Reid Hoffman  1:27  

In 2013 to 2014, I was on a panel in London with some Silicon Valley friends. We were asked what the secret of Silicon Valley is because just like the stats that Gina started with, it’s roughly speaking rounding up in the entire Silicon Valley areas, 4 million people. That’s not 4 million people in the tech industry. That’s 4 million people altogether. So the tech industry is a tiny, tiny fraction. Half of the NASDAQ. Why is that? 

The answer that Silicon Valley people frequently give is they say, “Well, we have this environment where people can immigrate here. We have an entrepreneurial culture that allows a general risk taking and doesn’t penalize failure. We have venture capital. We have technical universities and technical companies. We have enough shots on goal that this emerges these interesting things.”

I was reflecting as I was hearing this answer from my co-panelists, that we were really doing a disservice to the entrepreneurial community, in this case in London. It was like, “Well, you just need to get your… because they had all of the things other than the fear of failure culture. It’s like you just need to be bolder. You need to have less fear and then you’ll be just like Silicon Valley.”

I said, “Okay, this is really kind of a disservice where we really want this entrepreneurial understanding to spread everywhere. We want more places to be able to learn techniques like this. Do this. It creates technological innovation, the future of the companies, the future of the jobs. The future is a very good thing.” It’s a very good thing. 

I then started reflecting on why the answer was insufficient. What I realized was, it wasn’t so much the startup phase, which you now have at least 100 other areas other than Silicon Valley, even excluding China. Maybe it’s hundreds, but it’s actually in fact, this pattern of getting the scale. 

It’s a combination of a talent network. It’s a combination of an understanding which business models work and don’t work, which things you don’t need to do until later in order to get to scale quicker, which risks you can take as an acceptable kind of financial outcome as trying to make it work for the customers, for your investors, and for the employees. 

[It’s a matter of] making it all work. It was a set of these things, which is of course an evolving practice. I then thought we should really get this out there.

Stig Brodersen  3:40  

Like what Reid said, Silicon Valley is such a small area. I would be surprised as I’m the only person who would say, “How can an area that is so small come up with so much incredible innovation and so many great businesses? How is that even possible?” 

I was reflecting upon this and want to give my two cents but instead, I found this paragraph by Bill Gates where he’s giving his two cents on the secret of Silicon Valley, which I found really insightful. 

What he was talking about, in addition to Reid Hoffman here is that the secret of Silicon Valley is the rich ecosystem of service providers and outsourcing companies to support rapid growth. Many companies have gone through their own growth spurts. There are a lot of examples and best practices to learn from. 

He points out that with the feedback loop that you have in Silicon Valley. There’s just this constant stream of data that has to do with your product cycles that drops from yearly to weekly or even daily cycles. So Silicon Valley, it’s not just because they’re smarter. It’s just as much because they try more things faster. In many ways, it’s a numbers game. 

I know that we were supposed to talk about Reid Hoffman, I just wanted to add that here. We need to get a better understanding of why it is that an area with only 4 million people, that’s the population, that’s not people working in the tech industry. Why can they come up with so many incredible inventions?

Preston Pysh  5:10  

My only comment on this is just, I mean, it’s just sucking all the talent from anywhere in the country out to Silicon Valley. Mostly because I think you have MBA students, you have undergrads that hear the stories of young entrepreneurs going out to the Valley and hitting it big. They also see companies like Apple, and you name it, with very high market capitalizations. They know that the salaries out there are very high. 

I think a lot of college students miscalculate the cost of living when they hear the salary out in Silicon Valley is 150,000, or whatever it might be. They don’t realize what their cost of living is going to be and that maybe they’re actually taking a pay cut by going out there. Though I think a lot of that is just the momentum of taking very, very smart and talented people and placing them out there. The culture itself just kind of takes over once they arrive.

Stig Brodersen  6:03  

Yes and when we talk about technology and the clusters of innovation, it seems like Silicon Valley is the protocol. However, that’s not how that’s shared across the world. I was reading this book by Kai-Fu Lee called “AI Superpowers.” 

