Yesterday, Fred Wilson published a very interesting post talking about investment theses (he was commenting on Dave McClure’s recent article articulating his thesis, but this is largely irrelevant to my argument).  I am a big fan of using such mental models to guide thinking and decision-making and share Fred’s belief that investors should make their investment thesis public and articulate them well.

However, I think that investors are not the only ones that can benefit from having a mental model.  Entrepreneurs who are looking to evaluate startup opportunities can also gain a lot by having a framework that helps them find signals among all the noise.  To demonstrate how this can work in practice, I will outline a mental model that I use as an example for those looking to create their own.

Entrepreneurial Thesis: Evaluating Potential vs. Risk

I believe that a good way to think about startup opportunities is to consider the potential and risk of a particular idea:

Potential refers to how big the opportunity really is and is a function of the size of the market times the “core coefficient” of the product you are building.  A good market is either a quickly growing new market or a large market that your product can disrupt.  The “core coefficient” is the extent to which your product addresses a core need in the market.  A tool that helps graphic designers design (like Photoshop or Illustrator) is an absolutely necessity for that audience (thus having a core coefficient of 1).  A tool that helps designers get feedback better (like ConceptShare) is nice to have, but certainly not fundamental for most (and so has a lower core coefficient).  

Whatever you are building, make sure to think about the potential of that idea assuming the best case scenario (i.e. competition doesn’t affect you, you have enough capital, the right team, etc.).  After estimating the potential of your idea under these unrealistically positive assumptions, check to make sure that you are tackling something that is worth it depending on your preferences and goals.  The purpose of this exercise is not to come up with a very precise number – say estimate the core coefficient to be 0.73 – which is both impossible and stupid.  Rather, the goal is to make sure that the idea that you are about to dedicate the next few years to is really worth your time, effort, and passion.   

Risk is the second part of the model and is inherent in any new undertaking.  However, startups are in a unique position because they have limited resources and operate in extreme uncertainty.  As a result, the risk of failure is correspondingly very high.  It is worth noting that investors can reduce risk somewhat - e.g. by asking for traction and picking winners, which is essentially the norm in consumer internet startups today.  However, the lower cost of innovation in consumer internet doesn’t necessarily mean that founders can reduce risk similarly.  While cheap experimentation, app stores, etc. certainly help, my assumption is that they might reduce the risk from say 90% chances of failure to 70%, which is still very high.

Putting Potential and Risk Together

Putting the two notions of potential and risk together means pursuing opportunities that have appropriate potential given the level of risk you feel comfortable with.  My personal thesis is that startup risk is always very high due to the inherent characteristics of new ventures and therefore the only sensible bets are ones that have a very high potential payoff in order to compensate for the risk incurred.  Your thesis might be different, reflecting your unique skills, preferences, and personal situation.  Whatever it is, make sure that you give it some thought before jumping on the next seemingly good ideas, only to come out disappointed two years later.  Thinking through basic assumptions first might currently not be as sexy or popular as throwing things on the wall and seeing what sticks, but it is a good idea nonetheless.

The Silicon Valley news of the day is certainly Eric Ries’ Startup Lessons Learned conference. For those who may have not heard about it, the “lean startup” is a methodology for managing startups created and promoted by Eric Ries, a former entrepreneur. The Startup Lessons Learned conference was a culmination of his efforts to promote the idea of the lean startup and judging by the tweets and blogs I have been noticing today, the conference was a great success. I followed a bit via the live feed and highly recommend that entrepreneurs check out conference materials – just search for #sllconf on Twitter for many great links.

I believe that the popularity of Eric and the lean startup model are great news. I was privileged to learn from Eric (as well as his mentor and co-conspirator Steve Blank) while taking entrepreneurship classes at Stanford. I was incredibly impressed so I invited them to the 2009 E-Conference at the Stanford GSB that I was helping organize and they kindly agreed and delivered a great talk! I like the guy, he is smart, humble, responsive, and very articulate.

I also like the lean startup model. It just makes sense as a prudent approach to increasing the odds of creating a successful startup. I write about and follow a modified version of it myself – and it really works! The model has also done a wonderful job of creating a common language in the Silicon Valley about sound startup management practices. I have my minor issues of course: I don’t think that the word “lean” is necessary, because Eric is preaching foundational startup management principles and including the word has led to too many people misunderstanding what his methodology brings to the table. I guess that the “lean startup” phrase is a good marketing tool though, so no biggie. I am also not sure why he focuses so much on the topic of continuous deployment – it certainly has its pros, but in the grand scheme of creating a mindset shift, it is a minor detail.

