Tuesday, June 7, 2011

Carlson's Law, Software Innovation and Venture Capital

Tom Friedman's editorial in today's New York Times cited "Carlson's Law", a framework advanced by Curtis Carlson, the C.E.O. of SRI International:
"'In a world where so many people now have access to education and cheap tools of innovation, innovation that happens from the bottom up tends to be chaotic but smart. Innovation that happens from the top down tends to be orderly but dumb.' As a result, says Carlson, the sweet spot for innovation today is 'moving down,' closer to the people, not up".
Friedman used the idea to make a point about social disruption in the Arab world, but the same idea is equally applicable to the disruption now underway in the software innovation business.

The phrase "cheap tools of innovation" is as concise a description of the current state of the software business as I've come across.


Between powerful, open-source development frameworks like Ruby and PHP and cheap, pay-as-you-go cloud infrastructure services like Amazon Web Services, Urban Airship and Twilio, world-changing software innovations can now be created and brought to market by small teams of two or three developers. Ideas that once required millions of dollars of venture capital to build now require hundreds of thousands - or for the right team of motivated entrepreneurs, none at all. (Yes, additional capital is still needed to scale these innovations, please see below for more on funding innovation v. growth).

By pushing the atomic unit of innovation so far down the economic stack, the technology business has manufactured a set of unintended consequences that are still reverberating across the industry. I've outlined five consequences of this unfolding disruption here:

  1. Innovation has been outsourced to entrepreneurs

    From Bell Labs to DARPA to 3M, some of our most enduring legends of commercial innovation come from military and industrial R&D. In capital-intensive industries like materials science, manufacturing and biotech this is still true. But in software - and nearly every modern industry is massively reliant on software - the diversity, creativity and sheer speed of innovation now unfolding in the entrepreneurial community is running circles around enterprise R&D.

    Why is this true? Some of it surely has to do with the traditional entreprise complaint: bureaucracy. But much more important - and much harder to reverse - is the inevitable flow of creative talent away from entreprise roles to the various forms of creative free-agency afforded by a global information economy. When the means of creative expression, production and mass distribution are available to the many, the most creative and capable people will choose to create on their own terms (even if those creations are ultimately designed to serve the needs of enterprise).

  2. Venture capital has become growth capital

    For the last 50 years or so, the capital markets have delegated the high-risk task of innovation investing to venture capital firms. And when ideas need millions or tens of millions of dollars to evaluate, venture capital is still the right path. But firms with hundreds of millions dollars to manage and tens of partners to manage it can't afford to dribble it out in fifty- and hundred-thousand dollar increments. And for many - arguably most - new software ideas, those are the increments that make the most sense.

    This has put the traditional venture business in an awkward position: notionally the risk-seeking funder of first resort, venture firms are now seen by software entrepreneurs as slow-moving, risk averse growth investors, unwilling or unable to deal in denominations and on terms suited to the current state of the innovation marketplace. Some traditional firms are making smart moves and adding new offerings to address this new market reality; others seem still to be hoping that the genie will go back in the bottle.

  3. Entrepreneurs have become the primary funders of software innovation

    If venture firms are no longer structurally suited to or sought-after for early-stage capital, where are these dollars coming from today? From other entrepreneurs. Fred Wilson describes the phenomenon as "recycled capital", and it's a perfect description of what's now happening in Silicon Valley, New York, Seattle and other markets with healthy local innovation economies. Entrepreneurs who have realized excess returns from their own companies are now redeploying those gains to fund the next wave of innovation.

    Some of this is entrepreneur capital is coming from individuals, facilitated by new online market-makers for angel investments, but most of it is flowing from a new type of venture firm - variously described as "super angel" or "micro VC" funds. These aren't (or at least aren't billed as) baby VC firms just working their way up the funding ladder, but rather are purpose-built to operate at a scale better suited to the new reality. So rather than raising hundreds of millions and investing $10-$20 million in each deal, these funds have $20 or $50 million and invest as little as $50K at a time. And they aren't run by investment bankers - the best of these funds (firms like First Round Capital, Floodgate, IA Ventures and Founder Collective) were built by successful serial software entrepreneurs who saw this change coming and created the kind firm they would have wanted to work with as entrepreneurs.

  4. Consumers are the new arbiters of the innovation marketplace

    This is probably the most controversial idea on this list but I see evidence for it everywhere I look. When only a few dozen software firms were passing through the eye of the venture capital needle each year, a small number of well-connected investors effectively controlled the market for innovation. But when any qualified developer anywhere in the world can build a product and put it online for all to use, innovation can come from any corner of the economy. By implication, the actual users of these services are the ones that choose what succeeds and what fails, and the capital markets are now chasing small groups of influential early adopters in hopes of discovering and jumping on the investment bandwagon before the good ones get away.

    Nowhere is this more true than in the mobile software ecosystem. In just a few short years, Apple has created the highest-velocity channel for software innovation ever seen. Just four years after the iPhone was announced there are now more than 500,000 applications available for it in the Apple App Store, and a comparable number for the even younger Android ecosystem. Even in the enterprise, consumer-employees now dictate what devices and (to some extent) software they want to use and CIOs scramble to support and secure the resulting device/software/network topology.

  5. The war for attention is the first and hardest battle most entrepreneurs now face

    If consumers decide which innovations live and which die, how do winning ideas set themselves apart? Over time, speed and agility offer accretive advantages over slower competitors, but at launch all startups are created equal. The ones that win are those that combine elegant and simple user experiences with crafty attention-getting schemes that help them push through the massive information clutter of the modern media landscape. As Micah Baldwin puts it, every startup needs both a Hacker and a Hustler: the hacker builds while the hustler does whatever it takes to create and nurture that first wave of customer-promoters.

    In this context, it should come at no surprise that early stage entrepreneurs were the first to master social media marketing techniques: when you don't have money but you *do* have customers, the most effective marketing strategy is to enlist those customers as your promotional arm. Paid media costs money, but tweets and Facebook wall posts are free.
The "chaotic but smart" innovation now underway has created such a bloom of enthusiasm for software startups that many pundits are now wringing their hands about a new "bubble economy". Early-stage valuations are definitely creeping up, and many investors are likely to lose money on bets that don't cross over from early-adopter love to mainstream success. But the fact that the capital markets haven't yet figured out how to play this new game of bottom-up innovation doesn't make it any less real. And I don't see any way that this particular genie gets put back in the bottle...