Drama 2.0 Archive

What’s wrong with Silicon Valley? It’s a question Business Week asks on the cover of its January 12, 2009 issue.

According to BusinessWeek reporter Steve Hamm, "A road trip finds risk aversion, short-term thinking, and a few bold ideas." Given that some believe technological innovation is going to lead the United States out of its economic mess and restore its global competitiveness, those aren’t exactly the findings one probably wanted to receive.

I, of course, have been criticizing Silicon Valley for some time on The Drama 2.0 Show. While Valley inhabitants have celebrated consumer Internet startups like Facebook and Twitter and have demonstrated irrational exuberance over businesses they clearly don’t understand ( like energy), as an outsider I haven’t been able to help but notice that there hasn’t been much real innovation taking place.

This isn’t entirely surprising. Scientists and experienced technologists in the Valley have been forced to compete with hipsters and Harvard dropouts. Forward-thinking venture capitalists have been forced to share Sand Hill Road with young VCs who carry MBAs and list companies like McKinsey and Bain on their resumes. Substance has been forced to compete with hype. A desire to build real companies that produce real wealth in the form of profit has been forced to compete with the desire to "fund and flip."

Former Intel CEO Andy Grove has a bachelor’s degree in Chemical Engineering and a Ph.D. in Chemical Engineering. He was Intel’s third employee and did more for IBM during his career than perhaps any other person.

In his article, BusinessWeek’s Hamm relates Grove’s frustration at the state of Silicon Valley. Grove tells Hamm:

Intel never had an exit strategy. These days, people cobble something together. No capital. No technology. They measure eyeballs and sell advertising. Then they get rid of it. You can’t build an empire out of this kind of concoction. You don’t even try.

Cobbling something together. Hmm. Do you hear that, Paul Graham?

If you have followed the voices in the blogosphere, the Twittersphere, the mainstream media and the conference trail over the past several years, you may have been led to believe that there was a golden era in Silicon Valley.

Innovation was everywhere. Lower barriers to entry made it easier to launch a new company and raise financing on favorable terms. A more "democratic" funding environment made it possible for virtual nobodies to play ball. And the struggles of stodgy old companies in dinosauric industries somehow inured to the benefit of Silicon Valley upstarts looking to dethrone them.

I’m sure the excitement was palpable for those who found themselves in the midst of the second coming of the Internet but as an outsider, it was difficult for me to see how the companies and trends Silicon Valley was latching onto were all that important. How were social networks going to revolutionize an already sophisticated, complex and competitive global ad market? How were microblogging services going to revolutionize personal communications? How was citizen journalism going to replace the expensive exercise of covering the news without the financial resources held by major media organizations?

The bigger question I had: how was any of this going to make the type of money the venture capitalists funding it needed it to?

It wasn’t, and now that this is clear to all but those who rely on social networks, social media, citizen journalism, et. al., to pay the bills, the question for Silicon Valley becomes: where did we go wrong? There are a number of contributors to the flawed thinking that is now pervasive in Silicon Valley.

The Allure of Advertising Masks A Lack of Innovation

I’m not sure why everyone in Silicon Valley is so enamored with advertising as a business model. Perhaps it’s that Silicon Valley entrepreneurs and VCs have heard such fabulous things about the parties major brands and ad agencies throw at the Super Bowl and they hope that they’ll one day be invited. Or perhaps they like the fact that, on paper, advertising revenues seem potentially unlimited. The more you grow, the more you can make.

A great formula comes into focus: give something "cool" away for free, spark viral growth, hit critical mass, sell lots of advertising, profit. If only it were that simple.

To be sure, the advertising market is absolutely huge. And if you think like a VC, all you need is to capture a small sliver of it to make a lot of money. But selling advertising can be a real bitch and there’s a reason that it’s the big who tend to get bigger in this market. The existence of massive ad spend doesn’t guarantee you’re going to get any of it, there’s still a lot that’s driven by relationships, buying is cyclical and, of course, as everyone is now realizing (again): the fate of the advertising market is correlated quite closely with the fate of the economy.

The reality: ad-supported businesses have been so popular in Silicon Valley of late because the Valley folk have known, either consciously or unconsciously, that there aren’t a whole lot of people willing to pay a whole lot of money for most of the products and services they’re developing.

The best innovations are rarely subsidized by advertising. Because innovations offer a new way of doing something – whether more effectively, more efficiently or at lower cost – they’re typically something their end users will pay for.

Let’s consider a handful of the greatest innovations of the 20th century, as named by Forbes: sneakers, the television, the mass spectrometer, the personal computer, frozen food, the transistor, point of sales data, the discount brokerage firm, Tupperware, "the pill", the disposable diaper, the catalytic converter, the world wide web.

How many of these are paid for by their end users? All of them. For those interested in the subject of innovation, it’s an instructive exercise to go through Forbes’ list of the 20th century’s greatest innovations and to place each one of them in one of two columns: paid or ad-supported.

After doing so, you might be inclined to agree with Drama’s Law: the more innovative a product or service, the more willing its end user is likely to be to pay for it.

Unless you’re clueless and believe that this trend will change in the 21st century (even as we head into a deep recession), the question must be asked: why are so many of the Silicon Valley personalities widely publicized as being at the forefront of "innovation" spending so much time working on "innovations" that they clearly don’t believe end users would find valuable enough to pay for?

The logical answer: these people are not at the forefront of innovation.

Bubble 2.0, Stupid VCs and Short-Term Thinking

As the financial crisis unfolded, a lot of Web 2.0 types shouted "This isn’t our bubble!" To be sure, overvalued tech stocks didn’t produce the first half of the mother of all financial meltdowns (yes, there’s more to come). But to understand why Silicon Valley has been overrun by "me three" companies that produce little real innovation and even fewer profits, you need to understand that venture capitalists were able to raise such large amounts of money because of the economic bubble that was inflating around them. As I’ve stated before, Silicon Valley isn’t a walled garden insulated from the global economy.

