As the music industry recently announced its first annual revenue growth after 15 years of uninterrupted contraction, I thought it was a good time to share some of the things I learnt from reading Stephen Witt’s book How Music Got Free. It provides a fascinating account of how a relatively obscure scientific breakthrough — the discovery by German engineers of “psychoacoustic” principles according to which most of the information in recorded music is in fact inaudible to the human listener and can be thrown away — coupled with the distribution power of the Internet, radically transformed a large and profitable industry in a matter of years. As such, the history of the MP3 gives an excellent framework to anticipate how disruptive 10x innovations impact a market, and who the winners and losers of such breakthroughs will be.

1. The MP3 is a perfect case study of Innovator’s Dilemma.

Compared to the CD, the MP3 was an inferior product (lower audio quality) but radically cheaper and more convenient (1/12th smaller data footprint). It initially targeted a tiny niche of users: few people were on the Internet with a fast enough connection at the time, no one had an MP3 player, and there was nowhere convenient to download MP3 files. But following the rapid development of its ecosystem (desktop and then mobile MP3 players, Torrent and then download and streaming services), MP3s rapidly became a better option than CDs for the majority of the population, rendering the previous paradigm obsolete.

“The music industry does not believe in electronic music distribution”

As with other disrupted industries described by Clay Christensen in Innovator’s Dilemma, the incumbent players in the music sector at the time (labels, CD manufacturers and distributors, CD player manufacturers) initially dismissed the innovation as a low quality hack that would never take off. When Karlheinz Brandenburg, the genial inventor of the new format, approached the big record companies to recommend that they adopt a new copy-protected version of the file, he was “informed, diplomatically, that the music industry did not believe in electronic music distribution”. Similarly, when his group showed their prototype of the first portable MP3 player at an engineering fair in 1995, an executive from Philips told them: “There will never be a commercial MP3 player.”

Not only did the incumbents fail to grasp the potential value, but it would have made no sense for them to go after such a small unprofitable niche, which would have been irrelevant to their top line, and eating away at their bottom line (CDs were 90%+ gross margin products back then). By the time they realised what was coming, it was already too late for a lot of them to react — most of the value created would accrue to new entrants.

The dilemma extends beyond misaligned economics incentives. There is also a DNA issue at stake — incumbents simply did not have the right teams to adapt to the changing environment. “There’s no one in the record company that’s a technologist,” Morris explains. “That’s a misconception writers make all the time, that the record industry missed this. They didn’t. They just didn’t know what to do. It’s like if you were suddenly asked to operate on your dog to remove his kidney. What would you do?” Personally, I would hire a vet. But to Morris, even that wasn’t an option. “We didn’t know who to hire,” he says, becoming more agitated. “I wouldn’t be able to recognize a good technology person — anyone with a good bullshit story would have gotten past me.”

2. Engineering Vs. Craftsmanship

In Zen and the Art of Motorcycle Maintenance, Robert Pirsig contrasts the narrator’s classical approach to life (and motorcycling) to his artist friend John Sutherland’s romantic stance. While the former owns an older motorcycle which he is usually able to diagnose and repair himself through the use of rational problem-solving skills, the latter simply hopes for the best for his bike and focuses on being “In the moment”, and not on rational analysis.

“Still, this was engineering, where verified results should by necessity triumph over human sentiment.”

A similar dichotomy lies at the heart of the MP3 story, which helps explain the sector’s initial dismissal of the new format as an inferior product. As Witt puts it: “The studio engineers hated the mp3. These were the knob-twiddling soundboard jockeys who actually mixed the albums. Responsibility for the sound quality of recorded albums fell to them, and, in their consensus opinion, the mp3 sounded like shit. […] But it went beyond that — the studio engineers were irredeemable audiophiles who regarded even high-quality mp3s with disdain. For them, capturing the subtle acoustic qualities of recorded music was a professional obligation that bordered on obsession. Now Brandenburg was proposing to irretrievably delete 90 percent of their life’s work. For the studio guys, sound was an aesthetic quality that you described in terms of “tone” and “warmth.” For the researchers, sound was a physical property of the universe that you described in logarithmic units of air displacement.”

We now all know how that battle played out. As Witt concludes: “Still, this was engineering, where verified results should by necessity triumph over human sentiment.”

Watch out for any instances where incumbents bet their future on romantic, non-rational arguments. There is value to be created by betting against them and building better products based on first principles.

3. Network effects win: the revolutionary power of free

While the MP3 was genuinely better than the competing MP2, it was not as good as the AAC, which was designed to be its successor. However, the MP3 won the format war because it was the first “good enough” digital format to reach critical mass. Consumer adoption created a de facto standard that was then impossible to bypass due to network effects.

“Why would anyone purchase a music player if there was no music to be played on it?”

But how exactly, did the German researchers at the Fraunhofer Institute manage to win the market, against better funded and more business-savvy competitors? By doing what countless other consumer social apps have since done: giving real value away for free. After launching the format, they quickly realised that it had no chance to succeed if users did not have a simple way to listen to it. This was the typical chicken and egg problem that any new format faces: it cannot grow unless consumers are equipped to use it, but consumers don’t want to invest in expensive equipment until they know there is enough available content to justify it.

They therefore started by giving away a simple desktop-based MP3 encoder.

“After some internal discussion, Brandenburg made an executive decision: to promote the mp3 standard, Fraunhofer would simply give L3Enc [an encoding software they had developped] away. Thousands of floppy disks were made, and these were distributed at trade shows through late 1994 and early 1995. Brandenburg encouraged his team members to distribute the disks to friends, family, colleagues, and even competitors.

The freeware was quickly appropriated by pirates and turned it into a weapon of mass MP3isation.

“Using Fraunhofer’s L3Enc encoder, NetFraCk had started a new crew, the world’s first ever digital music piracy group: Compress ’Da Audio, or CDA for short. On August 10, 1996, CDA had released to IRC the world’s first “officially” pirated mp3: “Until It Sleeps,” by Metallica, off their album Load. Within weeks, there were numerous rival crews and thousands of pirated songs.”

The German researchers then proceeded to develop the second critical component in digital music consumption: the desktop MP3 player, which, this time, they decided to distribute as a freemium product.

“Grill finished the program in July and began distributing it on floppy disk as “crippleware.” WinPlay3 had the capacity to play twenty songs, and then, like a message from the Impossible Missions Force, it self-destructed. If you wanted to continue using it past that point, you were required to send a registration fee to Fraunhofer and wait for them to send you back a serial number.”

