Up & Right

I don’t know the folks at Synthetic Corp, the makers of the very popular Hipstamatic retro iPhone photo filter app, but I’ll tell you this—they came damn close. I want to analyze their situation for a moment.

Hipstamatic did almost everything right. They were first to market, launching in December 2009. Their product functioned perfectly. Hipstamatic had fantastic design from day one. On top of it all, they nailed the marketing by making it desirable, hip and giving it a backstory. Oh and they had a revenue model too selling the app and the in-app purchases for virtual lenses and film! (Imagine that—revenue!!!) Did I mention they won the coveted iPhone APP OF THE YEAR award in 2010 from Apple? From Apple! iPhone App of the Year!

Instagram, on the other hand, launched late coming out of Beta nearly a year after Hipstamatic in September 2010. In the world of mobile apps, a year is nearly an eternity. On the surface, many of the differences between the two products seemed somewhat subtle—both apps had retro iPhone photo filters, both had cutesy iOS hipster camera icons and both allowed you to share your photos to the outside world. Sure, Instagram was more social than Hipstamatic with the built-in photo feed and ability to follow users and “like” photos, but come on?! Another social network?! This is 2010! Who needs another social network?! You’re supposed to build everything on Facebook and Twitter these days, right?! 

Success is actually a pretty subtle phenomenon. You can do pretty much everything right, but not be the billion dollar company. The distance between Instagram & Hipstamatic or Dropbox & SugarSync is quantum: simultaneously pretty damn small and yet insurmountably large at the same time.

With 20/20 hindsight we can say that Instagram chose the winning strategy because photos are the killer social app and thus were really the first company to legitimately challenge Facebook. That made them easily worth just the ~1% of market cap pittance they were paid out even if that if that 1% translates into $1 billion. 

So what’s the lesson here? The lesson is simply: understand where your value comes from. At the end of the day the only real difference between Instagram and Hipstamatic was that Instagram knew that the value of a theoretical $1mm/year in revenue from a million users buying virtual lenses was less valuable than those same million users spending $0 but interacting socially and inviting millions more to eventually join them—they knew where the value would be created. Riskier? Hell yes. But it was also probably the only way to build the billion dollar company here. 

Note: None of this is meant at all as a criticism of Synthetic Corp in the least. Hipstamatic is fantastic. I was an early purchaser of their app and have no doubts they already have a large and interesting business and will continue to grow that business. 

“OMFG I just spilled hot coffee all over my hand.”

Every startup executive has to operate under the assumption that incoming employees have *no* working knowledge of what an employee stock option is or how it operates. Failing to abide by this simple rule can result in miscommunication, misaligned expectations and at worst executives taking advantage of employees. 

I’ve known more instances than I can count when a friend has applied for a job and asked if his/her proposed stock option grant is fair, stating only something such as “Is 30,000 options the right number for a Director level?” The prospective employee does not think or know to ask for the total share count of the company, the strike price, the post-money valuation on the last round of financing, if the company will require further financing that might be dilutive or even what grants comparable/senior/junior hires have received. Giving a compensation package with just an option grant total and no other supporting information is dishonest because we must assume employees do not understand stock options. 

And that’s only the beginning—literally. Then there’s the whole issue of employees leaving a startup. This can be equally problematic. I know of many instances of employees not understanding what either “vesting” or “exercising” mean, not exercising in the allowed time and startups failing to notify that options are about to expire.

I think the solution is straightforward. (And, yes, some startups are great about this already but a surprising percentage are not.) Presume no knowledge of options on behalf of hires and create a very basic script that you walk each employee through when they are hired and depart. Be explicit. Use examples. For instance, “This grant means that if the company were to be acquired for $100mm cash…” and go through the detail on what they would have to pay to exercise and what the tax effects might be. I’d probably want to do this for a range of exit valuations both very low and high. I’d also make sure that during exit interviews employees understand in no uncertain terms what the fate of their options will be, both their vested and unvested shares. Once again, even though the person might have been an employee for many years, I’d presume no knowledge of options. Once they leave the building, I think it is also appropriate for startups to give a final notice before vested options expire.

Most of this seems like common sense but I’ve seen it screwed up far too often.

Founders, especially first-time founders, can be prone to viewing the very concept of a Board of Directors as a necessary evil. However, a good Board can be a powerful and important tool for ensuring  a company doesn’t lose touch with the rest of the world.

The heart of the RIM debacle contains an important lesson for startups—the power of perspective. When you love your baby and have been raising it for years, you never want anyone to call it ugly. Founders and executives can behave in much the same way. In fact, this instinct is natural. This is one of the primary reasons corporations have Boards of Directors. When you’re very close to something, it is exceedingly difficult to be objective. The ideal director is engaged enough to understand the ins and outs of the business but is not so involved they lose perspective and objectivity. Independent directors are added to Boards because they have neither managerial nor (significant) financial interests in the company.

We all sit back in amazement at the ship wreck that is Research in Motion, makers of Blackberry. We wonder, “Shouldn’t they have known four years ago they needed to change course?” And “If not four years ago, shouldn’t they have screamed a collective ‘O shit!’ at least a year ago? Why now? Why did it take this long?”

Unfortunately, RIM is no outlier. At large companies and startups alike the Insiders only notice the ship is sinking moments from touching bottom. Yet casual Outsiders are quite lucidly able to see the gaping holes in the ship’s hull. Case in point, RIM announced today they will be giving up the consumer market and instead refocusing on the enterprise. As a casual observer, a year ago I wrote that RIM should give up on consumer and focus on the enterprise. (l aso proposed some additional measures I am sure they won’t get around to for another year.)