He talks about how the power of Silicon Valley is such that you are helping each other in so many ways. You’re even helping your employees get new jobs. You’re creating really good working conditions for them. 

However, what he talks about is that’s not how it is all around the globe. You don’t have that ecosystem of the networking effects. The companies, even though they might be competing with each other, they’re making each other better. They’re not copying each other. They’re helping each other to make each other better. 

For me, that was very profound. It might sound very logical when you hear of someone who’s been to Stanford, then he would work in Google, Facebook and Apple. That’s not necessarily what’s going on in the rest of the world. So really, the strength of the ecosystem is something I found really insightful here for this question.

Preston Pysh  7:06  

Yeah. The culture has definitely taken over at this point. There’s a culture out there that’s breeding this type of environment. 

Alright, on to the next question. In this question, Reid was asked, “For successful companies in Silicon Valley, you talk about a concept you refer to as blitzscaling. Please explain the concept and give an example of a company that has blitzscaled.” Here’s his response.

Reid Hoffman  7:27  

There’s three kinds of scale that you look at in business, you look at customer scale, revenue scale, organizational scale. Part of how you look at these modern businesses is you want a high customer and revenue scale per employee, as part of how these businesses work and have a highly leveraged global presence. 

However, actually, in fact, all of them end up having a high organization scale too, because you need customer service. You need salespeople, you end up moving from single threaded organizations to multi threaded organizations. So you’re working on a number of different products. You end up making your services much more robust

What we then did was we said, “All right, let’s take the organizational scale as the fundamental foundation,” even though you’re targeting the customer and revenue scale. Frequently, of course and blitzscaling, you’re targeting customer scale first with later figuring out revenue scale. 

Let’s look at what are the patterns that move. We roughly went orders of magnitude. You start with the folks in the garage. That’s a family that’s order of magnitude ones, 5 people, 10 people. Then you move to tribes, 10s peoples, like 15, 20, 30, 40. Village, hundreds; cities, thousands; nations, tens of thousands. Then you go through these different levels of order of magnitude of employees. 

What you realize when you begin to look at that is that things change radically as you go through these different levels. Even though frequently what happens with blitzscaling companies is they will double in size in three months or six months, which is an enormously kind of chaotic kind of situation. They will actually in fact, what changes is everything from how you recruit, how you onboard, what does management look like, what does communication within the company look like? 

Also, are you single threaded or multi threaded in terms of what you’re doing? Are you formal or informal? The slider on your operational processes as a company. All of these things change. 

Part of the reason you do that is because in blitzscaling, you’re doing it really quickly. You need to be able to make those shifts at some speed doing that. Year tends to be even more than… they sometimes say internet years or dog years, so it’s 7 x. Sometimes it even feels like more than that when you’re blitzscaling. 

Though maybe, to go back to the early days of PayPal. When we started, we launched the product. I think it was November of 1999. We started picking up some traction in December, with growing on eBay and really started growing in January. In between January and September, for a large swath of weeks, we were growing at 2% to 5% compounding per day in terms of customers, people using the service, and similar in terms of transaction volume. 

We moved from, “Hey, there were 25 of us in an office to there were hundreds of us by September.” We moved from a manageable burn rate to I think in August we burned $12 million in one month. I told Peter Thiel that if we were standing on the roof of the building throwing wads of hundred dollar bills over as fast as we could, we wouldn’t have spent money as fast as we were doing that. 

Those are the kinds of things that are the attributes of doing this. Meanwhile, we’re trying to figure out a business model because in January and February, we thought we didn’t have to figure out a business model for someone to acquire us and weld on a business model. 

Then we decided in March, we weren’t going to get acquired. We’re going to be a bank. Then by April or May, we decided that being a bank wasn’t going to work, and that we should reverse the process that we’ve been talking about. 

In August, we thought, “Oh gosh, we have one chance to get a business model and go figure it out.” In September, we took an off site, Peter, Max, and Luke Nosek, and I figured out we should be a master merchant and a payment service. We came back and did that. 

Stig Brodersen  11:13  

What an incredible story. I loved when he said, “We thought we should probably come up with a business model.”

