a Software as a Service (SaaS) model. Here the word service is a bit overloaded. The business itself is involved in building a product which is then sold to multiple users (or lent out in the form of a subscription), so it is a product business. However, the product itself is delivered in the form of a service, but it really just a business choice whether to sell it one time for a particular version of the software or to sell the usage rights to it in the form of a subscription.

A product business is much more risky, but also has a higher value potential thanks to scalability. The nature of a product in a business is something you can resell multiple times without changing much, so you don’t usually need to hire as many people in parallel, which is not the case with a service business. Especially with software, where the producing of the product’s cost quickly nears towards 0, the margin becomes infinite. But having a non-zero price for the software product means also having to have deep enough of a competitive moat, not to mention actually finding any demand for it.

Service

A service business is one that sells their time, and there is no tangible product at the end of it. Some examples might include consultancy, but also software work where the end product belongs to the client and is not resellable.

A service business has the advantage of being very upfront about the value provided. Since there is no tangible product, the usage of the business’ time (service) and expertise is what is being sold. If a business can sell such a service, it is quite clear how the customer receives value for their money. It is more direct.

An example of a service company is one that manages other companies’ Search Engine Optimisation (SEO) with their time and expertise. The value provided is the knowhow of optimizing visibility on the search engines and also measurable results through better ranking and discovery of the business. Naturally, since every company’s website and offering is different from each other (if they’re any good that is), the same SEO solution cannot be sold to each such company and needs a tailored approach. This is why a service company is much less scalable.

Paul Graham’s Advice

Y Combinator’s advice is to “do things that don’t scale”.

Does that mean we should indefinitely start from a service business? No, Paul Graham in the same linked post says that you need to forcefully push the company at the start, even though this pushing will not scale indefinitely. But once it scales big enough, you don’t need to do this sort of pushing anymore either.

Of course when you are doing all the legwork for the customer to sign up for your business, you have to be sure that in the end customer values what you have, otherwise the churn will be too strong to handle. PG did admit there is a way to start from doing everything manually (so a service business) and automating things along the way, but I am afraid this is not possible in areas that have been fossilized as a service businesses for a long time already, e.g., providing your services as a lawyer.

Summary

What is the optimal path to take?

I think if the stars are aligned enough for you to be able to yield to whatever building a Silicon Valley style startup demands of you, you should do it, as it has many boons.

Otherwise, I would follow Thiel’s mindset of finding secrets and building a company around it. It will most likely be some sort of a product or offering, and with careful planning and strategy the business will also attract investors.


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