Nicholas Carroll
September 21, 1999

I wrote this to crystallize my own thoughts, shortly after helping some high tech startups with their business plans. Or was I just there to watch them crash and burn? Hard to say.

The rise of dot-com companies, with their accompanying hype, has led nearly the entire nascent Internet business sector to see hype as not just a business strategy, but the only business strategy.

That's a narrow, stock price viewpoint. High-tech industries like Internet stock brokerages, ticket sales, and auctions clearly have profit reasons for existing. Even if dot-com stock prices crash in flames, it is certain that some of these companies will survive a market crash, and go on to dominant or at least sustainable market positions, making real profits.

Others will not. Many of the failures will be due to bad luck or timing or partners, poor capitalization, or misinformation, or arrogance. These have always been threats to startups. In the high-tech world, the arrogance takes on an extra sheen of naiveté, with entrepreneurs believing that the gods of genius or science will help them.

Naiveté and even a measure of arrogance have their place in startups. Little new is accomplished without them. Likewise hype has its place in the high-tech sector. But ultimately, it is the gods of business that rule this land. And if there is a common thread to failure in high-tech startups, it is this: when it was time for sobriety, they taunted the gods of business.

This is about the hype business models, the real business models, and those businesses that straddle the two worlds. It is about the freedom that hype gives you from the gods' rules, the rules that constrain real businesses, and the punishment that falls on those who misunderstand their position.

Contents

Hype - A Land Forgotten By the Gods

     The Limits of Hype

Business, a Land Ruled by Gods Large and Small

     The God of Simple Arithmetic

     The God of Speed

     The God of Caution

     The God of Planning

     Nemesis, Tried and True

Balancing the Two Models

     Hype businesses that try to become real

     Real businesses that add hype

     Businesses that straddle the two worlds

Conclusion

In the Middle Ages, European seamen who returned home with tales of mermaids were likely to face an unpleasant questioning from the clergy, or even the inquisitor. Seamen who more boldly and piously stated that they had witnessed a miracle - in the form of a mermaid - were better received. They avoided the stake, and the smell of the miracle attached itself to them – an auspicious image for the ambitious entrepreneur.

Religion is not available to startups. The right to prescribe belongs to the big battalions, whether church or Microsoft.

Which leaves magic, where the rules of miracles are the same: promise big – like Amazon.com's initial claim of being able to provide 2.5 million different books. The claim was, in a word, absurd. Any of 10,000 people in North America could have told the reporters that is the number of books listed as being in print, not the number actually available. But the reporters didn't check the facts, and Amazon was off and running.

And Amazon is still running. There is a second part to the largesse granted miracles; once the miracle is established, no further proof is necessary. Print it in the New York Times, and most of the other newspapers will repeat it as gospel. The false 1972 oil crisis has thus moved into history, now unchallengable. Jobs and Wozniak invented the personal computer; never mind the Altair 8800. And so on. As was observed 2,000 years ago: the victors write the history. Or at least the media writes it for them. So Amazon was never questioned again.

Of course mermaids and 2.5 million books are miracles calculated to appeal to the unwashed masses. It wouldn't work with businesspeople.

Or wouldn't it? That hype should also work within commerce is reasonable enough, when you consider that most people who work in businesses are not businesspeople at all, in the sense of being able to run a business. They just happen to get a paycheck there. It could have as easily been education or government.

In either case, retail or business customers, hype businesses sell miracles to the ignorant, with a vast disdain for facts. One useless piece of software, or a license for ten thousand? No matter, if the customer's bottom line will absorb it. No matter, if the loss can't be tracked to the bungler. No matter, if the buyer's humiliation is never made public, or even self-admitted.

Such a business model can't easily survive catering to traditional real-world businesses like farming or steel manufacturing. The executives are too cautious about new ideas, and the margins are too tight for management to be indulging in major fantasy expenses.

This leaves not only consumers, but a whole slew of businesses ready to buy fantasies. Some are hype industries themselves, like law or advertising. Others are monopolies with artificially inflated margins, or new industries pricing products high on customer ignorance. With customers like these, a business (or pseudo-business) can potentially live on for many years on hype.

It is hard to believe the gods are unaware of this land. It is more likely that they are fully aware, and look on with cynicism.

The Limits of Hype

Charles Ponzi, the perfector of the pyramid scheme, had an even better miracle than Amazon, but was less careful with regulators. When he needed to be boarding a fast ship for South America, he was living it up in Boston.

Con artists of modest ambition are fleet of foot, and when they sense the game is up, they collect their gear and fly for safer climes. Most corporations don't have that luxury, and sooner or later may face up to an audit. At that point bankruptcy often looks preferable to a jail sentence.

