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Steve Blank

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The New Internet Bubble and the New Rules for Startup Success

Posted: 03/18/11 11:51 AM ET

We're now in the second Internet bubble. The signals are loud and clear: seed and late stage valuations are getting frothy and wacky, and hiring talent in Silicon Valley is the toughest it has been since the dot.com bubble. The rules for making money are different in a bubble than in normal times. What are they, how do they differ and what can a startup do to take advantage of them?

First, to understand where we're going, it's important to know where we've been. Below is a quick history of the four waves of startup investing (Click here for slides).

The Golden Age (1970 - 1995)

VC's worked with entrepreneurs to build profitable and scalable businesses, with increasing revenue and consistent profitability -- quarter after quarter for at least five quarters. They taught you about customers, markets and profits. The reward for doing so was a liquidity event via an Initial Public Offering.

Startups needed millions of dollars of funding just to get their first product out the door to customers. Software companies had to buy specialized computers and license expensive software. A hardware startup had to equip a factory to manufacture the product. Startups built every possible feature the founding team envisioned (using "Waterfall development,") into a monolithic "release" of the product taking months or years to build a first product release.

The Business Plan (Concept-Alpha-Beta-FCS) became the playbook for startups. There was no repeatable methodology, startups and their VC's still operated like startups were simply a smaller version of a large company.

The world of building profitable startups ended in 1995.

The Dot.Com Bubble (August, 1995 - March, 2000)

With Netscape's IPO, there was suddenly a public market for companies with limited revenue and no profit. Underwriters realized that as long as the public was happy snapping up shares, they could make huge profits from the inflated valuations. Thus began the 5-year dot-com bubble.

For VC's and entrepreneurs the gold rush to liquidity was on. The old rules of sustainable revenue and consistent profitability went out the window. VC's engineered financial transactions, working with entrepreneurs to brand, hype and take public unprofitable companies with grand promises for the future. The goals were "first-mover advantage," "grab market share" and "get big fast." Like all bubbles, this was a game of musical chairs, where the last one standing looked dumb and everyone else got absurdly rich.

Startups still required millions of dollars of funding. But the bubble mantra of get "big fast" and "first-mover advantage" demanded tens of millions more to create a "brand." The goal was to get your firm public as soon as possible using whatever it took because the sooner you got your billion-dollar market cap, the sooner the VC firm could sell their shares and distribute their profits.

Just like the previous 25 years, startups still built every possible feature the founding team envisioned into a monolithic "release" of the product using "Waterfall development." But in the bubble, startups got creative and shortened the time needed to get a product to the customer by releasing "beta's" (buggy products still needing testing) and having the customers act as their Quality Assurance group.

The IPO offering document became the playbook for startups. With the bubble mantra of "get big fast," the repeatable methodology became "brand, hype, flip or IPO."

Back to Basics: The Lean Startup (2000-2010)

After the dot.com bubble collapsed, venture investors spent the next three years doing triage, sorting through the rubble to find companies that weren't bleeding cash and could actually be turned into businesses. Tech IPOs were a receding memory, and mergers and acquisitions became the only path to liquidity for startups. VC's went back to basics, to focus on building companies while their founders worked on building customers.

Over time, open source software fueled the rise of the next wave of web startups and the embrace of Agile Engineering meant that startups no longer needed millions of dollars to buy specialized computers and license expensive software -- they could start a company on their credit cards. Customer Development, Agile Engineering and the Lean Methodology enforced a process of incremental and iterative development. Startups could now get a first version of a product out to customers in weeks/months rather than months/years.

Startups began to recognize that they weren't merely a smaller version of a large company. Rather, they understood that a startup is a temporary organization designed to search for a repeatable and scalable business model. This meant that startups needed their own tools, techniques and methodologies distinct from those used in large companies. The concepts of Minimum Viable Product and the Pivot entered the lexicon along with Customer Discovery and Validation.

The New Bubble: 2011-2014

Signs of a new bubble have been appearing over the last year -- seed and late stage valuations are rapidly inflating, hiring talent in Silicon Valley is the toughest since the last bubble and investors are starting to openly wonder how this one will end.

Breathtaking Scale
The bubble is being driven by market forces on a scale never seen in the history of commerce. For the first time, startups can today think about a Total Available Market in the billions of users (smart phones, tablets, PC's, etc.) and aim for hundreds of millions of customers. And those customers may be using their devices/apps continuously. The revenue, profits and speed of scale of the winning companies can be breathtaking.

The New Exits
Rules for building a company in 2011 are different than they were in 2008 or 1998. Startup exits in the next three years will include IPO's as well as acquisitions. And unlike the last bubble, this bubble's first wave of IPO's will be companies showing "real" revenue, profits and customers in massive numbers. (Think Facebook, Zynga, Twitter, LinkedIn, Groupon, etc.) But like all bubbles, these initial IPO's will attract companies with less stellar financials, the quality IPO pipeline will diminish rapidly, and the bubble will pop.

At the same time, acquisition opportunities will expand as large existing companies, unable to keep up with the pace of innovation in these emerging Internet markets, "innovate" by buying startups. Finally, new forms of liquidity are emerging such as private-market stock exchanges for buying and selling illiquid assets (i.e. SecondMarket, SharesPost, etc.)

3 Rules in the New Bubble
Today's startups have all the tools needed for a short development cycle and rapid customer adoption: Agile and Customer Development plus Business Model Design.

The Four Steps to the Epiphany, Business Model Generation and the Lean Startup movement have become the playbook for startups. The payoff: in this bubble, a startup can actively "engineer for an acquisition." Here's how:

1. Order of Battle
Each market has a finite number of acquirers, and a finite number of deal makers, each looking to fill specific product/market holes. So determining who specifically to target and talk to is not an incalculable problem. For a specific startup, this list is probably a few hundred names.

2. Wide Adoption First, Revenue Later
Startups that win in the bubble will be those that get wide adoption (using freemium, viral growth, low costs, etc.) and massive distribution (i.e. Facebook, Android/Apple App store.) They will focus on getting massive user bases first, and let the revenue follow later.

3. Visibility
During the the Lean Startup era, the advice was clear: focus on building the company and avoid hype. Now that advice has changed. Like every bubble, this is a game of musical chairs. While you still need to focus on customers for your product, you and your company now need to be everywhere and look larger than life. Show and talk at conferences, be on lots of blogs, use social networks and build a brand. In the new bubble, PR may be your new best friend, so invest in it.

Lessons Learned

  • We're in a new wave of startup investing - it's the beginning of another bubble

  • Rules for liquidity for startups and investors are different in bubbles

  • Pay attention to what those rules are and how to play by them

  • Unlike the last bubble, this one is not about selling "vision" or concepts

  • You have to deliver. That requires building a company using Agile Engineering and Customer Development

  • Startups that master speed, tempo and pivot cycle time will win

 
 
 

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