But there is one issue that has been stuck on my mind and is not minor. It seems that the lean startup model is almost “too” successful and ends up promoting a mindset of marginal incrementalism. In other words, what I have been noticing is that people focus way too much on the process and not enough on the big picture at startups. Instead of talking about coming up with big, bold, crazy, audacious goals and visions that change the world, entrepreneurs discuss the best way to improve by 10% in a carefully designed test. This trend culminated with a tweet I read recently saying something along the lines of “the most important job for the startup CEO is to decide which metrics to track.” Try reading this out loud with a straight face. The most important job, really? An important job, certainly. But what about recruiting, fundraising, motivating employees, laying out a vision?

This trend of marginal incrementalism is dangerous because it focuses the attention of the entrepreneur on the day to day effort of studying ongoing experiments rather than thinking big about how to make the startup a huge success. Here’s how it can play out:

In a startup, the entrepreneurial team is faced with immense risk which is an inherent feature of new ventures, because they don’t know who their customer is or what their product is – and only have limited resources to find out. I think it is safe to assume that the risk in a typical startup is well above 50% - probably more in the order of 80-90% of you believe statistics that only 1 in 10 startup succeeds. Such high risk translates into a small likelihood of success. Therefore, in a highly risky startup environment, the only sensible bets are ones that have a very high potential payoff in order to compensate for the risk incurred. To manage the highly uncertain and volatile process of placing and validating these high-risk, high-return bets, entrepreneurs have to be able to balance daily experimentation with thinking and dreaming big. The lean startup however focuses attention only on designing good experiments and learning from them. This is not bad in itself, but taken to the extreme it focuses too much of the entrepreneurs’ time on daily operations. And once the startup falls into such a “thinking small” trap, new problems arise. Without a grand vision and a high potential payoff, it is harder to excite investors, more difficult to sign up customers, tougher to recruit employees, and so on. All of this leads to a dangerous vicious cycle, which kills a lot of startups.

So to sum up, it seems to me that the lean startup promotes a mindset of marginal incrementalism and has failed to acknowledge some of the dangers of such a mindset. To be clear, I firmly believe that the benefits of the lean startup model and its recent popularity far outweigh the costs. But it is worth thinking critically about the framework, because its biggest strength is also its biggest weakness. Especially since everyone seems to obsess over it just a little bit too much.

I am really excited about the upcoming flood of tablet devices, because I can easily see my use case: I read a lot (e.g. I never tweet without first reading the linked article!) and so having a light, mobile, 10-hour lasting multitouch screen that is optimized for reading sounds fantastic.  Of course, such devices are not available today so I haven’t tried one – or even held one – but with so many coming to the market soon, I remain optimistic that at least one company will solve the main concerns that I have (e.g. how to hold the 10-inch device so it is comfortable and easy to read).  For the record, I have major issues with the iPad and Apple in general (best summarized recently here) so my choice for tablet is most likely going to be the Notion Ink Adam, which looks like another word for awesome as you can see here.

However, despite all this excitement, I think that there is one killer feature that all tablets are missing: wireless recharging.  Imagine having your tablet lying on the coffee table in the living room, on the kitchen table, or on a random piece of furniture – and always completely charged because of wireless recharging going on in the background.  This would turn the device from a smaller laptop or smartphone to..  frankly, I don’t know what, perhaps a whole new category of tools unlike anything we are used to before!  No more “did I plug it in yesterday?”, “the battery is dying, I need to recharge!” - instead you pick up the tablet with your morning coffee, read the news and then throw it on the couch – where you find it in the evening after work and finish that long article on why Japan didn’t create the iPod.  In my mind, such an always-on device would be a true revolution in the way we interact with technology, the Internet, and content in general.

And for those wondering if I have gone crazy talking about wireless recharging, scientists have been researching wireless electricity for a long time and the technology already exists and is fairly advanced despite some limitations – as you can read by searching for “wireless electricity” or “wireless recharging” or simply checking out these sample articles: Dell’s wireless laptop or wireless charging for the iPhone and BlackBerry. While the exact vision I was outlining above is probably still a few years away, I can’t help but dream about having a tablet that recharges wirelessly and saves me the hassle of thinking about it as another machine that needs my attention.

Ah, I can’t wait for the future!