Hackers quickly cracked the arbitrary twenty songs limit, heralding the era of free, unlimited, digital music.

“The Fraunhofer team were no strangers to the Internet, but the Internet they knew was a collaborative tool for research and commerce, not some grimy subculture of anonymous teenage hackers. In their naiveté, they had not seen what was coming. Somewhere in the underworld, L3Enc, the DOS-based shareware encoder Grill had programmed several years back, was being used to create thousands upon thousands of pirated files. Meanwhile, somewhere else in the underworld, the commercial WinPlay3 player that supposedly self-destructed after twenty uses had been cracked, enabling full functionality. Together, the two were now being distributed in chat rooms and websites as a bundled package.”

While it may not have taken the shape they had originally envisioned, Brandenburg and Grill’s freemium distribution strategy is what created the MP3’s network effect it needed to dominate the market, even against more technologically sophisticated formats.

4. From the MP3 to the P2P revolution

But no matter how efficient the format and how convenient the player, no user would have been interested in taking part in the MP3 ecosystem without an easy way to access all this exciting new content. A new distribution infrastructure had to be built, superseding the brick-and-mortar record stores.

“With torrents, the more people who attempted to simultaneously download a file, the faster the download went.”

But sharing large catalog of heavy digital files on a global scale presented unique technical challenges, which the invention of torrents and their underlying P2P technology brilliantly solved.

“The greatest benefit of the torrent approach was the way it solved one of the Internet’s long-outstanding problems: the traffic bottleneck. Historically, popular files tended to crash servers, as millions of users crowded around a narrow doorway and tried to push their way in. But the matching schematic of torrents opened hundreds of doors at once, taking pressure off the server and transferring it to individuals. This inversion of the traditional paradigm of file distribution had a startling result: with torrents, the more people who attempted to simultaneously download a file, the faster the download went.”

Launched in 1999 as the more commercially mature incarnation of P2P tech, Napster demonstrated how quickly the technology could scale, both from an infrastructure and consumer demand point of view.

“Napster was a natural monopoly whose selection and speed only improved as more people joined. By early 2000 there were almost twenty million users, and by summer over 14,000 songs were being downloaded every minute. Every song ever produced anywhere could be procured in seconds. Download speeds were improving rapidly, even from a home connection, and songs often arrived in less time than they took to listen to. In essence, the song could be streamed. Napster wasn’t just a file-sharing service; it was the infinite digital jukebox. And it was free.”

Despite its eventual shutdown, Napster and other successful file sharing sites laid the technical and business foundations that the social web built on later on. It is no coincidence that early participants in these ventures ended up in the founding teams of companies like Facebook and Skype.

5. The emergence of a new value chain

The MP3 didn’t only change the way music got distributed, but transformed its entire value chain, from production and manufacturing to the role of the labels, and even the job of an artist. As with every other industry touched by the Internet, by dramatically lowering barriers to entry, the new format made it possible to bypass various middlemen and gatekeepers.

“Morris had once been a gatekeeper, the guy you needed to get past to get into the professional music studio, and the pressing plant, and the distribution network. But you didn’t need any of that stuff anymore. The studio was Pro Tools, the pressing plant was an mp3 encoder, and the distribution network was a torrent tracker. The entire industry could be run off a laptop.”

Labels have not disappeared though, but their revenue model has had to change, moving away from album sales towards all-encompassing “360” deals.

“Even as they abandoned the album, fans started arriving in droves to large-scale integrated music festivals. […] from 1999 to 2009 concert ticket sales in North America more than tripled. At the same time, increased demand from advertisers and sample-driven music producers led to a period of spectacular growth in the music publishing business. […] In response to these shifts, music executives began pushing artists to sign “360” deals that guaranteed labels not just a portion of album sales but live music and publishing rights as well. While 360 deals were controversial, artists still seemed to need labels, even in the digital era, and many, sometimes against their better judgment, signed on.”

6. Second and third order consequences: value goes up for complements and down for substitutes

A recent article in the Harvard Business Review titled “The Simple Economics of Machine Intelligence” offers a useful framework to think about the systemic impact of disruptive innovation. It goes as follows: “When the cost of a foundational input plummets, it often affects the value of other inputs. The value goes up for complements and down for substitutes. In the case of photography, the value of the hardware and software components associated with digital cameras went up as the cost of arithmetic dropped because demand increased — we wanted more of them. These components were complements to arithmetic; they were used together. In contrast, the value of film-related chemicals fell — we wanted less of them.”

In the case of the MP3, while it rendered the CD (a substitute) and its value chain obsolete, it created large complementary winners in distribution (Spotify), connected speakers/headsets (Sonos, Beats), or live music. But the most successful complementary technology of all has unquestionably been the portable MP3 player, the iPod in particular. It kickstarted Apple’s renaissance and served as the launching pad for the iPhone and the smartphone industry as a whole.

Whether it’s artificial intelligence, self-driving, blockchain, 3D-printing, or any other new disruptive technology, it’s useful to think in terms of complements and substitutes to identify winners and losers, and more accurately predict second and third order consequences, beyond the immediate impact on a narrow market.

7. Are VCs music labels in disguise?

As Witt was describing the day to day job of Doug Morris, once the most powerful executive in the history of music as head of Warner, I couldn’t help but notice how similar it was from mine as a VC. Find ways to identify talent earlier than competition, fight to sign exclusive agreements with them, spot the future winners and invest massively on them, as most returns are generated by a few outliers. Sounds familiar?

Morris even rose through the ranks by leveraging another one of VCs’ favourite tools: data.

“The shift in roles required Morris to pay closer attention to sales, but in the 1960s keeping score was difficult. Record stores weren’t always inclined to share their sales figures, and even if they had been, in an era before computers, collecting and sorting the data from thousands of retailers around the country was impossible. Only one person at Laurie could provide the numbers Morris needed, a functionary clerk whose real-world job was about as far away from the glamour of the music business as you could get: the order-taker. Morris haunted him like a ghost. Whenever a big order came in Morris demanded to know who had placed it, exactly how many units they wanted, and why. The order-taker was understandably perplexed. Shouldn’t Morris be at a nightclub somewhere, looking for the next Jimi Hendrix, instead of here, in the accounting department, pestering a back-office employee? But to Morris the order-taker was the key to the whole thing. How could he know what to sell if he didn’t know what people were buying? […]

Morris never forgot the experience of his first gold record, and he began to trust market research more than he trusted expert opinion — more, sometimes, than he trusted his own ears. Let the other A&Rs scout bands, and go to nightclubs, and fall in love with demos. Let them guess at trends, and fool themselves into believing they had some special insight into the next big thing. From now on, Morris was scouting the order-taker.”

