The only two ways to make money.

Gentlemen, there’s only two ways I know of to make money: bundling and unbundling.

– Jim Barksdale, CEO of Netscape

This quote has been bandied around a ton lately. Marc Andreessen discussed it with Fortune’s editor and even Harvard Business Review got in on it with an interview between HBR, Marc, and Jim.

Whether it’s higher education, Craigslist, music, or social media, this principle is everywhere. Right now, people clamor for an unbundled television subscription. Companies vacillate between consolidation and dis-intermediation in ebbs and flows.

By the by, bundling is kissing cousins to the commoditization/de-commoditization cycle I wrote about previously.

I’m super-nerd excited just thinking about it.

What if Startup Investing was like ETFs + Credit Default Swaps?

The JOBS Act was supposed to let the everyday person invest in startups. Years later, this is not a reality. Pretend they could though, the non-accredited investor would face the same challenges as any angel: it’s difficult to build a portfolio of companies and generate a positive investment return. Here’s an idea on how to invest cheaply, diversify, and make startup investing more liquid too. It’s called Startup Indexes.

Inspiration Part 1: ETFs & the Ability to Track Broad Market Performance

Exchange-Traded Funds (ETFs) are shares representing baskets of securities. For example, SPY is the SPDR S&P 500 ETF. It’s comprised of every stock in the S&P 500. As those stocks move up and down, the S&P 500 increases or decreases in value. Without products like ETFs, an investor would have to buy each component of the S&P 500 to mimic that exposure. With SPY, you can get the same exposure at a greatly decreased cost.

From this, Startup Indexes takes the concept of broad exposure to a market at low cost. However, one thing that doesn’t work is the constant nature of indexes like the S&P. Stocks get added or kicked out sometimes, but the index can’t withstand mass change. That doesn’t work with startups, where 70% of them can eventually go bust.

Inspiration Prat 2: CDS & the Vintage Years

Credit Default Swaps (CDS) are known as greedy Wall Street inventions that brought about the Great Recession. They’re actually rather ingenious financial products. At the most basic, an investor might own a lot of debt in one company. There is a risk that company doesn’t pay back its debts and the debt-holder loses big time. In CDS, the debt-holder (or a third party) can buy insurance on those defaults from an insurer.

But maybe you don’t want to insure against a single company. Maybe you have broad exposure to mortgages you want to hedge. Or maybe you own too much European debt. You have the ability to buy insurance on an index of companies. The indexes list each debt issuer and which specific debt is included. No two indexes will be the same. An index released in 2007 will look and perform differently from one in 2014, even if its the same general market. This is due to the different pieces of debt and companies that are included or excluded.

Startup Indexes steals the “Vintage” idea. I theorize that Series A is the right risk/return profile that could perhaps scale into my Index concept below. However, companies only go through Series A once, therefore it needs to be a moment-in-time snapshot like CDS Index Vintages. Beyond the vintage concept, Startup Indexes shares little to nothing with CDS.

Startup Index Definition

A management team goes out and does a large number of A-round deals each year. They invest a few million into each one, pool the investments together, and sell that portfolio’s future cash flow rights via Startup Indexes. A Startup Index owner would not have any control rights. The index value fluctuates with future financing events. When an exit occurs within the index, investors are paid out on a pro-rata basis. The management company charges an annual management fee and potentially carry. To capture a vintage effect, a new Index is sold every 12-24 months.

An Example: From Funding, Index Valuation, to Cash Payments

Over 12 months, the Management Company invests in 50 companies at $3 million each. Original “cost value” of the fund is $150 million. Management company decides to break it up into 10 million shares, cost valued at $15 each. The majority is sold via IPO and privately agreed upon transactions. Management retains some percentage to align interests.

Price changes are determined by the market. However, the actual cost value is changed by future financings. 5 companies raise another $50 million. 10 companies declare bankruptcy (initial investment of $3 million per, total loss of $30 million). Net value of the index increases $20 million, updated share cost value is $17. Share price will differ based on future expectations of financings.

Investment retain liquidity since shares can be actively traded. However, the underlying investments are still illiquid. Like venture capital, money is mostly made via exit. If Startup Indexes owns 25% of a company’s shares and that company is acquired, Startup Index gets 25% of the proceeds and allocates it to investors based on how much a person owns of the index. If a company IPOs, there needs to be a decision on whether those shares are sold or distributed back to the investors (likely sold). Allocations are again based on how much someone owns of the index.

The Obvious Problems

The management team needs to do ton of deals every 12-24 months to populate each vintage. Does that negatively impact selection? Once invested, can management truly remain active across so many investments? There are regulatory issues (though I believe this is do-able without any further action on the JOBS Act). But what level of disclosures is management required to make? There’s confidentiality issues for the underlying investments. There’s a size issue. This product may not be large enough to attract institutional attention for your 401K or pension. There’s the funding issue. Does management have to front the investment and hope people purchase it shares from them? If so, they have to do it for each vintage! But this is likely the tip of the iceberg.

