Investment Thesis: Ideas Drill-Down

This is the third installment in a series. For context, here are links to the prior two posts:
– Investment Thesis Envy
– Investment Thesis: The Basics

This one will focus on the beliefs and assumptions I use to evaluate the content of an investment opportunity (independent of the people behind it, or the price at which it’s offered). As noted in the previous post in the series, this framework is based in large part on my personal experiences, including things I’ve tried that worked and (more indelibly) things that didn’t.

One more reminder from the previous post: all of the notes below live within my self-defined “circle of competence”: using technology to connect individual consumers with stuff (whether it’s merchandise, digital content, service providers or – most important of all – other people) in a fun and emotionally satisfying way.

1. Mind the Gap

This is the headline opportunity that most of the themes below map into. Put simply, even though their customers are all online, most businesses still aren’t (or at least not in a way that matters). This is especially true for small and mid-market businesses, but even most global companies severely under-allocate resources to their online channels relative to their potential value. This was the foundation of our success at Adjacency (back in the first wave of Internet adoption), but it’s also the engine behind Google’s astounding rise as the default matchmaker between online searchers and (mostly) offline sellers. Nearly every other online enterprise that’s delivered value over time (think eBay, Amazon, Expedia) is a variation on the same theme, and it could be argued that Yahoo foundered because it never really figured out that this was the foundation of their business.

Despite the current excitement around online social media “platforms” like Facebook and MySpace, none of them has yet figured out how to translate all that online social activity into transactions in the way that Google has done in search. And while institutional VCs gamble on cracking that nut, small-scale seed investors like me can make hay just by closing the many persistent gaps that exist between online customers and real-world businesses.

2. Distribution, Distribution, Distribution

At last count more than a hundred million websites are now competing for the attention of the hundreds of millions of web users worldwide. Unless you have a global brand or a captive base of existing users, Google effectively owns the front door to your online business, and will send you customers (or not) depending on how well you conform to their ever-changing rules. No new online business can survive unless it makes distribution (i.e., customer acquisition) a fundamental pillar of their product and marketing strategy.

Most of the excitement (and correspondingly frothy valuations) surrounding large-scale online communities is owing to their theoretical ability to aggregate audience on behalf of partners. Everyone now wants to claim that their social network is a “platform” that can deliver targetable slices of audience to advertisers and merchants much like Google does in search.

Unfortunately, most of these claims will fall flat as partners begin to realize that the audiences don’t come to these applications in a buying mood, but there’s a kernel of insight here that shouldn’t be overlooked: building audience online is difficult, time-consuming and expensive, and the firms that can aggregate audience and purchase intent at the same time just might have a business on their hands. The new business ideas I like the best have one or more unique distribution insights built into their DNA, and assign that problem the same level of importance as their path to monetization.

3. Me-Value Delta

I’ve since repackaged the idea in a way that makes sense to me, but Brad Feld beat the concept of “Me Value” into my head as a Judy’s Book board member, and he’s absolutely right. Given the asymptotically infinite array of options and equally low switching costs of the Web, your only hope of success online is to channel JFK by asking as little as possible of your early adopters and delivering as much value as you possibly can in return. The bigger the gap (or delta, for the mathematically inclined) between your ask and the value delivered, the greater your chance of delighting your users, earning you referrals, feedback, repeat visits, and all the other positive-reinforcing cycles you need to succeed.

Too often I talk to founders (or prospective founders) who are so in love with the envisioned end-state of their product that they grossly overestimate what they can ask of their users during the initial engagement phase. My uniform response is that they should be thinking a lot harder about what they can do for that precious group of early users, and not what their users can do for them. Conversely, founders that are already planning to take smaller bites in order to focus on maximizing the Me Value Delta for their early adopters are much more likely to get my support.

4. Free is NOT a Business Model

Fred Wilson has written passionately and convincingly about Free as a business model, by which he really means that a 3rd-party payer is picking up the tab. And while I agree with him in theory and think this approach can make a lot of sense for VC-backed companies, it doesn’t make any sense at all for the kinds of companies I like to work with.

