Evaluating $5bn+ startups with Peter Thiel's 7 questions

I'm a volume reader.

In a good year I would read 25~30 books. 99% of the books that I read are literature, philosophy, arts, economics and history. I seldom read business books but read a lot of news articles and reports daily, weekly and monthly. In other words, I treat business reading as a dynamic, constantly evolving habit and refuse to dwell on the so-called classics, such as Built to Last or The Long Tail.

I recently finished Peter Thiel's highly acclaimed Zero to One and I'm glad that I did. I would have ignored it like I ignored most other popular business books had it not been referred to me by two fellow classmates at HEC that I respect a lot. And I'm glad that I did. And in fact I find it less a business book but more a philosophical book that should go into everyone's bookshelf. It gives an inspiring, forward-looking angle that's nowhere available in any classical pedagogy, whether it's the deterministic tracks of various sciences and engineerings, or the purely random-walk finance and economics.

In addition to the highly lucid and inspiring philosophical thinkings, Peter Thiel did provide some very pragmatic guidelines to entrepreneurs and venture capitalists. Above all, he highlighted seven key questions that entrepreneurs should reflect on and the VCs should ponder over, I quoted here verbatim:

  1. The Engineering Question – Can you create breakthrough technology instead of incremental improvements?
  2. The Timing Question – Is now the right time to start your particular business?
  3. The Monopoly Question – Are you starting with a big share of a small market?
  4. The People Question – Do you have the right team?
  5. The Distribution Question – Do you have a way to not just create but deliver your product?
  6. The Durability Question – Will your market position be defensible 10 and 20 years into the future?
  7. The Secret Question – Have you identified a unique opportunity that others don’t see?

I strongly suggest anyone who cares enough to read my articles to get this book and read in full what Peter Thiel meant by the 7 questions, including the great demonstration where he used Tesla, founded by his fellow Paypal co-founder Elon Musk, as an example that nailed all 7 questions in early stage of its life.

Exercising yourself over the 7 questions, above anything, might help you realize that what you have at hand is actually not going to go exponential, but instead is gonna trudge through inevitable linear growths and end up nowhere.

Reality check is extremely important for entrepreneurs. Just because you've spent so much effort on a certain product or service doesn't mean you shall stick with it without any self examination. VCs get it wrong all the time and you don't necessarily have to listen to us – more VCs passed up Uber and Airbnb than not, I believe – but you can't shy away from asking yourself the most relevant sensitive questions and Peter Thiel's list of 7 is a very good starting point, if not at all end point.

As a demonstration, I would like to take the most highly valued private companies (startups) today and examine them against the 7 questions. Below is a list of all startups that currently have a valuation of over $5B (move your cursor over the interactive Google doc graph to see the exact numbers):

First, notice how valuations today are REALLY REALLY high for startups that seem to be going toward the right direction. VCs are pouring in hundreds of millions and even more than 1 billion into late rounds. All of the 9 startups are currently valued higher than the following public tech firms (market cap as of Oct 24th, 2014):

  • Yelp: $4.38B
  • Groupon: $4.05B
  • King: $3.57B
  • Zynga: $2.21B

They are also valued higher than some prominent acquisitions recently:

  • Nest: $3.2B (acquired by Google)
  • Oculus: $2B (acquired by Facebook)

Whether we're witnessing another bubble is not a subject here. The point is this is the first time in history that we're having tech startups at such high valuations before going public. Moreover, some of them were even funded by Private Equity groups, such as the growth fund branch of TPG (in Airbnb). Always finance-oriented, PEs only come into an investment when there's some visibility about future Free Cash Flows (FCF). In the case of TPG-Airbnb, we could infer that Airbnb is either already positive in operational cash flow or will see that coming in the nearest future.

The point is, we're looking at the startups that are highly valued by the professional private investors. And the later is supposed to have done lots of analyses before pouring in hundreds of millions of capital. It would therefore be an interesting exercise to see how these startups fare under the examination of Peter Thiel's 7 questions, which is what I'm gonna present here.

Note that whatever we talk about here, we already suffer from survivorship/hindsight bias – these late-stage startups already sort of made it and it should not be surprising that they nail most of the questions in their current states. However, you'd be surprised how such a hindsight analysis can still reveal something valuable to any entrepreneur wannabe.