Business, a Land Ruled by Gods Large and Small

This is one reason primitive animists pray to the small gods: they might listen. And one might observe that these small gods are the ones most often taunted by entrepreneurs...

The God of Simple Arithmetic

Just using a calculator, many old-timers can run circles around a rookie with a spreadsheet package. Or even using their heads; John D. Rockefeller once recounted how he had kept a business partner talking about tennis(?) for an extra half hour, so he had time to calculate the loan interest in his head.

Techies often think of business - particularly marketing - as "soft sciences." Indeed most of business is a soft science. Unfortunately it has hard consequences. Numbers are particularly ruthless. They permit, or they do not. They can be ignored for a time, of course, and many entrepreneurs choose that course. Eventually most of them will feel the edge of the sword. Even pure hype businesses can fall to the god of simple arithmetic; you can only run in the red for so long. Bankers will ask about the quick ratio. VCs talk about the burn rate. I just ask for the belly-up point - the day the business will go bankrupt if none of the plans bear fruit. However you calculate it, the day of reckoning is out there somewhere.

Wildly ignorant of profit margins or even office expenses, new entrepreneurs answer the accountants' questions with mindless statements like:

"We'll lower our prices!"
"We'll raise our prices!"

Watching some startups is reminiscent of the old business parable about the brothers who bought oranges in Florida for $12 a case, trucked them to Chicago, and resold them for $10 a case. After two weeks one brother turned to the other and said, "We can't make a living this way. We have to get a bigger truck."

(The humor of that parable faded for me after I actually witnessed one startup cut their product's profit margin to less than zero. They just didn't know the numbers.)

The God of Speed

The speed of the changing high-tech economy - which en masse is fairly high - should not be confused with the speed of the people driving it - which is not outstanding. The high-tech economy surges because of a confluence of social and economic forces. (And despite that, Moscow, 1996; the 1849 California gold rush; New York City profiteering during the American Civil War; or Constantinople, the week the crusaders sacked it - in any one of these, business was faster-paced than today's high-tech sector.)

In the here and now, commercial real estate – where deals are hammered out over lunch and closed after dinner – can certainly move far faster than the high-tech sector. While commercial real estate is not a template for successful high-tech ventures, it does teach one of the essential elements of effective speed: the ability to strip away what is not essential. Parking clauses? Vital. Bath fixtures? Forget it and cut the deal.

Stripping away the non-essential can leave an entrepreneur time for a second element of effective speed: punctuated equilibrium, as the evolutionary biologists call it. Alternating speeds. Or as a Chinese billionaire described it: "Wait long, then move fast." Wait – watch – hit hard. Think – then move.

This theory is rarely seen in high-tech. It's speed all the way! Once one ignores the 95% of high-tech businesses that fail, the success stories seem inevitable. Sleep in your cubicle and succeed! For the ones that do succeed, it sometimes seems about as hard as falling in water and coming up on a wave. Yet the speed is often illusory, the progress only imagined. To onlookers, it looks like everyone is running around the deck, but the ship is not moving.

The relative sloth of the high-tech sector, however, may be giving way to a harsher world. Intel has been artificially pushing Moore's Law, and now many observers are hoping for a breather, as etching lasers approach their resolution limits. Yet nanolasers are coming fast, and the limits of electric circuitry may be instantly eclipsed by faster and more compact laser switching - or even molecular switching. Hardware bankruptcies will follow.

Software may be going the same way, and the growth of Linux alone may spell the end to vaporware.

In mid-1998 computer industry writers were observing that Linux was hard to install. By January 1999 mainstream tech writers were complaining that it was too hard to install.

The writing was on the wall, and observers began predicting easier installation in 6-12 months, a timetable that must have suited the numerous Linux companies who geared up to make money installing the OS for new customers.

All were wrong. At the March LinuxWorld convention, Caldera demonstrated an alpha version of easy installation for Open Linux, and a small startup demonstrated an alpha program that could install Linux in eight minutes. The same observers began predicting quick installation in 8-12 weeks.

Wrong again. Seven weeks later Caldera started shipping their quick installer. Anyone making plans based on battles of the vaporware must have been sorely disappointed.

This type of scheduling turns software announcements upside-down. Where a company used to prematurely announce products to scare off competitors, we may be entering an atmosphere in which companies trick the media into believing a real product is vaporware, to make their competitors complacent.

The general concept is explained well in Sun Tzu's The Art of War; when slow, feign speed, when fast, pretend to be slow - just be sure the competitors misjudge you one way or the other. As observed, the first option may be disappearing in high-tech.

