The Web and the World of Business

I've been thinking a lot about investment theses and their development and use over these last few months. As I observe some of the theses that I'm investing against now, I find that investment theses move through a cycle similar to Geoffrey Moore's Crossing the Chasm technology adoption life cycle model:

Source: Powerpoint-Templates on Slideshare

The earlier we develop a thesis, the further left on the graph we are. Thus, we truly are "Early Adopters" of this thesis because practically no one else has spotted yet, or very few. As we invest, we approach the chasm. This is where we find out if our thesis is right or not; if we are wrong, the thesis hits the chasm and falls to a brutal market death (taking our investment dollars along with it). Internet startups in this phase tackle the broad market since it is wide open with almost no competitors.

However if some of our investments start to do well, they gain market notice. Now other investors start jumping on the bandwagon. They too start to fund those startups which fit the thesis. Other (less imaginative) entrepreneurs start to see that startups got funded in a certain category before them, and they join in building startups too seeing that the investor community is beginning to favor these startups and raising money for them is easier. For internet startups, this begins the explosion of startups who start niche-ifying the early companies who tackled the broad market and try to do better by attacking a smaller segment more effectively than someone who is trying to satisfy the broad market. Series A investment rounds start populating the early startups who are still operating. This phase is the "Early Majority."

Now the early startups have survived and gained a lot of traction and are making money and/or generating excitement by their growing size. Later stage VCs start funding series B and beyond, infusing large amounts of growth capital to companies whose traction has largely been proven. Still, entrepreneurs begin companies that tackle the space; for internet startups, this means not only further niche-ifying but also additional feature development for those things we wish the giants would do but do not have time to build.

At the end of the cycle come the laggards. This can mean simply that there are those who believe that they can still find some startup that can survive the existence of heavy competition that can grow to great heights. It can also mean that the next phase is IPO, as the largest of the companies drive towards the public markets and the stock market takes hold, which usually means there is significant traction and revenue generated. But paradoxically, once companies become big, history has shown that they stop innovating and then it can be a great opportunity for new investment theses to develop in areas where opportunity was disappearing not too long ago.

When I applied this to the theses I had been using up until now, I realized that two of my theses were racing along the graph now. And that was when I also realized that one of my theses was quickly moving beyond us.

What do I mean by that? As an early stage investor, we need certain parameters to fall into place for us to execute a meaningful strategy in selecting investments. One of these is the fact that startups we select must have market conditions maximized for their success. In the case of one of my theses, and when I applied this chasm graph to it, I realized that the market had definitely jumped the chasm a year or so ago and we were racing up through Early Majority and into Late Majority. When this happens, it means that there is still a market opportunity but just that this opportunity is not as viable for us at early stage as it was before. Mostly, this is because companies who emerge in this thesis category require a ton of capital to survive the market dynamics of fast, easy competition and a consumer attention problem of enormous proportions. You essentially need a lot of capital simply to go out and buy users to accelerate the customer acquisition process or else your chances of surviving by utilizing free methods of acquisition are too slow. At early stage, we simply cannot do things to move the odds in our favor any more; these investments become the province of those with a lot more capital than us.

Can you guess which of my theses I refer to?

Developing investment theses has been a fascinating exercise for me. However, now that I had developed some, it is even more fascinating to watch how I apply them to my investment strategy, see them evolve through years (sometimes months now), and then go through the mental and emotional exercise of dropping them when they are not valid for us any more.

Richard White CEO of Uservoice posted a great read entitled Revenue could be fatal: 3 reasons your startup should consider waiting. Check out the comments and see a snapshot of the emotions that are stewing around the net right now (see more on Hacker News). All of this is on the heels of Instagram being purchased for $1 billion by Facebook. How is that fair? How can that be? A startup making no money being purchased for $1 billion! That sucks right?

I feel for you. Some of you are truly toiling away at a startup that makes real money. Some of you are trying to build "Instagram, the Sequel". Some of you get a lot of VC love and are showered with money while others can't get a dime. It's not fair, right?

Let's not forget investors. So many are quietly or noisily looking for the next Instagram now. Many are bemoaning the fact that they missed that investment and now they shift to go looking for the next one. Darn it, my previous investment strategy made perfect sense - how crazy is it to see that lucky set of investors make off like a bandit on a bullshit company that doesn't make any money!?! Life blows!

Well, here is some perspective. First, read this post, Mark Fletcher at Startup2Startup and the Evolution of Startup Business Strategy. It was at that Startup2Startup that I had that first AHA! moment about how the broader market can affect an entrepreneur's strategy on creating a company.

Then I met James Robinson at RRE Ventures who has been investing WAY LONGER than I have and through many market cycles. This prompted this post, Time Diversification: Strategy for Investors and it showed how important it was for investors to watch the market and adjust investing strategy accordingly.

So put the two together and you have a marketplace for startups and investors that can vary widely over the years.

It makes sense that you should just build a company with real revenue. In fact, in the hyper-risky world of startups, this is the conservative approach. Find a great idea, build it, make money, we all get rich. That works fine every time.

