Zero to One — Peter Thiel on Contrarian Questions and Other Start-up Notes

Vertical progress, contrarian questions and start-up notes

How do we find, build and scale great companies for the future? As PayPal cofounder Peter Thiel tells it, there’s “no formula for success”. Good engineering, timing, distribution and people are rarely enough. You have to see a truth or secret that nobody else has yet. Thiel expands on this very challenge in his excellent book Zero to One. From vertical progress to contrarian questions, this post shares the big lessons that I took from his book — some of which, I think, are worth incorporating into one’s entrepreneur or investor’s toolkit.

From zero to one to many

Before we can find or build great companies, we have to understand how progress and innovation works. While we cannot predict the future with certainty, we can probably assume two things about it: (1) “It’s going to be different”; and (2) “It must be rooted in today’s world”.

Horizontal progress

When thinking about innovation, Thiel likes to distinguish between horizontal progress and vertical progress. Horizontal progress is the transition from “one to many”. This involves copying or replicating good ideas. One such example is globalisation. When something is in strong demand, producers around the world may try to meet such needs.

Vertical progress

Vertical progress, by contrast, is the journey from zero to one. This involves creating something new. Unsurprisingly, vertical progress is more challenging and less predictable. It’s easier for people to improve upon the lightbulb than to invent it. If the problem was obvious, we’d have solved it already.

“The paradox of teaching entrepreneurship is that such a formula necessarily cannot exist; because every innovation is new and unique, no authority can prescribe in concrete terms how to be innovative. Indeed, the single most powerful pattern I have noticed is that successful people find value in unexpected places, and they do this by thinking about business from first principles instead of formulas.”
Peter Thiel and Blake Masters. (2014). Zero to One.

Goldilocks

Thiel says that start-ups are better placed to solve zero-to-one problems. While they’re small and nimble enough to try something different, they’re not so small as to not get anything done. Indeed, it’s often difficult to try new things at large organisations. Bureaucracies are cumbersome. Dysfunction is rife. And incentives to preserve the status quo are ever-present. Employees are more likely to pursue behaviours in the interest of career advancement over long-term company needs.

Contrarian questions to innovation

The essence of innovation, Thiel says, lies in your answer to the contrarian question: “What important truth do very few people agree with you on?” To the entrepreneur, we ask the following: “What valuable company is nobody building?”

What makes innovation difficult is that you must be both contrarian and correct at the same time. You have to look at the same problem differently.

“What does it mean to be contrarian? It does not mean simply doing the opposite of what the majority does — that’s just consensus thinking by a different guise … The most contrarian thing to do is to think independently. It is not without its risks, because there is no cover from the crowd, and because it frequently leads to conclusions with which no one else agrees.”
Bruce Gibney. Founders Fund Manifesto.

Technology matters more

To answer his own question, Thiel says that technology “matters more” than globalisation when it comes to “defining” the future. Personally, I’m not so sure if this is actually a contrarian answer. From the discovery of fire to the industrial revolution, technology has played a fundamental role in progress. I doubt there’ll be many who disagree with him. But I get his point.

“The most contrarian thing of all is not to oppose the crowd but to think for yourself … If you can identify a delusional popular belief, you can find what lies hidden behind it: the contrarian truth. … Every great business is built around a secret that’s hidden from the outside.”
Peter Thiel and Blake Masters. (2014). Zero to One.

Where good ideas come from

Contrarianism, I think, links well with Steven Johnson’s work on Where Good Ideas Come From. Johnson identifies seven common sources of innovation: (1) the adjacent possible; (2) error and selection; (3) exaptation; (4) slow hunches; (5) serendipity; (6) liquid networks; and (7) platforms. Each of these themes involves combining and building upon existing knowledge in different ways, whilst remaining connected to the ideas that preceded it.

Dot com mania and lessons

It’s also good to ask contrarian questions during times of extremes. The classic example, of course, was during the dotcom mania. For many, the bubble’s bursting was the clearest evidence of irrational exuberance. To Thiel, not all of it was so irrational. Some believers were just far too early.

Most entrepreneurs, Thiel says, took four lessons from the dotcom experience: (1) “small, incremental steps are the only safe path forward”; (2) “stay lean and flexible… planning is arrogant and inflexible”; (3) “improve on the competition: don’t try to create a new market prematurely”; and (4) “focus on product, not sales… bubble-era advertising was obviously wasteful”.

These lessons seem most sensible in light of the crash. But Thiel argues that the “opposite principles” are probably more practical in a start-up environment: (1) “It is better to risk boldness than triviality”; (2) “A bad plan is better than no plan”; (3) “Competitive markets destroy profits”; and (4) “Sales matter just as much as product”.

