Netflix, not surprisingly, reported a weak quarter with its first loss in several years. So what’s changed for Netflix in the past few months?

I think Netflix’s problem is threefold: partners, competitors and customers. First, it was obvious Netflix’s original margins were not sustainable in the long run. Netflix secured some of its early licenses at very low costs and it was clear that the content owners would seek more the next time around. So, netflix’s costs have gone up. This is not likely to get better for Netflix. Second, Netflix has more competition now with the likes of Hulu and Amazon and also streaming services being introduced by the incumbents (Comcast and others). This competition will only get worse in the next 12-24 months. Third, customers used to Netflix’s biggest strength in the past. They have delivered WOW consistently. The past year hasn’t been great for Netflix. They have had several missteps, most important of which was the recent debacle with pricing and the spinoff. I think this was the most painful for Netflix.

It’s not surprising that Netflix is being squeezed by both partners and competitors. However, it needs to continue growing its customer base and upselling existing customers in order to address the partner and competitor issues. Going forward, the key to Netflix’s success is to win back customer confidence. Investor confidence and wall street will follow.

As many folks have pointed out, there are too many inefficiencies in modern day education (high fees, bureaucracy, etc). I have been looking at Coursera, Udacity, Minerva and other higher Ed startups with great interest. I also had a nice recent discussion on the subject with John Katzman (founder of Princeton Review, 2tor). Here’s my take on the prospects for these firms. But first, a short summary:

Coursera & Udacity offer online access to top courses/professors. Students register for courses, access content online, complete assignments, get grades and are certified.
Minerva: If you could build a University from scratch, what’d it look like? Minerva wants to compete with the Ivy league through a hybrid online-offline model.

Coursera/Udacity: This model makes sense. Use the Internet to provide students who currently have poor access to goo teachers/content. Quality of content & delivery is highly variable and there is no reason why everyone cannot access the star teachers. There will likely be a big winner here.

Minerva: This one is tricky. It’s hard to compete with Ivy League & similar universities despite their inefficiencies. Reputation & branding matters (unfortunately) and I can’t see a good student foregoing Harvard to go to a startup university. Plus, students have access to 1000s of courses at Universities. They experiment with courses in various areas & find their way through college education. It’s too expensive to develop this many courses for a startup. And I don’t think 100 courses can provide the breadth of options that one has in college. John Katzman also reminded me that it’s hard to compete with the full college experience which includes college sports, extra-curricular activities and socializing. It’s hard to build that infrastructure overnight. So i am bearish on this. Am i missing something?

Apparently, there were 66 startup presentations but 400+ investors at the YC demo day yesterday. Standing room only. This is precisely why I feel it’s better to be an entrepreneur than an investor in the current climate.

My uncle, PG Bhat, forwarded a link to this interesting blog post about what makes exceptionally smart people different from the rest of us. According to the blogger, it is that they ask questions:

“I have noticed one overarching theme among smart people: they ask questions. When someone explains something new to me, I’ll usually just nod my head like I know what they’re talking about. If I don’t understand something, I’ll just Google it later. After all, I don’t want this person to think I’m a moron. Smart people are different. If they don’t understand something, or even if they think they understand something, they’ll ask questions.”

Let me add another closely related construct. It’s that they are modest and humble. If someone believes they are exceptionally smart and it gets “into their head,” this creates a conceit that gets in the way of asking questions and eventually in the way of growing. But why don’t all humble/modest people ask questions. The other quality of these exceptionally smart people is confidence. If you are confident, you don’t have to worry about being a moron. So, I suspect one needs to be in that narrow corridor – confident but not conceited – to ask questions.

Among the people I have met with the humility to ask questions despite their status are Herb Simon (Nobel prize in Econ, Turing award in CS, APA award in psychology and National Medal of Science) and Dr Irwin Jacobs (former MIT prof and founder of Qualcomm).

The startup world is highly hit-driven. For every success, there are over 30-40 failed startups. Even the top venture funds lose money on close to 75% of investments. And probably make meaningful returns on less than 10% of their investments. All that is about to change in the next few years … tech will be even more hit-driven than in the past.

Lots of smart (and not-so-smart) undergrads are dropping out of college to pursue startups like never before. Several of my students have dropped out just in the past 12 months. More engineers from top Engg schools are becoming entrepreneurs than ever before. Also the MBAs. While the typical (if there is one) Wharton MBA used to be a banker/consultant 5 years back, there is a marked shift towards tech & entrepreneurship. In short, there are lots of aspiring entrepreneurs. Further every other guy, self included, is an angel investor (the remaining folks, of course, are the said entrepreneurs). The supply of angels will only increase after the FB millionaires enter the fray. In short, there is a lot of money chasing these entrepreneurs. What does all this mean? IMO, too many startups will get funded and too many will fail.