Preston Pysh  11:20  

I nearly died when I heard that.

Stig Brodersen  11:23  

I like that. I would really like to talk about business models here and talk about how different that is for a company that’s been blitzscaling or whatever you want to call it, something that’s growing really, really fast. Apparently, so fast that you can just stand on the roof of a building and just throw out hundred dollar bills. They won’t even burn as fast as the burn rate of your company.

The business model of something that blitzscaled is really unique because you need to reach a tipping point before you start having these major margins. One example that comes to mind is something like Google AdWords. They’re making so much money, Google, on something that has clicked to zero marginal cost. So for every extra dollar they make on their advertising, they don’t have a lot of costs associated to that. 

The interesting thing is that they had to invest a ton of money and burned through a lot of cash before they went to this point in time where they can just scale. The key for them was just to have everyone on Google and then when everyone was on Google, it was very, very expensive to get people to do. Then they could make money out of something like AdWords.

You can mention something like PayPal, again, where Reid Hoffman was the CEO. They also have very little costs in terms of people transferring money to each other. So for them, it was also about reaching that critical mass or that tipping point where there were enough people on the network. Now they could start sending money to each other.  

I think today they have close to 280 million active users or something like that. So it has become extremely, extremely successful. It’s all automized and it’s all very convenient to use. 

The last thing I just wanted to to add here about blitzscaling is in a way, it’s also a competitive advantage because if you have to compete with someone like PayPal or to compete with someone like Google, you have to be willing to burn a lot of cash and handle that growth, which is very difficult in itself before you can compete in the same market space.

Preston Pysh  13:16  

I agree with your last point there. That where I think a lot of this is coming from is just a race to protect or create a competitive advantage and get in network effect before anyone else can. 

I think the advent of the internet and the connectivity of the world in the last 20 years has really kind of created this business model that if you’re going to do something in tech, you got to move out at a pace that is so breakneck. [The pace should be] no one can even attempt to keep up with you or sustain what you’re doing. 

You look at what Reid was describing there. Not many people can lead an organization through that kind of breakneck speed and keep it all together because you’re maybe hiring too fast or you’re creating some type of cultural dynamic. [The reason being] you’re hiring so quickly that you create cancer within your organization. You don’t have the ability to establish that culture and those protocols that you read about in books like “Good to Great” that you just can’t establish these things because of the speed at which you’re going. 

Then I think the other thing that’s rarely talked about is the ability to continue to do VC round after VC round and continue to sell investors on whatever it is that you’re doing. So for him saying, “We didn’t even have a business model,” but they got breakneck growth on users, you’ve got to sell that narrative to a VC and convince them that there is some type of way to make money on this. What is that valuation? 

A person who is truly gifted and doing that is wearing all of these hats. I just don’t think that that’s something that too many people out there really have a knack for it. I mean, when he was describing that year there at the end, that sounds like stress to a degree that you can’t even imagine.

My final point is this. If you haven’t read this book, “Bad Blood,” this is about Elizabeth Holmes and Theranos that went bankrupt. It is just a perfect example of when you’re blitzscaling and you have somebody who’s unethical at the helm, it shows you how badly and poorly things can go because it’s this exact blitzscaling model that Reid Hoffman is explaining. 

However, it’s with a person who’s leading that charge who has very questionable ethics, just downright dishonest. I mean, the implications that kind of fall out of that. It is just an incredible book that I think any young entrepreneur should read. 

For the next question, Reid was asked, “What are the best practices of networking, and how do you use networking to find new job opportunities?” This was how he responded.

Reid Hoffman  15:54  

The foundation of LinkedIn is the insight that every individual whether a student or Bill Gates, having a public professional identity that helps you navigate your world of work, what you’re particularly seeking to do is extremely helpful. 

It’s helpful both on an inbound basis because one of the truths about living and working in the networked age is that you have to have a strategy for how you’re found. Then how the right signal gets through to you and being found because there are millions of people out there. 

