Innovation: Uncertainty, But Not Too Much
European Straits #241
This marks the final part of a three-edition series of essays on startups and innovation. My objective throughout this series has been to restart my thinking process in evaluating the current state of tech startups and to identify the new promising prospects in terms of founding and investment. Here are the initial two editions: Startups: The Door Is Closing; Empowering Innovation: Real-Life Examples.
1/ Disclaimer: I'm not particularly enthusiastic about emphasizing innovation as the main goal of tech startups. In fact, a significant portion of my work over the past decade has revolved around advocating for startups among established elites in Europe. In doing so, I've learned that innovation is not universally appreciated. In many cases, it’s essential to communicate about startups differently as needed.
Yet although it's sometimes wise to downplay the emphasis on innovation, it is no less true that innovation remains a fundamental contributor to a startup’s success. While not all tech startups achieve innovation, all founders are attracted by innovation and all startups are originally founded with the aim of being innovative.
Therefore, at this pivotal moment where the metaphorical door is closing on startups, it's essential to reexamine two things: (i) why the entrepreneurial quest for innovation is best pursued through the creation of tech startups, and (ii) how exactly it should be pursued so that these startups transform into successful tech companies.
In short: This typically happens when the ideal founding team, operating within a healthy entrepreneurial ecosystem, decides to tackle a significant problem that is obscured by substantial uncertainty. This uncertainty initially acts as the indicator pinpointing the most promising innovation prospects. It then plays a significant role in the eventual success of a few among those who undertake this journey.
2/ What sets a business apart as innovative? In last week’s edition, I delved into the late Clayton Christensen's theory encompassing three categories of innovation: efficiency innovation (= streamlining car production for increasing margins), sustaining innovation (= enhancing car quality and convenience for a premium price), and empowering innovation (= on-demand ride services rendering car ownership obsolete and revolutionizing urban transportation).
This week, I want to explore the close relationship between innovation and uncertainty. For starters, it helps to quote the economist Frank Knight's distinction between risk and uncertainty:
Risk applies to situations where we do not know the outcome of a given situation, but can accurately measure the odds. Uncertainty, on the other hand, applies to situations where we cannot know all the information we need in order to set accurate odds in the first place.
When launching a new restaurant chain, for instance, there are significant risks, such as the possibility that customers may not show interest or that banks might hesitate to offer financial support until the business becomes profitable. However, these risks are known and quantifiable, and it so happens that successful restaurant owners don't heavily depend on innovation to mitigate them.
On the contrary, when Larry Page and Sergey Brin introduced Google in 1998, they faced more than risks—they faced massive uncertainty on multiple fronts. They had to grapple with questions like whether the PageRank algorithm would yield relevant results, if customers would enjoy the interface, whether the hardware could handle increased usage if the search engine gained widespread popularity, whether websites would agree to be listed in search results, if there was a viable revenue generation method, and whether investors would remain supportive until a profitable business model emerged. This substantial layer of uncertainty not only cleared the space around the Google co-founders, but also offered them the ideal environment and motivation to create and execute groundbreaking innovations.
3/ My understanding of uncertainty and its significance for startups has been influenced by various authors. One is Vaughn Tan, the author behind the book The Uncertainty Mindset. In it, Vaughn recounts his exploration at the forefront of the culinary world, where he encountered an entirely distinct approach to innovation, carefully crafted to confront the challenge of widespread uncertainty. This approach has relevance extending beyond the realm of cuisine:
Cutting-edge cuisine serves as a model system for grasping the uncertainty mindset and its implications for organizations in various sectors.
Another author is Jerry Neumann, a venture capitalist located in New York who is presently promoting his book Founder vs Investor, co-authored with founder Elizabeth Joy Zalman. When he’s not investing or writing books, Jerry is an insightful blogger who has crafted a compelling argument about how uncertainty serves as a protective barrier akin to a competitive advantage for tech startups. Here are excerpts from his landmark Productive Uncertainty (November 2020):
Uncertainty can shield against competition, allowing you to create excess value. If it does, it is productive uncertainty…
When something has not been done before, it may be that no one can predict the outcome. [This is what Jerry calls “novelty uncertainty”.]