So I hereby present the subjective analysis by the one-man committee – me, that is – on the nine $5B+ startups. Note that I skipped the People question since I don't personally know all those founding team members so I'm in no place to judge. But for the other questions I could form my opinion relatively easily. For the convenience of discussion, I also divided them into 4 main groups.

 

Group 1 – The sharing economy kings

Uber and Airbnb, the two highest valued startups, are both pioneers of the so-called sharing economy. This is probably not a coincidence as their business models run on the general public instead of on specific groups of consumers. This gives them the edge of a huge potential market and therefore fuels the imagination over valuations.

Note that neither appears to be especially high-technology — it does not seem to be that difficult to build another car hailing or apartment sharing platform. However, while Uber faces tons of competitors in every city that it operates in or trys to enter, Airbnb is somehow the only recognized brand in its market, and therefore a monopoly. We can probably quote Tolstoy on this:

All hailed cars (Uber) are the same; each shared apartment (Airbnb) is different in its own way.

In other words, Airbnb enjoyed the networking effect that Uber doesn't. Since each apartment is notably different, Airbnb's clients spend a considerable amount of time going through different items to pick one that suits them. Likewise, its suppliers (apartment owners) spend a considerable amount of time combing their listings. Given this built-in cost in both time and resources, once Airbnb became the dominant apartment sharing platform, the majority of supply and demand would go its way, much like what happened in the early days of eBay.

On the other hand, while Uber also has a chauffeur rating system, a high-end hailed car is just a high-end hailed car. It's fairly difficult to differentiate among them. A user routinely jumps from Uber to Lyft to whatever funnily-named hailing services in any random city. And it's apparently quite common that a driver has 4 or 5 iphones on his or her car, each for a different hailing service.

Both companies enjoy great native distribution – they almost don't need to do any advertisement as the benefits of the services are self-evident. Even their regulatory struggles brought wide press coverage – free PRs for better or worse. But do not forget that in the early days Airbnb hired professional photographers to take beautiful photos for high-potential apartments, while Uber until today still uses various incentive pacakges, including cash bonuses, to attract drivers in a new city. Both efforts, however, address the supply-side issue, while the demand side seems to take care of itself. This shows the power of solving a real pain point.

Timing-wise both are probably similar as the two came to define the term Sharing Economy. This is, of course, a bit of the survivorship bias but that probably doesn't matter here.

 

Group 2 – Hardcore tech-driven B2B or B2C services

For the hardcore tech nerds, this group is probably the closest to being heros for you as it is composed of the three most technology-oriented high-profile startups:

  • Palantir scores big with its high-end datatech, counting CIA and FBI as its clients with $1B annual revenue
  • Square is the unequivocal pioneer in solving the POS (point-of-sale) device problems for small businesses
  • Dropbox, fighting fiercely with its archrival Box, continues to be the synonym for on-line backup for regular users despite the fierce price undercutting by Google Drive

All three require highly-advanced and continuously-improving technologies, both in the main services itself and the security side. Any tech nerd would be proud to be working for any of them.

As of today, distribution also doesn't seem to be an issue for any of the three, although it's easy to imagine the hardship in early days for Palantir to win over data-analytic clients. On the other hand, both Square and Dropbox won over their users practically on word of mouth. Solving real pain points with good products always makes things much easier for distribution.

Palantir definitely holds up well in the secret question. And with both CIA and FBI on its client list, its image of holding an edge against its competitors would only self enhance. The fact that Dropbox is able to fend off fierce pricing from Google Drive shows that it knows something that we don't know as a user. Square definitely knows more than any of its copycats but with the advance of Apple Pay we have to be really cautious on its future.

 

Group 3 – The remaining private social-networking startups

Screen Shot 2014-10-26 at 9.17.23 PM.png

Everyday I struggle to consume all the info coming in from Facebook, Wechat, LINE, LinkedIn and Twitter. I really don't think there is much room on the market for more social networks – which means if you're starting a new one, it's better that you give up. That said, Snapchat and Pintrerest might be the last two social networks that would really matter, and therefore their high valuations at this moment.

