Chasing Monopolies

Capitalism and competition are not the same thing. Sound surprising, or perhaps slightly heretical? The conventional narrative is that capitalism is the only economic system that consistently encourages and nurtures competition. Peter Thiel thinks this is nonsense. According to Thiel’s new book Zero to One, we function in a highly regulated economy where the most successful firms are compelled to pretend that they are not monopolies:

Since they very much want their monopoly profits to continue unmolested, they tend to do whatever they can to conceal their monopoly – usually by exaggerating the power of their (nonexistent) competition.

So what about less dominant companies?:

Non-monopolists tell the opposite lie: “We’re in a league of our own.” Entrepreneurs are always biased to understate the scale of competition, but that is the biggest mistake a startup can make. The fatal temptation is to describe your market extremely narrowly so that you dominate it by definition.

Thiel is right. Every day we witness monopolies pretending that they face formidable rivals and ordinary companies spinning silly yarns about their own uniqueness. But if startups by definition have to begin with a small market, how do investors know whether a particular startup is going to grow into a firm that has the desirable characteristics of a monopoly?

This is a difficult puzzle, a recurrent problem that plagues every early stage investor. To appreciate the depth of this puzzle, consider Google, a company that today enjoys monopoly-like power.

When Google began at Stanford, its chief mission was to build a better search engine. At the time, search was a much smaller business than it is today (e.g., Yahoo!’s revenue in 1996 was $19.1 million), but it was an important technology with powerful incumbents. Google surpassed the incumbents and learned to monetize search more effectively, but its ascendance was deliberate and careful. The original web-crawler built at Stanford was operational in early 1996, but the company did not go public until 2004. Contrast this well-paced beginning with Google’s post-IPO growth, which has been nothing short of amazing: Starting with just over 30% of the US search engine market in late 2004, Google now commands 68% of that market.

It would have been foolish in 1997 to claim to “know” that Google was on this trajectory. Yet it would have been quite reasonable to speculate that search would one day become the backbone of internet commerce, allowing its creator to shape the very future of what was then known as the World Wide Web. With so much power to shape the Internet itself, it would be natural to expect that the victor of the search wars would dominate internet advertising, a market that was just beginning to mature in 1997.

Does that imply the best investors can see into the future? Not quite. Thiel’s core argument is that the best investors give extra attention to companies that start out by building small, mini-monopolies. For example, an early investor in Google would have been particularly interested in whether PageRank – Google’s webpage ranking algorithm – provided a unique advantage that would make it impossible for competitors to gain or retain market share. Similarly, an early investor in Facebook would have been intrigued by the strong, unparalleled demand for Facebook’s services at Harvard College.

It is still not clear what Thiel means. Is he arguing that the ideal investor has a higher probability of picking the next Google because she focuses narrowly on monopoly-enabling technologies? Could Thiel instead be contending that technologies that are sophisticated or hard to build will always prevail over simpler alternatives?

No, none of these capture Thiel’s view. He sees the ideal investor as someone that tirelessly looks for the right intersection between a specific technology and the economic environment that technology is designed to dominate. In fact, when I was reading Zero to One it occurred to me that evolutionary biology provides the best metaphor for what Thiel thinks the ideal investor should be doing: The young company she is looking for will show early signs of plasticity, nimbleness, and technical brilliance, characteristics that will improve the probability that this company will have no true peers in the future. In a world happy to accept normal, incremental adaptation, the ideal investor is looking for bold, unexpected transformations.

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