The limited partners who invested huge sums of money in the venture capital "asset class" over the past decade have largely been the same entities (i.e. pension funds, funds of funds, wealthy individuals, etc.) that were beneficiaries of the inflationary system that produced all of the economy’s illusory wealth in the first place. It was a vicious cycle: as almost every asset class rose in value, there was far more money to pump into all the asset classes.

This did three things in Silicon Valley: it led to oversize VC funds, it led to more VC firms and it led to a "fund and flip" mentality.

It’s important to recognize that most VCs are not investors so much as they are money managers paid by their limited partners to allocate capital, and like most money managers, they are prone to herd mentality. A trend develops and before you know it, every VC wants exposure to the trend, especially if there has been any M&A activity that supports the notion that a lucrative new market is emerging. When there are too many firms with too much money chasing too few ideas, herd mentality can be a very destructive thing.

First, lots of capital piles on in areas where it really isn’t needed. One need look no further than the number of social networks and video sharing services that have been funded over the past four years as an example. Today, there are a handful of winners and potential winners in these spaces and a whole lot of losers. Hundreds of millions (if not billions) of dollars that could have been allocated to more worthwhile investments were instead wasted on acquiring "exposure" to hot trends in hopes of funding the next YouTube or MySpace. This explains why VCs have been taking in more money than they’re generating in returns.

Second, herd mentality discourages forward-thinking investments. Remember: venture capitalists are money managers, not true investors. They therefore have a great incentive not to stray from the herd. If you’re a money manager and every other money manager you’re competing with is investing in social networks, online video, solar or biofuels, investing in "oddball" companies that are trying to do something different and bold is a potential liability. If those companies don’t succeed, you don’t have the plausible deniability that is created by looking like all the other members of the herd.

Exacerbating the problem is the fact that most VCs are ill-equipped to spot something truly unique and forward-thinking. The word "innovation" is thrown around so much by VCs that it’s clear they have no clue. The word itself is almost meaningless in Silicon Valley these days.

Which isn’t surprising. Look at the website of most VC firms and you’ll inevitably find more MBAs and finance types than you will mechanical engineers and physicists. You’re far more likely to meet a VC who went to Stanford and worked at McKinsey than you are to meet a VC who went to CalTech and worked at the Department of Energy. While you don’t need to be a scientist to recognize innovation, if you’re funding biofuels companies, for instance, it probably helps if you have more exposure to, say, chemical engineering than financial engineering. That makes it a little bit easier to spot a technology with real potential instead of one that will serve as the basis for a hot PowerPoint.

So what do you do when you’re clueless, flush with cash and find yourself in the middle of a bubble economy? Fund and flip, baby.

Why go out of your way to fund companies that are bold but risky? Why fund companies that have substantive potential but may take years to realize it? When times are good, VCs have little reason to take intelligent risk. Big jackpots that produce immediate returns, which VCs got their first widespread taste of in the late 1990s, seem well within reach. And since everybody loves easy money, "fund and flip" is a lot sexier than "fund and fiddle." It’s good for VCs, it’s good for their limited partners and it’s good for entrepreneurs who have a simple pitch (i.e. "we run a YouTube for dance that was co-founded by MC Hammer").

In short, it pretty much boils down to this: if the VC market had a healthier (read: smaller) number of firms and a healthier (read: lower) amount of capital available to invest, the venture capital "asset class" could have remained the niche asset class of technology innovation that it should have been instead of yet another get-rich-quick scam. Capital would have been allocated more selectively to forward-thinking companies by more knowledgeable VCs.

Conclusion

If Silicon Valley was a corporation named Silicon Valley Inc. (SVI), I’d provide the following advice: hire a turnaround expert and retain a new PR firm. Now.

SVI needs a new direction. Its strategy is shot and the products it has lost much of its relevance in the marketplace. And before you think that cleantech is the answer, consider that a shockingly large percentage of the Silicon Valley eco-entrepreneurs don’t seem to realize that Moore’s Law doesn’t apply to energy.

There’s also a lot of dead weight in Silicon Valley. From hipster CEOs like Kevin Rose, who, after 4 years and no profits, relayed to BusinessWeek that Digg is "stepping up its innovation game", to VCs who don’t know the difference between a proton and an electron, SVI needs to re-examine its recruiting practices. Metaphorically-speaking, there are far more people sitting around the water cooler than there are productive employees.

In short, SVI’s turnaround expert will help it define its core competencies, refocus on them and cut the slackers.

Once that’s done, SVI’s new PR firm will help ensure that Silicon Valley is sending the right messages to stakeholders, the public and the media. No more hyping novelties and no more "How This Kid Made $60 Million in 18 Months" cover stories.

SVI would instead highlight all the substantive innovation it is engaging in. It might even earn a cover story that reads "How This Technology Saved The Department of Defense $600 Million in 18 Months." But it would never lose sight of the fact that it’s job isn’t to inspire people with press releases and fluff but to help individuals and businesses while making a profit.

Fortunately, SVI does not need to restructure completely from the ground up. There is innovation taking place. Large companies like IBM and Intel haven’t thrown in the towel on R&D. And there are entrepreneurs, like Jeff Hawkins, the creator of the Palm Pilot and the Treo, who are working on bold new ideas. Hawkins’ newest startup, Numenta, which BusinessWeek mentioned in its article, is developing a computer memory system modeled after the human neocortex. It hasn’t raised venture capital. Apparently most VCs just can’t wrap their heads around the concept (no pun intended).

Of course, IBM, Intel and Numenta aren’t as sexy as Facebook, Digg and Twitter or all of the cleantech companies that are holding off on their innovations until a government bailout arrives, but if SVI wants sex appeal, it should change its name to Silicone Valley Inc. and relocate its corporate headquarters about 350 miles south to the San Fernando Valley. At the very least, the companies in Chatsworth could teach it a thing or two about making money.