[And then there’s “complexity uncertainty”:] Complexity is a barrier when predicting the evolution of new markets, whether they use new technology or not.
In 2019-2020, while delving into the works of both Vaughn and Jerry, I came to recognize the significance of uncertainty as a fundamental idea that distinguishes startups from the broader business landscape. Vaughn delves into haute cuisine, offering valuable insights on innovation and uncertainty from a management and organizational perspective. Meanwhile, Jerry's focus on uncertainty sheds light on the concept’s strategic importance for startups.
Now, let's explore what uncertainty entails for four pivotal groups in the realm of innovation: founders, investors, established corporations, and the state.
4/ From a founder’s perspective, the degree of uncertainty associated with solving a specific problem is a guide when selecting a startup idea. This relates to Peter Thiel’s famous distinction between good ideas that look like good ideas, and good ideas that look like bad ideas. Paul Graham discussed the differentiation in his 2012 essay Black Swan Farming:
The best startup ideas seem at first like bad ideas… If a good idea were obviously good, someone else would already have done it. So the most successful founders tend to work on ideas that few beside them realize are good. Which is not that far from a description of insanity, till you reach the point where you see results.
And here’s Ben Horowitz talking about the importance for a founder of thinking for themselves so as to make sure they act on a good idea, even though everybody else thinks it’s a bad idea:
You might come to me and say I've got an idea. And the biggest thing that I'll look for when you come to me with an idea is: Have you thought for yourself? Is there something that you know that nobody else knows? Or is it something that everybody knows?
How do those statements (Thiel’s, Graham’s, Horowitz’s) relate to uncertainty?
A good idea that looks like a good idea may be challenging to execute, but it comes with a relatively low level of uncertainty, making it exceptionally tough for startups to undertake. They will swiftly encounter established competitors throwing more resources at the problem, and then likely face defeat.
Conversely, a good idea that initially appears as a bad one is shrouded in substantial uncertainty in so many directions. As a result, there are few founders (or corporate managers, or anyone else) willing to risk their livelihood, assets, and reputation on pursuing such an opportunity. And this, specifically, is what renders it a worthwhile pursuit in a startup context.
5/ Now, let's consider the investor's viewpoint regarding uncertainty. Seasoned investors like Ben Horowitz ensure that a startup's idea doesn’t sound excessively brilliant and comes with a level of inherent uncertainty. Yet, an overwhelming level of uncertainty can spell certain failure. Thus, while uncertainty, unlike risk, defies quantification, it's imperative for investors that a startup isn't engulfed solely in uncertainty. Require a degree of uncertainty, but be worried if there’s too much of it.
In the startup sphere, uncertainty can emanate from four distinct sources, as outlined by experienced venture capitalist Bill Janeway (see Who Should Be in Control, 2021):
Technology: “When I plug it in, will it light up?”
Market: “Who will buy it if it does work?”
Financing: “Will the capital be there to fund the venture to positive cash flow?”
Business (or Management): “Will the team manage the transition from startup to sustainable business, especially given the challenge of building an effective channel to the market?”
With that in mind, here's how an investor typically evaluates a startup at the seed stage:
There's room for accepting both technological and market uncertainty, but it's advisable to steer clear of situations where both seem equally high (as often in the case of deep tech).
In situations involving technological uncertainty, it's crucial to ensure there's a ready market of eager customers willing to purchase the product and pay for it (as is often the case in biotech).
When market uncertainty is a factor, developing a business plan becomes futile, which is why investors typically don't require one at an early stage.
Investors typically don't dwell on financing uncertainty. If they're present and active, it indicates they are operating within a healthy entrepreneurial ecosystem. In such cases, numerous other investors are often ready to co-invest or provide subsequent funding in later stages (unless unfavorable macroeconomic conditions prevail, as they do today).
All in all, given the assurance of follow-up funding in healthy ecosystems and the tolerance for uncertainty in technology and market aspects, investors tend to place significant emphasis on the one element that can be assessed from day one: management.
In short: This is why pre-seed and seed investing are mostly about assessing the founding team and nothing else. It's the best course of action for an investor dealing with such high levels of uncertainty—or more accurately, it was the best course of action until the startup landscape began to change.