The evolution of music labels can therefore provide a relevant blueprint for the VC industry. In the same way that the switch to digital rendered the labels’ analogue monopolies obsolete, and made it possible for artists to bypass them and go direct to their audience, new tools like crowdfunding, online marketplace or even Initial Coin Offerings can challenge the traditional VC model, built around privileged LP access and proprietary dealflow. Some new VCs have attacked the market by offering more services to entrepreneurs (eg. A16Z). Others by sourcing talent earlier and at scale with a standardised low price high volume model (eg. YC). All forcing established players to keep improving on their offering.

The analogy is not perfect: VCs never enjoyed the market power and subsequent rent that music labels did, which has forced us to remain small and nimble. Online has so far been complementary rather than substitutive. But it is an interesting analogy nonetheless, as the key question remains the same: how can intermediaries keep providing value in a fully digital economy where platforms can match supply and demand with greater efficiency and scale? Tomorrow’s winning VCs will be the one who find the right answers to this question.

Conclusion

As a conclusion, I’d highly recommend reading Stephen Witt’s book. His account of the dark underworld that powered the early days of the digital music ecosystem is fascinating, as is his in-depth description of characters as extraordinary as Brandenburg and Morris. But even more interesting is the step by step breakdown of the impact a single algorithm has had on both the music and the tech industry at large. It provides another excellent case study of innovator’s dilemma, and a great framework to predict the future impact of nascent disruptive innovations. Whether it’s autonomous vehicles, 3D printing, bitcoin or AI, many radical innovations have recently appeared which have the potential to upend existing industry value chains by offering 10x improvement in cost and convenience. And as with the MP3, some of them may unleash second, or even third order consequences, as significant as Apple’s rise to dominance.

Can you imagine Nike was a startup once? A lone guy in his parents’ garage hustling his way through importing cheap running shoes from Japan and selling them door to door (or rather race track to race track). Such is the company’s current scale and standing in popular culture that it’s hard to imagine it once was nothing more than a scrappy upstart with chronic cash shortages. And yet, this is the story Phil Knight, Nike’s founder and long time CEO recounts in his brilliant autobiography Shoe dog. This post highlights my key takeaways from the book — I hope it will encourage you to go ahead and read it, the story is as compelling as it’s entertaining.

Studying how today’s greatest companies started is a good way to put things in perspective : they all struggled almost terminally at some point in their life, and yet managed to overcome adversity to become the giants they are today. Nike is a case in point. Its story will feel different — the way business gets conducted has massively changed since the 60s-70s — and yet so familiar to every contemporary entrepreneur. Hence many lessons from Phil Knight’s journey still apply today.

Here are a few of them:

1. Disruptive companies often start as gimmicks for hobbyists

Most radical innovations initially appear like curiosities, only entertained by geeks and weirdos. It took four and half years for the general public to acknowledge that the Wright brothers had successfully completed a human flight (people initially didn’t care, or simply didn’t believe it). Early adopters of the Internet were usually ignored, if not ridiculed . Only loonies were thought to be willing to let strangers sleep in their home, until Airbnb became more valuable than any hotel chains in the world. Etc.

“Get a horse!”

Surprisingly, running went through a similar evolution. It wasn’t a thing in the 60s and 70s, and, as hard as it is for us to imagine today, occasional joggers were generally perceived as maniacs:

“In fact, in 1965, running wasn’t even a sport. It wasn’t popular, it wasn’t unpopular — it just was. To go out for a three-mile run was something weirdos did, presumably to burn off manic energy. Running for pleasure, running for exercise, running for endorphins, running to live better and longer — these things were unheard of. People often went out of their way to mock runners. Drivers would slow down and honk their horns. “Get a horse!” they’d yell, throwing a beer or soda at the runner’s head. Johnson had been drenched by many a Pepsi. He wanted to change all this. He wanted to help all the oppressed runners of the world, to bring them into the light, enfold them in a community.”

Nike was born out of the tight runners’ community and started by addressing the needs of these early adopters. In similar fashion to many Silicon Valley startups, the founders simply scratched their own itch: they loved track running and single-mindedly dedicated their life to designing the best shoes to do so. There is therefore hope for all the drones, VR/AR, 3D printing, bitcoin, and other brain hacking enthusiasts out there. What looks like fringe activities today may well become mainstream once relentless tinkering and technological advances will have made them cheap and usable enough for the broader population to enjoy.

2. Product first

Product always came first at Nike. Decades before the lean startup jargon was invented, Nike’s founding team was busy applying the core principles of customer-centric design. Their story followed a familiar arc: working with early adopters to create a new product, receiving feedback from a larger group, iterating until finding broader product market fit, scaling production and marketing. Johnson, the company’s first employee, built an epistolary community of fellow runners (a forum of sorts), who, in exchange for his expert advice, would provide him with invaluable product feedback:

“ Unlike me, however, most customers came to depend on Johnson’s letters. Most wrote him back. They’d tell him about their lives, their troubles, their injuries, and Johnson would lavishly console, sympathize, and advise. Especially about injuries. Few in the 1960s knew the first thing about running injuries, or sports injuries in general, so Johnson’s letters were often filled with information that was impossible to find anywhere else. [..] Some customers freely volunteered their opinion about Tigers, so Johnson began aggregating this customer feedback, using it to create new design sketches. One man, for instance, complained that Tiger flats didn’t have enough cushion. He wanted to run the Boston Marathon but didn’t think Tigers would last the twenty-six miles. So Johnson hired a local cobbler to graft rubber soles from a pair of shower shoes into a pair of Tiger flats. Voilà.”

Keep in mind that at the time, Nike didn’t even produce its own shoes (it actually wasn’t even called Nike, but Blue Ribbon Athletics) but imported the Tiger brand from Japan — and so every product improvement would only benefit their consumers and Onitsuka, the manufacturer and owner of the design.

The communication may have taken place over the network of the US Postal rather than on a subreddit but the story has every other characteristic of Silicon Valley’s startup culture. A group of hobbyists tinkering in complete anonymity with products the rest of the world has no idea it will one day die for owning.