The God of Caution

One of the most common misperceptions about successful startups is that successful entrepreneurs are risk-takers. Actually, they take risks from necessity, because it comes with the territory. By personal inclination, successful entrepreneurs are risk-minimizers.

Startups show they have thoroughly misunderstood this when they start hanging inspirational posters bearing quotes from Hannibal or the SAS, such as "We will find a way or make a way," and "Who dares, wins." Determination has a place in all startups, daring in many. There is clearly more to it than that. The SAS puts in a lot of practice time, and Hannibal did not savage the Roman army for 20 years with a strategy of "Go for it, dude!"

When it comes to recklessness, Americans are not the worst. There are still cultures that actually seek out unnecessary risks. Eastern Europeans are particularly bad in this respect: "All the ducks lined up? Job too easy? ... Let's add some risk!"

Americans aren't quite that bad. They are not that much better, either. There is much truth in the Japanese criticism of American business strategy: "Ready! Fire! Aim!"

A more realistic balance is expressed by one of the minor Chinese monkey gods, "Be cautious, be bold." Properly balanced, the two work well hand-in-hand.

The God of Planning

• Not enough
• Too rigid

It is not really possible to overplan, unless the sheer time invested cripples action. It is very easy to be trapped by plans, or the planning process. Napoleon Bonaparte, one of history's most maniacal planners, built an empire in large part by anticipating every possible contingency. In this anticipation he also showed a huge respect for flexibility, once observing that "No battle plan survives contact with the enemy." Good project managers know the same thing, and expect to adapt to changing circumstances, tossing large chunks of their carefully-laid plans in the trash can.

Startups rarely perform like Bonaparte, or even a good project manager. Sloppy in their planning, they then lock on to a narrow plan as the only path to the holy IPO. (And that's the disciplined ones; the undisciplined ones just flit from notion to notion, not really planning at all.)

The rigid emphasis on following business plans, on the surface puzzling, flows from three sources:

Inexperience. Political campaigns, wars, neurosurgery, and bridge building teach the importance of planning. Endeavors with high stakes, complexity, high consequences. Few have this kind of background.

More inexperience. An experienced mountaineer can smell the wind, and say, "Something's wrong." First time up the mountain, you don't have much experience.

The third is the fears and lusts of lenders, who far too often are inexperienced as well. Bankers have a lot of experience with lending to businesses, but they are perpetual amateurs at running one. The same is often true for VCs, as they seek vicarious thrills through kibitzing the businesses they invest in. Understandable though the concerns are, they push startups toward rigidly following business plans, when it is a time for admitting setbacks and setting new strategies. (With an overly rigid business plan, Inktomi would still be a search engine company, instead of migrating into the data storage business, which now provides most of their revenue.)

While the gods do not necessarily set out to sabotage startups, they are relatively indifferent to human hopes and dreams. They change things for their own reasons. Planning can be useful even when it's not right on target, because when 100 contingencies are planned for, a business will be almost ready for the 101st exigency (if they are flexible enough to make the shift).

So though the god of planning is powerful, it is not all-powerful. It greatly rewards those who respect it. It shows utter contempt, eventually, to those who make it their only god.

Nemesis, Tried and True

Hype businesses that try to become real

In large part this is due to the character of the people who found hype businesses. The skills of the promoter are rarely the skills of business. They indulge in too much self-gratification, thus their thinking is usually too short.

Not long ago I closely observed a born huckster set up a "web farm," a.k.a. "Internet shopping mall," which sold minimalist web pages to companies that had no business on the Web, such as hair salons in Boise, Idaho. He raised a few million, hired staff, had logos designed, bought furniture, printed brochures, held meetings – and within two weeks was on the path to eventual bankruptcy, running in the red with no alternative plans to turn it around.

As a pure confidence game, collecting the money and running, he might have done well. His certain failure will not be due to the hype, but because he is stumbling outside the land of hype. While fully aware he is cooking the books to fool the investors, he has simultaneously developed a mad notion that he has a real business. Somehow - and this is a error common to business newbies - he has the idea that by pretending to be a business, he will be a business.

Regardless, the god of simple arithmetic is closing in. He has negative cash flow, and no stock to sell, so the only remaining source of income is the investors. Which will push him to expanding the investor base, and into a Ponzi game that can only have one of two ends: take the money and run, or go to jail. Not understanding what type of business model he has, it will be the latter. [Correction: when the feds finally closed him down this week, it was the Federal Trade Commission, not the Dept. of Justice. So he will escape jail.}

Other entrepreneurs see the future more clearly, and realize the limits of hype. This usually leaves them casting around for a working business model that can be grafted onto the hype operation.