I’ve been down that road myself, trading a big chunk of my cap table to buy the time required to chase a big 3rd-party-payer idea. I’ve also built a business on credit cards and cash flow, a much more nerve-wracking experience, but ultimately more rewarding in every sense of the word. While either path can work, I’ve come to believe that the customer focus and financial discipline enforced by the latter is healthier, more fun and more satisfying for everyone involved, including the seed investors who provide just enough capital to get the ball rolling. This point of view is only reinforced by Paul Graham and the Y Combinator team’s successful example of a new investment model: as the cost of doing business online falls toward zero, the capital allocated to starting a new Web business should come down as well.

So to get my attention with a new business idea, it has to be clear that someone will open their wallet for what you’re doing, and not just to rent out your eyeballs. And while that requirement may cause me to miss some great opportunities, it also filters out a lot of noise.

5. Niche is Nice

I learned this one the hard way. When Andy and I started Judy’s Book back in 2004 we saw a huge opportunity to help bridge the gap between online customers and local businesses. But rather than go deep in a specific vertical (e.g., plumbers, architects, real estate agents, etc.), we opted instead for an organic, user-driven approach in which members could list and review whatever kind of local business they wanted. And while this approach did help us quickly build a large and passionate user base, it also “randomized” our value proposition in a way that was ultimately destructive of that community, and of the business as a whole.

Almost every big idea has a niche analogue that will scale faster and more reliably than the ‘hail mary’ approach required to chase its more ambitious cousin. Similarly, there are dozens of proven playbooks that, with a little tweaking, can profitably be run somewhere new. Taking this route may require the founders to swallow a little pride and downsize their ambition to transform the world, but it’s much better to embrace that choice right at the start than be forced to the same conclusion when it’s really too late to do much about it.

6. The Web as Database

The Semantic Web is a genuinely exciting vision and rallying cry, but it’s years away from being realized, and even then will likely fall far short of the unified theory of everything put forth by folks like Tim Berners-Lee. But that hasn’t stopped some very bright people from figuring out how to use the Web in its current messy, unstructured form as an incredibly informative database. (In fact, the difficulties these teams have overcome amount to competitive barriers to entry, effective for as long as the Semantic Web remains a distant hope).

Google is the ultimate version of this, but less ambitious approaches can be equally powerful when applied to a specific business problem. In almost any field of online endeavor, if you can master the aggregation and normalization of data across many different public and private websites, patterns will emerge that can be leveraged to create value for you and your customers. I love it when I come across companies that are applying this insight, either to power their own business strategy or to create uniquely relevant business intelligence for others.

7. The Future is NOT Now

Entrepreneurs are futurists by nature: they imagine a world that is different and better because it includes some innovation of theirs, and then they set about making that future vision a reality. Unfortunately, the real world often takes a long time to align itself with those future visions (if it does so at all). Knowing this, I tend to favor bets that are likely to reveal their promise soon or not at all. And as much as I love to think about what the future of Web technology may hold, my check-writing appetite is limited to companies with low overall capital requirements, near-term cash flows and a target breakeven date measured in months, not years.

8. Think Locally, Act Globally

Economic globalization is massively complex topic, and investing strategically on this theme is light years beyond the reach of a small-scale investor like me. That said, the global nature of the Web means that global opportunities tend to find their way into the strategy of almost every company I work with, more by accident than by design. Maybe the founder has a family connection in another country, allowing core functions to be sourced overseas at competitive rates. Maybe the founders spot a theme that’s been played out in the U.S. but can be easily adapted to a foreign market. Whatever the reason, being open to global opportunities has become the accidental theme that keeps popping up in the companies I work with.

The formulation of this theme (and its last place appearance on the list) reflect its role in my investing activity. I don’t intentionally set out to chase global opportunities (quite the opposite, in fact), but I’m always on the lookout for creative ways to bring the global marketplace to bear to accelerate returns, lower costs or tap new customer audiences.

Now that I’ve started writing about it there’s plenty of other stuff swirling around in my head on this topic, but that should be enough to keep you busy for a while…