by Jerzi Gangi
September 11, 2015
This week Elon Musk announced plans for his new Hyperloop transportation system.
If you haven’t seen it in the news: it’s basically a giant tube that you sit inside of while you’re propelled hundreds of miles an hour to your destination. It’s sort of like the tube you put your checks in at the bank drive-thru… but instead of checks, it’s people.
It’s really cool, and it could easily disrupt airline and rail travel as we know it.
A SIMPLE QUESTION
As an entrepreneur, I began to wonder, “Why hasn’t anyone proposed this already?” It’s a great idea, but… Elon Musk can’t be the first person to think of it.
In doing some research online I found out that other American inventors have had similar designs and proposals for a decade. However, none of them were able to get taken seriously or obtain funding.
Why did that happen?
I want to tell you my answer.
My thesis is simple. We haven’t seen Silicon Valley develop a company like Hyperloop — even though the plans have been out there for over a decade — because there’s a systemic failure in the startup ecosystem. In short, Silicon Valley has killed major innovation.
In all of the hype around companies like Facebook and Instagram — what really are just glorified websites — we’ve lost sight of some real innovation opportunities, most of which occur in the offline world.
The entire culture of Silicon Valley, and entrepreneurship around the globe, has taken on a groupthink that prevents truly novel inventions, like the Hyperloop, from reaching the market.
The result is a major loss. It’s a loss to our society. It’s a loss to our capital markets. It’s a loss to private investors. And it’s a loss to entrepreneurs.
THIS IS A REALLY IMPORTANT QUESTION
The title of this article is, “Why silicon valley funds Instagrams, not Hyperloops.” Note the plural. I’m not necessarily talking about Instagram in particular, or the Hyperloop in particular.
No, I’m asking a question: Why are we funding these really silly internet companies and not major life changing innovations? Why is it that all of my peers are inventing little dinky iPhone apps instead of planes, trains, and automobiles?
I feel like this is a really important question. Because, if as a country, America is going to continue to lead in innovation, we can’t be spending our time developing toys. We have to innovate innovation itself. In fact, I’m actually not the first person to bring this up. There are a lot of thinkers surrounding the entrepreneurial space who have been asking this same question: Why are so many startups today creating such meaningless products?
I’m going to present nine theories as to why we’re funding Instagrams but not Hyperloops. By no means is this an exhaustive list. It’s just a place to start a conversation. Here we go:
THEORY 1: THE IPO MARKET SUCKS
We have an undesirable IPO market right now. It’s a bad time to take a company public.
A company like Hyperloop is too large to be an M&A exit. It’s an IPO exit. So if you are going to make the Hyperloop, an investor’s going to ask, “How are we going to exit this investment?” The answer is, “An IPO.” And, right there, a lot of investors lose interest. To many, it would seem that making the Hyperloop might be easier than having a successful IPO!
In parallel commentary to this, please read Mark Cuban’s post on the stock market. It really got me thinking:
The stock market used to be a place where entrepreneurs went and raised money for their companies. That’s what the stock market used to be. Today the stock market is a place where hedge fund managers and quant traders are shaving fractions of a penny off benign movements in price and volume. One of the byproducts of going from an entrepreneurial stock market to a hyper-traded stock market is that new companies can’t survive unless they have a market cap of at least $10 billion dollars. Don’t even bother going public with less than that. It’s not worth the time, or the money, or the effort.
Furthermore, the stock market isn’t influenced by value today like it was thirty years ago. Whenever I bring this conversation up, I always ask people, “If AOL comes out with a phenomenal new product, is the stock price guaranteed to go up?” No, of course not. “If Kaiser Permanente releases a drug that cures all cancers, is the stock price guaranteed to go up?” No, of course not. The stock price goes up or down based on supply and demand. It only responds to human action. And, therefore, the price of a stock is solely determined by how people think about the price of a stock. There’s nothing that forces a company’s actual business value to drive the ticker price.
