Lecture Transcript: http://www.tech.genius.com/Peter-thiel-lecture-5-business-strategy-and-monopoly-theory-annotated

Peter Thiel, founder of Paypal and Palantir, discusses business strategy and monopoly theory in "Competition is For Losers". 

See the slides and readings at http://www.startupclass.samaltman.com/courses/lec05

Discuss this lecture: http://www.startupclass.co/courses/how-to-start-a-startup/lectures/64034

Chapters (Powered by https://bit.ly/chapterme-yc) - 
00:00:00 - Introduction
00:00:50 - Outline
00:00:57 - Capturing value
00:01:57 - Big piece of a small pie
00:03:37 - Perfect competition
00:04:31 - Monopoly
00:05:33 - Lies people tell
00:05:36 - Differences underestimated
00:06:59 - Narratives
00:07:54 - British food in Palo Alto
00:08:40 - Do the intersections make money?
00:08:45 - Blockbuster movie
00:09:29 - Is the intersection valuable?
00:09:35 - Startup version
00:10:11 - The search market
00:11:00 - The advertising market
00:11:29 - The technology market
00:12:36 - Evidence of narrow markets
00:13:28 - How to build a monopoly
00:13:39 - The right size
00:14:36 - Start small and expand
00:17:05 - Start big and shrink
00:18:40 - Last mover advantage
00:18:45 - Characteristics of monopoly
00:27:10 - Value of the future
00:27:55 - History of innovation
00:28:28 - Technological innovation
00:30:16 - Capturing value
00:31:59 - Success cases
00:37:03 - Psychology of competition
00:38:14 - Mimetic preferences
00:38:33 - Competition as validation
00:42:22 - Q&A
00:42:26 - Q1
00:43:01 - Q2
00:43:38 - Q3
00:44:34 - Q4
00:46:40 - Q5
00:47:55 - Q6

Peter was the founder of PayPal and Palantir and Founders Fund, and has invested in most of the tech companies in Silicon Valley.

And he's going to talk about strategy and competition.

I, I sort of have a, I have a single eday fix that I'm completely obsessed with in on, on the business side, which is that if you're starting a company, if you're the founder, entrepreneur starting a company, you always want to aim for monopoly.

And and that and you want to always avoid competition.

I'd like to I'd like to start by saying something about the, the basic idea of when you start 1 of these companies, how you go about creating value.

And there's this question, what makes a business valuable?

And I want to, I want to suggest that there's basically a very simple very simple formula that you, you have a valuable company if 2 things are true.

Number 1, that it creates x dollars of value for the world, and number 2, that you capture y percent of x.

And, and the critical thing that that I think people always miss in this sort of analysis is that x and y are completely independent variables.

And so x can be very big, y can be very small.

X can be of intermediate size, and if y is, is reasonably big, you can still get a very big business.

So to create a valuable company, you have to basically both create something of value and capture some fraction of the value of what you've created.

And sort of just to, just to illustrate this as a, as a contrast There's, if you sort of compare the US airline industry with a company like Google on search.

If you sort of measure by the size of these industries, You could, you could say that airlines are still more important than search.

It was 195 billion in domestic revenues in 2000 2012.

And so, and certainly sort of on some intuitive level if you said if you were given a choice and said, well, do you want to get rid of air, all air travel?

Or do you want to get rid of your ability to use search engines?

The intuition would be that air travel is something that's more important than search.

And this is of course just the domestic numbers.

If you'd looked at this globally, airlines are much, much bigger than than than than searcher, than Google is.

But but the profit margins are quite a bit less.

You know, they were marginally profitable in 2012.

I think the entire 100 year history of the airline industry, the cumulative profits in the US have been approximately 0.

The companies make money, they episodically go bankrupt, they get recapitalized, and you sort of cycle and repeat.

And this is reflected in, you know, the, the combined market capitalization of the, of the airline industries may be something of the US airline industry something like a quarter that of Google.

So, so you have, you have a search engine much, much smaller than, than air travel, but much more valuable.

I think this, this reflects these very different valuations on x and y.

So you know, if we look at perfect competition, you know, there are sort of, There's some pros and cons to the world of perfect competition.

On a high level it's always this is what you study in econ 1.

It's always, it's easy to model, which I think is why econ professors like talking about perfect competition.

It somehow is efficient, especially in a world where things are static, because you have all the consumer surplus gets captured by everybody.

And and politically it's what what we're, what we're told is good in our society, that you, you want to have competition.

It's, it's generally not that good if you're, you're you're involved in anything that's hyper competitive.

I'll come back to this a little bit later.

