Would You Spend the Next 20-30 Years of Your Career in Silicon Valley?

I have to admit that the genesis for this post was a conversation I had with some of my business-minded friends during the first half of the Super Bowl. One of my friends, who runs his own venture-backed company, asked the group whether we thought the classic Silicon Valley, venture-funded tech startup scene was the best place to be for the next 20 years (I’m paraphrasing – he actually did a much better job of posing the question). Earlier in the week, I read a post on Fred Wilson’s blog that actually got me thinking along these lines as well – that post was about the miserable margins for some of our web 2.0 darlings. Why is it that the tech industry has been floundering (in terms of building really big businesses with strong margins) since the last bubble? And what does that mean for people who want to work in technology?

The Old Model

Capital + People + Idea + Technology = Technology Product (chip, software application, communications system, etc)

When I first got into the technology industry, it felt like there were a lot more companies who used technology inputs to product technology outputs. What does this mean? Well, there were a lot of companies who used technology as an input to produce new technology outputs. Communications systems companies built on existing chip IP to make new boxes / switches / gear that was better than the stuff before. Enterprise software companies did the same. The goal always appeared (to me at least) to move up the margin stack – take the stuff that was available or soon to be available, get some smart people and some money, and build a product where you could capture some margin.

For this whole model to work, I think you have to have products that attack large markets AND generate real margins. Why do margins matter? Well, margins allow you to build big businesses (you have money to invest in R&D, you can get off the fundraising treadmill, and people can start looking at your business and comparing it to public competitors). Also, given the returns that investors needed to see, the amount of dilution company founders took, and the time to liquidity, this model worked really well for business that both get big from a revenue standpoint and have really great margins.

The New(ish) Model

Capital + People + Idea = Technology Service (consumer web service, e-commerce concept, etc)

I think one of the biggest things I’ve seen that’s difference is that we build different stuff. Whether it was chips, enterprise software systems, internet infrastructure components, chips, radios, or antennas, the stuff that Silicon Valley made were things where it was pretty clear as to how you turned them into businesses that had the potential to become real breakout, standalone companies. Those were items where the end customer was both known, reasonably well-understood, and (most importantly) willing to pay for the end product that was created. Sure, there was technical risk, market risk, execution risk, and all of that – but if you could navigate those risks, there was a pretty good chance that you could build a business that was a threat to go public or get acquired at a nice multiple.

Things today are a lot different. There are a lot more companies today where technology is an input and the actual output is a tech-enabled service. Look at Digg, Twitter, Facebook, Salesforce or just about any of your favorite web 2.0 company. For the most part, they take widely-available technology inputs and use those as the foundation for technology-enabled services. I don’t want to imply that those companies aren’t innovating, pushing the envelope, or otherwise creating new stuff that’s changing the landscape of the Internet. But their output is a service and services have very different margin structure and business trajectories than product companies. And that means a lot when you’re looking at how to finance and value these opportunities as businesses.

We have had some past successes in creating web-based service companies that really work at scale. Amazon. eBay. Netflix. Zappos. And a few others. But if service-as-the-product is the new norm, we’re going to have to get much better at that way of doing business if we have sincere hopes of building another generation of great entrepreneurial web-based service companies.

I think the biggest challenge facing the technomoneyplex (the combination of technology innovation and investment that powers the Silicon Valley) is what to do next. Do we stick to the high-margin product model and find a new target (maybe clean tech? maybe digital media? maybe some yet-to-be-identified market) where those rules still apply? Or do we get good at building, financing, and nurturing service businesses.

It still feels to me like we’re trying to jam a square peg (the old model) into companies who are round holed (the new model). And this isn’t just a consumer web problem. Look at the economics of software-as-a-service businesses vs traditional packaged software. This is an issue that cuts across a lot of technology markets. I think there is a TON of value to be created by figuring out how to build, nurture, and grow web-based service companies. But the question is whether people want to and / or can do it. It’s hard to both love the old model (profitable as it was) and embrace the new unknown at the same time.

Thoughts, comments, disagreeements, etc are all welcome.

  • Great stuff, as always.

    The round peg-square hole analogy is great. Most existing VC funds were raised before the new economics were clearly understood and are still targeting exit opportunities that are unlikely to work out given the move from product->service businesses. The new economics can support plenty of exits at good multiples as long as the economics/expectations are well understood and that will happen when we start hearing about Dogster as the Web2.0 posterchild rather than DIgg.

  • Everything ultimately depends on the outputs. The old model worked because the ultimate outcomes (widely adopted products, big-money IPOs and M&A) were large enough to pay for the front end of the process.

    Right now, no one knows whether the ultimate outcomes for web services and SaaS will be large enough to pay for the front end investment.

    Yet at the same time, the old model no longer works either; consumers and businesses are no longer willing to fork over the dough for an upgrade cycle or for perpetual licenses.

    My guess is that the front end will have to be reengineered, with bootstrapping having to suffice until the entrepreneur has built a scalable business with a clear path to profitability (which, by the way, Digg and Twitter have not).

  • Chris,

    I couldn't agree with you more. Even so, I still worry about what happens on the back end if the bootstrapped businesses end up being reasonably unattractive (albeit profitable) businesses for public market investors or potential M&A suitors.

  • Alan Patricof had a relevant take in the NYT Dealbook today http://dealbook.blogs.nytimes.com/2009/02/09/an

  • It may very well be that startups stratify into two layers–those which have a shot at outsized returns, and those that don't. Entrepreneurship doesn't always have to follow the traditional Silicon Valley model…think of “The Millionaire Next Door.” Most millionaires are owner/proprietors of low-tech businesses like dry cleaners and car washes.

    It may be that we'll see a split between “car wash” startups and “change the world” startups. Which would reflect a natural maturation, though I must admit, I too prefer the “change the world”-style returns!

  • That was a good find – I read it and was thinking the same thing.

  • Chris,

    Yeah, I think we're starting to see just the stratification you mention. I
    just hope that the car wash crew doesn't try to finance themselves for the
    home run shot.

  • The models that have worked in the past two decades were during times when money was flowing and growing in the financial system. But will they post-credit-crunch? Even if you look beyond a few years, I do wonder if the capital market is changed forever…

    Maybe there will be more car wash businesses where you do need the cash flow and you're focused on rev – cost = profit

  • There's also been a change in the central asset that silicon valley startups generate. Intel's asset is its technology, but Facebook's central asset is its social graph. These assets are harder to measure and value. Whether or not you've made a faster chip or a smarter router is a matter of science, but whether a social graph or real-time chatter can be a monetizable asset is a far more difficult thing to asses.

  • I am really very glad to have started http://www.dealtattle.com . It is a coupon code and discount start up. The economic model seems to support this effort. But, time will tell.