Want to start a startup? Get funded by Y Combinator.

May 2005

(This essay is derived from a talk at the Berkeley CSUA.)

The three big powers on the Internet now are Yahoo, Google, and Microsoft. Average age of their founders: 24. So it is pretty well established now that grad students can start successful companies. And if grad students can do it, why not undergrads?

Like everything else in technology, the cost of starting a startup has decreased dramatically. Now it's so low that it has disappeared into the noise. The main cost of starting a Web-based startup is food and rent. Which means it doesn't cost much more to start a company than to be a total slacker. You can probably start a startup on ten thousand dollars of seed funding, if you're prepared to live on ramen.

The less it costs to start a company, the less you need the permission of investors to do it. So a lot of people will be able to start companies now who never could have before.

The most interesting subset may be those in their early twenties. I'm not so excited about founders who have everything investors want except intelligence, or everything except energy. The most promising group to be liberated by the new, lower threshold are those who have everything investors want except experience.

Market Rate

I once claimed that nerds were unpopular in secondary school mainly because they had better things to do than work full-time at being popular. Some said I was just telling people what they wanted to hear. Well, I'm now about to do that in a spectacular way: I think undergraduates are undervalued.

Or more precisely, I think few realize the huge spread in the value of 20 year olds. Some, it's true, are not very capable. But others are more capable than all but a handful of 30 year olds. [1]

Till now the problem has always been that it's difficult to pick them out. Every VC in the world, if they could go back in time, would try to invest in Microsoft. But which would have then? How many would have understood that this particular 19 year old was Bill Gates?

It's hard to judge the young because (a) they change rapidly, (b) there is great variation between them, and (c) they're individually inconsistent. That last one is a big problem. When you're young, you occasionally say and do stupid things even when you're smart. So if the algorithm is to filter out people who say stupid things, as many investors and employers unconsciously do, you're going to get a lot of false positives.

Most organizations who hire people right out of college are only aware of the average value of 22 year olds, which is not that high. And so the idea for most of the twentieth century was that everyone had to begin as a trainee in some entry-level job. Organizations realized there was a lot of variation in the incoming stream, but instead of pursuing this thought they tended to suppress it, in the belief that it was good for even the most promising kids to start at the bottom, so they didn't get swelled heads.

The most productive young people will always be undervalued by large organizations, because the young have no performance to measure yet, and any error in guessing their ability will tend toward the mean.

What's an especially productive 22 year old to do? One thing you can do is go over the heads of organizations, directly to the users. Any company that hires you is, economically, acting as a proxy for the customer. The rate at which they value you (though they may not consciously realize it) is an attempt to guess your value to the user. But there's a way to appeal their judgement. If you want, you can opt to be valued directly by users, by starting your own company.

The market is a lot more discerning than any employer. And it is completely non-discriminatory. On the Internet, nobody knows you're a dog. And more to the point, nobody knows you're 22. All users care about is whether your site or software gives them what they want. They don't care if the person behind it is a high school kid.

If you're really productive, why not make employers pay market rate for you? Why go work as an ordinary employee for a big company, when you could start a startup and make them buy it to get you?

When most people hear the word "startup," they think of the famous ones that have gone public. But most startups that succeed do it by getting bought. And usually the acquirer doesn't just want the technology, but the people who created it as well.

Often big companies buy startups before they're profitable. Obviously in such cases they're not after revenues. What they want is the development team and the software they've built so far. When a startup gets bought for 2 or 3 million six months in, it's really more of a hiring bonus than an acquisition.

I think this sort of thing will happen more and more, and that it will be better for everyone. It's obviously better for the people who start the startup, because they get a big chunk of money up front. But I think it will be better for the acquirers too. The central problem in big companies, and the main reason they're so much less productive than small companies, is the difficulty of valuing each person's work. Buying larval startups solves that problem for them: the acquirer doesn't pay till the developers have proven themselves. Acquirers are protected on the downside, but still get most of the upside.

Product Development

Buying startups also solves another problem afflicting big companies: they can't do product development. Big companies are good at extracting the value from existing products, but bad at creating new ones.

Why? It's worth studying this phenomenon in detail, because this is the raison d'etre of startups.

