Zero to One Notes on Startups, Or How to Build the Future

Zero to One Notes on Startups, or How to Build the Future

In business, every breakthrough innovation only happens once. There may be another Bill Gates one day, but he won’t create a world-beating operating system. Nor will the next Larry Page or Sergey Brin make an incomparable search engine. Nor will the next Mark Zuckerberg create a ubiquitous social network. Lighting never strikes the same way twice.

The thing is, if you aspire to become the next Gates, Brin or Zuckerberg, it’s awfully tempting to try and copy them. After all, it’s far easier to simply copy a proven model than to go and create something new. But according to Peter Thiel - the co-founder of PayPal, successful venture capitalist, and author of Zero to One - if you’re merely copying these innovators, you aren’t learning from them.

“Doing something that folks already know how to do takes the world from one to two,” explains Thiel. “You’re merely adding one more unit to something that’s already familiar. But when you create something that’s truly new, you take the world from zero to one. The act of creation is singular, and the result is something fresh, and quite possibly amazing.”

Zero to One is about how to build companies that create new things. It draws on everything Thiel has learned as a co-founder of PayPal and as an investor in dozens of successful startups, including Facebook and LinkedIn.

Thiel’s book asks the questions any budding entrepreneur must answer to succeed in the business of doing new things. His book isn’t intended to be a step-by-step manual, because every business is different (or at least, every business should be different). Rather, Zero to One is intended to be an exercise in thinking. It’s meant to plant a seed that may one day grow into something new, and great.

The World Needs More Tech Start-Ups If you’re working in a large corporation or government organization, it’s extremely difficult to take a new innovation from zero to one. Large corporations are more interested in copying or refining products and services that have already been proven to work. Bureaucratic hierarchies tend to move slowly, and entrenched

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interests shy away from risk. In general, big corporations also tend to underinvest in new technology.

This is why, in Peter Thiel’s estimation, the world needs more start-ups. Contrary to popular opinion, the biggest advantage any start-up has going for it isn’t its small size, or nimbleness. Its key competitive advantage is its willingness to embrace new technology, coupled with new ways of thinking.

Build a Monopoly So what kind of tech start-up should you create? The one that nobody else is building. With any new start-up, your goal should be to turn it into a monopoly service provider. It’s not good enough to establish a billion dollar a year business if you end up having to share most of that value with other people. “Creating a lot of value is not enough,” warns Thiel. “You also need to capture most of the value you create.”

As a practical matter, this means that even very big businesses can be bad businesses. For example, U.S. airline companies serve millions of passengers and create hundreds of billions of dollars of value each year. But in 2012, when the average airfare each way was $178, the airlines made only 37 cents per passenger trip. Imagine that: only 37 cents!

Now compare the airlines to Google, which creates less overall economic value than the airlines do, but captures far more of the value it creates. Google brought in $50 billion in 2012 (versus $160 billion for the airlines), but it kept 21% of those revenues as profits. That’s more than 100 times the airline industry’s profit margin that year. Google makes so much money that it’s now worth three times more than every U.S. airline combined.

The key difference between the airlines and Google is that the airlines operate in a highly competitive marketplace, whereas Google has few, if any, competitors in many areas of its business. For the airlines, all that competition has the effect of driving prices down. This is a boon for consumers, of course. But if you happen to own one of the airlines, you might wish that you had fewer competitors so you could jack up your prices a bit more.

The lesson for technology entrepreneurs in all of this is clear - if you want to create and capture lasting value, don’t build an undifferentiated commodity business. Try to build a monopoly instead. Do something that no one else is doing. Go from zero to one.

And by the way, when you set out to create a monopoly in a particular market, make sure it’s a real one, not an imagined one. In Thiel’s experiences, many entrepreneurs delude themselves into thinking that they’re in a league of their own by defining their target market so narrowly so that they dominate it by definition. That can be a big mistake.

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To illustrate his point about narrowcasting, Thiel talks of how, back in 2001, he and his co-workers at PayPal would often go for lunch on Castro Street in Mountain View. Thiel and his friends had their pick of excellent restaurants, within broad categories like Indian, sushi, and burgers. Then, within those broad categories, there were more sub-options once they settled on a general type: North Indian or South Indian, cheaper or fancier, and so on.