3. Marketing second

Nike currently spends more than $3bn a year on advertising, or 10% of revenues, and is considered one of the world’s most valuable brand. It is synonymous with high-impact, mass-market advertising. However, it wasn’t always this way — originally, Knight was not interested and did not believe in the power of advertising. Their early focus was exclusively on getting athletes to wear their wares. Not only so that they could be widely seen, but also to validate the quality of the product they had designed. If the best athletes trusted Nike to win, so could the Sunday jogger. Marketing was merely used as another form of product validation.

4. Culture is what made the team stick together and achieve greatness in the long run

There are as many corporate cultures as there are companies, but great companies tend to communicate theirs more clearly (and be more polarising as a result). Google is all about excellence in software engineering. Apple is about creating the most beautifully efficient designs and experiences.

Nike is about achieving greatness in the face of adversity. It is intimately linked to the management team’s deep-seated inferiority complex and desire to prove its worth. Knight repeatedly points out how much of a freak show his executive team must have appeared to outsiders:

“I can see myself so clearly at the head of a conference table, shouting, being shouted at — laughing until my voice was gone. The problems confronting us were grave, complex, seemingly insurmountable, made more so by the fact we were separated from each other by three thousand miles, at a time when communication wasn’t easy or instant. And yet we were always laughing. Sometimes, after a really cathartic guffaw, I’d look around the table and feel overcome by emotion. Camaraderie, loyalty, gratitude. Even love. Surely love. But I also remember feeling shocked that these were the men I’d assembled. These were the founding fathers of a multimillion-dollar company that sold athletic shoes? A paralyzed guy, two morbidly obese guys, a chain-smoking guy? […]

Undoubtedly we looked, to any casual observer, like a sorry, motley crew, hopelessly mismatched. But in fact, we were more alike than different, and that gave a coherence to our goals and our efforts. We were mostly Oregon guys, which was important. We had an inborn need to prove ourselves, to show the world that we weren’t hicks and hayseeds. And we were nearly all merciless self-loathers, which kept the egos in check. There was none of that smartest-guy-in-the-room foolishness. Hayes, Strasser, Woodell, Johnson, each would have been the smartest guy in any room, but none believed it of himself, or the next guy.”

Remarkably, the theme of the underdog thriving for greatness is still the dominant message in their advertising today:

5. Silicon valley is not a place, it’s a mindset

While a lot of the Nike story sounds like a familiar Silicon Valley tale, none of it actually happened in the Valley, but in rural Oregon. The team built on what could have been a drag and turned it into the fuel for their ambition. Seeing themselves as the perennial underdog, they set to show the world they could build the largest sports company in the world. And they proved in the process that great companies can come from anywhere.

6. No matter how hard it is today, it was much harder before

By definition, entrepreneurship has and always will be one of the most difficult human endeavours. However, reading about the challenges Knight encountered to import sneakers from Japan in the 60s (before the Internet, emails, Alibaba, cheap phone communications, etc.) is a good reminder of how much harder and slower business was back then. He spent most of the early years of the company worrying not only about when the next shipment would come, but whether it would come at all, and what he would find inside if it did. With no data to rely on, importers flew blind and relied on trust entirely.

“Long on contrition, short on credit”

Not only were the tools slower and less reliable, the mindset was different as well. Silicon Valley hadn’t fully emerged yet, and the concept of reinvesting all profits into faster growth was not well understood or accepted, especially outside of big trading cities. The time he didn’t spend waiting for news from his supplier, Knight would typically spend begging his banker to extend an extra loan, and not to shut his account down. With venture capital out of the equation, and only two business banks in his town, he couldn’t afford to lose one of them.

“I recall one day, sitting in Wallace’s office. Both he and White were working me over pretty good. Wallace seemed to be enjoying himself, though White kept giving me looks that said, “Sorry, pal, this is my job.” As always I politely took the abuse they dished out, playing the role of meek small business owner. Long on contrition, short on credit. I knew the role backward and forward, but I remember feeling that at any moment I might cut loose a bloodcurdling scream. Here I’d built this dynamic company, from nothing, and, by all measures it was a beast — sales doubling every year, like clockwork — and this was the thanks I got? Two bankers treating me like a deadbeat? […]

At issue was more than the old philosophical disagreement about growth. Blue Ribbon was approaching six hundred thousand dollars in sales, and that day I’d gone in to ask for a loan of $1.2 million, a number that had symbolic meaning for Wallace. It was the first time I’d broken the million-dollar barrier. In his mind this was like the four-minute mile. Very few people were meant to break it. He was weary of this whole thing, he said, weary of me. For the umpteenth time he explained that he lived on cash balances, and for the umpteenth time I suggested ever so politely that if my sales and earnings were going up, up, up, Wallace should be happy to have my business. Wallace rapped his pen on the table. My credit was maxed out, he said. Officially, irrevocably, immediately. He wasn’t authorizing one more cent until I put some cash in my account and left it there. Meanwhile, henceforth, he’d be imposing strict sales quotas for me to meet. Miss one quota, he said, by even one day, and, well . . . He didn’t finish the sentence. His voice trailed off, and I was left to fill the silence with worst-case scenarios.”

A VC treating an entrepreneur that way today wouldn’t stay in business for long…

7. You “only” need to grow 33% year over year to reach Nike’s size

Nike was never a rocket ship. They never grew revenues 10x year over year. They had $8,000 of revenues in 1964 (the year they started trading), and $20,000 in 1965. It took them 7 years to “pivot” into manufacturing and distributing their own brand. By then, they only had $2m in annual revenues. The real acceleration happened after 1975 when they almost doubled every year until 1981, the year they crossed $450m in revenues and became a public company. They remained profitable throughout, generating $25m of net income in 1981.

Their growth naturally slowed down with scale but maintained a remarkable consistency over time: $3bn of revenues in 91, $9.5bn in 2001, $21bn in 2010 and $32bn in 2015. All in all, from the $20,000 of revenues in 1965 to the $32bn in 2015, Nike “only” grew 33% each year. The message is clear: if your company is riding a deep, long-lasting trend (in Nike’s case: the democratisation of sports and the primacy of comfort through technology), and operates in a market with no winner-takes-all dynamics (an important caveat, especially for tech platforms), growth at all costs doesn’t make sense. The important thing is to survive long enough and grow with the market. Remember, you only need to grow your business by a third every year for 50 years to build a $90bn company (Nike’s current market cap). [But more realistically, you’ll need to double it every year for the first ten years as it’ll naturally slow down with scale].