But the markets can be really nutty. There can appear times in the markets where it makes sense to build a company for other reasons, potentially not for revenue. As Mark Fletcher had noted, there were times in the past when it made sense to build for acquisition. Pre-2008 most of us were investing in startups whose goal was to get a million users before their money ran out and raise the series A; this seemed to be the norm amongst startups at that time. Thus, a bunch of my startups that raised money right before 2008 and whose money ran out in late 2008/early 2009 were sunk. The economic crisis of 2008 hit and it was nearly impossible to raise money unless you had revenue. A bunch of my startups died during those years which totally sucked. Now the markets have changed again.

As Instagram has shown, tremendous value has been created in a company that makes virtually no money but then became a threat to another company and thus got bought for an exorbitant amount of money. There have to be buyers with the appropriate resources and reasons, competitive conditions which drive those purchases to be made, and sometimes a lot of luck to be an employee or investor in the acquired company. Market conditions were right for this happen; they may have had this fact in mind, or maybe they just fell into it when Instagram took off.

Try this in 2008-09 and you probably would have failed to get funding. Could Instagram have survived through those few tough years? Maybe they could have; maybe they would have died.

So now I've been hearing word that investors are out looking for Instagram-ish investments. Doesn't make those companies raising money with real revenue feel any better when they don't fit the "momentum play" mold. I would, however, say that feeling hatred and jealousy is natural but it's time to let go and learn from this.

You need to watch the markets like a hawk. Like Mark Fletcher, he adjusted his startup building and fund raising strategy according to what the markets were like at that time. You go out and try to raise for one type of startup when the markets are looking for another type, right or wrong, and that means your chances of raising a round could actually be much less! (We pesky investors just love to follow the herd and be ultra-risky.) So much luck is bound in this business that the timing could just shift on you and you're dead in the water - or you just hit the jackpot by raising at a momentum level valuation.

For us investors, we need to also watch the macro conditions and decide how we're going to invest. Some investors will look at their strategies and available funds and go for what is hot now. Others will stick to their guns and be more conservative. Higher risk = higher potential return…or higher loss. Losing all your money in bad investments is bad enough when it's your own money; it's career ending when you lose your LPs' money. Or you could be one of the investors in Instagram and now you're a hero. Which one will you go for?

But for each of us, getting cranky, jealous and hateful isn't productive. For me, this is whole ecosystem is fascinating and why I enjoy being an investor. It is a huge challenge to me to play in this topsy-turvy, ever-shifting world. Will I be right? Will I make the right decisions? Or will I lose everything? How can I be smarter and better than everyone else? Will I be lucky? Have I created enough luck? By the way, these decisions I make today may not have results, good or bad, for months, maybe even years. Timing is nearly impossible. Never hating, always learning and improving.

The pace of change is incredibly fast now. Launch Capital's research into the megatrends revealed that the speed of these changes is only going get faster. It can be bewildering to think that investing in revenue generating startups was in vogue only 2-3 years ago and now people are chasing startups that have momentum in users, revenue or no. It could be mere months when the next big shift happens.

I, for one, am enjoying the ride on this rollercoaster and patting those on the back who manage to make money no matter what the market conditions are at that time.

Semil Shah (@semil) tweeted a response to my tweet about my post, Working on New Investment Theses:

@bznotes @dshen what if one's thesis is to simply find the most exceptional technical founding teams?

I thought I'd run this through some of the process described in that post and in my older post Predicting the Future: Research and Thesis Development. I will use YCombinator as an example, since they are the most visible supporters of this thesis (see disclaimer at end of post).

First, some from "Predicting the Future..":

1. Look at your own personal interests and areas of expertise.

Currently, the most vocal of proponents of this strategy is Ycombinator, who recently announced that they were going to accept founder teams that have no idea. Ycombinator has always looked for hacker credibility in its applicants, accepting only the cream of the crop from top schools all over the world. The Ycombinator group is also composed of hackers as well. Given their experience from a multitude of Ycombinator classes, they have seen that often times all it takes is hyper intelligence plus entrepreneurial traits that can yield a tremendous winner in a startup.

So it would be natural for them to take this leap.

2. What else is unique about you?

a. Do you have a flow of proprietary deals from some source(s)?

Of course YC does. Their brand attracts the best of the best of the best to apply each class.

b. Can you influence outcomes based on your experience, contacts, expertise, etc.?

YC now has amazing support from the community from other businesses, investors and their startup network. They also get amazing press coverage for whatever they do. They are universally respected for everything they say. If you are a startup that has gone through YC, it gives you a badge of honor that you can't get anywhere else. Investors travel great distances to view Demo Day and then pick the best of the best to invest in, no matter what the valuation. These factors give their startups an advantage in the marketplace over those who are not YC alums.

c. Where are you based?

YC was in Boston, then became bi-coastal, then decided to relocate permanently to the Bay area. Being in "entrepreneurism central" helps them in all their operations, and allows them to optimize them without worrying about missing startup resources in other locales.

d. Now, we move into lots of data...

YC has been doing this for 7 years now. There experience in doing this for so many years, through so many classes of startups has led them here.