In contrast to their local restaurant market, PayPal was at that time the only email- based payments company in the world. Thiel employed fewer people than did all the neighboring restaurants on Castro Street, but his business was much more valuable than all of those restaurants combined. That’s because running a South Indian restaurant is a really hard way to make money. You might think that your restaurant is differentiated from the others because, for example, your naan is superior because of your great-grandmother’s recipe. But great naan or not, you’re just another Indian restaurant. “If you lose sight of the actual competitive reality you’re facing and focus on trivial differentiating factors as a way to establish your market dominance, your business is unlikely to survive,” warns Thiel.

And for his readers who have aspirations of doing a lot of good in the world, while they make a lot of money, Thiel points out that the problem with running a non- monopoly business goes beyond lack of profits. “Imagine you’re running one of those restaurants in Mountain View,” he writes. “You’re not that different from dozens of your competitors, so you’ve got to fight extra hard to survive. You will probably only be able to pay your employees minimum wage, and you’ll need to squeeze out every efficiency.” If that is the case, how will you be able to make the world a substantively better place than it is today?

A monopoly business like Google doesn’t face the same constraints. Since Google doesn’t have to worry about competing with anyone, it has more latitude to care about its workers, including paying them well. Google also has the freedom to spend time considering its impact on the wider world. Google’s motto – “Don’t be evil” – may be, in part, a clever branding ploy. But it’s also characteristic of a kind of business that’s successful enough to take ethics seriously without jeopardizing its own existence.

Defining Characteristics of a Monopoly Business By definition, every monopoly is unique. But according to Thiel, they usually share some combination of the following four characteristics: proprietary technology, network effects, economies of scale, and branding:

1. Proprietary Technology

“Proprietary technology is far and away the most substantive advantage a company can have because it makes your product difficult or impossible to replicate,” explains Thiel. Google’s search algorithms, for example, return results much better than

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anyone else’s.

As a good rule of thumb, Thiel advises that your proprietary technology should be at least 10 times better than its closest substitute in some important dimension if you ever hope to achieve a real monopolistic advantage. Achieving modest improvements over the competing technology isn’t good enough because most customers won’t notice, or care.

The clearest way to make a 10X improvement is to invent something completely new. “If you build something valuable where there was nothing before, the increase in value that your customers and prospective customers will perceive is theoretically infinite,” he says.

2. Network Effects

Network effects make a product or service more useful as more people use it. For example, if all your friends are on Facebook, it makes sense for you to join Facebook, too.

When you’re starting a brand new platform, it’s hard to create a network effect because, by definition, you’ll have relatively few users at that point. That’s why it’s imperative to recruit an initial group of users who are highly influential within their particular sphere of the market. Facebook started with just Harvard students living on campus in particular residences. Mark Zuckerberg’s first product was designed to get the most popular freshman at one of the world’s best schools signed up. While it may have been Zuckerberg’s ultimate objective to attract all people of Earth, he didn’t start there.

When you’re cultivating a new network of users, always err on the side of starting too small. The reason is simple: it’s easier to carve out a differentiated space in a small market than a large one. If you think your initial market might be too big, it almost certainly is.

“Any big market is a bad choice,” explains Thiel. “And a big market that’s already served by competing companies is even worse.” This is why for a venture capitalist like Thiel, it’s always a red flag when entrepreneurs talk about getting 1% of a $100 billion market.

Take eBay for example. eBay started by dominating a small, niche market. When it launched its auction marketplace in 1995, eBay didn’t want the whole world to adopt it at once. It tested its product first with small groups of power users and intense interest groups, like Beanie Baby obsessives. Because the product rollout was carefully managed, and it responded to the needs of a core group of users, the network grew rapidly from there.

3. Economies of Scale

A monopoly business always gets much, much stronger as it gets bigger. This is

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because the fixed costs of creating a product (e.g. engineering, management, office space) can be spread out over ever greater quantities of sales. Notice the use of the word “product.”

Service-based businesses are very difficult to make into monopolies. If you own a yoga studio or a hair salon, for example, you’ll only be able to serve a certain number of customers. You can hire more instructors or hair stylists, and expand to more locations, but your margins will remain low because of all the people you’ll need to employ.

“Any start-up venture that’s worth your time pursuing should have the potential for great economies of scale baked right into its business model,” says Thiel. “Twitter already has more than 250 million users today. It doesn’t need to add too many more staff in order to acquire more users, and there’s no inherent reason why it should ever stop growing.”