So when an investor says, “I don’t like investing in companies that have an IPO track,” he’s not crazy. It’s actually a very reasonable thing today — as a investor or an entrepreneur — to say, “I want to make a company that’s going to get acquired.” That’s really the most intelligent and reasonable strategy.
But without a public equities market to which investors can exit early-stage investments, and where retail investors can buy stock in new companies that will continue to grow, inventions like the Hyperloop can’t go public. And if it can’t go public, it’s not exiting; and if it’s not exiting, no one is going to invest. Under these circumstances, the only way that the Hyperloop is ever developed is if someone like Elon Musk has enough capital of his own to finance it.
And that’s really a shame for America. We really need to look into that. We need to figure out how we’re going to make the IPO market better, because if we want to have innovative products, we have to repair the process of going public and make it appealing again. Right now, the only sane choice is to aim for an acquisition. But mergers and acquisitions are on average $100 million a piece. There’s no way to have a company as large as Hyperloop acquired because it’s a multi billion-dollar company. You just can’t do it. So, how are you going to exit? You can’t. And that’s one reason why it won’t get funded.
THEORY 2: CONTEMPORARY PORTFOLIO STRATEGY FAVORS LAYUPS AND DISCOURAGES 3-POINTERS
There is a portfolio strategy in place by investors and incubators that promotes a shotgun approach as opposed to a sniper rifle approach. What does this mean? It means that early stage funds, super angels, and micro VC’s are primarily interested in investing $50,000 a piece in hundreds of different startups instead of investing $4,000,000 a piece in a select few. The shotgun portfolio strategy speculates that a few startups will be successful, and will pay for all of the losers. When the smoke clears, there’s some cream on top, and that’s your investment return.
This isn’t always how it used to be. From the early days of venture capital through the 90’s, there was a sniper rifle approach.Investors were more thoughtful, plotting. They picked a couple winners that they really believed in.
But in the same way that our nation’s politics is driven by a belief system, so is our leading investment strategy. And the prime belief behind the shotgun approach is that, “You can’t pick winners. Picking winners is a fool’s errand.” And, therefore, the only sane approach is to weed out the losers and invest in as many potential winners as possible. Incubators like Y-Combinator and Dream It have perfected this approach.
I’m not saying it’s necessarily a bad approach.But I want to point out the sniper rifle approach also works. It got us companies like HP, Kentucky Fried Chicken, and Hyundai.
Why does this matter for our discussion about Hyperloop? A shotgun approach is predicated on a lot of small investments by angels. Instead of an angel writing a $5 million check, an angel writes a $50,000 check. Well, a company like Hyperloop is going to take a first round from angels of at least $20 million just to produce a limited engineering proof-of-concept. If angels are investing on a shotgun approach, the size of the check isn’t there, plain and simple. A company like Hyperloop is too big — because when you’re investing with a shotgun method, you don’t want to get involved in big companies. You want to get involved in companies where $50,000 gets you pretty far. And those tend to be companies where the product is code. So for any investor that has a shotgun portfolio strategy, which is most, Hyperloop would be a horrible investment — totally outside of your investment parameters.
Entrepreneurs today — and maybe even Elon Musk twenty years ago, before Paypal, Tesla, and SpaceX — cannot get an angel to invest the necessary seed funds for a large company. It won’t happen, and the reason it won’t happen is because people are writing small checks.
Shotgun investors also do not spend all of their time on any one company. A venture that seems too crazy, or too big, must be brushed aside simply because the investor is operating on avolume investing system, not a valueinvesting system. Hyperloop would take up quite a lot of an investor’s time. If you’re on a sniper rifle approach, you have that time. It’s simply a part of your investing methodology. But on a shotgun approach, your investing methodology is bulk. Therefore, it would be hard to even get taken seriously enough to schedule a meeting with a shotgun angel investor if you were presenting a company like Hyperloop. You’re going against the predominant portfolio strategy too much.
THEORY 3: “WE DON’T FUND IDEAS”
The next theory is one that — not just for Hyperloop, but for lots of other inventions — is stifling innovation. As I said earlier, in the same way that beliefs shape our political system, beliefs shape our entrepreneurial system.