Moving on to my latest post, here are some analyses from Working on New Investment Theses:

1. Is there a place where it makes sense for us to play? Do we have or have not expertise in that area?

Yes because YC is made of hackers and hackers is what they know best.

2. What about valuations?

This is one of the strongest advantages of YC - they give a low amount of money for a disproportionately large part of the startup. In the early days, this was appropriate for the risk - each YC startup used to start their project from nothing when their class began. Over the years, this has changed dramatically. Many startups coming to YC have been in operation for over a year and often with significant revenue. Still YC invests relatively low amounts of money and gets a big chunk of the company even at this stage; startups come to YC for the advantages of being associated with YC and are happy to pay that price for the value they receive.

The valuation that YC receives is one of its biggest strengths in getting outsized returns for capital deployed and thus makes sense at the riskiest stage of a startup.

3. What do others think?

YC has always had its bit of controversy. Other investors both applaud and ridicule this style of investing. In many ways, YC walks the world very much as an individual and does not march to any other tune. They hold to their convictions and also adapt quickly and nimbly when things need to change. So investing in founding teams with no idea has its detractors but if anyone can make it work, YC can with all their experience.

And as I mentioned in my post, we have discovered in our own portfolio that not following the herd has resulted in the startups doing the best.

4. What does the world need to look like in order for this area to start taking off?

To me, this goes along with my statement:

By socializing the opportunity to both investors and entrepreneurs, is it possible to literally bring the future to life by our own actions?

The credibility that YC has in the industry means that if they take a stand on something, many will simply follow or believe it to be true because YC said so and they trust their analyses. Therefore, even as that post from YC said they were simply trying this and didn't know if it would work, many now have taken this to be truth.

NOTE: Even before YC made this move, there are funds that have shouted the "founders first" mantra. However, I would contend that even though they say this, upon further examination of their startups, they still are picking even if one of their criteria is a rockstar founder team.

Calling out one point which is examining Specific Industry Trends from "Predicting the Future...":

Many things have happened since YC started back in 2005:

i. Development tools became more readily available and it became easier and easier to build high technology startups over time. Amazon's EC2 and AWS then made it so much easier to setup a server and backend and you didn't have to worry about that at early stage to test your concept.

ii. Educational materials got better. Credit Eric Ries and Steve Blank for creating startup manuals and methodologies like the Lean Startup and The Startup Owner's Manual.

iii. The economy went into the crapper. With interest rates near zero and volatility in the stock market going crazy, the only place that seemed to be making money was in startup investing. This meant that the marketplace filled up with eager investors, both large and small, searching for returns in the most riskiest asset class of all.

iv. With so many jobless, and hatred for big corporations at an all time high, and the few outsized returns generated by internet startups of today's internet boom, young people flock to startups and are encouraged to be entrepreneurs. Incubators flourish to help, universities all offer entrepreneurism programs and classes.

v. Celebrity status of both investors and entrepreneurs also drives subtly the urge to become either. Who doesn't want to be famous?

vi. The internet marketplace for startups becomes exponentially filled up with early stage startups. It's so easy to build one now, and there are tons of resources to help people start something. New investors coming to the market help fuel their creation and existence for at least a short amount of time, unless they become successful. Competition becomes ridiculous for most ideas and for each idea, you find many competitors.

vii. Consumers (and the beleaguered IT guy at a big company) are deluged by pokes, flirts, offers, friend requests, requests to join and play - our limited slices of attention are getting deluged by more and more of these interruptions and we can't keep up. Viral loops stop working. Growth gets harder and harder to get.

Given that the world looks like this for internet only startups, I find that there are still the class of investors who believe in this world which i call "true believers." These are the people who still think they can find the next Instagram or Facebook even in today's crowded world.

My contention is this - if you still believe that the internet is place to invest in, and you are a "true believer" and want to find the next Groupon or Zynga, then you have NO CHOICE BUT TO DO WHAT YC DOES - gather all the smart, talented people you can find and then invest in as many as you can, spending as little as possible to get as much % ownership of the company as you can. You have no idea if an idea will work because of market conditions; but there will be some that will even if you don't know which ones. But betting widely means you'll increase the odds that you'll find the next Groupon/Zynga and you need to reduce the chance that you missed one. Rumors say that YC has proven that even with their failure rate, they have gone positive in their return relative to capital that they have deployed.

All investment theses are highly situational - nothing works forever, and something that didn't work before can work again if market conditions change. Or can work for one person but totally impossible for another. And by the way, luck can confound the best of strategies.

As you think through some investment thesis you're thinking about investing against, can you muster up as many advantages as YC has, in investing in awesome technical teams without ideas? If you can't, you might want to think twice about investing against SOMEONE ELSE'S thesis...(yes you do get points for original thinking and for having the guts and conviction to bet against the crowd! Extra points for literally forcing the (your) future into being through your own efforts...)

As I talked about in my latest thesis post, it's all about swaying the odds in your favor. Unfortunately, they are still odds and no matter what you may still roll snake eyes and lose your shirt. Oh, and that other investor who started investing on a thesis you painstakingly built just become an investing genius because he found the startup that gave him 100X return and you passed on it...

