Understand the Mature Ecosystem of Silicon Valley

This is the Chapter 2 of my e-book Silicon Valley for Foreigners, that can be downloaded for free on www.siliconvalleybook.com or purchased for $2.99 on the iBookStore and Kindle. A new chapter will be posted on this blog every week.

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The term Silicon Valley originally referred to large numbers of silicon chip innovators and manufacturers of the Santa Clara Valley in the 1950s and 1960s, but eventually came to refer to all high-tech businesses located in the San Francisco Bay Area where 7 million people call home.

In this chapter, my focus is to dissect Silicon Valley’s six main players:

1. Startups; 2. Large tech companies; 3. Investors; 4. Accelerators; 5. Universities; 6. Co-working spaces.

Understanding what they are, how they work, and the many ways they interact is extremely important to grasp the culture that makes Silicon Valley unique.

The Bay Area ecosystem may be compared to an orchestra where each player is equivalent to a musical ensemble. If any of them fails, the musicality of the whole orchestra is compromised.

1. Startups

Startups are newborn companies founded by ambitious entrepreneurs with just an idea in their minds. They are, by far, the most important player in the Valley ecosystem. Startups can either be defined as a bunch of guys in their rooms or powerful consolidated companies such as Airbnb or Uber.

It is not an easy task to understand what a startup is in the eyes of the local community in the Valley. Ask ten different people and you will get ten different definitions.

To be sure we are on the same page throughout this book, I will lay out my own definition. To be considered as startups in Silicon Valley they must have all the following characteristics.

A startup must be scalable

Contrary to other regions in the world, Silicon Valley does not consider small entities such as law firms, a family owned restaurant or a consultancy firm as startups. These companies are called lifestyle businesses because they may be perfect to attain a comfortable lifestyle without ever being scalable.

For instance, if you founded a company with an amazing team of five attorneys and consultants that are the best in town, and have a hundred clients per year, you would need basically to clone the original team to 50 thousand to reach a million clients. That takes time, it is very expensive, and probably cannot be replicated in other jurisdictions or countries consistently.

To transform a business such as a law or a consultancy firm into a scalable enterprise, you would need to automate the simplest and most repeatable processes through software and focus your business solely on them. That is exactly what companies like Clerky (automation of standard legal documents) or Rocket Lawyer (initial legal advice) did. You cannot have it all.

When analyzing technology startups, the immediate conclusion is that scalability must be built into the business at the moment of conception. The reason is simple; it takes a long time to make money in tech, and any startup must reach millions or even billions of customers in a few years to dominate a category and be economically viable.

WhatsApp, founded in 2009, is a great example of scalability done right. It started with a small, unpretentious founding team and a basic app to replace SMS in emerging countries. Four years later it had 200 million active users without any marketing dollar spent. Due to network effects, the app reached 1.2 billion active users by January 2017 and became the incontestable category leader even after bleeding cash for so many years. It is just a matter of time until WhatsApp starts making a lot of money like its cousin Instagram.

Uber, founded in 2009, is another great case in scalability. The startup operates in more than 80 countries and six hundred cities around the world as of May 2017. The company was able to grow so fast due to the influx of more than $16 billion dollars in venture capital to finance its expansion and subsidize its fares.

By July of 2016, Uber completed 2 billion rides without ever owning a car fleet. That is the main reason for Uber’s humongous valuation of $69 billion. Meanwhile, Sidecar, which raised $35 million dollars to operate in ten cities, and was the former third largest transportation network company in the United States, closed its doors in 2016.

In tech, usually the winner takes it all and scalability is key to dominating a market and destroying the competition in the long term. The strategy can be proven by the success of leaders in their respective industries such as Amazon, Netflix, Google, and Facebook. There is space for maybe two or three competitors in each digital category.

It may sound counterintuitive that tech startups need to lose money in the short term in order to stay in business in the long term. But the unabashed success attained by the west coast tech giants is incontestable proof that scalability works.

In May of 2017, the market capitalization of Amazon, Apple, Facebook, Microsoft, and Alphabet (the holding that owns Google) reached $2.6 trillion, making them the most valuable companies in the world and worth more than all the companies listed on the stock exchanges of Brazil, South Korea, and Russia combined. In 2016, the five tech giants had $600 billion in the bank with combined profits of a hundred billion dollars.