Amazon is a business that has to date successfully danced along the edge of the precipice. The name Amazon and the claim of being the world's biggest bookstore were bold stuff. One might think their plan was a pseudo-business from the start. On the contrary: conversations with some of the earlier employees revealed that Amazon had every intention of being a real business from the start. They just didn't know the book industry.

Their first hurdle was that they couldn't get credit. Bookstores have great trouble getting credit from publishers, based on a long tradition of not paying their bills. Amazon partly solved this by offering to prepay, by sending checks immediately, and by offering their personal credit card numbers. Word got around, and publishers were soon giving them credit.

The second problem was – and remains – insurmountable: sourcing 2.5 million books (3 million claimed now). Amazon initially depended upon Northwest U.S. wholesalers like Ingram and Pacific Pipeline for quick sourcing. This gave them a product selection of perhaps 120,000 titles, which looked decent until one reflects that most Borders bookstores have that many titles or more. Unsurprisingly, Amazon would soon learn that in order to differentiate themselves, they needed not the first 100,000 books, but the second 100,000 - those books that were passably popular, but could not be found at a bricks and mortar superstore.

At that point they were forced to source from publishers. But Amazon had grossly underestimated the ineptitude of publishers, thinking they were dealing with predictable businesses like paperclip manufacturers or auto parts suppliers. Eventually they built their own distribution centers (so much for the savings of just-in-time supply), and now have immediate access to between 400,000 and 700,000 titles, depending on reports.

And they probably have internal reports quoting 90%+ fulfillment. This sounds good until one reflects that they lose money. A hotel losing money can't afford 90% occupancy; it needs 98%. Likewise Amazon needs 98% fulfillment. 100% fulfillment on $25 bestsellers at a 3% profit margin is not replacing the profits they are missing due to 0% fulfillment on $150 professional books at a 35% margin.

Amazon's problems largely stemmed from misinformation, hard to avoid in the book trade. They also suffered from an unexpected trend towards book discounting. Yet many of their problems were born of cockiness. And regardless of origins, they are a good model of the hype-to-business transition, for they pose the fundamental question: can this "business" be converted to something sustainable?

Maybe, maybe not. Many business empires have withered and died when their business model stopped working. Hype businesses don't even have a business model; they're still in search of one.

Real businesses that add hype

Amazon billed out $610 million in 1998. This looks good until you notice that boring little businesses like Mars candies had revenues of $14 billion. They made a profit, too. In 1998 AOL billed $2.6 billion. Meanwhile privately owned companies you never heard of - like agriculture supplier Cargill - billed $51 billion.

Numbers like $14 or $51 billion make you think hype is an obvious next step. Certainly a billion dollars will set your local banker to polishing your shoes, and makes media success seem a natural. In fact real businesses are usually baffled by the concept of hype. There is often something pathetic about their first efforts. They gamely try to hype by emphasizing reality. But how can a product that is merely "The Best Diesel Generator Made" compare with a competitor's product that is "Awesome Power!"? The answer is, it often can't. A hype-based sales model is different from a reality-based sales model.

These real-world companies often try to bridge the gap by hiring on more salespeople and buying more "creative" advertising. Sometimes they hire the right person, as legend says Apple did when they approached Regis McKenna.

Some will deny there is a distinction between hype and real businesses, quoting "there's no biz without showbiz." Yet there is a significant step, I believe, from adding a bit of show biz, to the grandiosity of high-tech hype.

Nevertheless some companies make the transition with skill, if perhaps lacking in grace. Online auction company eBay was faintly defensive about actually making a profit when they announced their IPO in Fall 1998. They knew there was a credibility gap to hurdle, if they were to be recognized as a true dot-com company.
(In fact, by Doonesbury comic strip standards they were considered losers:
     Daughter: "Daddy, do any Internet companies make a profit?"
     Doonesbury: "Only the wimps.")

Yet, according to reports, the profits allowed them to strike better deals with the bankers. And then, whether by accident or wisdom, they stood back and allowed the "dot-com" magic do its stuff, wafting their share price into the stratosphere.

More recently eBay bought the San Francisco-based Butterfield & Butterfield auction house. In an interesting bit of sleight-of-hand, or perhaps luck, the media gave this the full "dot-com makes acquisition!" story. Yet Butterfield is actually a real-world business that makes a profit, based on a business model hundreds of years old.

Perverse though this seems, one has to suspect eBay of being a real company that tricked the media and day traders into thinking it was a hype business. And trickery leads to the next business model, that of ...

Businesses that straddle the two worlds