What does competition actually look like in the startup world? How can young businesses be competitive? And is our society’s relationship with competition healthy?
Peter Thiel — cofounder of PayPal, early investor in Facebook, and cofounder of Founders Fund — answered these questions and more during his lecture at Stanford University as part of Y Combinator president Sam Altman’s How to Start a Startup course.
(For more startup advice, check out How to Start a Startup: The Book. It’s the ultimate reference guide to creating a successful tech startup.)
Creating Value
Comparing the size of the airline industry to the size of the search industry, you would come to the conclusion that airlines are more important than search. But Thiel points out that the airline industry’s profit margins are significantly less than those of the search industry.
In the airline industry, the companies make money, go bankrupt, get recapitalized, and then that cycle repeats itself. This is reflected in the combined market capitalization of the airline industry, which is close to a quarter of Google‘s. So even though the search industry is much smaller than air travel, it’s actually more valuable.
So how do you go about creating value when you first start a business and what makes a company valuable? Thiel says you have to create something of value and capture some fraction of the value of what you’ve created.
Perfect competition
Perfect competition has pros and cons. Here’s a refresher of the definition of perfect competition according to Investopedia,
“A market structure in which the following five criteria are met:
- All firms sell an identical product.
- All firms are price takers — they cannot control the market price of their product.
- All firms have a relatively small market share.
- Buyers have complete information about the product being sold and the prices charged by each firm.
- The industry is characterized by freedom of entry and exit.”
Pros: Perfect competition is always easy to model and it’s efficient, especially in a world where things are static.
Cons: Perfect competition doesn’t make money when a lot of competition is involved. (Thiel touches on this later.)
Thiel sees the business world as a binary. On one end of the spectrum you have industries that are perfectly competitive, and at the other end of the spectrum are monopolies. The latter are stabler long-term businesses and they have more capital. And if you get a creative monopoly for inventing something new, it often means you’ve created something really valuable.
“There are exactly two kinds of businesses in this world,” Thiel says. “There are businesses that are perfectly competitive and there are businesses that are monopolies. There is shockingly little that is in between.”
The Lies We Tell
According to Thiel, monopolies tend to lie. They don’t want the government to regulate them, so they won’t call themselves a monopoly. What do they do to escape scrutiny? They pretend to have a lot of competition.
For example, Google has a 66% market share of the search industry. But you’ll never hear them describe themselves as a search engine anymore. Sometimes they call themselves an advertising company and sometimes they refer to themselves as a technology company.
There’s a good reason for this renaming. The technology market is valued at close to one trillion dollars. So Google’s narrative is that they’re competing with all the car companies with their self-driving cars, they’re competing with Apple on TVs and smartphones, they’re competing with Microsoft on office products, and they’re competing with Amazon on cloud services.
They’ve positioned themselves in the humongous technology market where there’s competition everywhere. That’s how they escape the threat of regulating their monopoly.
The companies on the other end of the spectrum, who exist in a highly competitive industry, are also tempted to lie because they know they won’t make any money.
They’ll say they’re doing something unique that is less competitive than it looks. They want to elevate themselves from the rest of the herd and attract capital. They do this to increase their perceived value, explains Thiel.
So a new restaurant that no one wants to invest in because restaurants are notoriously bad investments will be tempted to rebrand themselves. They’ll exclaim that they’re the only British food restaurant in Palo Alto. That’s too small of a market. But because of the way they talk about their place in the market, it seems like they have a monopoly on British food in Palo Alto.
In a world where monopolists pretend not to have monopolies and non-monopolies pretend to have monopolies, it seems like the difference between the two is very small. But in reality, the real difference is vast. These lies produce a distortion of the business world, says Thiel.
Look at the big tech companies: Apple, Google, Microsoft, and Amazon. They have just been building up cash for years, producing incredibly high profit margins.
Thiel says that the U.S. tech industry has been so successful financially because it’s prone to creating monopoly-like businesses. These companies accumulate so much cash that they don’t even know what to do with it beyond a certain point.
Go After Small Markets
If you’re a startup, you want to have a monopoly. Monopolies possess a large share of the market. But how do you get there? Thiel advises beginning with a really small market, taking over said market, and then expanding that market in concentric circles.
The biggest mistake you can make as a young startup is going after a giant market from the get-go. That signifies that you haven’t defined categories correctly. And you’re going to be dealing with too much competition in one way or another.
Amazon started with just a bookstore. Their selling point was that they had all the books in the world. And because it was online, there were things customers could do that they couldn’t do before. After they established themselves as a bookstore, they expanded into different types of ecommerce.
Your company needs to be unique. In Thiel’s words: “You don’t want to be the fourth online pet food company. You don’t want to be the tenth solar panel company.”
In the tech world, there’s this feeling that, in technology’s history, every moment happens only once.
“The next Mark Zuckerberg won’t build a social network and the next Larry Page won’t be building a search engine, and the next Bill Gates won’t be building an operating system. If you are copying these people, you are not learning from them,” Thiel says.
“All unhappy companies are alike because they failed to escape the essential sameness in competition,” Thiel adds.
Last Mover Advantage
You want technology whose magnitude is 10x better than the next best thing. Amazon had over 10 times as many books, but it wasn’t that high tech. Before PayPal, they were using checks to send money on Ebay, which took almost 10 days to clear. PayPal was almost 10 times faster.