DISCLAIMER: This post was written without any discussion with any YC member but only from outside observations as a friend to YC who has studied their growth and ascendance in the entrepreneurial and incubator community. I may be totally wrong in their thinking. If someone from YC reads this and tells me so, I will be happy to edit this post. But readers, please do take this analysis with this in mind.

Some of us at Launch Capital have been thinking hard about what areas to invest in next. For me these areas have been:

1. Ecommerce
2. Unsexy offline businesses that get the Internet thrown on top
3. Hardware+Software+Internet

But we are always on the look out for the next new areas. Following this post with my conversation with Mark Suster, Predicting the Future: Research and Thesis Development, we looked around the world and found some possible new areas.

With each of these possible areas, we then thought about:

Where is the real oppty? Is it in a single product? is it in the application of the product or service? Is it in the creation of the product? Is it in raw materials that create the product? is it in a business that faciliates product creation? Is it a financing biz that gives them away for free? Or can you make money on some other related way?

Is there a place where it makes sense for us to play? Do we have or have not expertise in that area? Do we care (see my latest blog post about learning new things: The Jack of Neverending Trades)?

What about valuations? Is that area a place where others have not pushed valuations past where we can participate?

What do others think? My managing director and I talked about this yesterday and he recounted that he found that the best investments are where the herd completely ditched them. I concur - many things we will look at will have the world totally against us. I think this is where the biggest opportunity is, which is to find stuff before others do, make the bet, and hope that we're right. Also we're going to be wrong - probably a lot. But this is early stage, the next closest thing to slot machine gambling….and we're trying to find that magic magnetic ring that pulls all the 7s to come up...

Are there like-minded investors? Should we reach out to them and see where there thoughts are? Try socializing the idea quietly at first. Do people think we're crazy or think that's the best idea in the world?

What does the world need to look like in order for this area to start taking off? To become mainstream? Is this achievable? Under what conditions is it achievable? How long would we estimate it will take? Are there any big market forces to watch - ie. any big corporations starting to make noise about it? Any futurists, bloggers, or journalists talking about it? Will the US governmentt pass legislation to juice this area (they have definitely juiced others)?

Are there any like minded entrepeneurs? Can we socialize with them? Figure out what they are working on? Use their creativity to seed ours?

Afterwards, we gather all this information and stew on it. Let our subconscious minds mull over it. Think about it in the shower (where i do my best thinking haha!). Let our creative minds pull together all the elements.

After doing all this, do these new areas still make sense from an investment thesis standpoint? If so, then it's onwards to quietly watch the world and see if investment opportunities come up. Perhaps we can even seed the market by quietly planting ideas. By socializing the opportunity to both investors and entrepreneurs, is it possible to literally bring the future to life by our own actions?

As an early stage investor, I find that this thesis work is really interesting. Given that we need to invest as early as possible into opportunities and trends, we take the most risk from all avenues. This is why I consider thesis development immensely important for us. By thinking about the future and developing visions for it, it is my belief that thesis development can help tip the odds in our favor that we'll find wildly successful ventures to invest in. Following the herd can also yield good results, but if I take all the possible variables (ie. our fund mathematics, industry trends, valuation trends, competitive trends, etc.) into account, I can only see that developing theses will make us better and smarter investors than the others who do not.

UPDATED:

Two other great recent posts to read on thinking about investment theses and the future:

What I’m Obsessed About At Work by Brad Feld

WIRED: How to Spot the Future

One of my favorite things about being a startup investor is learning about all sorts of new things. The first is about the investing business itself - I can safely say that I've only touched the tip of that iceberg for sure. The second thing I learned was much more broad.

Actually the second "thing" is really "things" plural.

As most people know, I invest typically in all things internet. I am fortunate that I worked at Yahoo! where we worked on a pretty broad swath of things, and I've had exposure to a multitude of products and services. As head of user experience and design, I oversaw a lot of it and learned a ton about a lot of things, becoming a jack of all trades of sorts. Even then, there were many things we didn't do. When I started investing, I found my broad exposure very valuable both to me as an investor, and also helpful to entrepreneurs as I could tell them all the good and dumb things we did at Yahoo! in those industries. But then, the internet filled up with the usual stuff.

Now I'm looking at stuff I know little about, or nothing about!

Some things I'll never get into - personal resonance is still very relevant and important. For others - there could be something there... it would also mean a lot of effort and time in learning about the business, industry, its customers, everything about it I can. Enough to be an expert maybe, certainly enough to be dangerous!

I get extreme joy when I learn about some area I know nothing about. I look stuff up in books and on the internet, I talk to experts, customers, advisors, and others in the industry. I may even visit places where the product is sold, or where the pain point is felt. My team's research department pulls up every shred of info on a subject and I devour it all.

Then, this is most exciting to me - making a monetary bet in that area in a company and knowing I made the right call if it exits. Unfortunately, the chance of a successful exit is pretty low at early stage but I am still left the knowledgeable I've gained which is satisfying and, I'm sure, will prove useful in the future.