8. You create your own luck (also, new brand names always sound stupid)

Knight tends to present Nike’s story as a succession of lucky breaks. He randomly bumped into the graphic design student who later came up with the swoosh logo. One of his employees had a mystical experience and saw the word “Nike” appear before him in his sleep, the day before launching production of their own brand. Knight actually hesitated for a long time before eventually settling for Nike, which he didn’t like at first. There was certainly no grand plan or vision for what the brand would become:

“What’d you decide?” Woodell asked me at the end of the day. “Nike,” I mumbled. “Hm,” he said. “Yeah, I know,” I said. “Maybe it’ll grow on us,” he said. Maybe.

But what in isolation may have looked like a moment of blind luck was the fruit of years of work to reach that decision point. They had to have assembled a team of brilliant people capable of dreaming such name, be ready to build a cutting-edge product, distribute it to a passionate base of early adopters, and manage the whole operation. While memory tends to reduce success stories to a few pivotal moments, it downplays the critical work that came into reaching these decision points. In all likelihood, Nike would have succeeded under another name, and Knight would today be pondering on how lucky they had been when choosing that name.

9. It’s about the journey, not the money

From his parents’ spare bedroom to his retirement as a CEO of Nike, Phil Knight accumulated north of $10bn in personal wealth (it helps to be a sole founder). While an extraordinary achievement, this is not what he takes out of that 50-year journey.

“Just before getting on the plane home we signed deals with two Chinese factories, and officially became the first American shoemaker in twenty-five years to be allowed to do business in China.

It seems wrong to call it “business”. It seems wrong to throw all those hectic days and sleepless nights, all those magnificent triumphs and desperate struggles, under that bland, generic banner: business. What we were doing felt like so much more. Each new day brought fifty new problems, fifty tough decisions that needed to be made, right now, and we were acutely aware that one rash move, one wrong decision could be the end. The margin for error was forever getting narrower, while the stakes were forever creeping higher — and none of us wavered in the belief that “stakes” didn’t mean “money”. For some, I realise, business is the all-out pursuit of profits, period, full stop, but for us business was no more about making money than being human is about making blood. Yes, the human body needs blood. It needs to manufacture red and white cells and platelets and redistribute them evenly, smoothly, to all the right places, on time, or else. But that day-to-day business of the human body isn’t our mission as human beings. It’s a basic process that enables our higher aims, and life always thrives to transcend the basic processes of living- and at some point in the late 1970s, I did, too. I redefined winning, expanded it beyond my original definition of not losing, of merely staying alive. That was no longer enough to sustain me, or my company. We wanted, as all great businesses do, to create, to contribute, and we dared to say so aloud. When you make something, when you improve something, when you deliver something, when you add some new thing or service to the lives of strangers, making them happier, or healthier, or safer, or better, and when you do it all crisply and efficiently, smartly, the way everything should be done but so seldom is — you’re participating more fully in the whole grand human drama. More than simply alive, you’re helping other to live more fully, and if that’s business, all right, call me a businessman.

Maybe it will grow on me.”

Some (especially us Europeans) may cringe at this kind of grand, almost transcendental, spiel. But I am inclined to take it at face value. A lot of the entrepreneurs I work with would say the same thing. Maybe not with as much emphasis, but with the same spirit. Because this is the true spirit of entrepreneurship.

So, in summary, I highly recommend Phil Knight’s Shoe Dog to whoever has an interest in entrepreneurship or brand building. As one of the greatest success story of our age, Nike teaches us a few essential lessons on how to play the long game in business: if you pick a large enough space that you are passionate about, there is no limit to the size your business can reach, and for how long you could be working on it. Solve a problem you really care about (even if only you and a few people do too in the beginning), obsess about constantly improving your product, surround yourself with people who share your values, focus on steady progress rather than one-off growth hacks, and enjoy the journey while remembering that no matter how hard it is today, it used to be much worse.

Following a friend’s recommendation, I attended my first Toastmasters event last week. Having no idea what to expect, I left amazed by how well thought out and choreographed the event was. Here are 8 tips I took away from it on how to run effective meetups, onboard new users and keep old users engaged.

Toastmasters is a century old US-born organisation dedicated to improving their 350,000 members’ public speaking capabilities through a precise program of speeches and feedback, which can last multiple years. They use a Tupperware-like model whereas employees at the “district” level supervise volunteers who run the day-to-day operations of some 15,900 clubs across 142 countries. By my estimates, it’s a 150-employee strong, nicely profitable, asset-light, $30–40m+ annual recurring revenue business, growing 5% YoY through word of mouth. Not bad for a bootstrapped non-profit.

1. Timing is everything — make every second count

A typical Toastmasters session lasts for 1 hour 45 minutes and as you can see on the illustrative schedule above (left and right column), time-keeping is a serious matter. Every session sees a member designated as the official timekeeper, and equipped with a hammer and flags of various colours to indicate whether speeches are running on time or not. Interestingly, time-keeping doesn’t only apply to the main formal speeches, but to every single intervention (introduction, reviews, conclusion, vote, etc.). The timekeeper herself then produces a time-constrained report on how well timing was respected.

2. Iterate until you find the right structure — then stick with it

Every Toastmasters session follows the same tried and tested template. It alternates long prepared speeches, reviews, and free-form shorter exercises to keep things entertaining.

3. Assign roles/personas

Experienced members get assigned various roles at each event — President, Toastmaster, Timekeeper, Linguist, Topics evaluator, General Evaluator. While these titles may sound esoteric to first-time attendees (like me), they turn out to be very effective in giving a strong hierarchy, who is responsible for actively guiding the session. It also offers new responsibilities to older members, which help to keep them engaged and teach them new skills.

4. Get everyone to contribute

Even first-time attendees (who are not members yet) are encouraged (if not forced) to get up and speak for a minute or two. They get asked a random question and have to come up on the spot with whatever crosses their mind. Perfect ice-breaker.

5. Get everyone to state their goals upfront

Everyone needs to make their goal clear before the session starts. Whether it’s to prepare a best man speech, a big keynote at a conference, or simply the desire to overcome the fear of public speaking, it’s important that everyone states their goals clearly and publicly, to be held accountable for it and make progress towards them.