Not only are most of the hottest Web 2.0 startups unprofitable, quite a few lack viable revenue models altogether. This has led cynics like me to criticize these startups quite harshly over the past several years.

Twitter, for instance, is the perfect example of the prototypical Web 2.0 startup that has captured the hearts and minds of the Web 2.0 "community" but hasn’t captured any real money (outside of venture capital).

When confronted with questions about the financial viability of their hottest startups, Web 2.0 proponents usually have a similar response: Rome wasn’t built in a day. When Google launched, we’re reminded, it didn’t know how exactly how it was going to make money. For young Web 2.0 startups that are growing rapidly, we’re often told that growth and "critical mass" are more important than revenue models and profitability.

As we recently learned that Digg was still losing money on revenue numbers that look quite paltry, it occurred to me that Digg and some of Web 2.0′s other hot young startups really aren’t hot young startups anymore.

Continue reading “Web 2.0, Revenue Models and Profitability: A Web 1.0 Comparison” »

I’ve always been a bit harsh on VCs and I do feel that my criticism of VCs has been deserved. If you look at the business of venture capital over the past 10 years, it’s pretty clear that VCs aren’t the sharpest tools in the shed.

That said, there is a place for venture capital and VCs have funded some wonderful companies over the years. The reality is that venture capital is not entirely useless; in recent years there have simply been far too many firms with far too much capital chasing too few good startups.

I think VCs have done a great disservice to themselves and to innovation over the past decade by allowing themselves to get caught up in an irrational exuberance that encouraged investment in overhyped startups that never should have received investment in the first place.

But I feel that the current infatuation VCs have with "cleantech" investments may be far more dangerous to Silicon Valley’s future than the irrational exuberance we’ve seen over the past decade for several reasons.

VC Cleantech Investments Are Being Driven by the Broken Economics of Venture Capital

Even though the ongoing global financial crisis has nothing to do with Silicon Valley directly, VCs have been the beneficiaries of capital glut that fueled one of Wall Street’s most impressive ponzi schemes ever.

As The Deal recently observed, "Many of those same [limited partners] that fattened venture funds are the same pension funds, endowments and other institutions that levered up, piled into hedge and private equity funds, and otherwise made a big problem even bigger."

Earlier this year, Paul Kedrosky argued that "venture capital still has too much money under management" and pointed out that if you took "pre-bubble 1994 figures" and adjusted for inflation, the average fund size in 2008 would be $100 million, not the $200 million that it is.

VCs have been put in an unusual position: many have been able to raise oversize funds but there really haven’t been many good markets to put a lot of money to work efficiently. Although a considerable amount of good money has been thrown after bad consumer Internet plays (especially in the Web 2.0 space), VCs weren’t completely clueless as to the changing economics of their business.

Obviously, investing an oversize fund across a larger number of smaller startups in markets like Web 2.0 isn’t viable. The economics of smaller deals don’t make sense and it’s been clear for some time M&A and IPO exits were not viable for the vast majority of these startups.

Cleantech startups, on the other hand, have been a VC’s wet dream.

Unlike most startups that have traditionally appealed to VCs, which target multi-billion dollar markets, cleantech startups target a much bigger market – the multi-trillion dollar global energy market.

But for startups taking on this trillion-dollar market which is already dominated by some of the world’s most powerful companies, a lot of capital is needed. And that’s just what VCs with oversize funds looking to invest large chunks of capital in one fell swoop like to hear.

I’ve seen few VCs actually question whether or not the economics of their business have changed for the better. Obviously, VCs have good reason to like their oversize funds (their management fees are based on committed capital), but I’ve yet to see many VCs consider that raising more money and investing it in more capital- intensive markets (like cleantech) is actually what they’re best positioned and best equipped to do.

VCs Don’t Know What They’re Doing

I would argue that VCs aren’t best positioned and best equipped to invest in this fashion. Although "cleantech" is tech, it’s not tech as VCs know it and I think most have absolutely no idea what they’re doing.

Case in point: Vinod Khosla, the Sun founder who is one of the most prominent Silicon Valley cleantech investors, invested in "an idea for a new sustainable cement" after receiving an email from a man he knew only casually.

Regardless of whether or not his investment in Calera turns out to be his "biggest win ever," Khosla’s approach highlights the new breed of irrational exuberance that cleantech has sparked. But if the recent shakeup at Tesla highlights one thing, it’s this: saving the world and making a fortune one startup at a time is not easy.

The reality is that most cleantech startups will never get off the ground commercially. Developing something that works in the lab is very different than developing something that works in the real world. And while much of the VC money flowing into the cleantech sector is currently being spent on R&D, it’s the scaling (for the technologies that even work) that will kill the VCs.

In short, the model that has worked for "traditional" VC technology investments will not work for cleantech.

Neal Dikeman of Jane Capital Partners explained this perfectly when he wrote:

In energy, there is no disruptive technology, only disruptive policy that makes some technologies look disruptive after the fact. In energy, the risk is in the scale up, not the R&D, and the end application is so massive, so capital intensive, and so utterly dependent on commodity prices, that you can’t invest in it like you invest in IT. It takes longer, 10x as much money, and the ante up to play the game for one project is the size of your largest fund. At scale, there is no capital efficient strategy in energy.

But we are Silicon Valley and we smash open gates with technology, and we know better than those energy dinosaurs in Houston, London, and Abu Dhabi, right? They just don’t get it, right? One game changing technology can force the oil companies and power companies to their knees. The one I’ve found really is new and different. This entrepreneur has discovered something new. And it can be *cheaper* than oil (if you define cheaper right).