There are many in my field who say to never invest in anything you know nothing about. I would say that is true, except that it leaves out the part about going out and learning about that thing that you knew nothing about. It is disheartening to see that many investors stop learning or become lazy and lean on others' expertise.

To me, becoming a jack of neverending trades is one of the best things about being a startup investor.

If you're an investor, have you ever gone through this:

You meet an entrepreneur and go over their startup idea. As he's talking, your mind starts racing ahead and imagining all the wonderful places this startup will grow to be. The entrepreneur continues his demo of the site, faithfully calling out how great his features are, and how the visual design is awesome. But you're only half listening; your brain is thinking about all the possibilities and how big this is going to get. You voice some of them; the entrepreneur nods and you see his nodding as "Yes I agree with this sage of an investor before me!" He continues onwards with his pitch, noting all the awesome features one by one but you're still thinking about the $100M opportunity. At the end, he asks for your measly $100K to join him on his journey, him working on his nice product, and you living out your version of his startup along with your awesome vision of where it will go. You sign on the dotted line, transfer the money, and you're on your way.

As he works on his coding and congratulates himself on his 100th user signup, you start chatting about how he's going to achieve your ideas and your vision. He nods sometimes, but slowly but surely he starts talking as if he doesn't have any idea what you're talking about. He's got a product to build, dang it! He's got 100 users who are emailing him and making him think he's the most awesome guy in the world! He needs to take care of them! You continue to talk about your vision, and he continues to move nowhere near where you're talking about.

After about a year of this, you realize that the entrepreneur isn't really listening to you. Instead, he's been giving you grinfucks; you thought that you were convincing him that there was a better way but in actuality, he's been thinking that his way was the only way, thank you very much.

In the end, your startup dies a miserable death. The entrepreneur got some awesome lean startup experience, and you (and your buddies too) have wasted $100K. He's off to raise money on his next big feature for the web, and you're still not recovered from a year of frustration that someone didn't listen to your investor awesomeness.

In my early years as an angel investor, I fell into this trap several times. And this trap has many elements to it.

It is sometimes indeed possible that you really do have some investor awesomeness - call it life and work experiences as well as experience in spotting opportunities as an investor in many startups. And sometimes you are probably right in thinking that an entrepreneur should take his startup in some direction or another. The trap you have to watch out for is investing into his startup when you imagine and do not have actual verification that he believes in the vision or direction in the same way you do.

This is not about whether he may be right in the end, or you may be wrong. Or even if the outcome is awesome despite either or both of you being right or wrong. What I'm talking about is thinking you're investing into a project of a certain nature when it's actually not - you're only wishing and imagining it to be something but it wasn't real.

In many ways, it's like meeting your perfect significant other, but that perfection is in your mind and you think he/she has the perfect traits for you, but in reality they are someone else and can never be that fantasy significant other for you.

A lot of this is about the fact that it is nearly impossible to transfer your idea to someone else. There can be many reasons for this. You and the other person simply have different viewpoints and experiences. When you say something, they may totally interpret that in a way that you didn't mean for them to interpret it. Or they may not even know what you're talking about. If you make a suggestion for a direction, it may be that, given your experiences and skills, you are the only one who can execute that direction and they may not be able to do it at all.

Today I was talking about this very thing with one of my entrepreneurs. Two weeks ago I pushed them on generating a big vision out of what they were working on. We went like this for several days. But they could only come up with something that I considered too likely to produce a small outcome for me to invest in. I sent them an email to that effect and then I went off on vacation.

However, we caught up today after I got back and spoke live about my email. I basically explained to him that I needed to hear that they were on board with some big vision. I had already come up with some possible big vision directions in my mind, but having some experience now I did not imagine them to also have the same visions; I wanted and NEEDED to hear them say it to have confidence that they understood and internalized whatever big vision there was, and were really on board to execute against that, versus what they presented to me two weeks ago. Given my desire for investing in big ideas with world dominating plans, I needed to hear them telling me the plan and not me telling them what the plan was.

To re-emphasize, this is not about who's right or who's wrong. It is entirely possible that in my investor awesomeness (in my own mind) that I am totally wrong on whatever vision I am imagining for a startup - and I've definitely been wrong many times. It's all about making sure that you have comfort in whatever you and the entrepreneur can see eye to eye on, or lack thereof, and then making the investment decision based on that reality and not just what's in your imagination.

My buddy Maneesh Arora asks:

Have you successfully been able to get pro-rata rights as an angel (assuming putting in small-ish amounts of money of $25k or $50k, something along those lines), on Convertible Note deals?

This was in response to my old post Taking Your Pro Rata as Angel Investing Strategy.

First, given that I'm at Launch Capital now and our investment sizes are $100K-$150K, we typically fall into the camp of auto-qualifying for pro rata rights in equity deals (many equity deals have a restriction that only "Major Investors" get pro rata rights, with a "Major Investor" being defined as someone who invests a minimum amount of money).

I looked back on the last few deals I have done, both equity and convertible notes. With respect to pro rata, I have found:

1. Most angels don't invest pro rata or they don't understand the effect of pro rata investing, so they don't speak up when the round doesn't give them pro rata rights for whatever reason.