You have to think each CPU processor, each *inaudible* person, how do you get found by the right person, the right people, and how do you do business with them? Then also, how do you find the right people? How do you find expertise? How do you find business opportunities? How do you find jobs? How to invest in yourself? Both of those are through the network as a fabric and as a foundation.

I realized during my time at Social Net, talking to Peter, and Max with PayPal, that this would be another fundamental way to transform people’s lives. For example, to enrich their economic opportunity and to enrich their ability to either work, to start companies, to navigate whatever economic life is important to them. 

Even today, most people who come into LinkedIn don’t really realize how strong the tools are because most people when they look for work… We have job listings on LinkedIn, they go and look at the job listings. It’s a perfectly valid thing to do. 

But the really interesting thing is to say, “Well, who do you know who is, in our language of LinkedIn, two degrees away from you? Who can help give you guidance? Who can say well, this company is a good place to work or there’s opportunity here?” 

I mean, it goes all the way back to my work and my business career started with a call to a Stanford friend whose roommate was working at Apple. How do you discover those opportunities? Well, that all comes from the network. Even today, with well over 300 million people on LinkedIn, most people have yet to learn how to use their network.

Stig Brodersen  18:00  

I think he’s spot on when he talks about the misperception about networking. I know that he’s also here sitting here promoting his own company. I’m not blind to that but I think he’s right that if you approach LinkedIn and LinkedIn could be your, a metaphor if is networking in general, with the attitude of “give me a job please,” you will probably not be successful. 

Even if you get a job that way, there’s a good chance it’s the wrong one. I think that looking at job listings and that being your go-to place might have been a very good way to do that a few decades ago. 

I think the best fits is really what will come from your network. Someone who knows you and thinks you would be a good fit not just for the job description, but also more from a cultural perspective, which I deem even more important to really reveal your true potential. 

It’s important to realize that networking is in essence making yourself and your network smarter. Typically, I’d say that what you give is what you get. If you help a person in your network, a second link. Say it could be me helping one of Preston’s friends. I know it might sound out there, but it does work like magic. You do get it back. Not necessarily from Preston or from Preston’s friend, but in aggregate, I think you get multiples of what you send out. 

I’m also saying this as an avid user of LinkedIn. I actually go onto LinkedIn every single day. I absolutely love the networking aspect of that. It’s not to give anyone a job or it’s not to ask for a job. That’s not why I’m doing it. It’s really to invest in myself and give back to my network. 

So just a few examples here. I have really smart people in my network who share valuable resources. That’s something I’m interested in and I can engage with that content. I also have a lot of communication with the people on LinkedIn. But again, this could be another place. 

I think that is so powerful because you have this description of the person that you’re speaking to, because it’s not just one link out. It might be two links out. So you’re not too familiar with that person, but you already have his resume. You have a really good starting point. 

I also just want to say for the record, Reid Hoffman is not paying me to say this. Though I am a huge fan of LinkedIn, but also because I travel a lot. I travel, I don’t know… eight times a year or ten times a year. I always use LinkedIn when I come to a new city, a new country, to locate my network there and to see who’s there. Who can I do business with? Who can I learn from? 

Not too long ago, I went to a live event in New York that we had for the listeners of TIP. I met up with a young entrepreneur and I was lucky enough to help him with a few things. He actually told me that he had reached out to me a few times before and apparently I’ve just said no when we did that.

When you meet people in person, which is really the very first step that comes on something like LinkedIn or networking in general. [Anyway, when you meet someone in person,] you will meet someone, there’s just a different connection. You sometimes need something to facilitate that meet up one way or the other and to meet up with the right people. That’s why I’m such a big fan of that. 

I just wanted to put that out there. You don’t have to use LinkedIn, you don’t have to use the network the same way as I’m doing. If there’s one key takeaway, I think you can take from this discussion and what Reid Hoffman said is that you can change your job every four years or whatnot. Then that’s the only time you want to help other people. That’s when you count on your network to fix your job situation for you. It’s really the other way around.