Beware Silicon Valley, the great fortunes, wars, and economic crises of the world for 100 years are not technology ones, they were energy made. Half the schools you went to were built by oil money. And the entreprenuerial spirit in this industry was born in the hardscrabble oilfields of Pensylvania and Texas, and grew up in the far reaches of the globe. And the oil companies those entrepreneurs founded have forgotten more about technology in energy than you even know existed.

Be forewarned, you do not have a comparative advantage here. The oil men invented risk taking, AND risk management. The oil men are bigger, faster, smarter, richer, have more scientists and more entreprenuerial spirit than you, AND they know energy.

So while you fight the good fight to develop technology to change the world, don’t forget, be humble, learn what can be learned, build what can be built, and walk softly, because the elephant in this room floats like a butterfly and stings like a bee, and he has yet to take the field.

VCs clearly haven’t quite recognized this, although I think the situation at Telsa demonstrates that they’re finally getting clued in to reality a bit.

The bottom line is that many VCs are betting the farm on cleantech and they’re biting off more than they can chew.

VCs Are Becoming Subsidy-Hungry

So what are VCs supposed to do now that they’re playing in a market where they are really not equipped to compete? Ask for government handouts, of course!

Before I address this, a disclosure: I am not an American citizen and I could care less about who wins the United States presidency. Now that this is out of the way, let’s move on.

The fact that VCs are, by in large, supporting Barack Obama to be the next president of the United States is no secret. They’ve raised millions of dollars for his campaign.

And for good reason: he has called for an investment of $150 billion over the next 10 years "to catalyze private efforts to build a clean energy future." From direct investment to incentives to tax breaks, Obama’s plan appeals to cleantech-infatuated VCs for one simple reason: they expect that it will benefit their investments either directly or indirectly.

While their support is to be expected because of this, I think it’s worrisome that VCs are so attached to the outcome of a presidential election. If VCs are investing in companies that they feel can only thrive with a president who will provide investment, incentives and tax breaks that happen to support their portfolio companies, haven’t they lost their way? Are they not supposed to be investing in companies with the potential to do great things on their own?

In a 2005 post, Kedrosky wrote:

Too many people are trying to boil the ocean in clean power investments that require the world to change for them to be successful. Much better is finding opportunities where you can succeed nicely even if the world doesn’t oblige, and where you succeed wonderfully if the planet plays along.

Unfortunately, VCs know that the world isn’t going to change and are hoping that the not-so-invisible hand of government is going to change it for them.

Even one of my least favorite Silicon Valley movers and shakers, Carly Fiorina, observed:

Barack Obama believes a big government program is the answer, and I find it interesting that the Valley, which has historically believed that you let entrepreneurs and businesses do as much as possible, supports this: that’s anathema to how the Valley works.

I agree.

About a month and a half ago, I spoke with a hedge fund manager who took the time to tell me about a new cleantech fund he was launching. It was not the virtues of the companies he planned to invest in that he extolled; it was the tax benefits that would exist for the fund because of the nature of the investments.

This highlights a major problem that is created when subsidies come into play: the benefits of the subsidies (some of which may on their own guarantee a return of some sort) distort the normal investment decision-making process. Investments are not necessarily made in companies because those companies can compete in a fundamentally sound manner on their own but because a benefit can be realized from the subsidies that will be available to them.

For VCs who typically make their money from "home run" exits, investing in markets manipulated by government handouts is problematic for obvious reasons – most of these markets will not miraculously become self-sustaining at some point in the future. Instead, these markets will remain attached to the teat of government.

In the United States, for instance, it’s established that corn ethanol is not all that it was cracked up to be. Not only has it not benefitted the environment, it has made gas costlier. Yet in an effort to "level the playing field," billions of dollars in corn ethanol subsidies have created a powerful special interest group that it looks like Americans won’t be able to get rid of.

From my perspective, technologies that are commercially viable don’t need subsidies and if VCs are calling for them, it means they think they’ve invested in technologies that aren’t viable.

So Why Does Any of this Matter?

By now, you’re probably asking: why does any of this matter? Why should I care about VCs and their cleantech investments?

The answer is simple: while I don’t believe most startups need it and I think it is glamorized, venture capital has played an important role in Silicon Valley. Venture capital does have a place in the market and it has contributed to the development of some of the most successful technology companies ever built.

But the economics of venture capital are out of whack and that in turn has forced VCs into markets where they really have business being. VCs now find themselves in a position where they’re investing in companies that they really shouldn’t be investing in, many of which will need government handouts to even have a chance at surviving in the market.

In short, VCs have gone in the wrong direction and I would argue that their investments in the cleantech space represent a misallocation of their capital.

None of this is good news for the type of technology entrepreneurs who VCs have traditionally backed (and I’m not talking about the Kevin Roses and Mark Zuckerbergs of the world).

Over the long term, this will likely change the face of Silicon Valley in negative ways.

In the simplest analysis, some firms are not looking to create the next Intel, Microsoft or Google. They’re looking to create the next Exxon Mobil and we can expect this trend to continue if the next president of the United States moves ahead with a cleantech welfare program.

But just as one probably wouldn’t find it sensible to appoint Exxon Mobil CEO Rex Tillerson the CEO of Google, it’s not sensible for Silicon Valley VCs who know more about software and semiconductors to think themselves modern day John D. Rockefellers.

Rockefeller’s biographer wrote that the rise of Standard Oil "was not meteor-like, but accomplished over a quarter of a century by courageous venturing in a field so risky that most large capitalists avoided it, by arduous labors, and by more sagacious and farsighted planning than had been applied to any other American industry."

VCs should not dream of finding the cleantech version of Standard Oil. It’s likely a search for El Dorado.

VCs should instead downsize and get back to the basics. VCs do play a role in fostering innovation in Silicon Valley and judging by their investments over the past decade, there’s a lot of room for improvement.

Silicon Valley as we know it may depend on that improvement.

This post was contributed by Drama 2.0.