2. Bigger funds tend to put limits on who gets pro rata and who does not on subsequent rounds. It would seem natural that they would want to keep as much ownership as possible, and future ownership rights too.

3. Smarter entrepreneurs will use pro rata rights to entice every investor to put in more money. But that does not help the angel who simply does not have enough resources to produce the minimum amount.

4. There are investor entities who are more friendly than others to angels in the round. They tend to give pro rata rights to everyone regardless of the investment amount, on the belief that we are all friendly, invest together often, are thankful of everyone's help, and want everyone to get the chance to participate in the upside.

5. Being useful, friendly, and present to the CEO increases your chance that you'll get pro rata rights. Or you may get the chance to put more money in subsequent rounds even if you don't have pro rata rights.

6. A more direct note to Maneesh's question: Convertible notes do not guarantee pro rata rights of any sort in the next round. Even if you put those terms in, rarely do those terms express themselves in the next round since they tend to be subject to the new investor's negotiations. I have rarely seen convertible note terms beyond interest rate accrual get honored. Even during acquisition, any kind of terms that award investors a multiple of the investment may not even get honored.

This is why Convertible Notes are not investor friendly at all, despite the fact that they are the dominant investment structure out there today.

So more money always talks, and smaller amounts don't give you much negotiating power, nor your pro rata rights, and this is why you must strive to move up the value chain as an investor, angel or otherwise. That can be hard if your resources aren't enough where you can come up with that much money.

HOWEVER, I still believe that if more angels spoke up, then potentially we would, as a group, have more ability to obtain pro rata rights for all involved and not just "Major Investors". This is worth going out to angels and getting them more educated on why pro rata investing is important and why they should ask for those rights and walk away when they don't get them.

Still, investing in your pro rata for as long as your resources can enable you to will allow you to maximize your portion of future success in a startup.

Last week I got my Lytro from pre-order in the mail and was excited to try it out in the field. I went to the California Academy of Sciences in SF to see what it could do.

About the Industrial Design

It fit well in the hand, although I was very scared of it slipping out and me dropping it. Since it is in a horizontal configuration, I wish it had a palm strap like camcorders do. The wrist strap was OK, but there was no way to tighten it on my wrist and I felt like it was swinging precariously as I walked around. Most of the time I just stuck it in my bag.

The magnetic cap in front was slick, but it kept falling off when I removed my camera from my bag. Couldn't they have figured out some way of doing a built-in iris protector or attached cap? I'm pretty sure I'm going to lose it at some time in the future. At least a screw on cap won't fall off, even if it is a pain to get off. Snap-ons might work but they aren't perfect either.

The on/off switch is a small depression the bottom of the unit. It was hard to find, but eventually I got the hang of just pressing generally where it was.

There was a zoom but I totally didn't know about it until I got home and read the instructions - who reads instructions right? This is a small row of dashes on the top of the unit. I suppose that could be better and more clearly labeled.

The button to take a picture was a small depression on top. I think I got the hang of where that was to take pictures.

The screen was too small in my opinion. You can press on it to refocus into some area, but the image was so small that you couldn't tell if the focus changed or not.

The UI in the camera was pretty simple. At least there are no fancy menus to confuse you. The point is to just shoot a lot and not worry about things, right?

Images

Reviewing images on the tiny screen sucked. So I downloaded them to take a look at home. Most of them were pretty good. Image quality is up there although it doesn't match up to my favorite camera, the Canon G12.

It even seemed to deal with low light fairly well. The lens seemed set at f/2, supposedly to minimize field of view and get you the nice blurred surroundings effect. Noise seemed very limited.

However, I did not really enjoy what I perceive to be the main cool feature of this camera, which was to be able to focus in on different parts of the image while other elements blurred out. After just shooting around, I only had one image out of the whole set which I could do this with, an image of some funky blue jellyfish:

Try clicking on some of the jellyfish, especially the ones in back. Very cool indeed!

So here is where my issues begin.

In order to see the coolness of the camera, I now have to think about the what is in the scene to make this feature come alive. I have to take pictures with things very close to me in the foreground, and then have things in multiple distances all the way into infinity. In that way, the blurriness is accentuated and I can pick around the image to see this happen. Most of the images I shot did not have this quality, and were good images but you can't really see any blurriness come out when you pick around the image.

This is what happened when I bought a 3D camera, the Fujifilm Finepix Real 3D camera. I had to also think about what I could shoot that would really highlight the 3D-ness of the resulting image. If I just shot some random shot, the 3D effect may not really be noticeable because the elements are too far away and everything still seems flat, which is arguably what you would see in reality.

This makes me think too much. I want the camera to do magic, not make me think about how to make magic. If I wanted to think (and I do with my Canon 60D) then I would just use my old cameras.

But I think we're in an era where we want cameras to take magical pictures, almost pictures of what we perceive, not what we actually see, or what physics says is out there in the scene.

Take high contrast scenes where there is brightly lit areas inserted in darkness for example. Most cameras fight to figure out how to expose such scenes. Bright light areas often are too bright if you try to expose more of dark areas. Or if you try to expose the bright light areas to get more detail there, then all of the darker areas go black.