A startup must have a repeatable business model

In the digital realm, it becomes much easier for customers to dump your product. On a smartphone, just press home and download another app; on a computer, enter a new address or a search term on Google. In seconds, the product you have been working so hard to launch might go to the trash bin.

For those reasons, tech entrepreneurs must focus on having an engaging product where customers come back, potentially, every day. The more customers use your product, the easier it becomes to monetize. Brands do not mean much if there is no loyalty. Achieving business model repeatability on an app or site is only possible if there are high rates of engagement and retention.

Instagram is a prime example of a startup that has super loyal users (700 million of them). Its goal has always been on building a great product that people use frequently. The startup, which has not made any money in the first years of operation, has recently figured out a repeatable business model (advertising) that is working really well. Instagram is poised to make more than $3 billion in 2017.

Uber and Airbnb have also been able to attract engaged users and, therefore, they have achieved business model repeatability. The more expensive ticket per transaction has allowed both startups to maintain a viable business model even if their customers return weekly or monthly. The lifetime value for the average Uber or Airbnb customer is probably in the hundreds of dollars.

Business model repeatability is fundamental for a sustainable long-term strategy. When startups achieve this milestone, they begin to grow revenues exponentially and, in a few years, usually cease to be startups to become publicly traded companies such as Google. The former startup, which made only $400 million fifteen years ago, continue to surprise investors and, in 2016, surpassed $90 billion in revenue with high profit margins.

A startup must have a clear value proposition

Simplicity is key to achieve both scalability and repeatability, hallmarks of a successful product from a Silicon Valley startup. Simplicity equals to a clear value proposition to customers and a very user-friendly experience. The more a startup captures an existing trend or habit and makes it easier, faster or better, the more successful it becomes.

Again, Instagram comes to mind. Since the 19th century, people have been taking pictures and sharing them with family and friends. However, until recently, it was still very difficult, expensive, and time-consuming for an average person to take good pictures and conveniently share them.

The situation changed completely with the popularization of smartphones starting in 2008. Instagram, launched in 2010, captured the moment in a timely manner. It enabled anyone to take beautiful pictures on their phones and share them easily and quickly. There was no need to explain what the app did, everyone understood its value proposition.

The same can be said about Facebook and WhatsApp, products that have a very clear value proposition of connecting people. Or Google, which is an oracle for curiosity, research, and where all the human knowledge can be accessed for free.

Simplicity leads to high engagement and, therefore, to a sustainable and repeatable business model that is able to transform tiny startups into the most influential and valuable companies in the world.

2. Large companies

Large tech companies founded in Silicon Valley such as Apple, Google, Facebook, HP, Intel, NVidia, Oracle, Netflix, and Salesforce were once startups. As of May 2017, their combined market capitalization was superior to 2.5 trillion dollars.

On their journey from tiny startups to large companies, today’s tech giants became aware that they too could be disrupted at any moment by the startups of tomorrow. In the tech world, companies may become irrelevant or even go out of business in less than a decade, as the recent examples of Myspace, Fab.com, BlackBerry, and Nokia highlight.

Maybe self-preservation is one reason why large companies in Silicon Valley engage with entrepreneurs and are willing to learn from them. The tech giants add great value to the ecosystem by mentoring, investing, acquiring or partnering with startups. The symbiosis between corporations and startups in Silicon Valley is very tight, unlike in most regions of the United States and the world.

In recent years, there have been additional developments. Companies from non-tech sectors such as banking, aerospace, Pharma, cars, and clothing are opening Silicon Valley offices to learn from the startup scene and acquire essential technologies for their survival.

Large companies know startups can outdo them in efficiency and innovation. The option, then, is to join the enemy. The pragmatic approach has resulted in some very large deals.

Much of Google’s success, for instance, can be attributed to strategic acquisition such as Applied Semantics (which became AdWords, their cash cow), YouTube, Android, Endoxon (Google Maps Europe), Waze, and Nest.

Facebook acquired Instagram, WhatsApp, and smaller startups to reposition itself as a cool destination for teenagers and young adults. Apple engulfed the original creators of Siri, Palo Alto Semiconductor (which now creates all Apple’s mobile chips), and dozens of tiny startups in this decade alone. General Motors Corp. acquired self-driving startup Cruise Automation for a billion dollars in 2016.