Just what does Drama 2.0 do? One of activities I’m most heavily involved with is the trading of financial instruments (primarily option contracts). Trading is a wonderful exercise not only because there’s a lot of money to be made (and lost, of course) but because the most powerful human emotions – fear and greed – are grappled with an on almost daily basis.

There are a lot of life lessons to be learned and many of the "rules" of trading can be applied to the world of technology entrepreneurship, especially in a day and age where startups are built to be "flipped" and entrepreneurial employees jump from one startup to another in search of the "big hit." Here are several trading "rules" that can be useful for technology entrepreneurs.

The Trend is Your Friend

In the startup world, spotting market trends in technology isn’t as easy as looking at a trendline on a price chart but it’s not too difficult either.

Most savvy and experienced entrepreneurs have a good sense of trends. They know which markets are meeting needs and seeing the creation of potentially valuable businesses, they know which markets are seeing increasing inflows of investment capital and they know which markets have a healthy level of M&A interest or activity.

While most entrepreneurs want to get into hot markets before they’re hot because there is the perception of greater profit potential, it’s worth noting that in the financial markets, the average investor only makes money in the middle of a trend. This is often called the "meat of the move." As such, entrepreneurs should consider that they don’t necessarily have to try to predict new trends and can instead place their bets when a trend has been established.

Example: Friendster popularized the modern day version of the "social network." It launched in March 2002 and it didn’t take long for Friendster to take off. Social networking was officially "hot." Yet a number of startups that launched after the social networking "trend" had been established have done far better for themselves.

MySpace, which launched in August 2003, sold to News Corp. for $580m in July 2005. Facebook, which launched in February 2004, has reportedly entertained 10-figure buyout offers. And Bebo, which launched in January 2005, recently sold to AOL for $850mn in the largest social network acquisition to date.

The lesson? You don’t always need to be "first."

The Trend is Your Friend Until the End

Some trends last longer than others but all eventually come to an end, hence the saying "The trend is your friend until the end."  Entrepreneurs should recognize that no matter how much they believe in the trend they’ve invested themselves in, the trend is only working in their favor while it’s intact.

In the world of startups, once a trend ends, if you don’t already have a viable, self-sustaining business and a revenue model that can realistically withstand a bit of a shakeout, any advantages that inured to you when you were going "in the direction of the trend" are eliminated.

Example: online video startups have raised lots of money and much of this money flowed into the market after Google’s $1.65 billion acquisition of YouTube in October 2006. And yet while online video has a bright future, the trend that supported online video startups looks to be waning. The fire sale of heavily-funded startups like Revver and PodTech is likely just the first part of a shakeout I predicted earlier this year and online video entrepreneurs relying solely on the "online video is hot" trend are not likely to fare well.

Don’t Try to Call Tops and Bottoms

One of the biggest mistakes a trader can make is to call market "tops" and "bottoms." In fact, this mistake probably accounts for the majority of the losses amateur traders make. Professional traders understand that they have no control over the markets. They are successful because they keep their emotions in check, think objectively, play probabilities and understand the importance of money management.

Amateur traders think success is dependent upon predicting what the market is going to do. They will rush head-first into trades because they think they can call market highs and lows. When it comes to startups, entrepreneurs should recognize that they don’t know when the hot new markets they’re in will lose their luster. Thus, getting greedy and trying to predict when it will "peak" so as to "get out" at the very top is foolish. See "Pigs Get Slaughtered" below.

Conversely, trying to predict when a market will rebound is equally foolish and the saying "never try to catch a falling knife" serves as a reminder to those who think they can call bottoms.

Example: with it becoming clear that many Web 2.0 startups aren’t going to make it, Om Malik suggested that it might be time to start a vulture fund that buys up distressed Web 2.0 "assets" at a bargain basement price. But just what is a bargain basement price? A startup that once raised $10 million but is being sold off for $1 million may still be overvalued and the worst could still be yet to come.

As I noted, "successful vultures don’t reap financial windfalls by buying everything that declines significantly in value." The bottom line is that most of the time, trying to predict when an asset has hit its lowest point in value usually leaves one holding an asset that continues to fall in value.

Pigs Get Slaughtered

Greed is the second most powerful emotion in financial markets (behind fear). Traders who are unable to control their greed and leave everything on the table inevitably become "pigs" and "pigs get slaughtered." While some "pigs" don’t think at all, many "pigs" believe that they will be able to predict the "top" of the market, as discussed above, giving them an ability to maximize profits. Few are successful and those that are typically mistake luck for skill.

The same goes for entrepreneurs. Knowing that trends don’t last forever and accepting that they have no knowledge of or control over when they’ll end, smart entrepreneurs recognize that there’s a time to take money off the table. In today’s Internet startup world, taking money off the table typically means selling your company. How do entrepreneurs know that they’re selling too early? They don’t.

Example: Facebook. The company led by wunderkind Mark Zuckerberg reportedly turned down 10-figure offers and instead choose to raise money at a ridiculous valuation, maintaining that he felt the company is better off remaining public and eventually going public sometime after 2008.

Yet Facebook’s valuation raised eyebrows – and skepticism. The company’s revolutionary advertising play (Beacon) flopped and the company’s shortcomings (especially around monetization) are now well-known. The public markets don’t look like they’ll be conducive to an IPO anytime soon given the company’s financials, leaving shareholders illiquid. Hence it’s no surprise that some Facebook shareholders are attempting not to be pigs – they’re looking to sell their shares privately.

Respect Support and Resistance

In the financial markets, support and resistance are key points at which supply and demand are in alignment. Support is the point at which demand keeps price from falling further and resistance is the point at which supply keeps price from rising further. Support and resistance are often found in the form of previous highs and lows, moving averages, floor trader pivots, etc.

While "buying into support" and "selling into resistance" are not hard and fast rules (support and resistance do break all the time), not recognizing support and resistance levels is a huge mistake. In the startup world, a similar dynamic of supply and demand exists.