However, we do not remember such scenes like that - our eyes are darting around and readjusting what we focus on, and our memories are of what is in the bright areas as well in the dark areas. Certainly there is artistry that results from high contrast images, taking the dark areas and making the mysterious silhouettes in the brighter areas. But sometimes, we want magic to happen. We want to see what is in the bright areas and more detail in the darker areas without having the bright areas wash out.

So I want magic and I want reality when I want them and don't want to think. I just want to shoot and see awesome results.

This is where I think smartphone cameras like on the iPhone are really the next wave of photography. I would meld Lytro with a image computer that can take both reality and imagined reality and then produce the result I want later with ease and not making me think about the technology. I just want to shoot and have magic come out the other end.

Lytro has some really cool things going for it. As a first iteration, it's pretty cool but I think I'm demanding more from cameras these days.

Today I just sent this email to a buddy of mine working on a startup:

If [competitor.com] was a physical store on a street and you wanted to build a store right next to them, what would you build? Would you build exactly the same store or would you do something different?

I always talk about so many me-too products and startups out there today, and the ease of building competitors to just about anything. But entrepreneurs don't seem to want to stop thinking they can exist and thrive with essentially a clone of something else out there.

My statement/question above is a problem about the internet. In the real world, if you were to build a store on a busy street, would you build exactly the same store? Probably not. You would see that if you wanted all those pedestrians to walk into your store, you'd want to build something with some kind of uniqueness to attract them, and rarely would you want to build the same business that already existed on the street. But on the internet, you can't see what's on your street so easily. The browser detaches ourselves from the brutal reality that your competition can be literally a virtual store or two down from you but yet you can't perceive it as a problem because it's virtual and not something physically experienced.

And this problem is exponential on the internet as the virtual street you're building on is limitless in available storefront. Imagine a street with a limited number of pedestrians but tens, if not hundreds of storefronts are squeezing all onto that street, creating ever smaller slices of storefronts for internet pedestrians to walk by, all screaming at them to come in and buy my stuff please!

So ask yourself again - do you want to be yet another storefront on an infinite street or do you want to build something that is truly unique to attract internet pedestrians away from all the same stuff?

"Makers are enthusiasts who hack and modify the world around them in interesting and whimsical ways. Tools and services that used to be inaccessible to all but large manufacturers are now available to everyone. Foreign factories that were impenetrable before are now an email away. Design software costing thousands of dollars per seat is freely available (or very cheap). Hackers are mixing all of these elements together and re-imagining entire industries from the ground up."

- Vinod Khosla, The Unhyped New Areas in Internet and Mobile, Techcrunch, February 19, 2012.

Vinod Khosla is right. The time is ripe for startups working on products combining hardware, software, and the internet.

Those who know me know that I have been tooting the HW+SW+Internet horn since early 2010. I hinted at it in my post Internet Startup Bubble and The Supposed Super Seed Crash back in July of 2010. But now, more than ever, the evidence is here that hardware is ready to make a comeback in startups. In fact, it already is.

But it's been hard talking about this for the last 2 years. I've met nothing but resistance from the investor community. Practically every VC I've talked to has told me that hardware is awful and that software and internet is much better as an investment. And for a long time, it's been true.

If you think about it, the last VC who was OK with investing in hardware startups entered into the VC business in 1994. After that, the internet came into being and from that point forward, every VC who didn't jump on the internet bandwagon missed one of the biggest opportunities to make a ton of money. (Of course, those that didn't jump off the bandwagon at the right time lost their shirts and more). Still, memories about the downsides of bubbles are short; those same VCs were heroes for the money they made and they continued to invest in the internet, and training hordes of emerging VCs along the way. This has continued for 17 years now. Think about it; 17 years of VCs whose thinking has been molded by the success of internet startups and investing in them. And also the advantages of not having to build physical product to get there.

I think the world has changed to the point where the previous advantages of internet/software startups has been declining, and the advantages of hardware startups are ascending.

For a long time, internet/software startups had a distinct advantage over hardware startups. You didn't have to use up money in paying for inventory of product. Digital products cost so much less and upon copying the bits digitally, the cost of the product declined over time as you sold more. Plus, the internet created distribution mechanisms that were hard to compete with; customers could be reached with extremely low cost and sold to with great ease. But that has changed:

1. Competition in internet/software startups is way too fierce. You start something and competitors pop-up all over the place. With all the easy ways to create software, it is extremely easy to build something that somebody else has built and do it fast.

2. Given the rise of competition and the fact that consumers, along with B2B customers, are deluged by these startups screaming for your attention and your money, the money that you would need to pay for hardware inventory is now money required by internet/software startups to buy traffic. This was not true not too many years ago; now the competitive world has changed - the battle for consumer mindshare AND the IT manager's mindshare in B2B customers has risen exponentially.

3. Some argue that distribution channels for hardware are limited. However, social, word of mouth, and viral mechanisms for internet/software startups do not work any more and you have to market traditionally to build awareness and brand. This more than equalizes the distribution channels for hardware. At least hardware is unique and not just another website product or service which gives hardware a leg up in customers' eyes simply because of uniqueness. Do we need another photosharing app?