Preston Pysh  21:35  

One of the things that’s interesting with Reid Hoffman is he obviously founded a social network with LinkedIn. You go back in time and Reid Hoffman was the co-founder of a company called SocialNet.com. This is back in 1997. It focused on online dating and matching up people with similar interests. For example, you were a golfer and you wanted to find other people in the neighborhood who were golfers, you could use socialnet.com to do that.

The next question that we’re going to play here is where Reid talked about what he learned from starting this company back in 1997. Here it goes.

Reid Hoffman  22:11  

Social Net basically returned its capital to its investors, but didn’t actually do very well. There were key problems. The first one being financing strategy was central. In 1997 to 1998, we raised our second round… All of our competitors were going on to the market and saying, “We’re going to build these free websites. They’re going to have the whole world on them and you should give us $40 million to go do that.”

We were going on the market saying, well, we think subscription data is one of the real places where you can make money on the internet. You should give us $5 million, because we’re going to make a subscription web service and make it happen. Our business model, we think, is really sound. The business model is sound, if you look at  match.com and eHarmony, and a bunch of other things now.

The problem was it was the wrong strategy at the time. *inaudible* time was when everyone else was raising $40 to $50 million dollars and was going in advertising and buying deals and everything else about money… We were sitting here trying to make our little business model work, which in that financing climate was a dumb strategy. 

Your strategy has to be reflected in what your finance ability is right? Our area, which is an unusual one is very frothy capital markets, all your competitors are going to be well-capitalized. If you undercapitalized relative to competitors, you’re screwed. 

The other one, of course, is can you actually raise money for this at all? Because if you can’t raise money for it, you’re not attentive to what the financing market looks like for what you’re doing. Then you may also die because you have inadequate financing. 

Second thing I learned is what’s frequently said of retail is that there are three words: location, location, location. With consumer internet, it is distribution, distribution, distribution. 

As a matter of fact, one of the ways when I’m talking to panels and stuff about entrepreneurship and consumer internet is value what you’ve built without distribution, approximate value zero. You do not get distribution. Technology is not valuable. Teams are not valuable. Doesn’t matter. 

If you haven’t acquired a whole bunch of users through generally natural organic means, virality is one… Most people use the word not knowing what it means. Viral distribution is one. There are other forms of distribution that are natural organic that work, then your value is zero. 

When I had done Social Net, I hadn’t realized because when you work at like Apple and Fujitsu, you work at these places which have big channels of customers already. I didn’t realize that distribution strategy was central. That’s the very first thing you worry about, especially on the consumer internet.

Preston Pysh  24:32  

I thoroughly liked that clip. I think that the reason why that clip is so powerful is because when he was saying those things, it was at a time way back before he became kind of really, really famous like he is now. Just some real nuggets there about the whole VC comment that he wasn’t asking for enough money because he wasn’t reading the environment at the time correctly. 

His competitors were going out and raising 10x what he was and he just didn’t have the ability to compete because he wasn’t informed enough to know that he should have been asking for more money. Those kinds of things are just incredible. 

His comment about attracting users and having a user base being central to a service based online business is something that so many people don’t understand. They’ll go out and then start a blog or they’ll try to replicate maybe something else that they’re seeing. Then, they don’t realize that without any type of user community, you’re just dead on arrival.

You can have the best program in the world but if you don’t have the traffic to bring to that business, just dead on arrival. Let me tell you, that is a very, very insanely difficult thing to do. I know with our own business, attracting users and for us it’s listeners, that is not an easy task. It is something that is incredibly hard and difficult to do. 

So to hear Reid kind of hit on these points is refreshing to hear. It’s something that I think a lot of people don’t necessarily know unless they have somebody like him that says these things.

Stig Brodersen  26:07  

If I could mention one more component of something that Reid Hoffman did wrong, with socialnet.com back in the late 90s, is that perhaps he was just ahead of his time. You can see the success of social networks later. 

I mean, perhaps the internet was just too new. We were just not there. It was definitely the future and I think his own company, LinkedIn would be a great example of that. Buthe was probably just too early there. 

I just wanted to piggyback on some of the things that you and Reid talked about in terms of the distribution piece. I think he also mentioned location, location, location, whenever we’re talking about real estate. 