Every "hot" new market gets hot because there is some demand. This leads, of course, to the creation of startups to meet it. Yet at some point, the supply exceeds the demand and the market is left with a field of companies that have essentially failed.

Entrepreneurs must be realistic and should observe the supply and demand dynamics in their markets.

Example: social networks. It’s unlikely that MySpace and Facebook are going away anytime soon because there is demand for them (support), yet the rise of the social networking market led to literally hundreds of social networking startups (more than a few of them funded). Clearly, the supply of social networks now exceeds the demand (resistance). Thus, launching a social networking startup today would be akin to "buying into resistance" and unless an entrepreneur has a valid rationale for that, it’s probably not a wise move.

Patience is a Virtue

In the fast-paced world of financial markets, it’s really easy to lose patience. When you miss a great trade, the desire to "chase profits" creeps in. When you’re looking too hard for trading signals that just aren’t there, "overtrading" can occur. The same problems are present for entrepreneurs who often find themselves scrambling to enter hot new markets when they feel they’re missing the boat or who feel the need to explore every opportunity that they think exists even when these opportunities are objectively dismissed.

Patience is a virtue for both traders and entrepreneurs.

For traders, patience often means sitting on the sidelines when there is no opportunity that gives you a discernable edge. It also sometimes means sticking with a trade (i.e. letting your stops take you out of a long trade despite your emotional desire to get out sooner).

For entrepreneurs, patience also often means waiting for the right opportunity. And while it’s far too easy to get emotionally attached to a company and not "cut your losses" when you should, patience can mean sticking with good opportunities even when they don’t get realized overnight.

Example: one need go no further than the conference and party circuit in Silicon Valley to meet entrepreneurs chasing opportunity and jumping from ship to ship in search of it. Most will not be rewarded by chasing success in this fashion.

And one need look no further than a company like Shutterfly to find entrepreneurs who were patient and "stuck with it." Shutterfly struggled to make it through Bubble 1.0 and its future still has a lot of uncertainty but it was able to go public in 2006.

Conclusions

Obviously, there are a lot of similarities between "traders" and "entrepreneurs." But there are a lot of differences too. While a considerable amount of wisdom gleamed from the financial markets can be applied to the entrepreneurial experience, I personally don’t recommend that entrepreneurs treat their business decisions like pure trading decisions.

Unlike with trading, some emotion is good for entrepreneurs – starting a new business (or going to work for a startup) shouldn’t be a detached process that is driven solely by profit. After all, the best entrepreneurs truly believe that their companies are doing something important and that they have what it takes – the best traders believe in no such thing.

Yet exercising the objectivity and discipline traders strive for and which the rules above demand can help entrepreneurs make better, more logical decisions. And that’s a good thing, especially at a time when so many entrepreneurs (and wannabe entrepreneurs) have discarded logic for hype.

Addendum

My predictions on Schlumberger and Google proved to be quite profitable.

I’ve been speaking with this "Drama 2.0" character for a while now. In fact, I was the one who performed the upgrade from Drama 1.0 to the current Drama 2.0. We believe it’s a he and that he lives somewhere on an island. His advice on the Drama 2.0 blog is typically excellent and is well worth a read. Uncov wishes they were Drama. I tried tracing the emails I sent to him but after the 4th hop over Antartica, the trace goes cold. Here’s our interview transcript. Read it once and get the content, and then read it backwards to try to find any hidden messages please.

Allen: Let’s start with a brief bio.

Drama 2.0: I expected you to ask for something like this. The two questions I get most are "Who are you?" and "How old are you?"

Drama 2.0 is a highly-successful businessman and connoisseur. He’s basically Web 2.0’s Keyser Söze. Constantly traveling the globe in search of opportunity, he has a penchant for the finer things in life and the faster things in life.

The man behind Drama 2.0 is as charismatic and charming as his alter ego, but has a tighter grip on his indulgences. Right now, he is an entrepreneur running some sort of company that might or might not succeed. Through his extensive business dabblings over the years, voracious reading habit and graduate degree from the School of Hard Knocks, he has acquired the wisdom that he distributes to the world through Drama 2.0.

Since I know bloggers love an exclusive and I’ve been disappointed that some people apparently think I’m an old man, I will officially reveal my age on Center Networks: I am older than 25 and younger than 28.

Allen: What do you view as 3 trends that will be hot in 2008?

Drama 2.0: Besides Drama 2.0?

1. I think online video will continue to be hot. While I’m not convinced that the substance matches the hype and that the WGA strike is going to do for online video what some bloggers have predicted it will do, I am excited by the opportunities for professional original online video content and don’t think there will be any shortage of activity in the space.

2. I anticipate that revenue will become a lot more important to startups as the economic situation gets tougher. In my opinion, a recession in the United States is inevitable. I’ve discussed the problems this poses for advertising-dependent businesses and therefore I think "revenue" is going to be fashionable again in 2008. When it comes to the type of things that can drive revenue for consumer Internet startups, I’m actually a fan of virtual goods. Over $2 billion/year is now spent on these items and while it seems silly on the surface, once you recognize that, for better or worse, an increasing number of people find that their online identities are just as important as their offline identities, you’ll realize that the same psychology that drives the purchase of $1,000 hand bags and $700 jeans can drive the virtual goods market pretty far.

3. I like niches because I think far too many startups are attacking the mainstream market. There’s a finite amount of room for winners there but I still see a lot of room for solid niche plays. It’s important to note, however, that a solid niche play does not entail creating a generic MySpace clone for sci-fi lovers or a generic Digg clone for activists. Niches have to be done well by people who understand the niche.

Allen: Which big companies will succeed in 2008?

