SocialStartups.com

quoted from The bowling pin strategy

A huge challenge for user-generated websites is overcoming the chicken-and-egg problem: attracting users and contributors when you are starting with zero content. One way to approach this challenge is to use what Geoffrey Moore calls the bowling pin strategy: find a niche where the chicken-and-egg problem is more easily overcome and then find ways to hop from that niche to other niches and eventually to the broader market.

Facebook executed the bowling pin strategy brilliantly by starting at Harvard and then spreading out to other colleges and eventually the general public.  If Facebook started out with, say, 1000 users spread randomly across the world, it wouldn’t have been very useful to anyone.  But having the first 1000 users at Harvard made it extremely useful to Harvard students.  Those students in turn had friends at other colleges, allowing Facebook to hop from one school to another.

Yelp also used a bowling pin strategy by focusing first on getting critical mass in one location – San Francisco – and then expanding out from there.  They also focused on activities that (at the time) social networking users favored: dining out, clubbing and shopping. Contrast this to their direct competitors that were started around the same time, were equally well funded, yet have been far less successful.

How do you identify a good initial niche?  First, it has to be a true community – people who have shared interests and frequently interact with one another.  They should also have a particularly strong need for your product to be willing to put up with an initial lack of content. Stack Overflow chose programmers as their first niche, presumably because that’s a community where the Stack Overflow founders were influential and where the competing websites weren’t satisfying demand. Quora chose technology investors and entrepreneurs, presumably also because that’s where the founders were influential and well connected. Both of these niches tend to be very active online and are likely to have have many other interests, hence the spillover potential into other niches is high. (Stack Overflow’s cooking site is growing nicely – many of the initial users are programmers who crossed over).

Location based services like Foursquare started out focused primarily on dense cities like New York City where users are more likely to serendipitously bump into friends or use tips to discover new things. Facebook has such massive scale that it is able to roll out its LBS product (Places) to 500M users at once and not bother with a niche strategy.  Presumably certain groups are more likely to use Facebook check-ins than others, but with Facebook’s scale they can let the users figure this out instead of having to plan it deliberately. That said, history suggests that big companies who rely on this “carpet bombing strategy” are often upended by focused startups who take over one niche at a time.

Focus is a really important for early stage startups, as it forces you to stay close to your customers while achieving product / market fit. It also allows you to concentrate any word-of-mouth effects you may have, helping you build your brand + critical mass. Great post by Chris (as usual).

(This was published to my letter.ly newsletter June 17th. To get more like this, sign up at letter.ly/dave. Thanks! It helps pay my rent. I'm not kidding — letter.ly already pays 30% of my rent!)

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(This was originally sent to my email newsletter list. I'm posting this publicly because people have asked for examples of what I publish. You can sign up at letter.ly/dave)

Hot topic the last few days are VCs railing against the proposed new tax legislation on carried interest. The proposal is to tax the money VCs make on their investments as regular income instead of as capital gains (which is the tax you pay if you were to make money buying stocks on the stock market). The argument for the tax is that it is income, and special capital gains treatment should be reserved for cases when you are investing your own money (a big risk), not somebody elses (and getting paid to do so).

Here's more detail, for those of you who aren't familiar. University endowments, giant pension funds, and the like invest their money in a bunch of different ways to both maximize their returns and diversify their risk. One of these "asset classes" is venture capital. They pay VC firms a fee of 2% of the total money invested to take their money and invest it into promising startups. To encourage VCs to pick the most promising startups, they also give VCs 20% of the profits from the startups that are successful. This is called the "carry". 

From the NY Times article:

"Under current rules, carried interest is taxed federally at a rate of 15 percent because it is treated as a capital gain. That contrasts with the tax rate on ordinary income, which can be as high as 35 percent. The plan approved by the House, which overcame strong lobbying pressure from Wall Street, amounted to a compromise that would tax 75 percent of carried interest as ordinary income and 25 percent as capital gains. It is expected to raise more than $17 billion in tax revenue over the next decade."

The argument against the tax increase is that VCs will immediately pass along the higher tax cost to the LPs in an effort to maintain their profit margins. In the face of reduced revenues, LPs will divert money going to VCs into other asset classes that have higher returns. This (they claim) will result in fewer dollars available to invest into startups, which will result in the creation of fewer jobs. Therefore, the new tax hurts the economy.

I don't buy it, and here's why. First of all, the best startups will always be able to find VC money because VC money isn't disappearing, just shrinking (maybe). And it's the best startups that result in creating the majority of jobs. It's also the best startups that create the 100x returns that VC funds are structured to require. The top funds result in the majority of VC returns, with the rest (over the last decade) barely breaking even or worse. So LPs will be even more competitive to try and get their money into the top funds, and it's the poor performing funds that will suffer. So yes, fewer jobs will be created, in that sucky VC firms will die and the bad investments they would have made will never exist. In my opinion, the projected $17 Billion in tax revenue seems more than enough to make up for it.

My argument breaks down if LPs shift so much money away from VC that it affects the top VC firms. I don't think that will happen, as LPs need to diversify their portfolios and high risk / high reward asset classes like VC are important pieces of that portfolio. The poor returns of VC funds over the last decade will be a good test of this theory – who cares what the tax rate is if your ROI was 0%!

This is definitely a complex issue, and I want to hear your thoughts on the matter, so please reply!