Peter Thiel on Value Capture, Creative Monopolies and Questions for Every Start-up

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Peter Thiel on value capture, monopolies, competitive advantages, and his questions for start-ups

Elusive whales

PayPal cofounder Peter Thiel shares his thoughts on value capture and creative monopolies, and his questionnaire for start-up analysis, in his book Zero to One. This post looks at the book’s big lessons and adds to the notes I began previously. While I don’t always agree with Thiel’s views on competition, it’s healthy to test our assumptions. I include those disagreements here and leave the rest to your judgement.

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Finding value in competition and monopolies

Peter Thiel points out that for companies to thrive, it must capture some of the value it creates. Those that fail this requirement will lack the resources to meet long-term challenges. It’s also for this reason that entrepreneurs and investors must understand the relationship between value creation, value capture and the forces of competition.

Competitive intensity tends to lie somewhere between perfect competition and monopoly. To recognise the prospects for value capture, Thiel says it’s important to know where your company sits on this shifting spectrum. Compare, for example, the profitability of the airline industry to that of the search engine market. While both industries create a lot of value for customers, one industry captures substantially more profit than the other.

“If you want to create and capture lasting value, don’t build an undifferentiated commodity business.”

Peter Thiel and Blake Masters. (2014). Zero to One.

Frame your market carefully

Whether you’re an entrepreneur or investor, you have to frame your market, competitors, and substitutes with utmost care. On one end, you risk deluding yourself about the degree of differentiation your company enjoys. And on the other, you risk neglecting defensible niches that might actually exist.

“Starting a new South Indian restaurant is a really hard way to make money. If you lose sight of competitive reality and focus on trivial differentiating factors—maybe you think your naan is superior because of your great-grandmother’s recipe — your business is unlikely to survive.”

Peter Thiel and Blake Masters. (2014). Zero to One.

The lies monopolists tell

Thiel has a simple trick to distinguish between perfect competition and monopolists. Monopolists tend to lie about the severity of competition. They want to discourage new entrants, avoid antitrust lawsuits and “conceal” their market power. So, they tend to frame “their market as the union of several large markets”.

By contrast, companies in highly competitive industries will lie about their uniqueness in what is a largely homogenous market. Executives and entrepreneurs can rationalise their point of differentiation in all sorts of ways. How else might they drum up value? You ought to ask yourself if what they’re saying is really true.

“Non-monopolists exaggerate their distinction by defining their market as the intersection of various smaller markets. … Monopolists, by contrast, disguise their monopoly by framing their market as the union of several large markets.”

Peter Thiel and Blake Masters. (2014). Zero to One

Ominous delusions

I’d add too that management lies can present a more ominous risk: that they pursue the wrong strategy because of the delusions they’ve come to believe. For companies with little hope for differentiation, survival tends to come from superior execution, operating efficiency and economies of scale. In this scenario, grandiose marketing budgets might represent a significant opportunity cost to the organisation. So, it’s important to check what management is saying, what the company is actually doing, and whether any of it makes sense.

“Competition can make people hallucinate opportunities where none exist.”

Peter Thiel and Blake Masters. (2014). Zero to One.

The ‘monopolist’ advantage?

“In business, money is either an important thing or it is everything. … The competitive ecosystem pushes people toward ruthlessness or death. … Only one thing can allow a business to transcend the daily brute struggle for survival: monopoly profits.”

Peter Thiel and Blake Masters. (2014). Zero to One.

Perfect competition, Thiel says, tends to generate short-termism. While intense competition pushes these companies to focus on immediate earnings, creative monopolists, by contrast, have room to experiment and plan for the long-term. In Thiel’s view, the “history of progress is a history of better monopoly businesses replacing incumbents”.

The Valley’s claim

I must say, I don’t quite agree with Thiel here. He suggests, for example, that monopoly profits create “a powerful incentive to innovate”. But monopolists are not immune to lethargy. Just look at the railroad industry today. They were once former hot shots of a bygone era. The runway for innovation is, in part, intrinsic to the maturity of industry itself.