Drama 2.0: I’m assuming you’re not looking for answers like Schlumberger (SLB), which makes this difficult. I think 2008 is going to be a challenging year for big technology companies because the economic landscape in general is going to be challenging. Quite honestly, there’s no major technology company that I’d feel compelled to hold shares of right now.

Allen: Which ones will flop?

Drama 2.0: While I don’t think the heavyweights are going to crumble, I do believe that a consumer-led economic slowdown is going to have a notable impact on a lot of companies. Google, for instance, has been overvalued for some time and is vulnerable to recession in my opinion.

I do anticipate that we’ll start seeing a lot more little flops as an increasing number of VC-backed startups that have failed to develop into viable businesses start to run out of cash. The truth is that far too much money was invested in startups chasing the same dream. Take online video: dozens of startups, many of which have no differentiation whatsoever, received funding, some of it sizable. VCs looked at YouTube and threw far too much money at online video plays because their funds had to have some presence in the market. The outcome of this is inevitable. Personally, I think it will be entertaining to watch.

Allen: Do you see any major acquisitions this year? If so, who?

Drama 2.0: You’re really putting me on the spot here with all of these predictions! Are you sure this interview isn’t part of some conspiracy to make me look like a complete idiot? Admittedly I might be one so I’ll continue to bite. In the Web 2.0 space, we obviously have a number of "hot" startups like Digg and Plaxo that are being shopped by investment banks and there are rumors circulating about a big IAC acquisition of Flixter. I would not be surprised if some of the recognizable first and second-tier Web 2.0 startups get bought for hefty sums, even though I think these properties are way too expensive and offer little long-term value to a buyer.

If the economy gets as bad as I think it will, I expect the overall trend will be for big companies looking to acquire to continue to seek out promising early-stage startups that they can purchase inexpensively. Big acquisitions should be reserved for startups with big revenues and/or potentially lucrative proprietary technologies that are defensible.

Allen: Sum up the general state of the online advertising market.

Drama 2.0: Lots of hype, lots of potential, far less substance. The potential is real but I think publishers have to deliver more for advertisers if this potential is to be fully realized. Despite all of the hype, online advertising really isn’t delivering knockout results for most advertisers. In fact, some of the results advertisers have reported on hyped properties like Facebook are quite atrocious.

On the startup side of this equation, the most dishonest part of the hype is that there’s this huge and growing pie of advertiser cash up for grabs and that every Web 2.0 startup can get enough of it to build a great business. The truth is that a relatively small number of big properties and networks are getting most of that cash and the proportion they get is only likely to increase the bigger the pie gets.

Allen: What suggestions do you have for someone just getting started with their service or product online?

Drama 2.0: Well, before you even build a new service or product, I think it makes sense to have an honest dialog with yourself and/or your team. I see so many new ventures where it’s clear that the people behind them really didn’t put a whole lot of thought into answering the basics, such as:

• What is our target market and what’s the real size of this market?
• What problem are we solving?
• How are we going to acquire users or customers?
• How are we eventually going to make enough money to create a self-sustaining business?
• How are we going to differentiate ourselves?
• How can we build something defensible?

Unfortunately, far too many ventures don’t have answers to these questions or the answers they do have are not satisfactory. For instance, I do not believe that "viral marketing" and "word-of-mouth" are realistic marketing strategies for new ventures.

Every battle is won before it is ever fought and in the business world, this means that before you launch, you have given some serious thought to what you’re doing and have some idea about how you need to execute.

Allen: MySpace or Facebook?

Drama 2.0: MySpace. MySpace users are just a whole lot more interesting. Facebook is boring. I don’t know if that’s because the design is about as bland as Mark Zuckerberg’s personality or if Facebook is just the social network that everybody taking Paxil uses. In any case, until my fake profile on Facebook starts getting daily messages (like the ones I get on MySpace) from women who want to do live webcam chats with me, I think I’ll stick with Tom.

Allen: What tips do you have for those seeking VC funding?

Drama 2.0: Don’t. In general, I believe VC funding is a huge mistake for most Internet startups and if some companies spent as much time actually building their businesses as they do making the rounds on Sand Hill Road, they’d be far further along in their development. While there are certainly some situations where raising money makes sense and is necessary to further grow an already-growing business (with revenues), contrary to the beliefs of many entrepreneurs, taking money from VCs usually doesn’t solve your problems and actually creates quite a few of them. I’ve discussed this topic a lot on my blog and I agree with Mark Cuban: most companies need more brains, not more capital.

I’m a fan of the bootstrap model for building a company, and in the consumer Internet space, I think most viable companies have the ability to get to where they need to go with little more than angel funding (if necessary). Personally, I think it’s wise to consider that if you can’t get a business off the ground with your own resources and scale that business using revenues, starting your own company might not be the right path.

For companies that do decide to go down the VC route, my only real advice is "caveat emptor." Recognize that in a number of key areas, the VC’s interests are not going to be aligned with yours and that this can play a major role in whether your company succeeds or fails. Also recognize that spiels about the knowledge and relationships VCs give you access to is, at best, oversold, and at worst, pure bullshit. Most VCs are not entrepreneurs so thinking that they’re going to bring a lot more to the table than their (expensive) capital is like thinking that your dentist can advise you on the embarrassing festering wart you have on your thigh.

Allen: What country do you make your residence in?

Drama 2.0: I don’t know yet. I’ll be sure to let everyone know when I decide. South America looks good right now, but the Mediterranean is tempting too.

Allen: 1945 Chateau d’Yquem or 1945 Chateau Mouton-Rothschild?

Drama 2.0: d’Yquem hands down, although I’d honestly prefer the ’76.

Allen: Which feeds are you reading these days?

Drama 2.0: I’m a closet luddite and I don’t have a feed reader. The tech blogs that I load up manually in Netscape 7.0 on a regular basis are Center Networks (Allen Stern is the man), TechCrunch, Mashable, GigaOm and the best tech blog of all – The Drama 2.0 Show (damn that guy is good).

