The Fifth Protocol

“Wait a minute… Make up your mind. This Snow Crash thing—is it a virus, a drug, or a religion?”

Juanita shrugs. “What’s the difference?”

- Snow Crash

Cryptocurrencies will create a fifth protocol layer powering the next generation of the Internet.

Humans don’t *need* math-based cryptocurrencies when dealing with other humans. We walk slowly, talk slowly, and buy big things. Credit cards, cash, wires, checks – the world seems fine.

Machines, on the other hand, are far chattier and quicker to exchange information. The Four Layers of the Internet Protocol Suite are constantly communicating. The Link Layer puts packets on a wire. The Internet Layer routes them across networks. The Transport Layer persists communication across a given conversation. And the Application Layer delivers entire documents and applications.

This chatty, anonymous network treats resources as “too cheap to meter.” It’s a giant grid that transfers data but doesn’t transfer value. DDoS attacks, email spam, and flooded VPNs result. Names and identities are controlled by overlords – ICANN, DNS Servers, Facebook, Twitter, and Certificate “Authorities.”

Where’s the protocol layer for exchanging value, not just data? Where’s the distributed, anonymous, permission-less system for chatty machines to allocate their scarce resources? Where is the “virtual money” to create this “virtual economy?”

Cryptocurrencies like Bitcoin are already trustless – any machine can accept it from any other, securely. They are (nearly) free. They are global – no central bank required, and any machine can speak the language. And they’re one to two steps from being quick, anonymous, and capable of authentication.

Suppose we had a QuickCoin, which cleared transactions nearly instantly, anonymously, and for infinitesimal mining fees. It could use the Bitcoin blockchain for security or for easy trading in and out. SMTP would demand QuickCoin to weed out spam. Routers would exchange QuickCoin to shut down DDoS attacks. Tor Gateways would demand Quickcoin to anonymously route traffic. Machines would bypass centralized DNS and OAuth servers, using Coins to establish ownership.

Why stop at one Coin? Let’s posit a dozen new Appcoins. Using application-specific coins rewards the open-source developers with a pre-mined quantity. A TorCoin can be paid to its developers and gateways and by Tor users, achieving consensus via proof-of-bandwidth. We can allocate any scarce network resource this way – i.e., BoxCoin for Storage, CacheCoin for Caching, etc.

Lets move on to other networks. Can a completely distributed grid of small generators trade power with each other, using a decentralized and trustless cryptocurrency? Can a traffic jam of self-driving cars clear itself as the computerized vehicles bid for right of way? Can a mass of people crossing a street take priority over a single car waiting at the traffic light, as their phones vote, trustlessly and reliably, for their presence? Can we efficiently route networks of assets like water and power, and liabilities like pollutants and sewage, across a distributed grid? Can we trade stocks and financial assets with no brokers, custodians, or agents?

Cryptocurrencies are electronic cash, and as such, will be used by electronic agents to exchange value, verify contracts, and track identity and reputation. All of a sudden, the computing resources spent by the Bitcoin miners doesn’t seem wasted – it seems efficient, given that it can be used for congestion control and routing of other network resources.

Cryptocurrencies are an emergent property of the Internet – almost a fifth protocol in the Internet suite. If Satoshi Nakomoto did not exist, it would still be necessary to invent them. Someday, they will be used by the machines in our network, on our desk, in our garage, and in our pocket to exchange value and achieve consensus at blinding speeds, anonymously, and at minimal cost.

When that day arrives, large distributed networks that we rely upon will change. Starting with the Internet, they will become de-centralized market economies, far more intelligent than they are today. Just as human brains co-evolved with our ability to trade and exchange goods with people who weren’t related to us, so the network will become more intelligent as it learns to trade currency and contracts with unrelated nodes.

Eventually, there will be no functioning Internet or Internet of Things at the protocol layer without deep cryptocurrency integration. Turning off this fifth protocol will be impossible. Cryptocurrencies also remain mediums of exchange and stores of value. Nation states that are used to imposing capital controls will face a quandary – ban cryptocurrencies, and live in the technology dustbin. Enable them, and this virus, this religion, this protocol – will enable the free flow of money and language, along with packets, around the globe.

The Bitcoin Model for Crowdfunding

Bitcoin is not just a protocol or money, it’s a new business model for Open Source Software. Prior to Bitcoin, you had to raise money, write software, distribute your product, build a business model, and work towards liquidity. Angels, VCs, salespeople and bankers guided you the entire way, through a maze of tolls and controls.

The Bitcoin model for crowdfunding dispenses with everything except the software:

  • Write software to power a completely distributed network in which any node can participate anonymously.
  • Allocate scarce resources in the network using a scarce token – an “Appcoin”. Users need this Appcoin to use the network. Owners of scarce resources get paid in Appcoins.
  • Pre-mine or early-mine Appcoins and keep some non-threatening amount. These are shares of your company, equity that will appreciate in value if the network is adopted.
  • Give network operators the ability to collect new Appcoins in proportion to their contribution. Route a small fraction of each transaction output to the developer foundation (Mastercoin does this). These revenues are used to pay for operations, and bounties for ongoing development.
  • As network usage increases, so does equity value and revenue. 
  • Anyone can buy Appcoins, anywhere, anytime, anonymously. Ship your code, ring the IPO bell.

This is true crowdfunding – get funded by your users in proportion to their usage. Reward early adopters, network operators, and developers with upside.