If you have the right distribution, it is like having your real estate in Manhattan. If you have the worst real estate in Manhattan, it doesn’t matter too much because the location is just so important. You can build something else on it and because it’s so valuable in itself. 

I think it’s interesting that throughout this episode, when Reid Hoffman has talked about business, he’s more or less not talked about the business model, or he doesn’t talk about the product. That’s not important, as much as everything that’s around it. 

I think that’s a common misperception among entrepreneurs, and also *inaudible* people that as long as the product or service is really, really good, the rest will follow. I think that’s completely wrong. That’s also what he’s getting at here. If you have the distribution right, then everything else will follow because you can mess up a lot of different things if you have the distribution right. You can get out to the people. 

Preston Pysh  27:37  

I don’t know if I agree with that. I think first and foremost, you have to have the product and the service right. Period. If there’s not a reason for somebody to praise it in a review, it is not a long term strategy. It’s not something that’s going to last long term, once you have that product or service right, because that’s what’s adding value to the end user. That’s what is adding value to the end user. 

Once that’s established, and once that’s there, without a distribution strategy and without all the other things that support the growth of that product or service, it’s just dead. 

I think that that’s where you see a lot of entrepreneurs kind of make their mistake is they might have the distribution perfect and then the product stinks. Then they sell a bunch of it up front, but in the end, it ends up failing, because it’s not actually adding value to the end user. So it’s a short term strategy. 

I think in order for a business to have a long term strategy, the product and the service actually has to add value. Period. It has to be.

Let me give you an example, you write a book, and the book stinks. But you have one heck of a marketing strategy and you’re putting it in the hands of all these celebrities and everyone’s raving, “Oh, you’re going to sell a ton of books when the book launches.” 

But in the end, two or three years later, you’re going to stop selling that book because the reviews of its value are going to be posted on whatever website. Then people are not going to buy that book anymore. 

I don’t know if that’s the point you were saying that one’s more important than the other. I don’t think that’s what the point you’re making. I think you were just basically saying that you got to have all these things in place in order for the product or service to be successful.

Stig Brodersen  29:16  

Before you think too long about the product that you’re creating, you should think about the distribution, building up the distribution if you can for yourself, or figure out how to distribute it. Because if you can’t do that, it’s going to be very difficult for you. 

It’s also in the mindset of you can pivot multiple times. You can do so many different things. However, it’s very difficult to do that, if you don’t have the distribution, say that you build up a big online community. If you have the community, you can do many different things. You can fail multiple times with different products, as long as you have the distribution. 

I’m not saying you should send out bad products in the hands of the consumers. You can come up with a filter that’s better than what you can find on Instagram, but more people would use the inferior Instagram Filter because, “Hey, it’s on Instagram already.” That’s an important factor to include. I don’t know if we speak the same thing or not.

Preston Pysh  30:06  

I think we are talking about the same thing and I think that there’s some truth to what you’re saying, because I’m not going to say any names here, but you see some people on the internet that obviously have a huge following. 

I would argue that whatever the product or services that they’re selling is not necessarily the best. But yet they continue to be able to do what they’re doing because of the distribution that you’re talking about. 

My opinion early on would have been that your goodwill and your brand is eventually going to destroy that distribution that you have in place. But maybe there’s a little bit of truth to what you’re saying and maybe there’s it’s really kind of situational dependent where sometimes like what I was just described, it can continue to float and continue to happen. Whereas, in other types of businesses that won’t last because of the brand and the goodwill that’s kind of established over time. Very interesting discussion. 

I think that if I was going to guess I think it can only exist on the internet. I don’t know that you could… I guess from a brick and mortar standpoint, it’d be a little harder. It has to be a flow of traffic that is not unique to the local area that would continue to populate a business simply because the traffic’s going through. I’m sure people have seen brick and mortar businesses like this, tourist trap kind of things.

Stig Brodersen  31:23  

Now I’m not the big coffee drinker, but I do drink other things than coffee whenever I go to Starbucks. Starbucks is not the place in the world where you have the best tea or where you have the best cappuccino…

Preston Pysh  31:35  

You bite your tongue.