Thanks for your time Drama 2.0!

The following post was contributed by Drama 2.0. I have enjoyed reading his or her comments (along with many others) across the various tech blogs. Drama 2.0 has just started his/her own blog and is very much worth a RSS subscription. I told Drama 2.0 that if the name was not revealed to me, I would send some goombas over there, but no go. So for now, the mystery of who is behind the name Drama 2.0 remains a mystery.

There's arguably no hotter sector in Web 2.0 than online video. Spurred on by Google's blockbuster $1.65 billion acquisition of YouTube, entrepreneurs have flocked into the market and venture capitalists have had no problem funding them. There's no doubt in my mind that online video is and will continue to be the most important part of the surging Internet consumer market in the near future, however I do believe that the froth has reached a level where it's time to step back and take a hard look at where the market is and where it's going to be.With that, I'm going to go out on a limb here and make some online video predictions.

The Shakeout Occurs

Venture capitalists have invested a staggering amount in online video startups. The rationale is obvious: online video is one of the hottest sectors in the revitalized consumer Internet space so an online video startup is almost a portfolio necessity. Take a look at the portfolio of any top-tier venture capital firm and one is likely to find one or more of these startups, many of which mainstream consumers have probably never heard of.

In 2006, YouTube, arguably the hottest consumer Internet property, reportedly generated only $15 million in revenues. These revenue numbers should be cause for concern for investors. If you are an investor who has put even a small amount into a startup in the space, you might want to ask "If YouTube, the most popular online video service, only generated $15 million revenues, is it possible that we have overestimated the size of the market and the amount of monetization that is possible?" The only logical answer is "yes!"

Clearly, the market is still fairly immature and business models are still being experimented with, but the truth is that there are far too many online video startups that lack significant differentiation and smaller players will not be able to survive. The YouTube revenue numbers hint that these players will not generate anywhere near what their investors most likely projected, and with the number of startups greatly exceeding the number of potential acquirers, the future for many of these startups does not look promising.

Therefore, it's inevitable that a shakeout will occur, probably within the next year. Of course, I'm not the only one who has predicted this shakeout (Om Malik predicted one last June in Business 2.0), but I will go so far as to say that some will end up being surprised at how willing many venture capitalists will be to prop up online video investments which any rational person would realize have failed. This will make the shakeout more painful or amusing to watch, depending on who you are.

Professional Content Wins Out

In general, there are two forms of video content: professional and user-generated. There are some who argue that user-generated content is displacing professional content. I touch on this briefly in my blog post "Will Silicon Valley Own Hollywood?". I believe that user-generated content has been overhyped. The sheer volume of copyrighted professional content on services like YouTube seems to indicate that professional content has never been in greater demand.

This does not fit in with the argument that because anybody can now be a content producer, professional content is a thing of the past. If it was, why are people sharing and consuming large volumes of it online? What I do think is clear is that consumers are demanding more flexibility in how they can access the professional content that they love. Being able to time-shift content, for instance, is a must for modern consumers and major content producers are increasingly accommodating consumer demands.

What does this all mean? In my opinion, it means services that focus on professional content will emerge as the most dominant players in the online video space. Joost is the obvious bet at the current time, as it has significant backing and content licensing deals. Whether Joost fulfills its promise and becomes the dominant player remains to be seen, but I'm a firm believer that the mainstream winners in the space will be services able to acquire the best and largest portfolio of popular professional content.

Services which either can't acquire such content or which decide to focus on user-generated content will, at best, most likely be relegated to niche markets. At the end of the day, phrases like "content is king" and "quality over quantity" will be back in vogue.

Hollywood Continues to Leverage New Media as a Recruiting Tool

Hollywood is increasingly leveraging online video services like YouTube to locate and recruit talent. While I personally find the vast majority of user-generated content to be utterly horrific (as Simon Cowell might put it), there are talented people out there who are waiting to be discovered. A growing number of them have been signed by Hollywood.

Some might argue that as online video business models emerge, it will be possible for independent producers of content to stay online and earn a living without having to "sell out," but I still believe that the appeal of Hollywood cannot be underestimated. Why? There are a number of reasons:

1. Success in Hollywood can lead to mind-boggling fame and fortune. Droves of people with big dreams arrive in Hollywood every year looking for their opportunity to make it. Even for content producers who don't desire this, the ability to earn a consistent living from the work they're passionate about is appealing.

2. Hollywood has substantial resources that most independent content producers would never dream of having. Access to these resources is a compelling value proposition when Hollywood comes knocking.

3. While many people claim that "old media" mediums like television and cable are dead, a reasonable person cannot discount the fact that because of their exclusive, closed nature, these mediums are the ultimate pedestal on which a content producer can have his or her work displayed. Anybody can upload his or her video clip to YouTube; not every person can have their work displayed on a major television network.

The bottom line is that while a crop of talented content producers will find an audience and possible living on the Internet, online services like YouTube will serve as the minor leagues for "old media" mediums like television and cable, not as their replacements.

Viacom Wins, Even If it Loses

I personally believe that, barring a settlement, Viacom will win its lawsuit against Google. Without going into the technical details of why I think Viacom has a strong case, I also believe that even if I'm wrong and Viacom loses a court ruling, media companies will lobby Congress to change the law, arguing that the 1998 Digital Millennium Copyright Act (DMCA) never anticipated services like YouTube, which takes advantage of advances in technology and wider access to broadband Internet access to make sharing previously unfathomable volumes of copyrighted material so easy.

If YouTube, for instance, is found to qualify for the Safe Harbor provisions of the DMCA, media companies will have a valid argument that the burdens placed on their businesses to police third-party services would be unfair, unreasonable and more logistically challenging than forcing those services to take an active role in copyright enforcement. Given the significant lobbying presence old media has in Washington, I think these arguments will fall on sympathetic ears.