Maximizing the Efficiency of the Startup Ecosystem

This post is a revision of written for emergent fool.

Over the last 3 decades the technology entrepreneurship sector has been the primary sector driving economic growth. The sector initiated the information economy and has given life to thousands of innovative companies, four of which are ten of the biggest companies in the United States, including Google, Apple, Microsoft and IBM. By any metric the sector has been wildly successful, but it’s possible to make the ecosystem even more efficient and realize an even greater number of opportunities.

Currently, projects that succeed are squeezing through a very tight bottle neck, and only the right combination of personality, skill and luck can breakthrough. Better infrastructure widens that bottle neck, so potential impact can be realized at a greater rate.

This post will look at how we can increase efficiency in the entrepreneurship ecosystem, but the significance of this effort may extend beyond the tech sector to the future of the information economy. My post on that topic is here.

Systems Perspective on Entrepreneurship

To increase efficiency further requires looking at the entrepreneurship ecosystem as a system in order to find the holes and the greatest points of leverage. But before we focus on improving the efficiency of system we need to understand the difference between the primary and secondary causes that drive innovation. There is nearly unanimous agreement that the most important players in the startup ecosystem are the founders and CEO’s who start from nothing and go on to create and control billion dollar markets. Society can’t stop glorifying entrepreneurs like Steve Jobs, Bill Gates and Richard Branson. But while they deserve immense praise and adulation the impact they are able to have has more to do with the surrounding innovation ecosystem than their individual ability and vision.

Something new and innovative can only be created and scaled if a confluence of forces come together— market, team, systems that allow you to find your team, capital, advice, cost of production, cost of distribution and culture (whether people are ready for it) etc. Breakthroughs are the result of way more than an individual with insight; they emerge from the last iteration of the system, building on top of existing tools and a huge history of knowledge.

Products and companies do make a huge impact but their success has more to do with the state and incentives of the system than the entrepreneur. It’s not the company that changes the world, it’s the system that creates the right incentives to make the creation of world changing breakthroughs extremely probable.

As the startup ecosystem has been fine tuned it has made the existence of certain products and companies almost inevitable, because the system exerts so much pressure to make opportunities come about once the timing is right. In Apple’s and Microsoft’s case there was immense pressure exerted on bringing about computer hardware and software companies.

If you are looking to bet on an individual company than a great entrepreneur is certainly the centerpiece. But if you want to maximize the innovation of a certain sector then you must look at the system, in this case the startup ecosystem. From the system perspective you just want a need to be filled and you don’t care who fills it. Thus the individual matters less, because there’s enough talent out there that if the incentives are strong enough someone will capitalize. But taking the system perspective far from trivializes the entrepreneur. In fact, talent development, which must have a very humanistic lens to be effective, is a critical part of an efficient startup ecosystem because potential talent needs to be actualized at a high rate.

The startup ecosystem is already extremely effective, just look around at the mark it has already left on the world in only a few decades, but if we want to make the system even more efficient and increase both the quality and quantity of innovative breakthroughs and great companies, we must identify places where friction is reducing the possibility of successful ventures and create solutions to remove this friction.

How The Startup Ecosystem Works Now

If we look at the rise of 3 of Silicon Valley’s fastest growing companies: Google, Facebook, and Twitter, in the context of the startup ecosystem it’s possible to see the existence of a category leader as almost inevitable, and the eventual winner as extremely unlikely. This matters because as long as someone can seize the opportunity and fill the market need, the battle from a macroeconomic perspective has already been won, it’s just a matter of which individual player will earn the spoils and how long they can maintain relevance before a new competitor overtakes them or the market becomes mature and commoditized.

Google, Facebook and Twitter now each dominate a category: Search, Social Networks and Microblogging, but there was plenty of competition and uncertainty at one point (remember Altavista, Yahoo, Myspace and Friendster? With better execution these companies could have also won). Once these categories were identified either consciously or by accident, the startup ecosystem was effective enough to support the formation of many teams, supplying them with capital, services, people, and advisors in hopes of capitalizing on a billion dollar market opportunity. And the team that executed the best won. The individual winner was unpredictable but the system was good enough to make sure someone won. That humans’ evolved a system that can create many competitors and then naturally select the winner based on merit or “fitness” is a tremendous accomplishment for this industry and for the world, and it is what makes tech the most innovative industry on the planet.

The success of these companies had a lot more to do the size of the market, the timing for when it was ready to be capitalized on and the resources in the startup ecosystem that supported effective scaling than the founders or the idea. The markets they operated in were big enough that inevitably an industry giant would emerge who would be able to use the lucrativeness of the market to generate a runaway positive feedback loop up until saturation, using their momentum to continually take market share and capture the best talent.

This evolutionary competitive process continues even after an industry giant has saturated a market, because there are always new markets emerging. While it would be very hard for Facebook and Google to screw up and concede supremacy in their primary markets, it is probable a new company will beat them in the new markets that they try to extend to that fall outside of their core competencies. (For more on why the market is the most important factor for a startup’s success check out this Marc Andressen’s post).

In summary, once the timing and conditions are ripe there will be enough people trying to tackle the clear billion dollar markets that somebody will get the execution right. The startup ecosystem is that good at providing all the puzzle pieces to make sure this happens!

Future billion dollar companies will ride trends such as the move to the cloud, mobile information, the real-time web, extreme personalization, and new kinds of data enabled by smaller and cheaper sensors.