To start with, most big companies have some kind of turf to protect, and this tends to warp their development decisions. For example, Web-based applications are hot now, but within Microsoft there must be a lot of ambivalence about them, because the very idea of Web-based software threatens the desktop. So any Web-based application that Microsoft ends up with, will probably, like Hotmail, be something developed outside the company.

Another reason big companies are bad at developing new products is that the kind of people who do that tend not to have much power in big companies (unless they happen to be the CEO). Disruptive technologies are developed by disruptive people. And they either don't work for the big company, or have been outmaneuvered by yes-men and have comparatively little influence.

Big companies also lose because they usually only build one of each thing. When you only have one Web browser, you can't do anything really risky with it. If ten different startups design ten different Web browsers and you take the best, you'll probably get something better.

The more general version of this problem is that there are too many new ideas for companies to explore them all. There might be 500 startups right now who think they're making something Microsoft might buy. Even Microsoft probably couldn't manage 500 development projects in-house.

Big companies also don't pay people the right way. People developing a new product at a big company get paid roughly the same whether it succeeds or fails. People at a startup expect to get rich if the product succeeds, and get nothing if it fails. [2] So naturally the people at the startup work a lot harder.

The mere bigness of big companies is an obstacle. In startups, developers are often forced to talk directly to users, whether they want to or not, because there is no one else to do sales and support. It's painful doing sales, but you learn much more from trying to sell people something than reading what they said in focus groups.

And then of course, big companies are bad at product development because they're bad at everything. Everything happens slower in big companies than small ones, and product development is something that has to happen fast, because you have to go through a lot of iterations to get something good.

Trend

I think the trend of big companies buying startups will only accelerate. One of the biggest remaining obstacles is pride. Most companies, at least unconsciously, feel they ought to be able to develop stuff in house, and that buying startups is to some degree an admission of failure. And so, as people generally do with admissions of failure, they put it off for as long as possible. That makes the acquisition very expensive when it finally happens.

What companies should do is go out and discover startups when they're young, before VCs have puffed them up into something that costs hundreds of millions to acquire. Much of what VCs add, the acquirer doesn't need anyway.

Why don't acquirers try to predict the companies they're going to have to buy for hundreds of millions, and grab them early for a tenth or a twentieth of that? Because they can't predict the winners in advance? If they're only paying a twentieth as much, they only have to predict a twentieth as well. Surely they can manage that.

I think companies that acquire technology will gradually learn to go after earlier stage startups. They won't necessarily buy them outright. The solution may be some hybrid of investment and acquisition: for example, to buy a chunk of the company and get an option to buy the rest later.

When companies buy startups, they're effectively fusing recruiting and product development. And I think that's more efficient than doing the two separately, because you always get people who are really committed to what they're working on.

Plus this method yields teams of developers who already work well together. Any conflicts between them have been ironed out under the very hot iron of running a startup. By the time the acquirer gets them, they're finishing one another's sentences. That's valuable in software, because so many bugs occur at the boundaries between different people's code.

Investors

The increasing cheapness of starting a company doesn't just give hackers more power relative to employers. It also gives them more power relative to investors.

The conventional wisdom among VCs is that hackers shouldn't be allowed to run their own companies. The founders are supposed to accept MBAs as their bosses, and themselves take on some title like Chief Technical Officer. There may be cases where this is a good idea. But I think founders will increasingly be able to push back in the matter of control, because they just don't need the investors' money as much as they used to.

Startups are a comparatively new phenomenon. Fairchild Semiconductor is considered the first VC-backed startup, and they were founded in 1959, less than fifty years ago. Measured on the time scale of social change, what we have now is pre-beta. So we shouldn't assume the way startups work now is the way they have to work.

Fairchild needed a lot of money to get started. They had to build actual factories. What does the first round of venture funding for a Web-based startup get spent on today? More money can't get software written faster; it isn't needed for facilities, because those can now be quite cheap; all money can really buy you is sales and marketing. A sales force is worth something, I'll admit. But marketing is increasingly irrelevant. On the Internet, anything genuinely good will spread by word of mouth.

Investors' power comes from money. When startups need less money, investors have less power over them. So future founders may not have to accept new CEOs if they don't want them. The VCs will have to be dragged kicking and screaming down this road, but like many things people have to be dragged kicking and screaming toward, it may actually be good for them.