Stig Brodersen  31:37  

Yeah, I know. They’ve launched so many different drinks over the years that have not been good, but it’s still immensely popular because they have the distribution. I’m a big fan of Starbucks by the way, don’t get me wrong. I’m saying this. I do think that… I don’t know. 

Anyway, I guess that’s just like one more comment to that but a very interesting discussion. If any other listeners have anything you want to add to this discussion, hook us up on Twitter. We’d love to discuss business with our listeners. So go ahead, guys.

Preston Pysh  32:07  

I don’t drink coffee. So this is the point in the show where we play a question from our audience. This question comes from Alistair.

Alistair  32:17  

Preston and Stig, thanks for a great show. It seems as though the best investment returns have been earned recently by people investing in unlisted securities, with the returns on stock market listed investments being disappointing by comparison. So my question is, how do we apply the principles of value based investing to early stage unlisted securities, many of which are growing fast, but don’t look good on conventional cash flow metrics?

Preston Pysh  32:44  

Alistair, that’s a pretty difficult question because it really depends on which industry you’re talking about. It could depend on a lot of other factors, but what you’re really talking about is private equity here. Some of it is just pure competition when you have less participants bidding up the price of something that can create value. 

When you’re talking about risks associated with investing in a company that maybe doesn’t have these characteristics that you’re talking about, like having a standard value based investment, some of it is just institutional knowledge. 

For example, Reid Hoffman seeing a business and being able to invest in a business. Then I’m not calling everybody that’s in that space a Reid Hoffman, but people who have invested in that space for a long period of time kind of know what to look for, because they’ve done it one or two times previously. 

Some of it might just be…. because I don’t know the statistics on this. Some of it might just be perception that there are better returns in these spaces without actually knowing that they in fact are. From the friends that I have in private equity, they tell me that the discount rates that they’re using are definitely higher than what you’re seeing in the public markets.

Stig Brodersen  33:53  

It’s a very timely question, now that we’re doing this episode about Reid Hoffman. Think back on the question about PayPal. How would you value PayPal when they pivot three or four times during nine months? How are you going to value that? You probably don’t want to do that. It is definitely not by conventional metrics. 

One of the things that Preston was talking about there is typically referred to as survivorship bias. You might think back on companies like Facebook, a company like Square right now, which is very relevant. They’re been making tremendous returns to their investors. There have been so many companies that have tried to make payments easier and failed. 

We look at Square now and we look at those who invested in Square back then that they have made so much money, but it’s very, very difficult. You do see the survivors and not those who failed. 

The underlying principle of what we’re talking about here on the show, is that you can foresee with somewhat reasonable accuracy what the future will bring. If you can’t do that you can’t make this discounting of the expected future cash flows because, well, you don’t know what to expect. So you can’t really make an assessment of the value. 

If we take a company like Facebook as an example. If you look at their year-over-year growth in the early years, one year 2,150% growth, the following year 433% growth, and then 219% growth. So they’re going from very little to $153 million in revenue in 2007. I mean, how are you going to value that? 

The other side of the coin is also that Preston was talking about, your discount rates of north of 7% to 8% or whatnot. Depending on where you are in the states of these companies, you have to use a really, really high discount rate. If you’re talking about companies that would either grow by 500% or fail because they’re just burning cash, I wouldn’t know what type of discount rate I would use at all. 

I would like to say a few things about venture capital here because yes, we’re doing this episode about Reid Hoffman. We’ve done a bunch of episodes before about Silicon Valley and venture capital. For me, it’s very glamorous and it’s very exciting. I would also like to bash and *inaudible* here and say, “Yes, it is important for society that you have risks *inaudible* capital. It’s a very important role to fill out. Venture capitalists, you have all the praise for that.”

When you go to the bank, they say you can’t do that, because you don’t have a proven business model. That’s whenever you have Silicon Valley and venture capital, because by definition, if you have blitzscaling companies that do not have a proven business model. I think the issue that I have with some of these tycoons and everything that’s around it, is that they’re looking at funding as the means to exit the company. Typically, in the shape of an IPO or a takeover for someone else. But why is it that all these VC companies want IPOs for their investments?