Do you agree?

Power laws in venture capital

When thinking about the future, Thiel says it’s important to consider the likely distribution of events. Not all things are normally distributed. Many things are actually governed by power laws. Common examples include Zipf’s law, which maps the frequency of words; Kleiber’s law, which describes the relationship between animal size and metabolism; and the Pareto principle, which gave rise to the famous 80-20 rule.

“Everyone needs to know exactly one thing that even venture capitalists struggle to understand: we don’t live in a normal world; we live under a power law. … The biggest secret in venture capital is that the best investment in a successful fund equals or outperforms the entire rest of the fund combined.”
Peter Thiel and Blake Masters. (2014). Zero to One.

Non-normal distributions are also common in socioeconomic systems. Examples include city population, household incomes and market capitalisation. We observe similar patterns too in the mortality rates of new businesses. Many start-ups arise and die each year. It follows that the very few start-ups that make it to maturity tend to dominate the venture capitalist’s portfolio. If you assume risk and returns are normally distributed, you might make incorrect selections and capital allocation decisions.

Thiel’s criterion

In a power law world, Thiel offers a handy tip:

“Only invest in companies that have the potential to return the value of the entire fund. … Even the best venture investors have a portfolio, but investors who understand the power law make as few investments as possible.”
Peter Thiel and Blake Masters. (2014). Zero to One.

While this is a restrictive criterion, his reasoning makes sense. If the bulk of your holdings are expected to fail, each holding should exhibit some chance to recover the totality of expected losses and more. You risk “buying lottery tickets” when you focus more on diversification and less on “the substance of a business”.

Bad eggs, bad money

Yes, investors don’t like to lose money. But that’s the nature of venture capital and investing. Thiel observes how VCs tend to spend more time on the bad eggs than the good. This represents an opportunity cost in attention and resources.

This problem is not unique to start-ups. Activists and short sellers face a similar problem too. Pershing Square’s Bill Ackman, for example, lost inordinate amounts of time navigating his situation with Valeant and Herbalife. Pershing’s big winners, like Chipotle Mexican Grill, didn’t require nearly as much attention.

Power and complexity

Thiel rightly points out that schools do not train students to see power law systems. I’d add too that students do not learn enough about complex systems either. The problems we ask kids to solve tend to contain definite solutions. And adults that fail to unlearn this worldview may see opportunities and regularities where none exist.

Berkshire Hathaway’s Charlie Munger made a similar observation in The Art of Stock Picking. He highlights the enormous value in understanding basic probability for solving real life problems. Munger made the effort, for example, to understand the shape of Gaussian and Poisson distributions, and where they arise in everyday life.

“You can’t trust a world that denies the power law to accurately frame your decisions for you, so what’s most important is rarely obvious. It might even be secret. But in a power law world, you can’t afford not to think hard about where your actions will fall on the curve.”
Peter Thiel and Blake Masters. (2014). Zero to One.

Thiel’s law for startups

“Thiel’s law”: A startup messed up at its foundations cannot be fixed.
Peter Thiel and Blake Masters. (2014). Zero to One.

While I dislike the modern trend of calling everything a law, Thiel’s law (or reminder) is a helpful one. Poor foundations and incentives from the beginning sets the enterprise up for failure. Here, Thiel offers a few words of wisdom:

Marry carefully

Much “like getting married”, your choice of co-founders is the critical first step. In addition to technical and complementary skills, founders should “share a prehistory”. They have to know that they can work well together.

Eat your own cooking

People who do not earn a salary from the company, or own shares in them, are “fundamentally misaligned”. For this reason, Thiel doesn’t believe in hiring consultants for cash-strapped start-ups. Right or wrong, he is also hesitant about hiring part-time employees and remote workers. (I do wonder if his attitudes have changed since COVID-19.)

Set the tone with your salary

CEO pay is very important as well. When a young company is in dire need of cash, it’s a big red flag when the owner is paying him or herself an unjustifiable salary. Thiel says the CEO should set a precedent “by taking the lowest salary in the company”. Alternatively, the CEO can take the highest but modest salary to set “an effective ceiling on cash compensation”.

Founders must also remunerate their employees fairly on an absolute and relative basis. As Thiel puts it, “resentment at this stage can kill the company”.

“A company does better the less it pays the CEO—that’s one of the single clearest patterns I’ve noticed from investing in hundreds of start-ups. In no case should a CEO of an early-stage, venture-backed start-up receive more than $150,000 per year in salary. If a CEO collects $300,000 per year, he risks becoming more like a politician than a founder. High pay incentivizes him to defend the status quo along with his salary, not to work with everyone else to surface problems and fix them aggressively. A cash-poor executive, by contrast, will focus on increasing the value of the company as a whole.”
Peter Thiel and Blake Masters. (2014). Zero to One.