To be fair, Thiel is talking about creative monopolists in Silicon Valley. And I agree that “creative monopoly means new products that benefit everybody”. The real question, I think, is how to ensure they stay that way. Intel and Hewlett Packard, once beacons of technological progress, are criticised today for their idleness. It remains to be seen whether the creative ‘monopolists’ of our time can maintain their innovation streak. They’ll have to overcome the negative forces of bureaucracy and dysfunction as they scale and age. That’s easier said than done.

Tail-end and lock-in risk

What’s more, monopolists, no matter how creative, present risk to the overall system. Today, much of the information economy is beholden to the quality of Google’s service. We might find ourselves locked-in should Google’s management, culture, and innovation pipeline deteriorate. Yes, creative monopolies might create wonderful products. But their very existence inhibits the emergence of newcomers and alternatives. Sometimes, a little redundancy and competition can help to offset the tail-end risk of lock-in.

Creative monopoly potential

Perhaps, to refine Thiel’s language, what we’re really talking about are companies with creative monopoly potential. Apple, Microsoft, Facebook and Amazon, for example, were not endowed with monopolistic powers. Some of you might remember MySpace, Bebo, and other social networks during the early days of Facebook. Apple, likewise, was floundering for years until Steve Job’s messianic return. It was their combination of novel innovation, founding intensity, superior execution, innate structural advantages and some lucky timing that paved their road to dominance.

Characteristics of creative monopolies

What then are the characteristics of creative monopoly potential? In Thiel’s view, monopolies tend to share four traits: (1) proprietary technology; (2) network effects; (3) economies of scale; and (4) branding.

Proprietary technology

Companies require an advantage that incumbents and new entrants find difficult to replicate or imitate. Using Google’s search algorithms as an example, Thiel’s rule of thumb requires the technology be “10 times better” than its nearest substitute to constitute a “real monopolistic advantage”.

Network effects

Network effects generate greater value to people as more people use the product or service. Facebook or LinkedIn are classic examples. It’s hard to switch social networks when all your friends or colleagues are on the incumbent network.

Economies of scale

Businesses enjoy economies of scale when their costs-per-product fall with growth in sales and production. Software companies like Microsoft are popular examples here. They enjoy superior economies of scale since the marginal cost of each additional software sale is very low. Even if a young upstart has a superior product, it’s often difficult to displace the large incumbent with economies of scale due to high cost and pricing differentials.

Branding

A strong brand can help a creative monopoly. But brands aren’t born purely out of marketing and sales. It requires cultivation, consistent execution and attention to detail. As Steve Jobs put it, effective branding comes from a company’s relentless dedication to quality and experience. A good brand, once established, can contribute mightily to the creative monopoly’s virtuous cycle: higher willingness to pay, lower transaction and informational costs, greater word of mouth, and so on.

Durability, franchises, and timing

Thiel’s framework is not dissimilar to other views on the topic. In Competition Demystified, Bruce Greenwald points out that competitive advantages are most durable when if companies combine demand advantages, like high switching costs, habit formation and network effects, with economies of scale.

Likewise, in his 1991 letter to Berkshire Hathaway shareholders, Warren Buffett noted that economic ‘franchises’ that generate high returns on capital tend to: (1) meet a strong consumer need or desire; (2) possess few close substitutes; and (3) enjoy pricing power of low risk to regulation. By contrast, commodity businesses rely on low-cost operations and tight market supply to generate high returns. The latter is subject to superior execution, while the latter is sensitive to the vagaries of the industry and economic cycle.

I also loved this passage from Bruce Gibney at the Founders Fund:

“Real technology companies tend to create durable returns, making timing much less important. If you invested in webvan.com, your window of opportunity was measured in months; if you backed Intel, your window of opportunity was measured in decades. Therefore, as investors, we should seek companies developing real technologies.”

Bruce Gibney. Founders Fund Manifesto. Founders Fund.

Scaling monopolies

Technology, networks, scale, and branding alone does not guarantee success. Start-ups must “choose [their] market carefully and expand deliberately”. Thiel suggests that start-ups ought to “start small and monopolise” first. The goal is to dominate a manageable, niche market.

