The reality of investing and exiting in the Internet age

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  • January 26, 2011

There has been a lot of discussion about building billion dollar vs <=$50MM exit opportunities. Everyone from Dave McClure, to Techcrunch’s Michael Arrington have weighed in on the debate. To quote Sarah Lacy from her Techcrunch post

There’s the obvious macro-economic answer: Everyone selling too early is bad, because no new tech giants are created. There’s the obvious micro-answer: A few million dollars is life changing for most people, and those entrepreneurs deserve to make a life-changing amount of money.

These are obvious answers, and very valid at that. The majority of the discussions have been back and forth on how these events change the consumer’s life later or the entrepreneurs life immediately. However, what’s not often discussed is the systemic changes to how businesses form and wind down and their subsequent impact on exit strategies. It’s why I believe the $50mm exit is more realistic.

The first corporation was founded around the 14th century when the only form of communication were written and delivered by hand, or word of mouth. The next major change in communication was the printing press, in the mid 15th century, which removed the need for hand written sources of data and made information much more accessible to the masses. Fast forwarding to the next significant iteration in communication, the telegraph facilitated data to be exchanged over longer distances in significantly shorter times, but to a narrow audience in the first half of the 19th century. The telephone opened up the first mass communication that facilitated information to be exchanged in real time at the pace that people could understand the spoken word first during the later half of the 19th century. Lastly, email and the Internet age has brought about mass communication at what will eventually be unrestricted levels of data exchange starting from the mid 20th century. Each iteration in communication technology has produced shorter and shorter leaps until the next major breakthrough in communication. This holds true until we discovered the Internet and it’s application theories that are still very much being iterated upon. This rapid growth in communication technologies has impacted the business life cycle in a similarly dramatic and ultimately disruptive fashion.

Businesses utilize people (human capital), and resources (industrial or financial capital) to acquire more resources (wealth). If the life blood of a business is employees and capital, then as communication efficiency increased, so does individual productivity. As individual productivity increased so too did the fruits of such labor produce better industrial and financial capital efficiency. This iterative process continues today and will tomorrow as communication and industrial capital continue to become further efficient. The problem however is that each iterative cycle continues to produce diminishing returns in productivity until the marginal utility gained from an iteration becomes ultimately indistinguishable and therefore irrelevant. It’s why when we talk about the value of infinity, a figure technically unobtainable, we say we approach infinity when applied to reality.

The Internet has placed us on the express train to quickly approaching infinity.

Now, here’s the real problem. While businesses continue to become more efficient, the wealth they strive for remains ultimately zero-sum, meaning there is a finite amount of real wealth available in our world for distribution. Since businesses are built upon the intersection of human, industrial and financial capital, in a world approaching infinity, the economic advantage of economies of scale provide significant advantages for large existing firms to capture an uneven percentage of real wealth. At the same time, smaller capital investments are capable of achieving significant results because of gains in efficiency of productivity.

Now here’s the irony. As these larger firms continue to expand to capitalize on economies of scale they become a victim of their very own success. In order to leverage economies of scale, larger firms must function as closely coupled in productivity as possible leading new innovation to smother within an environment that promotes uniformity in it’s creativity. This dilemma presents the opportunity for startups to innovate free of such constraints, and to iterate quickly to build something of value for which the world is willing to exchange their real wealth. This is the reason why large corporate entities become publishers of new innovation through acquisition and not through internal development. It’s why big pharmaceutical companies buy drug makers, and why Google has bought 23 companies 3 quarters into this year.

What does this all mean? Well, startups can always succeed by innovating free of the constraints larger businesses suffer. But as they grow from their initial innovation, they too become victims of success by accumulating their share of the finite real wealth willing to be exchanged for their innovation. So the startup must then innovate a new product in order to achieve further wealth. As this process iterates, it will eventually soon find itself needing to leverage economies of scale to compete with smaller startups that are able to innovate free of such constraints. In this manner, the cycle completes itself.

So why do I think smaller exits then larger are the new systemic reality? Because all resources, be they human, financial or industrial capital are ultimately finite and growing a startup beyond it’s initial innovation requires diminishing investment capital in a world where the incumbent large entities are already at an advantage against you in competing for those same exact resources. Whats worse is, ultimately to succeed under such conditions requires successful reiteration of new innovation over and over with diminishing returns with each iteration. And in a world where communication has pushed us to approach infinity faster, opportunity for significant gains in marginal utility has declined inversely. Even so, if the startup becomes larger, it becomes indigestible to many potential acquirers and therefore removes from the pool of chance acquirers whom provide exit opportunities outside of IPOs. This means the most marginal utility, or in this case, opportunity to be rewarded with real wealth, with the least amount of expenditure in resources (read risk) exists in capitalizing on singular innovations that larger corporations are unable to achieve. The entrepreneur’s goal should then be to iterate free of all constraints including the shell that holds the previous successful innovation.Lastly, when talking about successfully run acquisitions, a competitive bidding process will occur between the innovation publishers competing for your startup. The acquirer is then likely to fall victim to the winner’s curse, and because of the lack of data available about the profitability of such an innovation, over pay for your enterprise at the time of acquisition.

An entire generation of entrepreneurs are building dipshit companies and hoping that they sell to Google for $25 million – anonymous VC

Dipshit companies have the wind behind them in the new reality of investing and exiting in the Internet age. That doesn’t mean you can’t build something that’s more then just one product. It’s not at all impossible, it’s just harder and much more inefficient.

This post is likely a work in progress. I greatly welcome feedback.