A very prominent belief today is: “We don’t fund ideas. We don’t fund teams. We don’t fund pitch decks. We don’t fund business plans. So unless you’ve got a business with users , we’re not funding it.” It’s become this statement of pride, inside of investors and entrepreneurs, that all of the charlatans who are just running their mouths had better scram: “You’re not wanted here. This is for real entrepreneurs, who have an MVP and traction!”
The problem is that you’re leaving out everyone who has a company that requires capital before they can build anything. And there are those companies. In the case of Hyperloop, there is nothing that you would be able to do without initial funding. It’s simply too big of a project to make any sort of meaningful headway without cash. And so if you went to a Venture Capitalist, or an angel, or a high net worth individual who shares this belief that “we don’t fund ideas,” they would look at you and say, “All you have is an idea.”
The result? An inventor who has the idea for Hyperloop can’t get funding. He gets dismissed. It’s not because the idea is without merit. It’s not because he doesn’t have evidence and scientific proof stating that it’s possible. It’s not that he doesn’t have the infrastructure worked out. No. It’s because there is a dogmatic single-mindedness that writing a check based on an idea is a bad investment.
In fact, it’s not. It can be a bad investment. It canraise your risk. But it’s not always a bad investment.
And that leads us into the next theory, which addresses what I call “MVP Obsession.”
THEORY 4: MVP OBSESSION
There is another belief that permeates entrepreneurship today: the sacred, holy MVP, or “minimally viable product.”
Some of this is traced back to the book The Lean Startup, which advocates that startups make a minimal viable product and measure it in the marketplace before proceeding further. It’s a way of validating a business model and assuring that there are users who are willing to pay for it, before too much money or time are invested. If you have an idea and you don’t know if people are going to pay for it, launching a minimally viable product is really important.
But the obsession over MVP’s has gotten out of control, to the point where anyone who doesn’t have one can’t get the attention of investors.
Well, here’s the kicker. There wouldn’t be a minimally viable product for Hyperloop.The Hyperloop requires hundreds of millions of dollars, perhaps billions, of upfront capital — without an MVP — before any users or revenues are gained.
This is my contention: it’s okay that we don’t have an MVP of Hyperloop, because we don’t need to speculate if people will ride Hyperloop. You only need an MVP if you’re trying to prove something. If it’s a faster mode of transportation, if it’s a safer mode of transportation, then there’s nothing to prove. It’s not a huge leap of faith — in fact it’s not a leap of faith at all — to say that if you have a safer, faster means of transportation people are going to use it. No one likes flying in airplanes. Amtrack smells like farts. Greyhound buses are slow. You clearly don’t need an MVP for Hyperloop.
But…. there is a belief in the startup culture today that if you don’t have an MVP, you’re not even worthy of a discussion. You are not worthy of the time it takes to tell you, “Get out of my office and come back when you have an MVP.”
In fact, with a company like Hyperloop: once you have the MVP, most of the work is done. From there, you just have to build more rails, more passenger cars, and scale up. Juxtapose this with a lot of other tech startups, where the MVP is just the very beginning of a long product development road ahead. Therefore, to understand the different roles that an MVP plays in different kinds of ventures is important.
Another part of the MVP-obsessed culture is that you should launch “quickly and early.” However, there is no way to launch “quickly and early” with a company like Hyperloop. It is an infrastructure project. Yet, this idea of launching “quickly and early” is so ingrained in the startup groupthink that it could singlehandedly prevent a Hyperloop startup from getting funded.
One of the favorite pastimes of MVP-ites is to: “Just take your idea and make it simpler.” I guarantee if an entrepreneur had brought Hyperloop to angel investors, they would have grilled him about how to make it simpler. “Is there some way you can take this great idea and water it down into a worthless, half-baked MVP? That way we can have a $2M seed round.”
Making the hyperloop any simpler would be a waste of time and capital. You simply need the money to build it. You don’t need to make it simpler. And you don’t need to launch it earlier. And you don’t need an MVP.