Even startups such as Airbnb, Uber, and Stripe are now large enough to constantly “acquihire” great teams, patents or key technologies. Uber, for instance, spent $680 million on autonomous truck startup Otto in 2016.

In Silicon Valley, the startup virus infects even longtime employees who work at large corporations. It is common to see professionals leaving their jobs to found their own startups, sometimes even with the blessing of their former employers.

This collaboration between the Davids and Goliaths of tech creates a virtuous cycle that has become one of best kept secrets for the continuing success of the Silicon Valley ecosystem.

The good example set by HP founders William Hewlett and David Packard in the 1950s is followed to this day by successful entrepreneurs and investors in the Valley.

3. Investors

Money is abundant in Silicon Valley. Actually, this region concentrates more than 40 percent of the venture capital dollars invested in the United States in 2015.

It is important to stress that money alone does not generate results; otherwise, we would have seen the rise of many tech hubs around the world just because of private and public investments. An endless number of countries continue to pour billions of dollars into local entrepreneurial ecosystems with no visible results so far.

Nonetheless, investors are super important to the entrepreneurial ecosystem when they have the right mindset and long-term vision, which is the case in Silicon Valley. In this region, there are five main categories of investors.

Family and Friends

Many startups in the Valley begin their journey with money from non-professional investors. As the name implies, these investors may be relatives, friends, colleagues or classmates. Facebook, for instance, got their first $5,000 from co-founder Eduardo Saverin’s savings.

Family and friends are the first option for startups looking for cash. Investments are usually made on friendly terms at the idea stage due to a relationship of trust between the entrepreneur and investors. The amount invested may range from a few thousand to millions of dollars depending on how rich they are.

Entrepreneurs are usually advised to avoid raising much capital with this type of investor as they are considered dumb money and detrimental to the company’s long-term success. Their involvement may potentially become a red flag that will scare professional investors away.

Family and friends should not try to exercise any kind of control over the startup unless they are founders.

Angels

Angel investor is a term used to refer to a wealthy person who is generally a former or current executive or entrepreneur. This person allocates money to a startup in its early stages of formation in exchange for equity.

Angels in Silicon Valley are experienced investors who add value to the business with networking and advice. The majority of them never try to exert control over the companies invested and are deemed to be “smart money.”

One great example of a successful angel investor is Peter Thiel, founder of PayPal, who famously put $500,000 on Facebook in 2004. In 2012, after the Facebook IPO, he cashed out more than a billion dollars. Thiel is still a Facebook shareholder and board member.

Angels who only bring money to the table or try to dictate what the entrepreneurs should do are regarded as dumb money in Silicon Valley and thus excluded from the hottest deals.

Venture capital firms

These are companies founded with the specific goal of investing someone else’s money into startups. Think Sequoia Capital, which invested in the formative years of Google, YouTube, Apple, WhatsApp, Airbnb, etc.

Venture capital firms manage money raised from external investors, called Limited Partners, which is then put into one or several venture capital funds. LPs can be wealthy individuals, family offices, pension funds, universities’ endowments, banks, governments or even private companies. LPs invest in a venture capital fund to diversify their portfolio risk and multiply their money.

Large VC firms such as Andreessen Horowitz, Sequoia, and Accel Partners may manage several funds ranging from millions to billions of dollars. It all depends on each fund’s investment profile and strategy. For instance, Fund I may invest in super early stage startups with tickets ranging from a hundred thousand to five million dollars. Fund II might be a growth fund with investments from ten to a hundred million dollars.

Venture capital firms are managed by general partners who decide on which startups to invest. GPs are like the founders of a VC firm. They are paid a salary and make a cut (20 percent on average) based on the funds’ profits, generally after 10 years. For example: Venture capital company A raises a billion-dollar fund, and after 10 years, $2 billion is returned to the shareholders. Twenty percent of the extra billion ($200 million) would be the VC A profit. $1.8 billion would go back to the LPs.

In the case above, the return would be considered a failure as the LPs could have made more money investing in other options such as real state, bonds, stock or mutual funds. VC firms aim to return more than ten times the size of each fund over a ten-year period.

Venture capital funds are a very risky investment for LPs and not so much for the general partners who manage each fund. GPs have an average of 10 years to prove they can multiply the money before being considered a failure. During this time, they get a decent salary, build a huge network, and are in a very comfortable position within the ecosystem.