Conclusion…

Besides looking at those financial products as inspiration, Startup Indexes isn’t very different from something like Y Combinator or TechStars. Investors put money in and get a small amount of equity in return. That just doesn’t scale or help non-accredited investors. I don’t know if startup investing can successfully scale, but this is one potential way.

Startup Indexes has issues. I still think it injects liquidity into the system and allows cost-effective diversification into startups as an asset class. At a minimum, it was a fun thought experiment, right?

Competitive intelligence in a mobile-centric environment

You’re working on a new idea. Would you like to know if your space is over-crowded? Or if there isn’t as much direct competition as you thought? Maybe seeing what your competition is up to would cause you to revisit your original hypotheses. Or worst, maybe someone’s already doing what you’re doing. Wouldn’t you like to know what’s going on in your space?

More broadly speaking, how do you keep up with everything that happens in your business category? How about “download each new app in that category and try them out every day?” In today’s mobile-centric world: yep, that works.

This is a powerful but easy idea. You better know your competition. Each competitor does something slightly different (UI/UX, features, focus, etc.). This downloading strategy isn’t about stealing or mimicking someone else’s business. It’s about learning. That learning takes time. You try 10’s or 100’s of apps and gain an intuitive feel for what works or what doesn’t. Don’t copy those businesses, but do get inspired by them. All the while, you can sort through the best ones and strive to understand them better.

Here’s a concrete way this helps you even if you’re beyond initial idea formation. An investor asks about your competitive landscape. Previously, you took a quick mental inventory or walked through a slide. Instead of telling her, now you can show. Bring out your mobile device, pull out the travel folder, show the 5 most competitive apps. What differentiates them from each other? What are they doing well? Why are you serving that space better? Talk about the other companies that you’ve watched fail, show you understand why and why you’re different. Impress her by showing.

Competitive intelligence is a crucial. Thanks to the iTunes App Store and various Android stores, you  now have a funnel directing information to you. You should be thinking mobile anyways. Start using this.

h/t Jack McCloy

The Commoditization/De-Commoditization Cycle

Wayne Gretzky and the NHLPA All-Stars (Photo credit: Wikipedia)

Over the past month or two I’ve been slightly obsessed over an Innovator’s Dilemma concept: the commoditization/de-commoditization cycle. The theory is simple but has profound implications.

Products and processes are constantly improving. When performance still isn’t good enough to meet the market’s needs, businesses invest in unique proprietary systems to improve performance. Once a product becomes “good enough,” those improvements lead to over-performance relative to market expectations. If they do this right, they should be making money. To continue improving their bottom line (and top) results, companies move away from proprietary designs into more modular plug and play designs. Instead of producing those components in house, they outsource it. Their competitors can do the same thing. The end result can be commoditization.

But here’s the interesting corollary. For the original company to continue product improvement, their modular components need to perform better. For the modular components to perform better, their manufacturers resort to proprietary systems and designs. In effect, it’s taken a component that can be described as a commodity and de-commoditized it. As they hit over-performance, the same cycle happens all over again.

Think about it. Every time something becomes commoditized, something else becomes de-commoditized. A high margin opportunity disappears, opening the door for high margin opportunities somewhere else. That’s powerful knowledge.

It isn’t just about products and processes. This is applicable to any innovator.

This post’s title is taken from Christensen’s second book, The Innovator’s Solution. It’s a paraphrase of the great Wayne Gretzky quote:

I skate to where the puck’s going to be, not where it’s been.

Take the advice. Invest your time and money thinking about where the money’s going to be, not where it already is.

note: this is a simplistic explanation. I heartily recommend the Innovator’s series for someone with serious interest.

A Little Inspiration Perhaps

I’m reading The Four Steps to the Epiphany by Steve Blank after many recommendations, the book that launched the Lean Startup revolution. I regret it’s taken me this long. I wanted to put forward the first three paragraphs from the preface. Read and enjoy.

“A legendary hero is usually the founder of something – the founder of a new age, the founder of a new religion, the founder of a new city, the founder of a new way of life. In order to found something new, one has to leave the old and go on a quest of the seed idea, a germinal idea that will have the potential of bringing forward that new thing” — Joseph Campbell, Hero with a Thousand Faces

Joseph Campbell popularized the notion of an archetypal journey that recurs in the mythologies and religions of cultures around the world. From Moses and the burning bush to Luke Skywalker meeting Obi wan Kenobi, the journey always begins with a hero who hears a calling to a quest. At the outset of the voyage, the path is unclear, and the end is not in sight. Each hero meets a unique set of obstacles, yet Campbell’s keen insight was that the outline of these stories was always the same. There were not a thousand different heroes, but one hero with a thousand faces.

The hero’s journey is an apt way to think of startups. All new companies and new products begin with an almost mythological vision – a hope of what could be, with a goal few others can see. It’s this bright and burning vision that differentiates the entrepreneur from big company CEOs and startups from existing businesses. Founding entrepreneurs are out to prove their vision and business are real and not some hallucination; to succeed they must abandon the status quo and strike out on what appears to be a new path, often shrouded in uncertainty. Obstacles, hardships and disaster lie ahead, and their journey to success tests more than financial resources. It tests their stamina, agility, and the limits of courage.

Awesome.