Why Twitter's IPO is Bad for Startups

Twitter went public today, and I couldn't help but feel alarmed.

After seeing the 75% valuation pop from $14 billion to $25 billion, my initial condolences went to Twitter. A surge on IPO day is good of course, but 15-20% is more than enough; 75% simply means the company was mis-priced and that Twitter left over a billion in cash on the table.

Once my sympathies for Twitter subsided, I began to reflect on a much bigger problem that has been bubbling up in the tech community for the past couple of years, and is being tragically reflected and reinforced by this very public valuation.

The link between valuation and underlying value is quickly fading

Startup valuations are, to put it euphemistically, frothy.

Valuations are becoming entirely dissociated from intrinsic value, and investors are focusing entirely on reward with almost no regard for risk.

Snapchat and Pinterest are worth around $4 billion dollars each. Evernote and Airbnb are each worth over $2 billion. Path is worth $500 million. By comparison, Peabody Energy, the largest coal company in the world which owns almost 10 billion tons of coal, is worth about $5 billion.

I understand speculation and risk; it's been my job for the past two years. I know that these companies are still at an early enough stage that investors buy a basket of them hoping that one or two hit it out of the park. Is there a 10% chance Snapchat is worth $40 billion? Maybe, but that's not a bet I would take.

"Forget valuation multiples, how does the product make you *feel*?"

What worries me most about the valuations of companies like Twitter, Snapchat, and Path isn't the nose-bleed revenue multiples (nevermind positive earnings), but the emotional way the valuations are justified.

Today, the Twitterverse is lighting up with investors chattering excitedly about Twitter's reach, impact, connectivity, meaningfulness. "People who think the company is overvalued," they scoff, "just don't get the power of Twitter."

Twitter is an awesome company and I love the product too, but we need to try to remember that Twitter stock is a financial asset, and financial assets are worth the present value of the discounted future stream of cash flows. Full stop. (Alternatively, financial assets are worth what the next fool in line behind will be willing to pay a year later, but surely no self-respecting investor thinks that way.)

Valuations trickle down from the top

I'm worried about the entire startup ecosystem because startup valuations propagate down from the top of the market. This valuation (along with the recent surge in Facebook stock) will send a rising tide of valuations rippling down through the ecosystem until "my friend and I have a pitch deck and an idea for a web app" is worth $10 million.

Our tacit understanding is that while early stage investing is a crazy game, public investors do serious diligence and put the company through rigorous financial analysis, so their valuations must be grounded in reality. "So if Twitter is worth $25 billion and its size is X," thinks the VC to himself smugly, "this other startup must be worth $250 million because its size is 0.01X."

Big promises, frothy markets

Because human nature dictates that people have no patience and jealousy problems, the problem fuels itself. Investors see other investors getting rich off of pipe-dreams-turned-billion-dollar-exits, and they want a piece of the action. The only way to get the big returns is to have a piece of the big companies, so the dozen consumer companies that could plausibly go public in the next 12 months receive incredible attention. Emotions run high, valuations run high. Froth begets froth.

Maybe Twitter really is fairly valued at $25 billion, and maybe the same is true for Snapchat at $4 billion or Path at $500 million. I'd be shocked, but maybe.

The real problem here is that we increasingly live in a world where technology companies are valued on emotional whims and promises of unbelievable future growth. I wasn't paying attention back then, but I feel a hint of what I imagine was running rampant in 1999; excitable, short-sighted investors betting billions of dollars on large audiences with promises of inconceivable growth and eyeball monetization.

I'm not calling the top or saying we're in a bubble, but I think we would all do well to step back and think about what valuations actually mean and where they come from. This quote from Warren Buffett always seems to do the trick.

“You could take all the gold that’s ever been mined, and it would fill a cube 67 feet in each direction. For what it’s worth at current gold prices, you could buy — not some — all of the farmland in the United States. Plus, you could buy 10 Exxon Mobils (XOM), plus have $1 trillion of walking-around money. Or you could have a big cube of metal. Which would you take? Which is going to produce more value?” -Warren Buffett

Social-first: The new way to live

Last week I watched this interview between Chamath Palihapitiya and Robert Scoble and found myself nodding vigorously as Chamath articulated a phenomenon that has been swirling around my head for a while: people are beginning to do things in the real world for the purpose of sharing them online.

I think people will simultaneously have two opposing reactions to this. On one hand, people will disagree and say only techie weirdos and middle schoolers put their social media life ahead of their real lives. On the other, people will identify with times they have exhibited this behavior but write it off as a not a big deal.

In my opinion, these reactions are just wrong; a ton of people behave this way, and it's a very big deal.

So what if this is true? Initially, it's kind of a terrifying notion, and the questions that logically follow are almost offensive. Is it possible that people get more happiness from their new profile picture in front of Machu Picchu than from the trip itself? Could they be happier the day they got 400 likes and congratulations on Facebook than on the day they actually got engaged?