6. Incorporate continuous feedback

Four of the official roles and almost half of the speaking slots are dedicated to giving feedback. Attendees are also provided with physical feedback slips to give to each speaker. I couldn’t believe it when a man who’d been sitting quietly at the back for the whole session finally stood up and proceeded to review the preceding hour and a half (the venue, the decor, the tone of voice, the speeches, etc.), including the evaluators themselves. At Toastmasters, reviewers get reviewed too.

7. Gamify everything

Not only speeches but evaluators are getting voted on too. Not everyone is a winner, but everyone could be. Toastmasters also organise various national contests (humour speech for eg.), and deliver their own diplomas/badges at various stage of the learning process. Yep, just like Codecademy but for the physical world.

8. Freemium sells

People are free to attend as many Toastmasters’ sessions as they wish for free. But only by becoming a member can they receive the learning manuals, one-on-one mentoring sessions, and officially start their journey towards graduation. Many members bring friends along, who the day after the session receive an email from the club’s Treasurer giving them more details about membership plans. For what I could see, they don’t have a member-get-member referral system in place, but they otherwise run a solid freemium model.

So all in all, it was fascinating to observe how a century-old organisation had built layers after layers of features to turn an hour and a half session into an educating, entertaining and lucrative social machine. At a time where we at Index are thinking about how to run our Monday dealflow session more efficiently (a different scale of event, granted), there are a lot of smart innovations to take away from the way Toastmasters run their meetups.

Next Stop: Europe. Captain Train Joins Trainline

Every year, €70bn worth of train tickets are sold in Europe. However, given that the continent’s rail system is split between a multitude of rail operators, currencies and countries, the industry is fragmented and ticketing is a complex affair. And with the European Commission pushing for ever more competition, the direction of travel is clear: more choice for the consumers, more complexity for the distributors.

The more fragmented the market is, the more an independent distribution platform makes sense — a fact that was recognized early on by Jean-Daniel, Martin and Valentin, the three co-founders of Captain Train, an online booking platform and a mobile app that allows customers to book train tickets without any hassle and at the best price.

Launched in 2009, a couple of weeks after France’s competition commission officially liberalized international rail transport, the company slowly but surely established a unique strategic position for itself at the forefront of a powerful long-term trend. Today, the company covers 19 European countries and combines the offers of a large number of rail companies.

Relentlessly focusing on creating the most delightful user experience

It wasn’t always obvious that the company would get there. When we first met Jean-Daniel and his team, they shared their commission with so many intermediaries that they lost money on every ticket sold. And their only supplier at the time, France’s national train operator SNCF, also happened to co-own Voyage-SNCF, the website they were bound to replace.

However, the team was smart enough to enroll Jean de la Rochebrochard — better known as France’s best sales person — as one of their fundraisers. He helped the team focus their pitch on two essential areas: the product and the market. The market is huge, with tens of billions of sales every year, and the product they were developing was going to be first class, unlike anything else out there in this category. Convinced by this, we decided to lead Captain Train’s Seed round alongside CM-CIC in June 2012.

The team has delivered. They relentlessly executed on their vision of building the most delightful user experience to book train tickets across Europe, while assembling one of the continent’s most talented product and tech team. Patiently, they built up a base of hundred of thousands of customers so loyal that they would make the business behave like a subscription service rather than an ecommerce platform.

Captain Train’s exceptional retention is demonstrated by “smiling” cohorts of customers — that is, those who have been passive for a while will often come back months later when they need train tickets again.

This single chart is what made the company: in the early days, it is so much easier to build from a small but fanatical user base than a large uninterested audience.

Betting on the long-term

According to Peter Thiel’s “secret” theory, successful entrepreneurs know something unique about where the world is going to be in the next 10 to 20 years and this allows them to build outsized long-term value. The Captain Train team had a unique insight into the future of the rail market, and pursued their vision without flinching. That’s why we’re delighted to see Jean-Daniel and his team’s perseverance and dedication to their “secret” pay off.

Joining forces with Trainline

This week, Captain Train announced that it had been acquired by Trainline in a cash and shares transaction. As part of the deal, the Captain Train team will lead Trainline’s expansion in continental Europe, while Jean-Daniel and I will join Trainline’s board of directors. With the backing of Trainline’s resources and marketing know-how, Captain Train will have the platform it needs to become a household name as the default train and ground transportation booking engine in Europe.

Their story is an ode to the power of talent, conviction and perseverance, and we want to thank them for letting Index play a small part in it. We look forward to further working with them and the Trainline team as they fulfill their mission of using the best technology to make travelling in Europe a joy.

Charlie Munger (and his long-time partner Warren Buffett) seem to stand out as the antithesis of venture capitalists. Not only do they focus exclusively on large profitable businesses with long track records, but they also repeatedly stated that they don’t want to invest in the tech sector as they don’t understand it (better than the market). However, given their extraordinary investing performance at Berkshire Hathaway, I thought it was worth reading Tren Griffin’s Charlie Munger, the complete investor, published last September, and try to draw parallels between his philosophy of investing and ours at Index.

It turns out that there are way more similarities than dissemblance. Leaving aside the fact that we have different risk/reward profiles, and look at companies at different stages of their development, his core values are applicable:

1. View a stock as an ownership of a business

2. Make Mr. Market your servant rather than your master

3. Understand the importance of worldly wisdom

“What is elementary, worldly wisdom? Well, the first rule is that you can’t really know anything if you just remember isolated facts and try and bang ’em back. If the facts don’t hang together on a lattice-work of theory, you don’t have them in a usable form.”

4. Learn the psychology of human misjudgement to take advantage or protect against it

5. Develop the right human skills: patient, disciplined, calm, courageous, decisive, honest, confident, non-ideological, long-term oriented, studious, collegial, frugal

“Warren and I aren’t prodigies. We can’t play chess blindfolded or be concert pianists. But the results are prodigious, because we have a temperamental advantage that more than compensates for a pack of IQ points. “

6. Focus on core competencies and easy decisions

“I’m really better at determining my level of incompetency and then just avoiding that.”

7. Focus on a few investments rather than many (10, not 100)

8. Bet heavily on the very few exceptional opportunities that one has over a lifetime

“The wise one bet heavily when the world offers them that opportunity. They bet big when they have the odds. And the rest of the time, they don’t. It’s that simple.”

9. Focus on the very best companies, which create most of the value, even though it may mean paying up for them

“Leaving the question of price aside, the best business to own is one that, over an extended period, can employ large amounts of incremental capital at very high rates of return.”