So so I think at 1 end of the spectrum, you have industries that are perfectly competitive.

And at the other end of the spectrum you have things that I would say are monopolies and and they're you know they're much stable longer-term businesses you have more capital and and If you get a creative monopoly for inventing something new, I think it's symptomatic of having created something, something really valuable.

And so I do think this, you know, the, the, the sort of the, the, the extreme binary view of the world I, I always articulate is that there are exactly 2 kinds of businesses in this world.

There are businesses that are perfectly competitive and there are businesses that are monopolies.

And there's shockingly little that is in between.

And this dichotomy is not understood very well because people are constantly lying about the nature of the businesses they're in.

And this is why, this is, in my mind, this is the most important, it's not necessarily the most important thing in business, but I think it's the most important business idea that people don't understand, that there are just these 2 kinds of businesses.

And so let me say a little bit about the lies that people tell.

And so, you basically the basic, if you sort of imagine that there was a spectrum of companies from perfect competition to monopoly, the apparent differences are quite small.

Because the people who have monopolies pretend not to.

They will basically say you know, and it's because you don't want to get regulated by the government.

You don't want the government to come after you.

So you will never say that you have monopolies.

So anyone who has a monopoly will pretend that they're in incredible competition.

And on the other end of the spectrum, if you are incredibly competitive and if you're in some sort of business where you will never make any money, you'll be tempted to tell a lie that goes in the other direction.

Where you will say that you're doing something unique that is, is somehow less competitive than it looks.

Because because you want to, you will want to differentiate, you'll want to try to attract capital or something like that.

So if the monopolists pretend not to have monopolies, the non-monopolists pretend to have monopolies.

The apparent difference is very small, whereas the real difference I, I submit is, is actually quite big.

And so there's this distortion that happens because of the lies people tell about their businesses.

And the lies are sort of in these, these opposite direction.

Let me, let me drill a little bit down further on the the way these lies work.

And so You know, the, the, the basic lie you tell as a non-monopoly is that we're in a very small market.

The basic lie you tell as a monopoly is that the market you're in is much bigger than it looks.

And so and so typically, if you want to think of this in sort of set theoretic terms, you could say that a monopoly tells a lie where you describe your business as the union of these vastly different markets And the non-monopolist describes it as the intersection.

So that in effect if you're, if you're a non-monopolist, you will rhetorically describe your market as super small.

If you have monopoly, you will describe it as super big and there's lots of competition in it.

So some examples of how this, how this works in practice.

So I always use restaurants as the example of a terrible business, and this is always sort of my ideas.

Capitalism, someone who accumulates capital, world of perfect competition is a world where all the capital gets competed away.

So you're opening a restaurant business, no 1 wants to invest because you just lose money.

So you have to tell some idiosyncratic narrative and you'll say something like, well, we're the only British food restaurant in Palo Alto.

So it's British, Palo Alto, and of course that's too small a market because people may be able to drive all the way to Mountain View or even Menlo Park.

And there probably are no people who eat nothing but British food, at least no people who are still alive.

And so that's sort of a fictitiously narrow market.

There's sort of a Hollywood version of this where the way movies always get pitched is, you know, okay, it's like a college football star, you know, joins an elite group of hackers to catch the shark that killed his friend.

And so, that's, now that is a movie that has not yet been made.

But but, but the question is, is, is that the right category?

Or is the correct category, it's just another movie?

In which case, you know, there are lots of those.

It's super competitive, incredibly hard to make money.

No 1 ever makes money in Hollywood doing movies.

And so you always have this question about, does the intersection, does, is it real?

And of course, there are startup versions of this where you, and the sort of the bad, really bad versions.

You just take a whole series of buzzwords, sharing mobile, social apps, you combine them, and you have some kind of narrative.

And whether or not that's a real business or not is, is is, it's generally a bad sign.

So it's, it's almost this pattern recognition.

When you have this rhetoric of this sort of intersections it, It generally does not work.

The something of somewhere is really mostly just the nothing of nowhere.

The opposite lie is if you are, let's say, the search company that's down the street from here and has about a happy 66% market share and is, you know, is completely dominant in the search market.

Google has not, almost never describes itself as a search engine these days.

And instead, it describes itself in all these different ways.

So it sometimes says it's an advertising company.

So if it was search, you'd say, wow, it's like, it has this huge market share.

It's much bigger than, it's much, much more robust monopoly than Microsoft ever had in the 90s.

Maybe that's why it's making so much money.

But if you if you say it's an advertising market, you could say, well, there's search advertising is $17 billion.

And that's part of online advertising, which is much bigger.

And then by the time you get to global advertising, that's close to 500 billion.