If the answers to these questions are yes, you could reply that what appears to be social-first behavior is actually real-life-first behavior because people are simply sharing real experiences with real people who are sitting on the other side of those social media accounts. I don't quite buy that though; this feels like the same circular and semantic logic people employ when claiming that a mother who gives everything to her child is actually selfish because she's doing what makes her happy.

Social-first is a spectrum; not everyone does it, and not everyone who does it does it does it all the time. But I'm pretty sure this is a fundamentally new and growing trend. I know that I sometimes observe this behavior in myself and most people I've discussed this with have as well.

When a surprising new behavior is observed, it's better to embrace it than to deny it's existence. Instead of writing this off, we should build products that use this phenomenon to make us better people.

So what if our Pinterest account makes us take up a new hobby as we show off our newly reupholstered chair. Or maybe we read a book on [Oyster](https://www.oysterbooks.com/) because we know we can broadcast this activity to the world when we're done. And isn't it better to travel to exotic places than not, even if our new cover photo is the part we enjoy most?

Social-first living is an uncomfortable idea, but it is a real and growing secular trend, and we should have products that welcome it with open arms. 

Your best option is to be the best

"People overvalue optionality. It’s one thing I learned in chess. You just need to have one good option, instead of going for Option A or B or C or D." - Peter Thiel

There's a peculiar tradeoff we all must constantly make between keeping our options open and focusing very hard on one thing. From our earliest days in school we are told to make decisions that don't close any doors, and this sentiment generally sticks with people for a long time.

America's education system promotes liberal arts degrees for a huge part of the population, keeping us like generic stem cells until we are 22. Our international counterparts tend to begin differentiating at 18 when they graduate high school. Professionally, the country's top students seem to have an insatiable demand for banking and consulting jobs, which are valuable in large part because of the opportunities they lead to (industry, private equity, business school).

The urge to not close any doors and keep one's options open for as long as possible - to diversify  - is understandable. If you give yourself lots of chances to succeed, you'll be more likely to succeed, right?

At first blush this makes sense, but I think there is good reason to avoid taking this approach.

First is the superstar effect, which says there are huge gains to be had as you approach the top of a field. In a highly differentiated world, it's more valuable to have deep expertise in one or two areas than general proficiency in five or six.

Second is the counterintuitive truth that the best way to open lots of doors is to do one thing really well. The most successful people in the world have such strong operating leverage that they are able to get meaningfully involved in any endeavor they choose. They almost all got there by being extremely focused and good at one thing.

Naturally, the way I most often think about this tradeoff is with startups. When building a company, founders have a choice about how to handle the tradeoff between focus and optionality. Normally, the best startups look for one very good option and then find ways to make that happen. It's surprising how often I hear founders say they aren't sure what their business will look like yet, but they have lots of great options so something will probably work out.

Remember that on some level you can only do one thing at a time; it's better to get offers from your first choice job or school than your second through fifth choices. It's also normally better to be in the 99th percentile in one thing than the 90th percentile in two or the 80th percentile in three.

If there are free options you can layer into your life without losing focus you should take them; I'm not saying you should intentionally pigeonhole yourself. Instead, I'm trying to be a tugging force toward focus since I think people typically overvalue optionality and end up on the wrong side of the optimal balance. 

Should we do more to incentivize open source?

Open source is a fascinating phenomenon in the world of technology; there is an enormous wealth of software that is entirely public. Brilliant coders have poured countless hours of work into complex projects and then, instead of protecting their valuable intellectual property, released it publicly to the world, often for free.

Open source products fuel the modern internet

Many of the most powerful and widely used tools are open source, including languages like Ruby and Python, frameworks like Rails and Django, cloud application platforms like Heroku, operating systems like Linux, and web browsers like Mozilla Firefox.

Open source doesn't necessarily mean free (although it often is); it means the source code is available to the public so that anyone can look at it, use it, and contribute to it.

So today, when a new developer enters the startup scene, he is immediately perched onto the shoulders of giants. He gets to use Ruby thanks to Yukihiro Matsumoto, Git thanks to Linus Torvalds, jQuery thanks to John Resig, and the list goes on. The new programmer has only to stand on his metaphorical tip toes to produce awesome pieces of software. Meanwhile, these influential open source contributors get no direct compensation.

The power of open source

Collaboration is one of the most powerful forces allowing civilizations to undergo technological progress. Look around a city; skyscrapers are amazing. We built them with materials from the Earth and machines that we built with tools that we built with our bare hands. How did we accomplish this incredible undertaking? Wide-spread sharing of knowledge and collaboration over hundreds of years.

In software, open source is a powerful part of the community that drives significant innovation. Contributors can submit patches to current codebases or add large pieces of functionality. Future early adopters of the software can give feedback in real-time during the development, giving the authors of the code a significant advantage. Once the code is finished (not that code is ever finished), it is available to the entire world, and they can customize the software as they see fit. Open source also protects against product discontinuation (which would have been nice for Google Reader).

So why do people contribute to open source?

It goes without saying that open source has huge benefits in terms of production, distribution, and maintenance. But isn't it surprising that accomplished developers spend their valuable time writing and pushing free code out to the internets?