6/ Indeed, uncertainty isn’t forever. For several decades, our economy has been going through this paradigm shift from the old age of the automobile and mass production to the current age of computing and networks. With each startup established and lesson absorbed, we have diminished the realm of unknown information for founders and investors, thereby narrowing the sphere of uncertainty they face. The shift from one age to the other has now advanced to such an extent that today's business landscape leaves little room for uncertainty. As a result, it provides founders with less and less opportunities to innovate.
B2B SaaS startups provide a telling example of this. Sure, launching such a venture today remains highly risky. Market entry is tough, talent acquisition is critical, and balancing revenue with demanding key accounts poses challenges. It becomes an even riskier proposition in the presence of the common winner-takes-all phenomenon due to increasing returns to scale. David Galbraith of Aperture just published a compelling essay about artificial intelligence in which he mentions exactly this:
New business models meant new investment models. The risky bets needed to back the winners in winner-takes-all, internet platform opportunities, established the Venture Capital model of investment as the default one that underpinned the shift from the industrial to digital era. Venture Capital allowed the increased risk (only one winner from lots of contenders) to be offset with uncapped upside from equity in a way that traditional debt-based investment did not allow.
However, uncertainty is still going down in the realm of B2B SaaS. Startups in this segment have progressively become more structured and measurable. If you are a capable founding team, can attract exceptional talent, and embrace the accumulated SaaS wisdom of Point Nine Capital's 15-year journey as encapsulated in the insightful content found in their library, you're likely headed toward success.
Therefore, we've reached a point where numerous VC firms may seem like venture capitalists in name only. They still pursue returns in situations where one player dominates the market, but the startups they support encounter significantly less uncertainty compared to the early days of the paradigm shift.
And when substantial potential returns come with minimal uncertainty, it points to a market imbalance in need of correction. It's not surprising that traditional private equity is growing more intrigued by B2B SaaS startups, potentially supplanting complacent VCs because of their capacity to invest larger amounts of capital and to focus on things such as capital efficiency and profitability.
7/ Now, let's shift our focus to established companies, namely the major corporations that have long held sway in various markets and industries. In the 2010s, it seemed like established companies would succumb to Silicon Valley-style startups driven by software, echoing Marc Andreessen's 2011 essay.
However, this hasn't entirely materialized. In most industries, incumbents have regained control, often containing or even outperforming the brash new tech-savvy entrants. Two factors have contributed to this shift, and uncertainty is pivotal in both:
The first factor is the diminishing uncertainty level I mentioned earlier. As Jerry Neumann noted, established corporations struggle with uncertainty. They have much to lose, and their internal procedures demand careful documentation and risk mitigation for major decisions—something difficult when confronting challenges that typically pique startup interest. Yet, with uncertainty now more limited due to the ongoing paradigm shift's rapid progress, large corporations find it easier to venture into areas that startups might have tackled a decade ago. Moreover, they excel in execution, thanks to their vast resources in capital, talent, and government connections.
Another contributing factor is the current market deceleration and consolidation, as previously discussed two weeks ago. This situation mirrors the circumstances of the 1970s. Market growth is slowing down, leaving limited opportunities for newcomers to break into the market by leveraging innovation. At the same time, the increasingly stringent constraints lead certain established firms (those which Philippe Aghion calls “neck-and-neck firms”, which in the 1970s were the Japanese carmakers) to target innovation efforts at operational effectiveness and gaining market shares with a compelling combination of lower prices and higher quality.
In simpler terms, traditional corporations are now venturing into the territory that was once dominated by startups. Increased competition among established rivals in a sluggish economy fosters significant innovations within what Scott D. Anthony refers to as the “corporate garage,” surpassing the level of innovation observed in the startup arena. As uncertainty decreases, corporate innovation increases, and it’s become harder and harder to tackle interesting challenges as a startup.
8/ Lastly, we shouldn't overlook the role of the state. It is frequently forgotten when discussing uncertainty in the business realm. Nevertheless, economists and historians have consistently demonstrated that the state plays a crucial role in reducing uncertainty, enabling venture capital to thrive, and subsequently allowing uncertainty-savvy startups to secure the necessary funding for their success.