Lots of poor ideas will get funded. Lots of ideas will get funded too early. Lots of ideas will get funded at crazy valuations. It takes little to get funded these days. Don’t get me wrong. I am a big believer in the long-term prospects for tech, especially web/cloud (heck, I started a PhD focused on e-commerce in 1999 and did my first startup in 2000 … I’ve been a believer for a while now). And I continue to believe that the best innovations on the web are yet to come. So I do think there will some big hits in the future, perhaps bigger than in the past. That said, the supply of entrepreneurs and capital exceeds potential opportunities. So there will lots of failures. In short, the successes will be bigger than in the past and there will be more failures than in the past. As a result, the tech space will be more hit-driven than ever before.

What makes things worse is the quality of the median talent will only continue to decrease with the entry of so many folks into the tech world. Almost everyone is a hacker or “code ninja” these days. In the 90s, most of the engineers had degrees in CS and understood how databases & OSes work. Many of today’s code Ninjas are history or social science majors who sensed a better opportunity elsewhere. Solid understanding of fundamentals is not needed anymore coz there are enough companies looking to hire and enough capital chasing the talent. Here again, the best developers are way better than the last vintage and they will become even more valuable given the median developer out there.

So what’s the takeaway:

1. Consumers will be better off: So many ideas & opportunities will be pursued. This will bring more products & services to consumers.
2. Investors will be worse off: Median angel & venture returns will drop (it’s already fallen relative to the 90s).
3. Winners will be bigger than ever before: Good ideas will be off the ground faster (access to capital) and at lower cost (cloud). They will also scale faster (web-based businesses scale faster than traditional businesses). Small differences in quality will result in big differences in success because of this ability to scale. So winners will completely dominate their markets. So expect some big exits like FB. Expect some superstar developers. And expect some venture funds to win big while most venture funds, startups and tech talent will produce low returns.

I am rethinking my role as an angel.

Nokia just announced that it has sold over a million Lumia phones. Good for Nokia. However, I still don’t understand why Nokia would commit exclusively to Microsoft when it can also be making Android phones. That is, if you decided that it is not worth owning the software risk, then why not completely outsource the software risk and focus entirely on the hardware. Whether Windows wins or Android, you would be covered. Under the current strategy, one has just changed the software risk from Symbian risk to Windows mobile risk. While I think it was a good decision to go away from Symbian, it’s not clear it was the best decision to not add Android to the mix.

In this recent article in New York Times, I join Ben Horowitz and Mitch Kapoor to opine about the role of “pivots” in the startup world and why we are seeing more pivots than ever before.

Stated simply, a “pivot” is a significant change in direction for a firm. For example, going after a different product market or targeting very different customers. Pivots by Paypal and Groupon are by now famous. And there have been pivots by large, established firms as well (example, Nintendo’s decision to move from the playing cards market to video games). I think we see more of them in the tech space and more today than 20 years back because of the following reasons:

1. The tech space evolves more rapidly and calls for firms to revisit some of the core assumptions behind their business model. Example, iPads may well be changing the education space causing many firms in this space to pivot or perish.
2. The cost of pivoting is low these days with web startups. Build something, release to beta users and test your assumptions. And if it turns out that many of your assumptions were wrong, then pivot after having lost no more than $25-50K. With (say) semiconductor startups, it was not as trivial to play the build, release, test & pivot strategy.
3. The culture of silicon valley embraces failures. it’s OK to test a half-baked idea and pivot later if needed. The valley does not treat these as failures on the part of the entrepreneur. It’s an easier conversation with your board than in other industries.

The key question, however, is whether you pivot or quit or stick when things are not going as planned?: I face this question a lot with startups I work with. The answer is never clear. For me, it makes sense to stick when the product has been built but not enough consumers are aware of it (i.e. it’s too soon to call). It makes sense to pivot when enough consumers are aware of the product and are asking for something else. So pivot when consumer needs are different and they have made it clear. And it makes sense to quit when consumers just don’t like the product, are not asking for anything else and the entrepreneur has no ideas to offer. Obviously, this last option is one everyone concerned attempts to avoid. But I wonder if there’s a better heuristic to answer the pivot/quit/stick question.

The topic of fair equity compensation for employees has come up with every startup I have worked with. And I find myself repeating the same advice to all of them. I figured it’d make more sense to document it once and for all through this post.