4. Branding

Everyone knows that creating a strong brand is a powerful way to stake out a monopoly. But too many entrepreneurs spend too much time and energy focusing on branding, without realizing how easy it is for their competitors to imitate them.

For instance, many copycats have tried to take a page from Apple’s branding success. Slick advertising, branded stores, luxurious materials, playful keynote speeches, deliberately high prices, and even minimalist design are all part of Apple’s branding recipe. But each of these things is also highly susceptible to imitation. Which is why beginning your start-up journey with branding – as opposed to substance – can be very dangerous.

“When Steve Jobs returned to Apple from Pixar, he didn’t launch right into a giant branding exercise,” explains Thiel. “First, he slashed product lines to focus on the handful of opportunities for 10X improvements.” No successful start-up can be built on branding alone.

Don’t Disrupt “Silicon Valley has become obsessed with disruption,” says Thiel, shaking his head. As a result, the term “disruption” has turned into little more than a self-congratulatory buzzword for anything trendy and new. This seemingly trivial fad in the Valley is a big problem, explains Thiel, because it distorts a would-be entrepreneur’s self- understanding.

“If your company can be summed up by its opposition to already existing firms (i.e. how you’re going to disrupt an existing market), then your product or service most likely isn’t completely new,” says Thiel, “and it’s probably not going to become a monopoly.”

Worse still, the whole idea of disruption tends to attract the wrong kind of attention

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in the marketplace. “Disruptors are people who look for trouble and usually find it,” says Thiel.

At school, disruptive kids are the ones who get sent to the principal’s office – not good. Whereas in the marketplace, disruptive companies are often the ones that pick fights they can’t win. Think of Napster. Shawn Fanning and Sean Parker, Napster’s then-teenage founders, threatened to “disrupt” the powerful music industry in 1999. The next year, they made the cover of Time magazine. A year and a half after that, they ended up in bankruptcy court. One wonders if Fanning and Parker regret having sought such a high profile.

Successful technology monopolies, like Google, don’t set out to overthrow a system that was already creating economic and social value. Instead, they aim to create a brand new system where none existed before. And if they’re smart in the way they go about it, they also try to go about their business without attracting controversy. Controversy tends to result in expensive lawsuits and unwelcome regulatory crackdowns by governments.

You are Not a Lottery Ticket “You are not a lottery ticket,” writes Peter Thiel. What he means is don’t allow yourself to believe for one minute that your success will come from luck. Sure, at the end of the day, it never hurts to be a bit lucky. But there are no substitutes for skill and hard work.

In Thiel’s opinion, too many prominent authors and businesspeople are running around these days hyping the role of luck, and downplaying the critical role of effort. For example, Malcolm Gladwell, an author who often writes about successful people, declares in his book Outliers that success results from a “patchwork of lucky breaks and arbitrary advantages.” And Warren Buffett often jokes that he’s just a “member of the lucky sperm club.” Thiel sees these people’s views as both misleading and detrimental to would-be entrepreneurs.

“Perhaps these commentators are just being strategically humble,” writes Thiel. “However, the phenomenon of serial entrepreneurship would seem to call into question our tendency to explain success as the product of chance. Notable serial entrepreneurs like Steve Jobs, Jack Dorsey, and Elon Musk, have created several multibillion-dollar companies. If success were mostly a matter of luck, these kinds of serial entrepreneurs probably wouldn’t exist!”

If you come to expect that your future will be ruled by luck and randomness, you might give up trying to shape it. This would be a huge shame. Because, if you’re the founder of your own start-up company, that’s one endeavor over which you can have near complete mastery. If you choose to, you can have agency over a small, but perhaps one day very important part of the world. But this all starts by rejecting what Thiel refers to as “the unjust tyranny of chance.”

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Build a Great Foundation Every start-up company is unique, but there are a few things that every business must get right at the beginning. Thiel stresses this point so often that it’s been nicknamed “Thiel’s Law.” It holds that a start-up messed up at its foundation cannot be fixed.

To consider the importance of this, Thiel invites us to think back almost 230 years to the founding of the United States. A number of fundamental questions were on the table for debate by the Framers during the few months they spent together at the Constitutional Convention. How much power should the central government have? How should representation in Congress be apportioned?