4. Because it takes longer to gain mindshare in today's world, you must raise for longer runway - 18 months-24 months at least, which means more money is required in any case.

On the hardware side, advantages are emerging or here already:

1. Hardware technology is commoditized and cheap - what was previously rocket science is now readily available in chipsets to everyone. There is not much out there now that requires serious hardware design resources and custom chip fabrication resources. Advanced technologies of the past are now commonplace.

2. Contract manufacturing can make anything on contract - you don't need your own factories now. When I worked at Apple back in 1990-93, we had our own manufacturing both here in California and in Asia. I designed plastic parts and oversaw the construction of metal tooling to shoot the plastic. We had to build prototypes, test them and their manufacturability, and arrange our own staff to build everything. Now you can hand off all the manufacturing to contract manufacturers, whether here in the US or in Asia.

Because you do not have to setup factories and manufacturing yourself, you don't have to raise money to do so like in the past. You can raise the same amount of money as your typical internet/software startup and get product in boxes and on shelves.

3. In huge contrast to internet/software startups, there is *virtually no competition*. It is exceedingly rare that when I meet a hardware startup, that I can find another let alone two competitors! This gives hardware startups an unprecedented period of time where they can advance in the face of no competition and grow and learn.

Universities are graduating enormous numbers of software engineers and everyone is racing to internet/software. Hardware engineers, by comparison, don't exist in nearly as much quantity. In fact, opportunities for hardware engineers are so limited by a wide margin as these skills have moved offshore to Asia. Thus, nowhere near as many hardware startups appear versus the hordes of internet/software startups.

The barrier to entry is experience and knowledge of hardware. Most people fear it because they have never done it; it is natural to avoid that which is unknown.

4. We are now at the edge of what software can do by itself with respect to the physical world. Having humans type in information or self reporting data is just not practical and filled with potential errors. To do better, you need hardware to do the actual touching and sensing of the physical world and connecting that via software to the internet. An example is Quantified Self - self reporting of physical condition has reached its limits; we need 24/7 monitoring of physical condition to get to next level of knowledge, usage, and innovation.

5. Hardware has become small enough, low power enough to do amazing things for long periods of time. Huge possibilities open up due to low power, small size, and accessibility of the technology. Instead of wearing a huge box that is heavy and uncomfortable and needs to be recharged every few hours, we can wear small, unobtrusive sensors all day long, broadcasting vital information to the internet all day and night.

6. By selling hardware, you make money off every sale. By selling software services on top, you further monetize users far beyond the money made from the sale of the hardware. Due to the intense competition, internet/software startups often need to give away services for free which means survival until customers get to a point where they will pay for something you offer, whereas selling hardware means you make money each time you sell it. But then you offer a recurring, monetizable service on top of that to get more revenue.

This is why hardware+software+internet is the key, not just hardware alone.

7. Accelerator programs are now emerging to bring like-minded and experienced people together to enable better hardware product development. Thes are people like PCH International's accelerator program help new startups get off the ground and provide competitive advantage because the accelerator startups get access to PCH International's manufacturing capabilities. Other great accelerator programs are HAXLR8R, a combination China and Silicon Valley hardware accelerator, whose purpose is to spend some time in China to learn how to access and manage Asian manufacturing resources.

Other great hardware accelerators are Lemnos Labs, based in San Francisco, and the newly formed Bolt, to be based in Massachusetts.

The declining advantages of internet/software startups and the increasing advantages of hardware+software+internet startups make hardware the next big emerging opportunity.

The evidence is clear. Over the last two years, here is a list of fantastic startups, using hardware+software+internet:

Evoz - advanced baby monitors, analyzing baby cries with recorded data, and giving advice to new parents. [Disclosure: I'm an investor].

Fitbit - activity monitor and scale for better health and fitness.

Lark - silent alarm clock and personal sleep coach.

Zeo - your sleep manager.

Withings - WIFI enabled scale, blood pressure, baby monitoring.

Lumoback - back health and posture tracking.

Green Goose - making everyday things more playful with tiny wireless sensors that automatically measure what you do.

Leapset - a hardware POS play transforming the cash register for local merchants. [Disclosure: I'm an investor].

Metawatch - a platform for wrist based technology development.

Nest - the learning thermostat.

Elacarte - tablet based menu system for enhancing and optimizing ordering for restaurants. [Disclosure: I'm an investor].

And the list goes on. Still, I meet resistance on this issue.

17 years of entrenched thinking, and exploding economies to power profits and return on capital via internet/software startups make the opinion hard to change. And certainly what I argue doesn't apply to all hardware startups; for example, to build a new car business like Tesla would still require a ton of capital. However, for small, high technology, connected devices this is exceedingly true.

But that doesn't mean the VC community has to believe what I believe. If there is anything I've learned about investing, it's that the best returns are derived from not following the herd. This is definitely anti-herd, and I'll either be totally right or I'll be amazingly wrong - but if I'm right, I hope to be one of the first to ride the wave of this emerging class of startups to success.