The Evolving Startup Ecosystem

The tech industry has cracked the nut for how to tackle billion dollar market opportunities, making it better than any other industry at capitalizing on opportunity. But there is still a lot of room for growth. Increasing the effectiveness of the startup ecosystem matters as long as their are markets to be filled. The faster we can fill unmet with greater effectiveness the better off the world will be.

The tech ecosystem is now well tuned to hit the home run in billion dollar markets, but there is a shift happening as people began to realize there’s more opportunity and less risk to be had in aiming for singles and doubles, and hitting them consistently. The home runs of the previous era have created a new playing field and there is now a wealth of opportunities on the long tail with all kinds of business and consumer needs waiting to be met.

As the information economy has developed and become more complex, an increasing number of lucrative niches now make market sense to pursue. Whereas previously the opportunities either weren’t there (you couldn’t have a million dollar facebook app before facebook) or the costs were too high to have certain opportunities make sense (startups needed venture capitalists and VC’s only wanted to play in markets bigger than 100 million). But in recent years startups have become disentangled from their dependence on VC’s as the costs of starting a startup have continued to fall due to cheaper hardware and services moving to the cloud. This is driving a growing seed stage ecology where the primary actors are startup accelerators, angel investors and seed stage venture capitalists.

The focus now is on startups attacking smaller opportunities (though still in the 10’s of millions) with less investment capital. There will be an abundance of lucrative, unserved niches for startups to tackle. This coincides well with a number of trends:

– Science will be injected into the art of running a startup

Structure and methodology will be experimented with to increase the success rate of startups and startups will fail less because of self-destruction and more because of getting beat by competitors. As the overall number of startups in the ecosystem increase over the next few years, many of the startups in big markets will fail due to competitors, but in the huge number of opportunities in smaller markets startups will be more dispersed and there will be few direct competitors. In these markets startups that use a more scientific approach should be able to figure out how to hit the 10-100 million dollar markets with great consistency.

This consistency will enable the funding ecosystem to make sense for these smaller opportunities. When many investments are made in these smaller markets (<500 Million) the venture community’s approach of haphazardly throwing money at many petri dishes won’t work, because the upside potential is capped. Home run hitters can afford to strike out a lot, singles hitters can’t.

Even startups that lose to competitors in niche markets will find it easier to pivot, than pack it in and start from scratch, because the farther down the long tail you go the closer the adjacent verticals.

A fractal tree is a good analogy for why it’s easier to pivot in <100 million niches vs. billion dollar markets, if you consider the thickness of the branch equal to the size of the market. The core branches are very far apart. If your startup is set up to tackle a billion dollar opportunity it’s hard to pivot all the way over to another one, or shift gears and attack a smaller opportunity. But if you follow the analogy and you’re a startup attacking a niche as the tree branches further away from the trunk the twigs become closer together. The larger branches are too far away from each other to pivot from one to the other, but the small branches just require a little back tracking and a slight change in direction.

Creating a startup where the goal is to make something people want will still be a chaotic, iterative process but it’s possible to induce predictability and stability into chaotic systems.

– The potential for more collaboration horizontally and vertically across markets to create a more seamless experiences for the customer and more leverage for the startup. (I’ve started exploring this process, naming it the lego model)

– An increased demand for entrepreneurs due to clear ~10 million dollar opportunities just waiting to be tackled. This demand in the ecosystem for entrepreneurs coincides perfectly with changing cultural values about work, which will drive huge increase in the number of people pursuing entrepreneurship. And that in combination with a more entrepreneur friendly ecosystem evolving, will unleash a new golden age of entrepreneurship.

Here are two good posts on the changing seed stage ecology: Dave Mcclure’s presentation on the evolution of the startup ecosystem and Nathaniel Whittemore’s take on the seed stage ecology in the social sector..

New Efficiencies in the Startup Ecosystem

The startup ecosystem is certainly past its infancy, but it is still evolving rapidly and there are many more efficiencies to be unlocked that increase the success of startups further and support the long tail of innovation. Here’s my opinion on where we have opportunities to improve the system:

– Talent development

– Better conversion rate of people with ideas for companies, to entrepreneurs actually starting companies

– Pushing world’s brightest to choose entrepreneurship over other industries (college students starting companies instead of becoming an investment banker. Creating incentives for experienced execs to take risks starting something new instead of languishing in the rungs of the corporate ladder)

– Reducing friction in team formation, and better “deal flow” by interacting with more potential co-founders

– Aggregating startup services and service providers in order to remove distractions and allow startup teams to focus fully on the new innovation they’re trying to create

– Networks becoming more efficient in sharing assets (knowledge, people, code, strategy)

– More fluid and less cumbersome funding rounds, all the way from idea to scalable profitability

– Collaboration amongst startups to attack new verticals and interlink their advances to create networked impact— where success exists behind an activation energy only realizable by coordinated efforts of multiple startups

– Connecting entrepreneurs to the people and information at the time they need to support maximization of potential— time and energy will consistently be put in highest leverage places

– Better filters by injecting personalization and social graph into many tools

– Systems that use psychology and persuasion to nudge people to act in their own long term self interest, mitigating human kind’s insidious propensity for short term thinking

And what I’m personally targeting right now with Founders First: accelerated just in time learning.

Finally, a few projects and trends I think are very important:

Rise of startup accelerators and therefore an emerging market for post-startup accelerators and pre-startup accelerators. (I’m working on the post startup accelerator phase with Founders First. See all the new startup accelerators here and many of the companies here)

Venture Hacks Angel List and Startup List to reduce friction in the funding of startups.

Right Side Capital Management— A new kind of investment fund trying to dramatically increase deal flow to 100-200 investments a year. This will support faster expansion into niches.