Google is a sign of the way things are going. As a condition of funding, their investors insisted they hire someone old and experienced as CEO. But from what I've heard the founders didn't just give in and take whoever the VCs wanted. They delayed for an entire year, and when they did finally take a CEO, they chose a guy with a PhD in computer science.

It sounds to me as if the founders are still the most powerful people in the company, and judging by Google's performance, their youth and inexperience doesn't seem to have hurt them. Indeed, I suspect Google has done better than they would have if the founders had given the VCs what they wanted, when they wanted it, and let some MBA take over as soon as they got their first round of funding.

I'm not claiming the business guys installed by VCs have no value. Certainly they have. But they don't need to become the founders' bosses, which is what that title CEO means. I predict that in the future the executives installed by VCs will increasingly be COOs rather than CEOs. The founders will run engineering directly, and the rest of the company through the COO.

The Open Cage

With both employers and investors, the balance of power is slowly shifting towards the young. And yet they seem the last to realize it. Only the most ambitious undergrads even consider starting their own company when they graduate. Most just want to get a job.

Maybe this is as it should be. Maybe if the idea of starting a startup is intimidating, you filter out the uncommitted. But I suspect the filter is set a little too high. I think there are people who could, if they tried, start successful startups, and who instead let themselves be swept into the intake ducts of big companies.

Have you ever noticed that when animals are let out of cages, they don't always realize at first that the door's open? Often they have to be poked with a stick to get them out. Something similar happened with blogs. People could have been publishing online in 1995, and yet blogging has only really taken off in the last couple years. In 1995 we thought only professional writers were entitled to publish their ideas, and that anyone else who did was a crank. Now publishing online is becoming so popular that everyone wants to do it, even print journalists. But blogging has not taken off recently because of any technical innovation; it just took eight years for everyone to realize the cage was open.

I think most undergrads don't realize yet that the economic cage is open. A lot have been told by their parents that the route to success is to get a good job. This was true when their parents were in college, but it's less true now. The route to success is to build something valuable, and you don't have to be working for an existing company to do that. Indeed, you can often do it better if you're not.

When I talk to undergrads, what surprises me most about them is how conservative they are. Not politically, of course. I mean they don't seem to want to take risks. This is a mistake, because the younger you are, the more risk you can take.

Risk

Risk and reward are always proportionate. For example, stocks are riskier than bonds, and over time always have greater returns. So why does anyone invest in bonds? The catch is that phrase "over time." Stocks will generate greater returns over thirty years, but they might lose value from year to year. So what you should invest in depends on how soon you need the money. If you're young, you should take the riskiest investments you can find.

All this talk about investing may seem very theoretical. Most undergrads probably have more debts than assets. They may feel they have nothing to invest. But that's not true: they have their time to invest, and the same rule about risk applies there. Your early twenties are exactly the time to take insane career risks.

The reason risk is always proportionate to reward is that market forces make it so. People will pay extra for stability. So if you choose stability-- by buying bonds, or by going to work for a big company-- it's going to cost you.

Riskier career moves pay better on average, because there is less demand for them. Extreme choices like starting a startup are so frightening that most people won't even try. So you don't end up having as much competition as you might expect, considering the prizes at stake.

The math is brutal. While perhaps 9 out of 10 startups fail, the one that succeeds will pay the founders more than 10 times what they would have made in an ordinary job. [3] That's the sense in which startups pay better "on average."

Remember that. If you start a startup, you'll probably fail. Most startups fail. It's the nature of the business. But it's not necessarily a mistake to try something that has a 90% chance of failing, if you can afford the risk. Failing at 40, when you have a family to support, could be serious. But if you fail at 22, so what? If you try to start a startup right out of college and it tanks, you'll end up at 23 broke and a lot smarter. Which, if you think about it, is roughly what you hope to get from a graduate program.

Even if your startup does tank, you won't harm your prospects with employers. To make sure I asked some friends who work for big companies. I asked managers at Yahoo, Google, Amazon, Cisco and Microsoft how they'd feel about two candidates, both 24, with equal ability, one who'd tried to start a startup that tanked, and another who'd spent the two years since college working as a developer at a big company. Every one responded that they'd prefer the guy who'd tried to start his own company. Zod Nazem, who's in charge of engineering at Yahoo, said:

I actually put more value on the guy with the failed startup. And you can quote me!