This is one of Bill Janeway’s main takeaways in his recent article What to Do About Radical Uncertainty:
The post-war era was when the US state emerged as the dominant source of R&D funding. While the Department of Defense laid the groundwork for what would become the digital revolution, the National Institutes of Health played a similar role for biotechnology. By the 1980s, a professional VC industry had emerged to dance on the platforms created by the US state.
In fact, throughout recent history, each major wave of innovation has been closely associated with substantial state investment, often in a combined manner:
The state can allocate funding to support foundational research, enabling innovators to later refine and commercialize these findings once private investors take over.
The state can become an initial, critical customer, purchasing the initial production runs for essential purposes (typically, during wartime). This provides entrepreneurs with the necessary time, resources, and experience to achieve profitability.
Alternatively, in the realm of biotech, the state can establish a public insurance system, ensuring that if scientific advancements yield effective results and resulting drugs gain approval, they will be covered by a state-sponsored insurance program. This ensures that every patient in need can afford these treatments. This offers VC firms a level of confidence that encourages them to invest in scientific research projects significantly removed from immediate market applications.
Lastly, the state can enhance regulations to create a more favorable environment for innovation, similar to how the Japanese government imposed stricter fuel efficiency standards on automakers in the 1970s.
On the contrary, there are numerous instances of VC firms formulating ambitious strategies centered around specific technologies, only to achieve disappointing returns. This often occurred because their investment endeavors lacked substantial state-backed support. A notable example is the initial green tech/clean tech boom championed by John Doerr at Kleiner Perkins in the 2000s. In contrast, today's “climate tech” investors can operate with greater assurance, thanks to years of government investments, and they expect ongoing support, exemplified in the US by the recently passed Inflation Reduction Act.
9/ This leads us to a straightforward strategy for navigating the current landscape. Those genuinely keen on fostering innovation should focus on sectors where:
Considerable uncertainty exists, either in terms of technology or market dynamics. Failing to find uncertainty may result in competition with established firms that can overpower newcomers.
Government intervention, whether in the form of research funding, early adoption, or insurance guarantees, plays a significant (and effective) role. This ensures that while there's uncertainty, it remains within manageable bounds. Uncertainty, but not too much!
(As an additional note: I suggest looking for “effective” government intervention as a way to filter out unsuccessful initiatives or empty promises. Many governments engage in research and innovation efforts with good intentions but limited impact.
The optimal approach when picking a market or an industry worth investing in is to disregard actions undertaken for the “common good” and concentrate on measures taken in response to direct and often forceful pressures. Whether it's facing an adversary in a war (e.g., the US vs. Nazi Germany), competing on the global stage (e.g., the US vs. China today), or satisfying influential interest groups demanding increased funding and support. Have you ever wondered why the energy and agriculture sectors experience so much innovation? It's not (only) because of talented founders and deep-pocketed investors—but rather because these industries are backed by influential interest groups with strong ties to high-level government authorities.)
10/ Reading list (only past editions of European Straits today):
Clay Christensen, Our Secret Godfather (February 2018)
Macron’s Industrial Policy: More of the Same? (April 2018)
The Hard Truth About Deep Tech (June 2019)
Can Private Equity Firms Make Money in Tech? (June 2020)
Country Risk in an Uncertain World (July 2020)
Anyone Can Build an Entrepreneurial Ecosystem (July 2020)
An Important Point About Increasing Returns (September 2020)
On Jerry Neumann’s “Productive Uncertainty” (Round 1) (November 2020)
On Jerry Neumann’s Productive Uncertainty (Round 2) (December 2020)
The Uncertainty Mindset w/ Vaughn Tan (podcast—December 2020)
All About Risk and Uncertainty (December 2020)
Deep Tech: Many Roads May Lead There, But There’s Only One Rome (guest post by Bill Janeway—January 2021)
Does Elon Musk Master Productive Uncertainty? (February 2021)
Vaughn Tan on Uncertainty (February 2021)
An Investment Thesis: Help Software Digest the World (March 2021)
Bill Janeway on Who Should Be in Control (interview—April 2021)
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