So a tiny part of this much larger market.

Or If you don't want to be an advertising company, you can always say that you're a technology company.

And so the, and, and so And, and the technology market is something like a $1 trillion market.

And the narrative that you tell is Google and the, and the technology market is well, we're competing with all the car companies with our self-driving cars, we're competing with Apple on TVs and iPhones we're competing with Facebook, we're competing with Microsoft on, on Office products, we're competing with Amazon on cloud services, and so we are in this giant technology market where there's competition in every direction you, you look, and no we're not the monopoly the government's looking for and we should not get regulated in any way whatsoever.

And so I think 1 has to always be super aware that there are these these very powerful incentives to to distort the nature of these markets 1 way or the other.

So you know, the, the, the evidence of narrow markets in the in the tech industry is is if you basically just if you look at sort of the some of the big tech companies, Apple, Google, Microsoft, Amazon.

They just they've just been building up cash for year after year, and you have these incredibly high profit margins.

And I would, I would say that the, that 1 of the reasons the tech industry in the US has been has been so successful financially is because it's, it's prone to creating all these monopoly like businesses and that's, that's and it's reflected by the fact that these companies just accumulate so much cash, they don't even know what to do with it beyond a certain point.

And so, so let me say let me say a few things about about how to, how to build a monopoly.

And I think I think the, 1 of the sort of very counter intuitive ideas that comes out of this monopoly thread is that you want to go after small markets.

If you're a startup, you know, you want to get to a monopoly.

You're starting a new company, you wanna get to monopoly.

Monopoly is you have a large share of a market.

How do you get to a large share of a market?

You start with a really small market, and you take over that whole market.

And then, And then over time, you find ways to expand that market in concentric circles.

And the thing that's always a big mistake is going after a giant market on day 1.

Because that's typically evidence that you somehow haven't defined the categories correctly.

That, and it's, it normally means that there's going to be too much competition in 1 way or another.

And so I think almost all the successful companies in Silicon Valley had some model of starting with small markets and expanding.

And, you know, if you take Amazon, you start with, you start with, you know, just a bookstore.

So it's, it's a, it's a, it's a better bookstore than anybody else has in the world when it starts in the 90s, it's online, there's things you can do you can't do before, and then you gradually expand into all sorts of different forms of e-commerce and other things beyond that.

You know, eBay, you start with Pez dispensers, you move on to Beanie Babies.

And eventually it's, it's all these different auctions for all these sorts of different goods.

And and what was very counterintuitive about, what's very counterintuitive about many of these companies is they often start with markets that are so small that people don't think they don't think that they're valuable at all when you get started.

The PayPal version of this was we started with power sellers on eBay, which was about 20,000 people.

When we first saw this happening in December of 99, January 2000, right after we launched, there was a sense that these were all, it was such a small market, it was terrible.

We thought these were terrible customers to have.

It's just people selling junk on the Internet.

Why in the world do we want to be going after this market?

But but you, you know, you, there was a way to get a product that was much better for everybody in that market.

You could and we got to something like 25, 30% you know, market penetration in 2 or 3 months, and you got some walk-in, you got brand recognition, and you're able to build a business from there.

So I always think these very small markets are quite underrated.

The Facebook version of this I always give is that, you know, the initial market at Facebook was 10,000 people at Harvard.

It went from 0 to 60% market share in 10 days.

The way this gets analyzed in business schools is always, that's ridiculous.

It's such a small market, it can't have any value at all.

And so I think the business school analysis of Facebook early on, or of PayPal early on, or of eBay early on, is that the markets were perhaps so small as to have almost no value.

And they, they would have had little value had they stayed small, but it turned out there were ways to then grow them concentrically, and that's what made them, that's what made them so valuable.

Now I think the opposite version of this is always where you have super big markets.

And and I, there's so much, so many different things that went wrong with all the clean tech companies in the last decade, but but 1, 1 theme that ran through almost all of them was they all started with massive markets.

Every clean tech PowerPoint presentation that 1 saw in the years 2005 to 2008, which was sort of the clean tech bubble in, in Silicon Valley, started with, we're in the energy market, we're in a market that's measured in hundreds of billions or trillions of dollars.

And and then, you know, once you're sort of a, a minnow in a vast ocean that's not a good place to be.

That means that you have tons of competitors and you don't even know who all the competitors are.

And so, you want to be, you know, you want to be a 1 of a kind company where it's the only 1 in a small ecosystem.

You don't want to be the fourth online pet food company.

You don't want to be the tenth thin film solar panel company.

You don't want to be the hundredth restaurant in Palo Alto.