For that reason, many GPs become lazy due to the stability and the status provided by the job until they raise the next fund. Top firms such as Sequoia or Andreessen Horowitz must have a brilliant track record to stay in business and raise additional funds. It is an ultracompetitive and tough space.

Smaller venture capital firms, with less than a $100 million dollars under management, are under a lot of pressure lately as the capital requirements for private companies become larger.

The market in Silicon Valley is clearly being split into angels and super large funds, which may encompass private equity players that generally invest in the later stages (pre-IPO) of established companies.

Strategic investors

Strategic investors are large companies’ divisions which have the mandate to invest corporate money into startups complementary to their core businesses. Good examples of this category are Samsung Next, Intel Capital, and Qualcomm Ventures, all of them very active.

Some companies, like Alphabet (Google’s parent), prefer to have their venture capital arm totally independent from the holding. Google Ventures’ mandate is to simply make money. It allows, for instance, investment in competitors or businesses that have nothing to do with the Internet such as biotech or energy. In this regard, GV behaves much more like a traditional venture capital firm in terms of governance. The main difference is that GV keeps 100 percent of the profits as they do not have external investors (LPs).

Online platforms

The new kids on the block at the Silicon Valley investment scene are the online platforms. Spearheaded by AngelList, they allow innovative ways for regular people to participate in the startup ecosystem. AngelList created a product called investment syndicate, in 2013, which is disrupting smaller VC firms.

A syndicate is basically a private VC fund created to make a single investment. Syndicates may be led by experienced technology investors and financed by institutional investors and sophisticated angels. A syndicate allows investors to participate in a lead investor’s deals. In exchange, investors pay the lead carry (commission).

Here’s an example: Sara, a notable angel investor, decides to lead a syndicate. The syndicate investors agree to invest $200K total in each of her future deals and pay her 15 percent carry. When Sara makes her next investment, she offers to invest $250K in the company. She personally invests $50K and offers the remaining $200K to her syndicate. If the investment is successful, the syndicate investors first receive their $200K, after which every dollar of the syndicate’s profit is split 80 percent to the syndicate investors, 15 percent to Sara, and 5 percent to AngelList.

Using AngelList, investors get access to deals, leads get carried, and startups get more capital with fewer meetings. It is a win-win situation for everyone. AngelList transforms any respectable angel investor into his or her own VC firm.

The success of AngelList sparked the emergence of many competitors trying similar models, including direct crowdfunding equity on startups. Online platforms are certainly the future of startup investment.

4. Accelerators

Accelerators can be defined as a cross between a venture capital firm and an incubator. As the name implies, they are set up with the specific purpose to accelerate the chances of success of startups. The top accelerators invest around $120,000 for less than ten percent equity in each company.

Startups from all over the world can apply to accelerators located in Silicon Valley, but the selection process is more competitive than applying to Stanford or Harvard. If a startup is selected, its founders need to move to the Bay Area for three months and follow the activities in the program.

Some accelerators work merely as connectors. They facilitate meetings and dinners with successful entrepreneurs, executives, and investors. Others provide a more structured program and offer office space.

Accelerators count on an extensive network of entrepreneurs, investors, and executives from large companies that mentor founders on diverse subjects such as how to reach product/market fit, increasing revenue, designing a better user experience, hiring employees, and even raising additional capital.

The space became crowded in the last years. Dozens of accelerators have been popping up everywhere, some of them promising shady benefits and others offering terrible advice. The most successful accelerator in the Valley (and the world) is Y Combinator, which propelled to stardom several billion dollar companies such as Airbnb, Dropbox, Instacart, Machine Zone, Stripe, and Twitch.

YC’s secret is a very rigorous admittance process focused on selecting the best entrepreneurs as well as steering them toward building great products instead of raising money or spending money on marketing. Y Combinator’s partners are successful former entrepreneurs.

Being accepted in a tier one accelerator is, perhaps, the best way for young entrepreneurs or foreigners to build their network and reputation in Silicon Valley. A top accelerator may definitely propel promising startups to success, but founders expecting miracles or a revolution in their product offerings will be disappointed.

It is advised to carefully research your options before applying to any accelerator.