I’ve seen some really stupid ways that investors have tried to tell entrepreneurs — sometimes, entrepreneurs with great business models — about how to scale back their project to make it more “testable” in the market. I can hear the investor at the angel networking event telling an entrepreneur, “Why don’t you just build a tube that sends mail across an office, and prove that people are willing to pay for tube transportation?”
If we want to have companies like Hyperloop, we’re going to have to get rid of the MVP dogma. We’re going to have to say, “Sometimes there is a place for companies that only have a business plan, or that only have an idea and a sketch on a napkin… and that’s not a crazy thing. It can be a reckless way of investing, but to dismiss it carte blanche means you’re dismissing companies like the Hyperloop. We’re going to have to get rid of the “launch early and launch quick” mentality for startups where it does not apply. And we’re going to have to get rid of the idea that every business needs to be scaled down to the size of a teacup before it is reasonable to fund it.
Of course, if we want more Instagrams, we can keep doing what we’re doing.
THEORY 5: THE MARKET REWARDS EXITS, NOT INNOVATION AND VALUE
The way the capital markets operate today, investors earn profits from exits… not from revenue. If you build a VC-backed company with really solid revenue, but that can’t be sold, the company is worthless. I’m not saying this is good or bad, I’m just telling you what the market is today. It’s all about the exit.
And there’s a reason, actually, that investors invest this way. There’s a thing called time value of money. If you can sell an investment at a 10-year earnings multiple, and get out of it, you can take that money and invest in more startups. As an investor, you don’t wanna be tied up in investments that are illiquid and producing cash flow every month, because you would never be able to turn over your working capital.
The hyperloop is a business that will generate hundreds of millions of dollars a year in revenue, maybe more. It might be smarter to retain a privately held company, continue to earn cash flow, and never to take it public or have an exit event. The discounted cash flow might exceed the exit value.
Unfortunately, the market does not reward cash flow because the market does not reward value and innovation. The market rewards exits. So in a company like Hyperloop, if an entrepreneur said, “I think we can invest in this and simply return cash flow,” no VC would ever be interested. Why? There are other investment vehicles that doprovide an exit.
I’m not sure what to say about this. I’m not sure if it’s good or bad. But I do know that in exit-driven market, a company like Hyperloop might not fair very well because it goes against the grain.
THEORY 6: INVESTORS ARE TOO SPECIALIZED
From 2009 to 2011, I did a lot of advertising consulting. My partners and I rebuilt a ton of corporate websites. One of the recurring jokes was how specialized some of the consultants who bid against us were. Mocking these rivals, our favorite joke was, “We specialize in websites for women-owned renewable energy companies based in the mid-atlantic.” It was ludicrous how specialized some of these niche consultants were targeting their potential customers.
The next theory of why we haven’t gotten a Hyperloop, even though we’ve had the idea for years now, is because investors got too specialized.
Since the dot-com era, everyone felt a need to find an investing niche and stick to it religiously. During the dot-com boom, a lot of people invested in a lot of businesses they didn’t understand, and the antidote seemed to be, “Let me just invest in one niche I know, and that way I’m not investing in Pets.com.”
Today you’ll see investors advertising themselves as “social media investors” or “e-commerce investors.” It’s the silliest thing ever.
Here’s a piece of news: real investors don’t care what industry they invest in. Warren Buffet has invested in railroads, furniture companies, insurance companies, and hundreds more. He pays no mind to the industry. Picking an investment niche is a perfectly useless way of limiting portfolio risk. If you’re a bad investor, a bad company can happen right underneath your nose. It doesn’t matter how well or not you know the industry.
So if there’s “social media investors,” “ecommerce investors,” and other specialized niche investors, what kind of an investor would you bring Hyperloop to? There are no “new transportation infrastructure” angel investors, at least not that I’ve ever heard of. And even if there are three or four of them out in the world, it would be hard to raise money since 99% of other investors are specialized in what amounts to Instagram.