10. Obsess about moats: how high they are, and how long they can be maintained (be it through supply-side economies of scale, demand-side network effects, brand, regulation, or patents and intellectual property)

11. Favor businesses over teams, except with a few exceptional entrepreneurs

“If you have to chose one, bet on the business momentum, not the brilliance of the manager. But, very rarely, you find a manager who’s so good that you’re wise to follow him into what looks like a mediocre business.”

12. Run a decentralised network of trust vs. a centralised reporting/coercive structure

There are a few notable differences though, and they mainly revolve around the definition of value and tolerance/aversion to risk, and the different types of businesses we end up investing in. By definition, VCs cannot be risk-adverse. Also, we have to imagine the future, how moats are likely to develop over time, while Munger can afford to focus on the past and the present.

Still, the power law of returns in venture capital make his emphasis on large and focused bets on few high-quality companies especially relevant.

These slides support a keynote I gave at Slush’s “On-Demand Everything” conference — they summarize my thoughts on the space, which I’ve narrowly defined as mobile-first marketplaces connecting consumers to professionals offering a service (ie. not a product), in less than an hour.

These companies represent the 4th generation of online marketplaces, which evolved over time from generalist, passive classifieds (Craigslist), where all the work of matching supply and demand was left to the buyers and sellers, to ever more specialized and intelligent platforms, able to offer almost perfect and instantaneous matching, requiring virtually no work from both sides of the transaction (Uber’s “click of a button” experience).

While it’s safe to assume that every service will move towards such a seamless mobile experience, the pace at which the change is occurring, and whether it will be led by a new startup vs. an incumbent, depends on a few characteristics, which vary from sector to sector.

The following questions will determine the pace of adoption and the eventual success of on-demand startups:

1. How urgent is the need?

The more urgent the need, the more transformative the on-demand model, which by definition provides a service in less than an hour. While we need a cab in the next 5 minutes, and our food to be delivered in less than 30, it’s acceptable to wait a few hours for a lawyer to review our corporate documents or a cleaner to show up at our home. However, fast is always better than slow, and consumers expectations will keep on rising to demand ever more instantaneous service.

2. How frequent is the need?

Most of us need to eat 3 times a day, clean our houses and our clothes once a week, check up with our doctor a few times per year, and move/refurbish house at most once a year. Frequency of use varies widely across categories, and services which are not used on a regular, at least weekly basis, are at a disadvantage to create a lasting bond with the customer.

This is a particularly acute challenge for mobile first/only companies, where user retention matters as much as acquisition. While more than 1.5 million apps are available, people spend 80% of their time in their top 4 apps, and only use 25 app every month on average. Which means that if we don’t have a good reason to use an app regularly, it will probably never make it to our homescreen, and we will eventually forget and uninstall it. One way to increase frequency is to bundle different services together (a la Taskrabbit, which added cleaning and delivery to its original handyman/errands proposition), which creates other challenges in terms of user experience (it’s hard to offer a one-click experience when the services offered are heterogeneous).

3. How complex is the task?

Complex tasks are harder to make fit in a simple one-click interface, and also require a highly skilled workforce (lawyers, doctors), which tends to be harder to recruit and retain at scale. Also, complex tasks tend to require a lot of direct interaction between the consumer and the supplier, which may lead to leakage away from the platform once their relationship has been established.

4. Is mobile a game-changer?

Has mobile enabled a match-making between supply and demand that wasn’t possible before? Or is it simply a more convenient interface? Using the front-facing camera to do tele-medicine is a real improvement but it isn’t enabling a radically new experience that simply wasn’t possible before. While matching in real time a passenger and a driver on the fly was not possible until virtually everyone got equipped with a GPS-enabled smartphone.

5. Can it ever be profitable?

Every on-demand startup has a different business model and hence different unit economics but they tend to face a common conundrum: the extra convenience they provide is generally more costly at first than the existing options, and hence originally targeted only at the most time poor and cash rich segment of the population, which makes it challenging to generate enough demand to fully utilize their workforce. An easy way to solve it is to price the service lower than its actual cost — hence why so many on-demand startups are gross margin negative. It is a bet that growth will be strong enough to bring sufficient VC funding, in order to keep subsidizing demand and increasing utilization rates to demonstrate that the model can eventually be operated profitably. This is obviously a dangerous game as burn rates will increase exponentially with volume, and the low pricing may hide a blunt reality that the extra convenience provided may not actually be worth the extra cost.

1. San Francisco is currently an extraordinary open-air lab for the on-demand economy: hundreds of startups, investors and service providers are competing for a piece of the action — a whole ecosystem has sprung up in a mere few years, with unparalleled breadth and depth from anywhere else in the world.

2. Broadly defined as any service provided by a human in less than an hour and ordered through a mobile interface, the on-demand model is being applied to every imaginable vertical, from food delivery and transportation to healthcare, education or home improvements.

3. The barriers to entry keep on coming down, with most building blocks of on-demand apps being offered through easy to implement and cheap API-based SaaS products (Parse for mobile PaaS, Stripe for payment, Checkr for background checks, PlaybookHR for contractors management, Sinch for in-app communication, Algolia for Search, Lob for direct mail, OnFleet for delivery, etc.).

4. The more urgent and frequent the need, the more relevant the on-demand model, which explains why food and transportation have been the fastest growing categories to date. Healthcare (doctors consultation, prescription drug delivery, etc.) and enterprise services are being tipped by VCs as the next categories where very large companies are likely to emerge. Services with in-built virality (eg. sending parcels/flowers to someone w. Shyp/Bloomthat) or an inherently social component (taxi transport often has multiple passengers and/or happens in a social setting) will benefit from a strong scale effect.

5. Many subverticals will be too small and with too infrequent a usage to support VC backed companies, but could nevertheless make for good seed investments or lifestyle businesses.

6. Having said that, sizing the market can be a very difficult exercise as, if done well, these services will expand their underlying markets by making them so much more convenient to access.

In 2014, Uber generated $500m of gross revenues in San Francisco, its most mature market, vs. a local taxi market of c. $350–400m before it launched. And it’s supposedly on track to treble again this year.

David Bladow, CEO of Bloomthat, mentioned that they have been experiencing a similar phenomenon — by making it so much easier to get flowers delivered, they’ve turned it from a “special occasion” indulgence into a much more frequent and broader gifting habit.