So, the question is how much equity is fair to key early employees. Here’s my algorithm:

i. If it’s a post-Series-A company, key employees (VP-level executives with 5-10 years functional experience) should get anywhere from 1.5-3%. The more critical roles are at the higher end of that range. That is, most VPs end up with 1.5-2%. If it’s a tech-heavy company, the CTO or VP of Engg might get 2.0-2.5%. And if the CEO is hired post Series A, the CEO might get around 3% (or more if it’s a known superstar). Where do these numbers come from? The option pool is around 15-20%, so that leaves around 10-12% for VP-level execs and the rest for junior employees, coders and the rest.

ii. Now if you are hiring someone just before (3-4 months) Series A and you have not set aside an option pool as yet, one should expect around 50% dilution during Series A (35% to investor and 15% option pool). So, that implies a key employee should get 3-6% before Series A to end up at 1.5-3% after it. But one has to account for the employee taking on the risk of joining before Series A funding. So add another point for that which leads us to 4-7%. That is, most VPs get around 4-5%. VP of Engg or similar critical function might get 5-6% and a CEO hired just before Series A gets 7%.

iii. Now if one is hiring the employee well before Series A, you have to bump up equity further. If a small angel round has been raised but Series A is still a year or so away, I would increase the range above to 6-10% based on the functional role.

iv. Lastly, if we are talking about pre-seed VP, we additionally need to factor in 15-20% dilution in a $500K angel round, which in turn raises the equity to 7.5-12.5% (i.e 7.5% for regular roles, 10% for critical roles and 12.5% for CEO). This assumes that a founding team and an initial product are in place.

v. All of the above assumes that the candidate has ample experience for the role. Sometimes (usually with very early hires), you might hire someone who does not yet have the right experience for that role. Meaning the position is a big opportunity for that person and he/she would not have got the position at (say) a similar post-Series-A startup. Reduce the equity by 20-25% in that case.

vi. All of the above also assumes that the individual is a key employee but not a co-founder. The math is different for a cofounder and one has to think about how many cofounders are in the startup and other idiosyncratic factors of cofounder dynamics.

The above sounds very algorithmic and there are several reasons to deviate from it. But the algorithm is based on a very simple logic. There’s only 15-20% option pool and all employees need to be paid from there. So most of the numbers follow from that. To date, I have found the logic works quite well and is fair to both the employee and the founders. Let me know if you have a different approach

I am shocked to see all that’s happening at Kodak (bankruptcy protection, etc). The company made over $8B in revenues in 2010 ($6B ttm) and has a market cap of $100M. How can a company of Kodak’s scale be valued so low. Well, despithis way.e its scale, the company has been bleeding money like crazy. No operating profits in the last several years and revenues declining by over $1B every year. It’s sad to see an iconic company like Kodak go down the drain this way.

1. The company is in too many lines of business. A struggling company like Kodak has no business being in so many areas (cameras/film/printers/processing/kiosks/software/services … consumer/business/entertainment). Figure out whether you want to focus on consumer or business segment and which specific divisions within that segment.
2. Poor M&A work: Acquisitions have been all over the place, ranging from relief plates (Tokyo Ohka), prepress systems for printers (Creo), scanners (Boew bell), Radiography, etc. And yet Kodak talks about the consumer segment as its priority. If it takes its consumer services seriously, I am not sure how it managed to ignore companies like Snapfish and, more recently, Animoto.
3. Gross margin low. It’s in too many low-margin businesses.
4. R&D expenses too high: I am not sure Kodak can afford such a big R&D budget. It’s not working for the firm.
5. Poor monetization of its kiosk assets: Either shut them all down or figure out a new way to monetize (even rent to a partner) all those retail kiosks.
6. In too many geographic markets. The management says international expansion is a priority and yet international sales have been declining.

There are too many fires in too many divisions. Kodak needs to give some of the problems away to PE firms and focus on fewer problems to solve. Hope Kodak gets it right. The problems look solvable to me but I hope they choose the right people to solve them.

It’s good to see Yahoo’s decision to make Scott Thompson, Paypal’s President, their new CEO. The guy is a technologist and was previously the CTO of Paypal. I think it’s a good decision because what Yahoo needs right now is to return to its technology roots and become innovative again (rather than financial re-engineering, which was overdone under the previous CEO). The move will also help retain and attract technologists at the company.

As someone who was a regular user of several Yahoo products, I hope that Yahoo will reclaim its position as one of the leading (and growing) Internet companies.