Whatever your views on the compromises reached that summer in Philadelphia, the point is the Framers invested the time to think about them carefully and try to get them right. And it’s a good thing they did, because all these rules and compromises they came up with have been exceptionally hard to change ever since. After ratifying the Bill of Rights in 1791, Americans have amended their Constitution only 17 times. It’s very hard to do.

Start-up companies are a lot like countries in this way. Bad decisions made early on – if you choose the wrong partners or hire the wrong people, for example – are very hard to correct after they are made. “As a founder,” says Thiel, “your first job is to get the first things right, because you cannot build a great company on a flawed foundation.”

What sorts of foundational pitfalls should you be on the lookout for? Well, for starters, most conflicts in a startup erupt between ownership and control – that is, between founders and investors on the board. The potential for conflict increases over time as interests diverge: a board member might want to take a company public as soon as possible to score a win for his venture firm, while the founders would prefer to stay private and grow the business.

This is why it’s crucial to choose your board members wisely. Every single member of your board matters, particularly in the early days. Even one problem director can cause you pain, and may even jeopardize your company’s future.

Another big pitfall to avoid at the outset is hiring consultants or part-time employees to do the work of full-time employees as a way of saving money, or giving yourself more flexibility. This is almost always a mistake. As a general rule, everyone should be full-time. Sometimes you’ll have to break this rule; it usually makes sense to hire outside accountants, for example. But break it as little as you can. When your employer is a start-up company, you must be either “100% on the bus committed, or 100% off the bus” says Thiel. There’s no middle ground on this.

Another common mistake that founders make is trying too hard to avoid conflict when making compensation decisions, as opposed to using the compensation tools

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(including stock options) at their disposal to maximize commitment. “Start-ups don’t need to pay high salaries because they can offer something better: part ownership of the company itself,” writes Thiel. “Equity is the one form of compensation that can effectively orient people toward creating value in the future. However, for equity to create commitment rather than conflict, you must allocate it very carefully.”

In Thiel’s experience as both a founder and big-time investor, giving everyone equal shares is usually a mistake: every individual has different talents and responsibilities as well as different opportunity costs. Your only objective should be to do both what’s necessary and realistically possible on the compensation front to secure long- term commitments from your key employees. And some of them will be more key than others.

Since it’s impossible to achieve perfect fairness when distributing ownership, founders would do well to keep the details secret. “Sending out a mass email that lists everyone’s ownership stake would be like dropping a nuclear bomb in your office,” he jokes.

Conclusion William Shakespeare famously observed that all great combatants throughout history tend to look alike. It’s often not at all clear why these people are fighting, since they have so much in common to begin with. Consider the opening line from Romeo and Juliet: “Two households, both alike in dignity.” The two houses – Montague and Capulet – are very much alike, yet they hate each other. They grow even more similar as their great feud escalates. Soon, they lose sight of why the fight started in the first place.

From his lofty vantage point as a venture capitalist in Silicon Valley, Peter Thiel often gets to see the same Shakespearean tragedy playing out in the real world. Instead of Romeo and Juliet, imagine instead a modern day theater production called Microsoft and Google, where Montague is Microsoft and Capulet is Google. Two great corporate families, both run by similar people (alpha nerds), who come into conflict, purely on account of their sameness.

When they were merely start-ups, each family had been content to leave the other alone, and prosper independently. But as they grew, they began to focus on each other. The Montagues obsessed about the Capulets, and vice-versa. The result? War: Explorer vs. Chrome, Bing vs. Google Search, Office vs. Docs, and Surface vs. Nexus.

Just as that terrible feud in Romeo and Juliet cost the Montagues and Capulets their children, it eventually cost Microsoft and Google their market dominance – Apple came along and overtook them all. Apple’s market capitalization today sits at about $700 billion, while Google and Microsoft combined are worth about $660 billion. Just three years ago, Microsoft and Google were each more valuable than Apple. War is

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a costly business.

This twisted Shakespearean logic seems to be part of human nature. But just because it’s part of us, doesn’t mean we can’t learn to overcome it. “If you can recognize competition as a destructive force instead of a driver of value, then you’re saner than most,” writes Thiel. “Every entrepreneur should aspire to be the only player in his or her particular market.”

What this means is, if you want to succeed in business, you have but one singular task. Make something so new, different and valuable that you create a monopoly in your new market. In other words, you need to look for ways to take the world from zero to one.