Uphold the peace

Healthy relationships are central to any good start-up. To reduce the risk of internal conflict, Thiel recommends companies define clear roles, expectations, and responsibilities for employees. This can help to minimise internal competition, especially during the company’s early days, when job needs are nebulous and fluid.

We often attribute start-up failure to the valley of death and competition. But it’s important to see, Thiel says, that “every company is also its own ecosystem”. Failure due to external forces is often a symptom of underlying ailments. Internal resentment, conflict, and factionalism can weaken the company “like an autoimmune disease”.

Ownership, control and possession

Central to Thiel’s law is the problem of misalignment. Founders and investors should check for the quality of alignment at all levels of the company. In most start-ups, investors, founders, and employees share in the ownership. Founders and investors are usually in control, but managers and employees tend to have possession of day-to-day responsibilities.

Conflict and dysfunction are likely when misalignment between ownership, control, and possession exist. And the risk of misalignment grows with the size of the company and distribution of roles.

Control-possession problems

Thiel uses the U.S. Department of Motor Vehicles (DMV) as an extreme but humorous example of a control-possession problem. While the governor and legislature have “nominal control”, the “clerks and petty tyrants” possess the DMV with “small-time powers”. With limited accountability, the DMV succumbs to wretched bureaucracy.

Ownership-possession problems

Ownership-possession problems are common in large corporations. Many CEOs hold little equity in the companies they operate. Misalignment encourages them to “reward [themselves] through the power of possession rather than the value of ownership”. If the quarterly earnings look good, they get to keep their job, salary, perks and social status. Never mind the long-term returns. For them, that’s too many years away.

“Equity is a powerful tool … Anyone who prefers owning a part of your company to being paid in cash reveals a preference for the long term and a commitment to increasing your company’s value in the future. Equity can’t create perfect incentives, but it’s the best way for a founder to keep everyone in the company broadly aligned.”
Peter Thiel and Blake Masters. (2014). Zero to One.

Ownership-control problems

By contrast, most misalignment problems in the start-up scene are “between ownership and control — that is, between founders and investors on the board”. Here, Thiel says, “a board of three is ideal”. Smaller groups enable greater communication, oversight, and consensus building. While this risks stronger opposition should conflicts arise, Thiel advises against mega boards since they “exercise no effective oversight at all”.

If you build it, will they come?

“Even though sales is everywhere, most people underrate its importance. … Customers will not come just because you build it. … What nerds miss is that it takes hard work to make sales look easy.”
Peter Thiel and Blake Masters. (2014). Zero to One.

Chapter 11, ‘If you build it, will they come?’, was one of my favourites. I’ve always been a little sceptical of extravagant marketing and sales. With an engineering mindset, I wanted to believe that good products must see the light of day. As the quote above suggests, I’m one of those nerds that missed the broader point of sales.

Indeed, “the best product doesn’t always win”. Path dependence, product lock-in, cultural inertia and sheer happenstance can prevent people from adopting good products. As John Kenneth Galbraith highlighted in The Affluent Society, customer demand is not some mysterious independent variable. Sometimes, the firm plays the key role in creating demand and the market itself.

An essential design element

Thiel recommends we think of sales, marketing, and distribution as an “essential” element of the product’s design. A business is doomed if it cannot find ways to sell its product. Great sales can help the company to generate market power. Sometimes, they’re so subtle that people don’t realise they’ve been persuaded at all.

Strategy and priorities

Naturally, you have to choose the right strategy for the right product and customer. Can you imagine if Coca-Cola relied on door-to-door salespeople to distribute their products? Careful prioritisation is also critical. Thiel recalls, for example, how PayPal went after its two most valuable customer groups — emigrants that needed to wire money to families overseas and active sellers on eBay — before expanding into broader, more competitive segments.

Beyond your customers

Additionally, companies are not only selling their products to customers. They are selling themselves to prospective employees, suppliers, and investors too. Remember that start-ups, enterprises and governments are in the same market for talent and partners. If you fail in this department, you risk ceding incremental advantages to your competitors. Sales, marketing, and distribution matters.

Value creation and value capture

Of course, for start-ups and enterprises to thrive, they must capture some of the value they create. It’s vital then to understand the relationship between value creation, value capture and the forces of competition. On this topic, Thiel has many interesting things to say. But for brevity, I’ll end this post here and save that discussion for a separate post on creative monopolies.

References

Thiel, Peter., & Masters, Blake. (2014). Zero to One — Notes on Start-ups or How to Build the Future. Learn more about Thiel at <https://foundersfund.com/team/peter-thiel/>