Your restaurant industry is a trillion dollar industry.

So if you do a market size analysis, you can conclude restaurants are a fantastic business to go into.

And it's often large markets, large existing markets, typically mean that you have tons of competition, very, very hard to differentiate.

So the first very counterintuitive idea is to go after small markets, often markets that are so small people don't even notice them.

And then if those markets are able to expand, you can scale it into a big monopoly business.

A second sort of, there's sort of several different characteristics of these monopoly businesses that I like to focus on.

And there's probably no sort of single formula to it.

And I always think that in technology, there's always a sense that, you know, the history of technology is such that every moment happens only once.

And so, you know, the next Mark Zuckerberg won't build a social network, the next the next Larry Page won't be building a search engine.

The next Bill Gates won't be building an operating system.

And if you're copying these people, you're not learning from them.

But it's, it's, and so there is always these very unique businesses that are doing something that's not been done before end up end up having the potential to be a monopoly.

If you're, you know, the, the, the opening, the opening line in Anna Karenina is that all happy companies, sorry, all happy families, all happy families are alike.

All unhappy families are unhappy in their own special way.

And the opposite is true in business where I think all happy companies are different because they're doing something very unique.

All unhappy companies are alike because they fail to escape the essential sameness that is competition.

And so, so 1, 1 sort of characteristic of a monopoly technology company is some sort of proprietary technology.

My sort of crazy, somewhat arbitrary rule of thumb, is you want to have a technology that's an order of magnitude better than the next best thing.

So Amazon had over 10 times as many books, I mean it's maybe not that high tech, but you figure out a way to sell 10 times as many books in an efficient online way.

You know, PayPal, the alternative for PayPal was using was using checks to send money on eBay, took 7 to 10 days to clear.

PayPal could do it more than 10 times as fast.

So you want to have some sort of very, very powerful improvement in some, on, on, on some order, maybe an order of magnitude improvement on some key dimension.

Of course, you know, if you, if you actually come with something totally new It's, it's, it's just like an infinite improvement.

So I would say the, the iPhone was the first smart phone that worked.

And so that's, you know, that's like, maybe, maybe not infinite, but it's sort of definitely an order of magnitude or more of an improvement.

So I think the, The technology is designed to give you a massive delta over, over the next, the next best thing.

I think I think there often are network effects that can kick in that really help.

The thing that's very and These, these lead to monopolies over time.

The thing that's very tricky about network effects is they're often they're often very hard to get started.

And so so even though everyone understands how valuable they are there's always this incredibly tricky question.

Why is it valuable to the first person who's doing something?

Economies of scale, if you have something that, with very high fixed costs, very low marginal costs.

That's typically a monopoly like business.

And then then there's this thing of, of branding, which is sort of like just this idea that gets lodged in people's brains.

I, I never quite understand how branding works.

So I never invest in companies where it's just about branding.

But it is, I think, a real phenomenon that that creates that creates real value.

I think 1 of the things, I'm going to come back to this a little bit towards the end, but 1 of the things that's very striking is that software businesses are often, are for some reason very good at some of these things.

They're especially good at the economies of scale part.

Because the marginal cost of software is 0.

And so if you get something that works in software, it's often significantly better than the existing solution.

And then you have these tremendous economies of scale, and you can scale fairly quickly.

So even if the market starts small, you can grow your business quickly enough to stay at the same size as the growing market and maintain the sort of monopoly power.

Now, the critical thing about these monopolies is it's not enough to have a monopoly for just a moment.

The critical thing is to have 1 that lasts over time.

And so, you know, Silicon Valley is always this sort of idea that you want to be the first mover.

And I always think it's, in some ways, the better framing is, you want to be the last mover.

You want to be the last company in a category.

Those are the ones that are really valuable.

Microsoft was the last operating system, at least for many decades.

Facebook will be valuable if it turns out to be the last social networking site.

And and 1 way to, 1 way to think of this last mover value is this idea that most of the value in these companies exists far in the future.

If you do sort of a discounted cash flow analysis of a business, you look at, you have sort of all these profit streams, you have a growth rate, the growth rate's much higher than the discount rate, and so most of the value exists far in the future.

I did, I did this exercise at PayPal in March of 2001.

We'd been in business for about 27 months.

And and we sort of had, you know, the growth rate was 100% a year.

We were discounting future cash flows by about 30%.

And it turned out that about 3 quarters of the value of the business as of 2001 came from cash flows in years 2011 and beyond.

And and whenever you do the math on any of these tech companies, you get to an answer that's something like that.

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Competition is for Losers with Peter Thiel (How to Start a Startup 2014: 5)