Despite the fact that open source contributors typically don't enjoy any direct gain, there are fortunately several incentives that encourage individuals and corporations to contribute to the canon of open source. Coders build an online presence that helps them get jobs, start companies, or other generally productive things. Companies can get feedback on their software and build relationships with great developers to attract as hiring talent. Best of all, the programming community is still small enough that it feels a sense of camaraderie and desire to "give back", such that a lot of contributions may really be altruistic.

Despite what some of its most fervent supports will tell you, open source has some downsides. Version control can get unwieldy and confusing for users. Projects can fall apart when a key developer moves on. Support systems are tenuous because no one is paid to help you when you have problems. And perhaps most importantly of all, individuals and businesses may feel less willing to take risks with early versions of products if they're worried that the whole world will scrutinize them, or worse, that their competitors will steal from them.

What is the optimal amount of open source software?

Consider two extremes: at one end, 100% of the code in the world is private, and developers must intentionally share their code with others for it to be seen. At the other, 100% of code is public, and any code anyone writes is immediately part of the public domain.

The world of software today is somewhere in the middle, which is definitely where we want it, but have we struck the optimal balance? While there is a incredible set of tools available through the open source community, most of the world's software is still private.

The deeper I get into coding, the more I see the power of open source software. I think it's likely that we would all be better off with more of it. The drawbacks seem to pale in comparison into the opportunity for widespread, real-time, mass human collaboration, both in theory and in practice.

We're lucky that enough natural incentives are in place to generate the robust open source community we have, but I imagine more could be done. Platforms like Gittip are a nice way to give financial incentives directly to top open source contributors; as you would expect, data suggests that 10% of the world's open source authors have written about three quarters of the open source code.

Incentivizing open source behavior is tricky; the community is functioning very well as it stands, and it seems likely that there would be a strong backlash to incentive structures that were too anathema to the spirit of the community. However, if someone were creative enough to figure out how to encourage the behavior in an appropriate way, the benefits would be immense.

Although building a company on the heels of the open source community flies in the face of the its spirit, I wouldn't be surprised if we see a more formalized platform spring up to incentivize programmers to develop more software in open source. I hope we do; I think we would all be better off.

Optimize for success, not equity

Nothing in tech feels like more of a bubble than YC demo day. While the average seed deal in 2012 was valued at around $6 million, YC deals are routinely two or three times that expensive.

Hyper-expensive deals are a problem, but not so much so for investors. YC companies could easily be two or three times as likely to be successful as average startups, and as long as investors pick the good startups, they will do well regardless of the terms. YC has not yet proven to be a bubble; investors have done very well with these deals.

Instead, the main losers from these inflated valuations are the startup founders. Raising a seed round at a high valuation when you have relatively little traction is risky and damaging, and is generally done for the wrong reasons. Here are the main problems I've seen startups run into when they raise money at very high valuations.

Raising subsequent rounds gets much more difficult

You can usually only raise money on a promise once, and your seed round is the time to do it. This is your opportunity to partner with investors who want to invest in your team, your product, and your market. Investors will give you an implied valuation of millions of dollars in spite of the fact that little to no money is coming into your company.

The next round is not as forgiving. Series A investors do much deeper diligence on your revenues, operational costs, market potential, and key metrics, and they want to invest at a price that is (somewhat) grounded in reality. If you can't show investors serious traction 18 months after your seed round when you run out of money, you will get into trouble. You run the risk of raising a down round at a lower valuation (which brings on all kinds of problems), or not being able to raise more money at all.

Lower quality investors

Top tier investors often pay premiums to invest in good companies because they are actually very good. However, when a given startup artificially inflates its pricing relative to what it should be, it often ends up pushing out those high quality investors who know a good deal when they see one.

Another unfortunate consequence is that the investors you do get will be lower quality to you than they would be had you given them a better price. Because they will own a smaller stake in your company and feel less invested, they will be less incentivized to help you.

Waste of time

This is a really important one. Despite how it often seems, a startup CEO's main job is not actually to raise money; it's to lead the company to success. Fundraising is distracting from the important working of building a business, and should be done as quickly as possible.

When founders decide to raise at an obscene valuation, they can spend several weeks or months speaking to investors, and worse, all of their cognitive focus and emotional energy. Picking a reasonable valuation allows you get investors much more quickly so you can get back to building your business.

Some math

Just to drive home how insignificant the seed valuation of a startup is to the founders, here's a quick example.

If a startup raises a million dollars on a $4mm cap convertible note, it gives away 20%; if it raises a million on a $9mm cap note, it gives away 10%. For a founder who owns 30% of the company, we are talking about a difference between diluting down to 24% vs. 27%. *It just won't matter.* There will be a bigger variance in your eventual exit price based on the whims of your acquirer's M&A team that day, so forget about the equity.

Founders aim for high valuations so they can raise more money, suffer less dilution, and enjoy the internal satisfaction (or external competition with other founders) of running a valuable business.

Here is my advice: Founders, your outcome is binary. Either your startup will be a success and make you rich or it won't. Don't optimize for equity, optimize for success.