If we want to have companies like Hyperloop, investors have to start judging businesses based on their merits… not some silly niche like “social media.” A company like Hyperloop doesn’t fit into any of those neat checkboxes. We need investors who have an ability to think outside of the box, and invest outside of their comfort zone.
THEORY 7: MOST ANGELS AND VC’S ARE WIMPS
This brings me to the next reason why we don’t have a Hyperloop. In general it can be summed up as: angels and VC’s are wimps. Yes, that’s right: they have no cojones.
This is not to say you shouldn’t mitigate risk, and you shouldn’t manage it, and you shouldn’t choose it carefully, but the entire culture surrounding entrepreneurship has led to investors, or at least so-called investors, that aren’t willing to take leaps. Although it’s a small factor, a company like Hyperloop could singlehandedly fail from this one point. If you’re building a new major mode of transportation, you can’t do it with wimpy investors.
Look at the VC’s behind Atari. Those guys had balls. And quite simply today, no one has balls like that. And that’s why we have more Instagrams than we know what to do with.
You can always eliminate risk by having blanket risk mitigation measures in place. “We don’t fund companies without an MVP. We don’t fund companies that are just an idea. We don’t fund companies that aren’t in social media. We don’t fund companies that aren’t in ecommerce.” But when you make those rules, you tend to eliminate a lot of upswing and innovation at the same time.
One company that epitomizes the risk-adverse MVP culture is called Buffer.
They have users. So, congratulations. And actually the guy who runs it seems very smart to me. But the product is as innovative as a pile of dirt. It basically takes your tweets or facebook posts and spaces them out over the course of a day or a week, so that you don’t have to post them by hand.
Is this the kind of company, and the level of innovation, we expect of entrepreneurs today?
I think that Buffer is a perfect example of a company that is a byproduct of the startup culture I’ve outlined. Buffer has an MVP. It has users. It is an investment targeted to social media. It is a clear M&A target. And you don’t need any balls to invest in it.
IS THIS WHAT WE’VE COME TO? SPACING OUT OUR TWEETS?
Is this what we’ve come to? Spacing out our tweets?
Where is the upswing? What is this company going to do for America? What is this company going to do for the capital markets?
Is this what our brightest minds are being incentivized to do?
Until VC’s and angels stop being wimps, and start swallowing more risk, we’re not going to get innovation. We’re going to get more Buffer. And more Instagram. If we want to let another country’s economy overtake Silicon Valley, this is exactly how we should do it.
THEORY 7: CORPORATE R&D AND CORPORATE TALENT RETENTION SUCKS, SO CORPORATE M&A IS HUNGRY
The next reason that we don’t have Hyperloop, but we do have Instagram, is that Fortune 100 companies have notoriously bad in-house R&D. Therefore, acquisitions are driving most of the innovation. In turn, funding startups that aim to be acquired is consuming most of the available seed capital. For investors and entrepreneurs, M&A deals are like shooting fish in a barrel.
So, as many people know, almost every company that gets funded and exits today is through an acquisition.The M&A market can be characterized as a giant distributed R&D department for major corporations. Companies like Cisco are horrible at innovating, so they let entrepreneurs innovate, and when the entrepreneur has proven his innovation, they buy it. Simple as that.
There’s going to be a moment where — and I don’t know when it will be — big companies figure out that they can get the benefits of startup innovation without the $100 million price tag. And this whole game of making silly little companies and selling them for $100 million will come to an end. At that point, entrepreneurs are going to have to come up with something truly revolutionary, and not just something on par with what an R&D department 40 years ago would have created.
How does this tie into Hyperloop?
Well, the fact that large companies can’t innovate or retain talent means that acquisitions are at an all time high. Investors and entrepreneurs are responding to demand. That, in turn, is eating up a lot of the available capital and talent in the market. A lot of entrepreneurs and investors look at the merger and acquisition environment and say, “You know, we had this idea for the Hyperloop, but forget it. Yes, it’s true: that will make billions of dollars a year in revenue… but we couldjust spend a few years making something really simple, and we’ll sell it for $75 million guaranteed and walk away.”