You can argue good arguments that it’s the fund structure and they have to pay back their investors. They have to diversify. There are many good reasons why they’re selling. But keep in mind when the public has access to whatever kind of security there is, it’s Silicon Valley that sells it. 

They’re very aggressive in the way that they say, “This famous investor. Reid Hoffman! Peter Thiel!” He invested in them and has that approval stamp on it. Or this IPO company would take over the world. You should buy into it. 

You might be thinking that that sounds like a great business thesis. Also keep in mind, they’re selling a product, they’re basically saying, “Please take it off my hands. Here are all the good reasons why you should buy it, but I’m actually selling it, I’m not going to own it anymore.”

Preston Pysh  37:39  

I have to piggyback on this because it goes back to the book recommendation I had earlier in the show, which is this book called “Bad Blood.” One of the things that was really fascinating with the demise of this company was the amount of venture capital that kept being thrown at this company real fast.

Theranos was trying to take blood samples in wherever location and then this device, this piece of hardware, that whatever remote location. So if you were in a Safeway, you could go in and you could have a small blood sample taken and they put it in this machine. Then, this machine supposedly could conduct the lab result on station right there. I would be all done through the mechanical machine instead of sending it out to a lab for a couple days. Then the results will come back. 

Well, the technology was a total farce. The machine was supposed to be able to do hundreds of different lab tests, but it actually couldn’t.

Going to Stig’s point, they had VCs that kept throwing more and more money at it. From what I could gather from the book, it seemed like the reason it kept getting more and more money was because people would say, “So and so made a really big investment in this company. This thing is going to change the world.” 

Then people would immediately have a bias to there being a research being conducted by that really talented venture capitalist or that other venture capitalist firm. That was the outsourced knowledge. Also, the understanding of this very complex and technically challenging business to understand was just outsourced. The narrative was quickly derived that, “So and so invested in the technology. Must be gold.”

It wasn’t. It was all a falsehood, but it just shows you how the snowballing of some of this VC money can be built in brands of other investors. Just some really interesting things to think about, especially if somebody maybe recently had a windfall and you’re trying to step into the VC space. Be very careful of that. This book is so good, so I’m just going to leave it there.

Stig Brodersen  39:49  

The other thing I just like to say is for public listed companies, which is really like where Preston and I… The things we talk about that when we talk about security is typically something that’s positive. Just keep that in mind. It’s public. That’s actually the important thing. It sounds very boring. It probably is. It’s not as exotic as Uber, Square or Airbnb. 

But because it’s public, it’s also transparent. I’s not this machine that even if it was public *inaudible* everything is transparent and has to be transparent. It also means that your potential upside is probably not going to be as high if it’s public, but your downside, you don’t lose money. It’s a lot more limited too. 

I think that’s something I want to put out there. I don’t know Alistair if we really answered your question, other than you probably won’t. You probably won’t be using the tools that we have and the formulas to access the value of security. I think that should also tell you something if you can’t value it, don’t buy it.

Preston Pysh  40:48  

Alright, so Alistair, fantastic question. We were just so appreciative of this. Sorry, we took so long to respond and I think we covered some things that were probably outside of the scope of your question in the first place.

As a token of our appreciation for leaving your question ,we’re going to give you access to one of our free courses on the TIP Academy page on our website. The course that we’re going to give you is our intrinsic value course. 

Our intrinsic value course teaches people how to determine the value of an individual stock. It also teaches you how to think about the market cycle and when you’re buying your stock. It also teaches you some stuff about options trading. We’re really excited to give you this course.

If anybody else out there wants to check out the course, you can go to TIPintrinsic value.com or you can just go to our website and click on the Academy link at the top of the page and courses right there. If anyone else wants to leave a question on the show, go to asktheinvestors.com and if your question gets played on the show, you’ll get a free course.

Stig Brodersen  41:42  

Alright guys, that was all that Preston and I had for this week’s episode of The Investor’s Podcast. We will see each other again next week.

Outro 41:49  

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