5. Universities

I am not usually fond of the universities’ role in entrepreneurial ecosystems. I believe they teach outdated business models, use archaic methodologies, pay no due attention to recent technology developments, and employ professors with no understanding of how modern startups operate.

In the United States, however, things are different. Startups are often born inside universities. Some of the world’s largest and most successful startups such as Facebook, Google, Microsoft, and PayPal came to be when founders met in the classroom.

American universities became hotbeds for innovation and groundbreaking research due to their openness, highly qualified professors (including active scientists, entrepreneurs, executives, and politicians), and partnerships with private companies. For example, most of the research for autonomous vehicles, spearheaded by Google, actually came from Carnegie Mellon and Stanford projects ran by professors and Ph.D. students.

In Silicon Valley, Universities have a very important role. Institutions such as Stanford or UC Berkeley are so well integrated with the entrepreneurial community they might even be considered protagonists that bind the ecosystem together.

Silicon Valley’s top universities tend to admit students with intellectual curiosity and who pursue extracurricular interests or activities. For instance, if a student built something cool such as a game, applied to an internship at a Chinese NGO, plays an instrument or had traveled the world with no money; those are seen as positive traits. The focus at these universities seems to be to recruit people that can solve real problems, who are proactive, and who want to learn and expand their capabilities.

Closer to finishing their undergraduate, masters or Ph.D.s, students receive tons of competitive proposals from large companies inside and outside the Bay Area. The Silicon Valley tech giants tend to outbid banks and consulting firms when hiring the best candidates by offering more cash, stock options, an open and meritocratic culture, and perks such as free food or allowing people to bring their dogs to work. Students are then hired for important positions and trained extensively by the large tech companies.

After some time spent fine-tuning their skills, scaling the corporate ladder, and building a reputation, these young professionals may see a market opportunity and quit to found their own startups. Co-founders in Silicon Valley are usually former classmates or work colleagues.

Startups founded by former students of Stanford, Berkeley or Ivy League universities tend to receive much more attention from investors, accelerators, and prospective employees. The same happens with founders who worked at Google, Apple, Facebook, or any other influential tech company.

The rationale is that these guys were already battle tested by being selected to be part of some of the world’s most elitist entities and, therefore, must be really smart and hard working. Google and Instagram founders, for instance, met at Stanford University.

Years after being founded, some of these startups may be sold to large companies or become large companies themselves. The symbiosis with the ecosystem goes full circle when, decades later, successful alumni donate generous amounts of money to their alma-matters to boost research and development. Or, even more interesting, alumni companies sponsor projects or competitions at local universities to search for the next generation entrepreneurs.

This virtuous cycle has been going on for decades and happens in other tech ecosystems such as Los Angeles, Seattle, and New York as well. However, it is more pronounced in Silicon Valley due to the concentration of large tech companies and the thousands of startups spread out in the region.

6. Co-working spaces

Co-working spaces became really popular in Silicon Valley in the last seven years when the app based economy took off. They are shared offices where you can rent a desk or a small office to start your company.

Co-working spaces offer snacks, amenities, internet, services (accounting, legal assistance), and meeting rooms in an environment where you can easily meet other entrepreneurs and participate in events to network and inform yourself about what is going on.

Usually, there are weekly events at co-working spaces where you have the chance to listen to other founders, investors or executives talk about a specific subject such as artificial intelligence or raising money for fintech startups. It is also common for startups or companies to sponsor parties or dinners to get to know the entrepreneurs frequenting the office.

The best advantage of locating your company at a co-working space is the networking they provide. In powerful entrepreneurial ecosystems such as Silicon Valley meeting great people today can be very valuable tomorrow.

Co-working spaces are part of the Silicon Valley ecosystem because they are now the main link between new entrants in the Bay Area and local entrepreneurs, large companies, and investors. If you are a foreigner working at something cool, co-working spaces are the first option where you can find information, contacts, and embed yourself in the Valley’s fabric.

Interestingly enough, the best co-working spaces are startups themselves going to the same journey in terms of scaling, raising money, testing new ideas, etc. The large ones such as WeWork or Rocket Space were able to raise hundreds of millions of dollars from investors and have offices all around the world, which facilitate interactions with ecosystems from other countries.

Many co-working spaces also raised venture capital funds to invest in startups hosted at their spaces. Their ability to spot nascent talent and to connect people should not be underestimated.