Without such a hearty appetite for acquisitions, entrepreneurs and investors would have to take on riskier, larger-scale innovations.
THEORY 8: FIRST-TIME ENTREPRENEURS CAN’T BE TRUSTED
The next reason that Silicon Valley is funding Instagram and not Hyperloop is the belief that a first-time entrepreneur can’t take on a billion-dollar startup. It’s a rather odd belief, since first time entrepreneurs have founded companies like Fairchild Semiconductor, DHL, Amazon, and Google. But there is a certain nose-in-the-air quality amongst investors and entrepreneurs that unless you have a long track record you can’t take on a major startup.
Some of the very scientists that have written academic papers about a Hyperloop-type system in the last 15 years have been first-time entrepreneurs. They were panned by critics. Yet, as soon as Elon Musk talks about it, it’s the most genius idea since sliced bread. Undoubtedly, if we treated first-time entrepreneurs that same way that we treat serial entrepreneurs — and there’s no reason we shouldn’t, statistically speaking — we would already have the Hyperloop in America. But instead, we have Instagram.
THEORY 9: THE REAL REASON IS THAT WE’RE SHEEP
I do believe there’s a underlying rhyme-and-reason behind the contributing theories I listed above. I think it strikes at the very core of what it means to be a startup in 2013.
Investing and inventing has become way too dogmatic:
- Investors say, “We don’t fund ideas, we fund traction.”
- Entrepreneurs say, “You never make a business plan. You only make an MVP.”
- Investors say, “We like companies that are going to get acquired for $100M, not try to go for an IPO.”
- Entrepreneurs say, “I’ll just aim for an acqui-hire or a small M&A deal, it’s much lower risk.”
- Investors say, “We make a lot of small investments, instead of one or two that are potential home runs.
The underlying reason is that investors and entrepreneurs have stopped thinking, and have become victims of dogma. We have fallen into a trap: that there are hard and fast, black and white ways to build every start up. We’ve ignored the obvious: if our methods of building a startup are so great, why is the success rate 1 in 10? If you had a recipe that only produced one edible cookie at every ten you baked, you’d fire the chef.
Worst of all, we’ve started using the “N” word: “Never.” For every time that someone says “never,” a genius company is being left by the roadside and billions of dollars in value are being lost.
Instead, if we want companies like Hyperloop, we have to get over our ideas about the way things must “always” be. We must put on our thinking caps.
Sometimes, you should fund an idea. Sometimes, a description on a napkin can be the basis for a $10 million check. Sometimes, you need an MVP…. and sometimes you don’t. Sometimes you should write a business plan, and sometimes you shouldn’t. Sometimes you should aim for a merger and acquisition, and sometimes you should aim for an IPO.
But to say “never” — that is the real problem. The burden of proof should not be on the entrepreneur to explain why he is breaking the dogma, it should be on the purveyors of the dogma to explain why he should use it.
If we want to have companies like Hyperloop in Silicon Valley, and we want to have less companies like Instagram, we have to stop building startups based on a one-size-fits-all formula. This formula produces companies like Instagram and Buffer. They hit all of the checkboxes, but entirely fail to innovate. Not to mention, they’re boring.
Companies like Hyperloop break all of these rules. There is no MVP, it’s very high risk, there is no angel who specializes in it, it’s a first-time inventor, the company wants to go public, and all the founder has is a scribble on a legal pad to explain how it’s going to work. It goes against all conventional wisdom, but that may be the best investment of our generation.
Therefore, the answer of how Silicon Valley can produce dozens of companies like Hyperloop, and get rid of all of the meaningless startups like Instagram, is to create a new dogma — a new belief system — that challenges the old one. And here is the only rule: there are no rules. Here’s the investment strategy: there is no investment strategy. Here is the kind of industries we invest in: we invest in all industries. Here’s how you should build a company: there is no one way you to build a company. Here’s how much money you should raise on the first round: however much you need.
Here’s the new formula to innovation in America: we’re going to start thinking.