But Thiel says that it’s not enough to have a monopoly for just a moment; you want a business that lasts over time. He disagrees with the notion espoused by Silicon Valley that you need to be the first mover to be successful in business.
Thiel cites tech giants to make his point: “Microsoft was the last operating system, at least for many decades. Google was the last search engine. Facebook will be valuable if it turns out to be the last of social networking sites.”
What solidifies his claim that you need to be the last mover is that “most of the value in these companies exists far in the future.” Thiel adds, “If you do a discounted cash flow analysis of the business, you’ll look at all these profit streams. You have a growth rate. The growth rate’s much higher that the discount rate. And so most of the value exists far in the future.”
When Thiel was at PayPal in 2001, their growth rate was about 100% per year. And they had been in business for a little over two years. They were discounting future cash flows by 30%, but in actuality, about three quarters of the value of the business as of 2001 came from cash flows in the years 2011 and beyond.
According to Thiel, you get similar results if you analyze Silicon Valley tech companies like Airbnb, Twitter, Facebook, and any emerging Internet companies. The math will tell you that 85% of the value is coming from cash flows in years 2024 and beyond. So he says we need to stop overvaluing growth and undervaluing durability.
Everybody wants to have a huge breakthrough in technology, a eureka moment. But unless your breakthrough is the final breakthrough, you won’t last. Thiel explains your only other option is to make a breakthrough and constantly improve on it at a pace with which no one can keep up.
In the 80s, your disk drive could have been better than everyone else’s and that would probably get you about two years of control of the market. But after those two years, another company would come and replace you. So in 15 years, disk drives improved exponentially, which was great for consumers. That was not so great for the people who started these companies.
In sum, you want to be the last mover. You need to think about who will be the leading company 10 to 20 years from now.
Who Gets Rewarded
Steam engines, railways, the telephone, refrigeration, household appliances, the computer revolution, aviation – there has been countless incredible technological progress in the past 300 years. There has also been a lot of innovation in the sciences as well.
But what many don’t realize is that the people who invent these products do not get rewarded for their inventions. The scientists never make any money.
Thiel says that they’re always deluded into thinking that they live in a just universe that will reward them for their work and for their inventions. He calls this the “fundamental delusion that scientists tend to suffer from in our society.”
And Thiel says the same thing happened in the technology industry where the people who made these innovations didn’t receive any value for their inventions.
The smartest physicist of the 20th century comes up with special and general relativity, yet he doesn’t get to be a billionaire. Railroads were valuable, but because there was too much competition, they went bankrupt.
Competition Is for “Losers”
Thiel questions the seemingly obscure rationalizations for why certain things work and others don’t. For science, the rationale is that the scientists aren’t interested in making money; instead they’re supposed to be doing the work for charitable reasons.
Thiel does not say that people should always be motivated by money but thinks we should be more critical of these rationalizations.
Software is seen as the most valuable thing in the world because so many people have made buckets of money in the industry. The logic is that, if people at Twitter make billions of dollars, then Twitter must be worth more than anything Einstein did. This type of rationalization is dangerous, according to Thiel.
“We think of losers as the people who are slow on the track team in high school or do a little less well on standardized tests and don’t get into the right schools,” Thiel says.
Losers are seen as people who can’t compete. Thiel want us to rethink and revalue this concept and consider the possibility that the competition itself is off.
“I think it’s more than just an intellectual blind spot, but also a psychological blind spot, where we find ourselves very attracted to competition, and in one form or another we find it reassuring if other people do things. And this is a very problematic thing that we need to always think through and try to overcome,” Thiel advises.
Competition is seen as a form of validation in our society. But when a large number of people are all trying to do the same thing, it borders on the ridiculous. Twenty thousand people move to Los Angeles each year in an attempt to become movie stars, and about 20 people make it. Thiel thinks that’s ludicrous.
He wants you to ask yourself the question: Does the tournament make sense as you keep going? Does the intensity of the competition really make sense in grad school or post doctoral education?
People compete ferociously to differentiate themselves. That’s often more imaginary than real, Thiel says.
When Thiel was in eighth grade, one of his friends wrote “I know you’re going to get into Stanford” in his yearbook. He attended Stanford Law School several years later. Then he ended up at a big New York law firm where, as he puts it, “from the outside everybody wanted to get in and on the inside everybody wanted to leave.”
He didn’t like this dynamic and left the firm after seven months and three days. His colleagues applauded him for leaving, even though to him it was a simple act.
“So much of people’s identities got wrapped up in winning these competitions that they somehow lost sight of what was important, what was valuable,” Thiel says.
Competition does make you better at whatever it is you’re doing; Thiel is not questioning that benefit. But what he’s concerned about is what often comes with it – “this tremendous price that you stop asking some bigger questions about what’s truly important and truly valuable.”
As Thiel concludes, “Don’t always go through the tiny little door that everyone’s trying to rush through, maybe go around the corner and go through the vast gate that nobody is taking.”
Next Steps
If you enjoyed this post, be sure to check out How to Start a Startup: The Book. It’s the ultimate reference guide to creating a successful tech startup.
Featured image was taken from the video of Peter Thiel’s lecture at Stanford.
