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Friday, October 3, 2014

Will Venture Capitalists Drive the Next Spectacular Breakthrough?

Peter Thiel’s Zero to One is a provocative and stimulating book, however, the Silicon Valley institutional structure may not drive the future as much as it has the recent past.
In Zero to One, Peter Thiel claims that what is best for the economy and for individual entrepreneurs is for entrepreneurs to create unique businesses based on contrarian ideas.
Thiel cofounded PayPal and was the first outside investor in Facebook. The book is based on lectures that he gave at Stanford and on the notes from those lectures taken by Blake Masters.
Thiel views monopolistically competitive markets (when many firms try to eke out small profits by offering slightly differentiated products), such as urban restaurants, as uninteresting and incapable of generating major innovation. Instead, he lauds firms that attempt to radically alter markets and in the process establish, at least temporarily, pure monopolies in their new fields.

However, many innovative businesses are able to grow by reinvesting profits rather than raising venture capital. Five years ago, Paul Kedrosky of the Kauffman Foundation pointed out that “even among the fastest-growing and most successful companies in the U.S., less than one in five companies had venture investors.” In his book The Origin and Evolution of New Businesses, Amar Bhide gives the name “promising businesses” to companies that require less external investment to start up. These firms differ considerably from the venture-capital-funded firms that Thiel extols. They rely less on formal business plans than improvisation. The chart below lists a few of the differences between the typical promising business and the typical venture-capital-funded firm.
Thiel sees the Internet business environment favoring venture-capital funded firms, because of the importance of network effects and power laws. Companies like Google and Amazon achieve such overwhelming dominance that it becomes pointless to try to compete with them.
I see the Internet business environment as favorable to promising businesses. The Internet has greatly reduced the capital required to create a sales outlet, handle accounting and other administrative functions, and build a supply chain, making it easier to launch promising businesses.
Thiel offers a perspective which strikes me as skewed by his experiences as a business founder and venture capitalist in Silicon Valley over the past 20 years. The characteristics of that business environment are not necessarily those that will prevail going forward.
Thiel's view strikes me as skewed by his experiences as a business founder and venture capitalist in Silicon Valley over the past 20 years.
Thiel believes that our society needs the sorts of enterprises launched by contrarian founders and backed by venture capitalists — that without them we will not get spectacular innovation. He thinks that to achieve high impact, founders and investors must be optimistic and hold a definite outlook, meaning that they proceed confidently with a plan, rather than taking an improvisational or “hedge-your-bets” approach.
Where might we see powerful innovation? Thiel writes:
We are within reach not just of marginal goals set at the competitive edge of today's conventional disciplines, but of ambitions so great that even the boldest minds of the Scientific Revolution hesitated to announce them directly. We could cure cancer, dementia, and all the diseases of age and metabolic decay. We can find new ways to generate energy ... We can invent faster ways to travel.
However, the business environment of biotechnology, which Thiel and I agree is a very promising field for future economic growth, may be different from that of software. In software, companies like Microsoft and Facebook grew to dominance in large part because consumers find an advantage in using the same software as other consumers — this is the network effect. This in turn creates an opportunity for venture capitalists to back the rapid expansion of a firm that is unprofitable for a few years and then wildly profitable a few years later, once the network effect has been captured. It is not necessarily the case that biotechnology will exhibit network effects in which profits are created by rapidly expanding on an early lead.
Also, I question whether the same institutional structure that nurtured Apple, Google, PayPal, and Facebook can provide the hoped-for biotech revolution. It could be that what is needed now is more fundamental research and more dramatic scientific breakthroughs before we can envision the appropriate business models.
The major breakthroughs that made the computer revolution possible came in part from large-scale research institutions, such as Xerox PARC, Bell Labs, and DARPA. The Silicon Valley ecosystem then served to create firms that were able to commercialize, adapt, and improve on what these research institutions created. If synthetic biology or other important new fields still await these sorts of major breakthroughs, then perhaps the initial jump-start must come from large organizations, not venture-funded start-ups.
I see the Internet business environment as favorable to promising businesses.
Even if the biotech equivalent of the transistor, the graphical user interface, and the Internet should emerge, we do not know what sort of business model will be suited to achieving commercialization. It may well turn out to be something other than the Silicon Valley venture-capital model. It is by no means clear that rapid acquisition of a large customer base will be the essential step in creating a great biotechnology company.
Even so, Thiel and I do agree on many points. Both of us emphasize the importance of selling, in contrast to the hopes of engineers that a great product will sell itself. Both of us point out that the founders of a firm are like marriage partners, in that the personal relationship has to be very strong. We agree that CEOs at start-ups should earn little or no salary. We agree that the venture-capital model requires investing in out-of-the-park home runs, not in backing singles or doubles.
Zero to One is a provocative and stimulating book. However, I am not as confident as Thiel that the Silicon Valley model will be as dominant in driving innovation going forward as it has in the recent past.

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