Again, neither seems to require lots of advance technologies. Snapchat might have to stay a bit sharper given that its whole business relies on guaranteeing that their photos would not be stored in any place on the internet after the predefined time. Pinterest, on the other hand, probably only faces technical IT issues in scaling, much like the ones faced with Facebook in its expansion years.

Distrbution of both remains the best any startup can ask for: there's nothing more powerful than social networking when it comes to spreading your services out.

Snapchat seems to hold some secrets as all teenagers I've talked to – yes, I do talk to them just to stay in touch with the market – swore by its relevance and were not tempted by similar services offered by Facebook or Line. On the other hand, Pinterest's secret remains to be showcased in how they could really be the big-data marketing platform for fashion brands, home decors, or anything that's more visual than textual. For now, Pinterest has built a platform that's growing fast by itself and they could worry about the monetizing much later as the target market has a lot of real potential.

Both monopolize in their own respective market. However, I would personally give Pinterest more chance to sustain that monopoly (durability) than Snapchat. But that's just me and I could be very wrong of course.

 

Group 4 – The Chinese factor

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Arrrhh, China. In a country where the low end of GDP growth projection is 7%, anything is possible.

For those of you who are only Western-minded, JD.com is the fiercest rival of Alibaba – imagine if I had written this article a couple of months ago, I would have had to compare JD.com to Alibaba and then explain what Alibaba was as well – while Xiaomi has become practically the Apple of China.

Both can easily be accused of being copycats, but the Chinese factors are so strong that they're easily valued at over $5B – don't forget that Alibaba recently completed the largest IPO on NYSE, raising more than $20B in shining cash and its current market cap stands at a freaking $240B, which is way larger than Amazon ($132B) and eBay ($63.5B) combined – and Jerry Ma & Co. achieved all this without ever claiming to be more innovative than their Silicon Valley comparables.

That said, I have lots of respect for Xiaomi and I think most journalists and bloggers living only in the West had no idea what they're talking about when they bashed Xiaomi as a mere copycat. It's true that Xiaomi copies almost everything, from Apple to domestic startups. But if there ever is anyone besides Steve Jobs that is keen to build an Apple-style eco-system that will keep all its users up-close-and-personal, it would be easily be Jun Lei, the CEO of Xiaomi. It's hard for western consumers to understand, but Xiaomi has built in so many pain-point-solving services into its highly-speced smartphones that I feel it could really be the first major hardware company to achieve the dreamland of hardware-as-a-service (HaaS) – selling hardware at cost while making all the money back from bundled subscription services. And if they can really achieve that, even only in China, that would already have surpassed the wildest dream of Steve "The God" Jobs himself.

 

Final Words

What can we learn from this long exercise then?

Notice that only a few of the above-mentioned startups rely on technological advantages. Strictly speaking, only Palantir qualifies as really hardcore R&D-driven startups. However, note that even the technology-oriented startups score high on at least 3 or 4 other questions. What's my point here then?

Very simple: stop kidding yourself that just because you have a US patent (or worse, an EU patent) that you have an edge. It's execution on all fronts that matters. An edge in technology is only meaningful when the end products/services can find their way to the users and deliver the advantages brought forth by the technology.

Another key point, as Peter Thiel highlighted multiple times in his book, is that never underestimate the distribution question. Nothing sells by itself. Even word of mouth has to start somewhere, a sort of critical mass to be attained. Nobody will come just because you build it. And I've heard so many brilliant VCs using distribution as one of their screening criteria that I believe you risk not getting meaningful funding by not taking distribution seriously.

Timing is apparently very important. You can always be doing the right things at the wrong time. On the other hand, if you are at the right time (in the right place), you can succeed by doing the most obvious thing, like what JD.com has achieved.

And always strive to become the monopoly in your properly defined market. Peter Thiel spent a huge chunk of his book clarifying this so I won't repeat here. But don't ever go in with a mindset of grabbing a bite of a big market. In the real startup wars, winners always take all. You have to become the monopoly in a defined market, and expand beyond the market definition step-by-step from there.

Last but not the least, Zero to One only costs you $10.99 and I swear that it's better than many of the so-called entrepreneurship classes an MBA is so excited to take in a b-school. If you dream of creating your own billion-dollar business and you haven't yet read this book, do it now or I will kick your ass.

Period.

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