Even without having spent a single day in Waterloo, Canada I can say it was clearly a breakdown of RIM’s Board’s objectivity that led them to the unenviable position they are in today. A tough and objective Board with the right balance of power would have seen the issues for what they were. 

When my colleague Jim Robinson III bought First Data Corp while he was at American Express in 1980 for about $80 million it was probably pretty hard to imagine the company growing to become a $30 billion enterprise even if you were Jim.

As it turns out, payments can be a pretty big business. The question I hear today is just how big can Square become? Is Square, the next $50+ billion tech startup? RRE is not an investor in Square so below I give my personal and unbiased opinion. 

Square is in an exceptionally good place. What place are they in? A terribly complicated, fragmented one full of legacy players that compete tooth and nail on price alone. Traditional wisdom says, “Sure Square is cute, but the payments industry is about two things: price and price. Eventually Square will lose.” 

Funny thing is I remember many people, myself included, saying that was why Dell would win and Apple would lose in the in the late 1990s. Why? Computing is a price-sensitive, fragmented business with a complex supply chain that is all about efficiency and trying to price your suppliers out of business to deliver your customers “the only thing they want”—a cheap beige box. Hmmmm…sounds a lot like how most people describe payments today.

Apple has always been guided by one core insight: vertically integrated technology ecosystems offer certain advantages over complex, open ecosystems (there are trade-offs either way to be sure, but it is often optimal for customers to be able to choose between the two). Apple released the iPod in 2001, a little white plastic Trojan Horse, that ultimately sucked seemingly every US consumer into their ecosystem over the course of a decade. 

Square also has a little white plastic Trojan Horse. It is primarily drawing in individual proprietors and small businesses today but is also beginning a broader push. Today Square is exemplified by a mag-stripe reader but a decade from now perhaps it will have a full product line of merchant-side hardware. But what is Square really drawing us into? 

Witness Square Register, point-of-sale (POS) software for merchants by Square. But it’s not just OK—it is beautiful and intuitive (Cashiers can use it without training) and only requires an iPad for $400 not ridiculous bespoke hardware that costs in the tens of thousands of dollars to deploy. If you think Square Register is the last of Square’s merchant-side software ambitions, you’re mistaken. 

Then there’s Square Card Case, Square’s digital wallet for Consumers. This little app doesn’t just let you fund your purchases by entering your credit card info, it also uses proximity to obviate the need for a tap or swipe. But in the long run does Square even need you to fund via credit card? Couldn’t they pull the money via ACH directly from your bank account? Perhaps. There are lots of questions still to be answered around fraud, consumer addiction to rewards points (which are funded by the merchant discount rate) and the incentives of the banks in allowing real-time ACH. But then again, there were lots of questions left TBD when Apple launched iTunes without a digital music store, but Apple found a way in an industry that was too fragmented and conflicted to innovate on its own.

Looking back, Square already has its sights set on merchant hardware, merchant acquisition/processing, merchant software and the consumer wallet. That’s a pretty full stack. What does it leave untouched? Consumer and merchant banking, as well as some of the deeper and intermediary pieces of processing. I think if we look at Square’s business plan multiple years out it will grow to include banking for both consumers and merchants as well as the full processing stack. Why not? When you control the stack you have the power to make changes that were previously impossible. 

Where could all this go wrong? Oh, a ton of places. Too many for this post, but most importantly on distribution and friction. The payments industry has a very broad and far-reaching distribution network that touches every small merchant in the nation. Reaching merchants is incredibly hard and expensive. It has been the focus of the industry to date and the secret weapon it has been able to wield against all possible competition. But  genuinely useable and compelling products have a way of selling themselves and creating powerful word-of-mouth effects.

It goes something like this…Square gets adopted in the local hardware store and a customer goes to pay and has to sign with his/her finger and notices the beautiful software on the iPad. That customer happens to own the bakeshop in town and then decides to try Square at his/her shop too. But what if the bakeshop owner has a relationship with Chase for all their banking and thus uses them as their acquiring bank and doesn’t want to swtich to Square for processing? Ah ha! Friction! Square will fail after all! Not so fast. Remember how Apple would never succeed because of all the friction associated with switching from a PC to a Mac? Reducing friction is absolutely possible—especially if we imagine Square becoming a full-service bank that happens to offer a suite of services that are extremely compelling and work extraordinarily well with each other (think iPod to iTunes to Mac).

So can Square become a $50+ billion business? I believe the answer is that they can. They are in the right position and appear to have the right strategy. Now all that’s left to do is that little thing called execution that separates the Facebooks from the Friendsters.

According to this post on Priceonomics, when you factor in resale value and compare—an iPhone will set you back $13.20/month after 18 months and Android will cost 40% more. (Of course what model you choose and your particular carrier and cell phone plan affect the total bottom line.) Amazing how making a great product—even when making it with higher initial COGS—can actually yield a more cost effective product.

Not everyone looks at TCO especially at first (it’s a pretty complicated concept for a consumer) but many people eventually intuitively understand it even if they don’t have the exact numbers when they are considering buy their second or third product and selling their original. Automobiles are a great example of this. Customer retention rates have traditionally been higher for better than average TCO brands such as Toyota than worse than average brands such as GMC. 

Source: Priceonomics