7. The nature of the legal relationship between these platforms and the workforce that powers them is far from settled and remains a major threat to the model. Ongoing lawsuits are seeking to reclassify Uber and Lyft drivers from 1099 contractors to full-time employees, and similar questions are arising everywhere else, whether in the UK around the so-called 0-hour contract or in France with the auto-entrepreneur status.

8. Competition for the on-demand workforce is becoming extremely fierce, with hourly rates going up and retention a key issue. Employing workers full-time rather than as contractor is already being used by companies like ManagedByQ as a way to both attract better and more loyal people and to offer a better service. As Dan Teran, its CEO and co-founder, puts it:

in the on-demand economy your workforce is your User Interface.

9. City-by-city expansion (and sometimes even neighborhood by neighborhood) is extremely challenging and operationally complex. Startups shouldn’t try to sheepishly copy the Uber playbook of a roll-out of local teams in every city, which requires massive funding, but instead develop their own, finding the right balance between centralised vs. decentralised and in-house vs. outsourced services.

10. New interfaces may improve / transform the space again: voice (eg. Siri), button (eg. Amazon Dash), beacons (eg. Estimote), motion (eg. M8 chip), messaging (eg. FB messager/WeChat), text (eg. Magic), Slack channels…

Jean de la Rochebrochard (@jlr), a partner at TheFamily, recently published a very good piece on Medium titled “Here’s my investment thesis. What’s yours?” — below is my answer to his question.

When thinking about investment thesis, one has to ask oneself: what is the outcome I am aiming at for the companies I invest in? At Index, the answer is very clear: we want our investments to exit for > $1 billion in less than ten years post our investment — either through an IPO or a large trade sale. We are hunting “unicorns”.

Given that these exits are typically brokered by bulge bracket investment banks, one way to analyse them is through their lenses. What do they evaluate in a potential client? Four things: 1. Revenue, 2. Growth, 3. Margin, and 4. Risk.

And that’s it. Because these are the only four variables needed to build a Discounted Cash Flow (DCF) model — the closest thing there is to a “fair value” estimate for a company.

So here are the four key questions one needs to answer to estimate the unicorn potential of an investment:

1. Can it generate large enough revenues?

(for eg. at UBS we would not work on any transaction lower than $500m — at 10x current revenue multiple, this implies a $50m net revenue business as a minimum)

This obvious criteria has one essential corollary: the company must operate on a large enough market. Which means that they need to have enough people willing to pay a high enough price for whatever product/service they are offering.

There are two ways to size a market opportunity: top-down (adding up the revenues of all the companies operating on that market today) and bottom-up (coming up with an estimate for how many people would be willing to pay for the service, and at what price). Both approaches complement each other, especially for innovative tech companies which typically disrupt an existing market by undercutting the incumbents on the one hand (and hence shrinking the market), while creating a new use case attracting a larger number of new users on the other hand.

2. How quickly can it grow to reach this minimum revenue scale, and beyond?

It is (relatively) easy to grow fast for the first few years of the life of a startup, but maintaining that growth past $10m and then past $100m is a whole different game. The company will need to keep acquiring an ever greater number of users to overcome the natural churn of their growing user base, in order to maintain not only absolute growth, but also relative growth. The public markets only tolerate the risk of tech startups because they offer unparalleled growth rates.

The largest outcomes tend to have one common feature: something in their core product allows them to grow faster over time, while bringing acquisition costs lower — be it thanks to the network effects of peer-to-peer models or the natural virality of communication tools.

This is what enables this type of exponential charts:

3. How profitable can it be?

In the early days, “traction” is all that matters, whatever metric is being used to define it. But in the long run, Monthly Active Users (MAU) and other “activity” metrics, do not appear anywhere in a DCF model: net profit is the only number that counts.

Three main components determine the profit margin and its future evolution: variable costs (servers, costs of goods sold), fixed costs (salaries, rent) and marketing. Most software businesses have insignificant variable costs and high fixed costs. Marketing is where their economics differ widely and hence what VCs spend most of their time digging in. In other words: building a product always costs roughly the same, convincing people to use it is where costs differ widely and what sets apart exceptional companies from the rest.

The best businesses do not need to pay people anything to get them to use their product. Users either love it so much or need it so badly that they cannot imagine living without.

And, as importantly, they cannot find it anywhere else. The product has to offer a unique and proprietary selection (be it a feature, a technology, an inventory or a network of people).

If the company offers a non-replicable, must-have product, that sells itself with virtually no marketing, then its marginal cost will trend toward zero and margins will keep on expanding as the business grows.

4. How predictable are these profits in the long run?

This is the final piece of the investment puzzle: the defensibility of the business. The “moat” that investors and entrepreneurs are so obsessed about building around their activity. This concept has a financial translation too: the Weighted Average Cost of Capital (WACC), ie. the factor future profits get discounted by to value the business. The riskier the business is perceived, the higher its cost of debt and equity, and the lower the present value of its future profits.

Fred Wilson at USV recently posted their view about it and I think it sums it all up perfectly:

“So we asked ourselves, “what will provide defensibility” and the answer we came to was networks of users, transactions, or data inside the software.”

In other words, the best companies literally suck the air out of their market as they end up capturing an ever larger part of the users’ actions, which they then leverage to make their product better/smarter.

Blablacar’s offering keeps on getting better the more users join the network (as users become more likely to find a suitable date/time for their door-to-door journey), and the harder it becomes for anyone new to come in and disrupt them. Swiftkey’s product keeps on getting better the more users type through the app as the company gets access to more live data to improve their prediction engine, making it significantly harder for a new entrant to create a better product from scratch.

These characteristics make it very easy to plot the line of future earnings for these businesses, and lowering the WACC has as much impact on the value of a company than increasing the growth rate.

Conclusion

In the long run, these are the only four questions that matter to determine the potential of a business and whether it will be able to reach the “unicorn club”: how large can the revenues be? How fast can they grow? What costs will be needed to support them? How predictable are they going to be five/ten years from now? Obviously, the earlier the investment, the less precise these answers will be, but, whatever the stage, these questions remain valid.

And the outlier businesses all share the same characteristics: they disrupt/create huge markets with a non-replicable product offering a must-have service that keeps on getting better the more people use it.

BONUS

Here is a “quick and dirty” DCF model built using the Soulver app, which shows a back-of-the-envelope calculation of what is required to reach a $1bn valuation using this method.