Pursuing too many segments at the same time risks overstretch. Amazon, for example, began with books. eBay too, likewise, began as an “auction marketplace in 1995 … for intense interest groups, like Beanie Baby obsessives”. Only later did buyers and sellers from broader categories enter their ecosystems.

Additionally, it’s wise, Thiel says, to avoid direct disruption that “attracts attention” and “fights [you] can’t win”. PayPal, for example, “took some business away from Visa”, but the boom they created for internet payments “expanded the market for payments overall”. As the saying goes, if you want to beat Grandmaster Magnus Carlsen, you ought to challenge him at something other than chess.

“The most successful companies make the core progression—to first dominate a specific niche and then scale to adjacent markets—a part of their founding narrative.”

Peter Thiel and Blake Masters. (2014). Zero to One.

Thiel’s seven questions for start-ups

According to Thiel, every current and prospective start-up should ask itself the following seven questions:

  1. Engineering question: “Can you create breakthrough technology instead of incremental improvements?”
  2. Timing question: “Is now the right time to start your particular business?”
  3. Monopoly question: “Are you starting with a big share of a small market?”
  4. People question: “Do you have the right team?”
  5. Distribution question: “Do you have a way to not just create your products, but deliver your product?”
  6. Durability question: “Will your market position be defensible 10 and 20 years into the future?”
  7. The secret question: “Have you identified a unique opportunity that others don’t see?”

Companies that fail to answer two or more of these questions tend to face greater setbacks and likelihood of failure. Thiel says that many companies during the cleantech bubble and dotcom mania failed to meet these questions.

Founders Fund’s manifesto

Thiel’s questions are reflected in the Founders Fund, the venture capital arm he co-founded. As Bruce Gibney describes in their manifesto, the “best companies” (or best investments), tend to have four common traits:

  1. “They are not popular”. Popular investments are usually too expensive.
  2. “They are difficult to assess”, which dampens their popularity.
  3. “They have technology risk, but not insurmountable technology risk”.
  4. “If they succeed, their technology will be extraordinarily valuable”.

Thiel’s case on Tesla

In Thiel’s opinion, Tesla (NASDAQ: TSLA) has good answers for each of his seven questions. With regard to engineering, Tesla possessed battery, powertrain, motor, and integration technologies that other automakers previously relied upon. The company also got its timing right with an unprecedented $465 million loan from the United States Department of Energy.

Tesla saw the “secret” early on: that wealthy people wanted to buy clean tech whilst looking fashionable at the same time.  So, the company concentrated on the “market for high-end electric sports car” first, and expansion into mainstream markets after.

Furthermore, it helps that Elon Musk is “the consummate engineer and salesman”, who attracted a management team “that’s very good at both”. And unlike other automakers, Tesla controls its end-to-end distribution chain. While this might cost more than partnerships with independent dealers, Tesla gets to cultivate their brand and customer experience to greater effect.

With all that said, durability remains an unanswered question in my mind. Can they preserve and expand upon their first mover advantage? Automakers and airliners that made similar leaps and bounds in decades past were unable to do so. While Thiel believes that Tesla’s moat will “widen in the years ahead”, we’ll have to see if this is enough to justify the company’s premium valuations today.

Durability and the long game

Finally, entrepreneurs and investors often ignore the challenge of durability, and the threats that come from competition and replication. Even if you’ve done all the hard work to introduce a novel idea, value capture remains difficult if some other company is able to flood the market with comparable imitations.

Likewise, entrepreneurs that find themselves caught in the whirlwind of monthly targets and quarterly reporting are likely to lose sight of “harder-to-measure problems that threaten [their] durability”. Thiel highlights Zynga as an example. While the company found early success with its video game Farmville, it struggled to develop repeatable smash hits. Groupon, likewise, enjoyed tremendous growth in its early days, but struggled to retain customers and repeatable business.

Thiel sums it up best:

“If you focus on near-term growth above all else, you miss the most important question you should be asking: will this business still be around a decade from now? Numbers alone won’t tell you the answer; instead you must think critically about the qualitative characteristics of your business.”

Peter Thiel and Blake Masters. (2014). Zero to One.

References

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