In recent years I have been noticing a huge increase in the number of articles spelling the doom of the VC industry.  The argument is rather simple: VCs have not generated any good returns and there is too much VC capital, hence the number of firms and capital raised needs to shrink.  (Interestingly, while everyone agrees that the number of VCs is too high, I have yet to read about someone admitting that they are one of the VCs that need to go).  You can read a recent example of such an article here.

While I certainly understand why the argument is oversimplified when presented in the general media, I have been surprised and disappointed by the lack of critical thinking on the topic when discussed on different social media such as Twitter.  While journalists have an excuse for dumbing down content, experts and insiders should know – and say – better!

For example, nobody has added a key point missing from the discussion: the VC industry is incredibly concentrated.  Despite 900 or so VC firms in the US, 90% of returns are coming from the top 10% of venture capitalists.  (And furthermore, the top 50 VCs are investing 2/3 of all venture capital dollars – sources here and here).  As a side note, there are many reasons why this is the case, including (1) VC is a hit-driven business, and (2) there is a virtuous cycle created when a firm backs a big “win” that then opens up a better deal flow.

In light of this fact, what exactly is the “problem” facing the venture capital industry?  Based on what I have read, it seems that people think that the low overall returns of the sector are destroying trust in its value as an investment class.  But that is not true for a very simple reason: fund managers do not look simply at class returns, but rather at the VC firms that they have access to invest in (and their returns).  Since first-class limited partners crowd to invest in first-class VCs, those who are denied access to these top firms end up settling for second tier VCs, and so on.  That, combined with the need for investment diversification, is how VCs continue to raise ever bigger funds.  That is why the present over-investment in venture capital will remain for as long as the top VCs continue to deliver outstanding returns (which is certainly a challenge as startups get ever cheaper to start while fund sizes continue to grow).

But analyzing the VC industry is not the point I want to make with this post – I am by no means an expert on the topic, I just happen to talk to a lot of people in the industry.  Instead, the VC “problem” I analyzed above reveals some of the core challenges of social media: not everyone is talking and not everything that is relevant and important is being talked about.

What this means is that even though social media has the promise of democratizing news, this promise is not fulfilled automatically.  Instead, the same “old” media rules apply: not everything that is important or relevant ends up being popular, not everyone we should hear from has a say. 

When I told my dad that I use Twitter as my primary source of news these days, he immediately picked up on the problems I presented above and asked: “but how do you know you are not missing a certain piece of news or a valuable perspective?”  And the answer is you don’t: like in any other media, there will always be really loud people who simply miss the point, or analyses who don’t present all the facts. 

That is why rigorous, critical, and independent thinking grounded in facts is ever more important, especially in the technology age, which dramatically facilitates spreading information – which may or may not be correct, balanced, or useful.

When I came to Silicon Valley it was Facebook apps.  Then iPhone apps.  Now Twitter apps. As much as I enjoy playing games on my iPod Touch, I (among others) cannot help wondering if such superficial, incremental projects are the way some of the world’s best problem solvers should be spending their time.

This frustration and surprise of mine is perhaps best expressed by Grandmaster Garry Kasparov in a recent piece called The Chess Master and the Computer. He puts it beautifully: “we have discarded innovation and creativity in exchange for a steady supply of marketable products,” creating a world that is “technology-rich and innovation-poor.”

So why aren’t more people working on the Next Big Thing? After all, with the Internet and related technologies maturing, the possibilities to disrupt industries and fundamentally change the world have exploded. I believe that the answer to this question lies to a great extent in the changing nature of innovation.

The best way to illustrate this change in innovation is by using an example, like Dave McClure does in a recent article titled The Value of Design to Startups: to build Google or Microsoft, you need great engineers. But to eradicate poverty, you need to uniquely combine microfinance, web marketing, and a powerful technological platform. And that is hard.

The reason it is hard is because most of us are trained in a single field, which means that we struggle to understand interdisciplinary issues and work with a diverse set of people. For example, with few exceptions, computing is separated from other subjects, with engineers being educated and trained in isolation as the NY Times notes in New Programs Aim to Lure Young Into Digital Jobs. How does this make sense in a world where technology is a key type of infrastructure that impacts every aspect of our lives?

It doesn’t, of course. To successfully innovate, we need to overcome this interdisciplinary challenge and build diverse teams with expertise in multiple fields that have the creativity and skill to make the world a better place. My personal attempt to do that is Philanthropedia, which is changing the $250B philanthropy sector by tackling some of its most fundamental questions: how to identify and fund the few best nonprofits among the millions of organizations that exist in the US.

What is yours?