In economics, the artificially scarce token used to allocate scarce resources is called “money.” So Bitcoin is crowdfunded OSS to run an Economic network. Now, a new generation of Appcoins can be created as open source software, crowdfunded into existence, and go public on day one. They can run networks where Bitcoin may not work, or where separate funding and compensation is needed.

The Tor network is slow because it relies on volunteers to relay traffic. Anytime we see a line, the product in question is underpriced. Let’s crowdfund a Torcoin – users of relays will pay in Torcoins and operators of relays will get paid in TorCoins. Founding developers collect equity when TorCoins are first mined and sold. Non-founding developers and network operators are paid revenues from newly mined coins and transaction fees.

Can we just use Bitcoin instead of Torcoin? Isn’t money supposed to be fungible to all use cases? Perhaps not – Bitcoin’s transaction speed is too slow for a dynamic network allocating bandwidth – 10 to 60 minutes is far too long to negotiate with a relay. And payments have to be anonymous. So a fast-clearing (Fastcoin can clear a block in 12 seconds), fully anonymous (likeZerocoin) variant is needed.

What else can we allocate in a network? NameCoin is already working on Distributed DNS. Can we build a striped, encrypted, high-availability data store using Boxcoin which pays for disk availability? Can we build a caching infrastructure using Cachecoin which pays edge nodes with un-used resources to cache large, static content? A DDoScoin used by web servers to throttle incoming browser requests? A PKIcoin that provides a global, un-assailable encrypted and anonymous messaging network? Are there more applications, like Bitcoin, that map to the real world and bypass network resources altogether? 

In a world of numerous Appcoins, easy to create, integrate, and crowdfund, what’s the role of Bitcoin? 

Bitcoin itself will be used as the currency of choice in many cases, when its slow transaction clearing and pseudonymity are not issues. And most of the world’s resources are not networked software which can benefit from its own Appcoin.

Some Appcoins may just be a protocol layer on top of Bitcoin to explicitly reward the creators, operators, and early adopters of the Appcoin’s network. PKIcoin may only be a financial incentive,  security outsourced to the Bitcoin mining pool, with entry / egress to PKIcoin through Bitcoin. In the cases that the Bitcoin blockchain is insufficient, such as Torcoin, Bitcoin will still be a reserve currency of sorts for moving into and out of Torcoin. 

Bitcoin is more than money, and more than a protocol. It’s a model and platform for true crowdfunding – open, distributed, and liquid all the way.

Thanks to Balaji Srinivasan for helping think through many of the ideas in this post. It’s really at least half his work. If you don’t follow him on twitter @balajis , you really should).

Bitcoin – The Internet of Money

This post is old – I wrote it for Wired, which just published an excerpt in “The Wired World in 2014″ issue, but the article was written in July. Apologies for the obsolescence.

Bitcoin will eventually be recognized as a platform for building new financial services.

Most people are only familiar with (b)itcoin the electronic currency, but more important is (B)itcoin, with a capital B, the underlying protocol, which encapsulates and distributes the functions of contract law.

Bitcoin encapsulates four fundamental technologies:

  • Digital Signatures – these can’t be forged and allow one party to securely verify a transaction with another.
  • Peer-to-Peer networks, like BitTorrent or TCP/IP – difficult to take down and no central trust
    required.
  • Proof-of-Work prevents users from spending the same money twice, without needing a central authority to distinguish valid from invalid transactions. Bitcoin creates an incentive for miners, who run powerful computers in the network, to validate transactions and to secure them from future tampering. The miners are paid by “discovering” new coins, and anyone with computational resources can anonymously and democratically become a miner.
  • Distributed Ledger – Bitcoin puts a history of each and every transaction into every wallet. This “block chain” means that anyone can validate that a given transaction was performed.

Thanks to these technical underpinnings, bitcoins are scarce (Central Banks can’t inflate them away), durable (they don’t degrade), portable (can be carried and transmitted electronically or as numbers in your head), divisible (into trillionths), verifiable (through everyone’s block chain), easy to store (paper or electronic), fungible (each bitcoin is equal), difficult to counterfeit (cryptographically impossible), and can achieve widespread use – many of the technologists that brought us advances on the Internet are now working overtime to improve Bitcoin.

Proponents of the role of government argue that a currency with fixed supply will fail. They posit that inflation is required to keep people spending and that prices and wages are still as sticky as they were decades ago. They overlook that the world functioned on fixed money supplies until 40 years ago (the gold standard), and that bitcoin can gather many uses and value long before it has to become the main currency in which all prices are denominated. Another fear is that a central actor could take over the Bitcoin computing network – but the combined Bitcoin distributed supercomputer runs at the equivalent of 2,250 PetaFLOPS, 90x the rate of the fastest supercomputer (note – in Nov, it’s now 48,000 PetaFLOPS!), and consumes an infinitesimal fraction of the resources used by a bloated banking system. Many label it as a speculative pyramid scheme – without realizing that all government-printed money is such. To the extent anyone holds cash over other assets, they are speculating that other assets will decline in relative value. Concerns abound over the security of the encryption scheme, the speed of transactions, the size of the block chain, the irreversibility of the transactions, and the potential for hacking and theft. All are fixable through third-party services and protocol upgrades. It’s better to think about Bitcoin the protocol as Bitcoin 1.0, destined to evolve just as HTTP 1.0 evolved beyond of simple text and image-only web-browsers.

So why not just use Pounds or Dollars? One can use bitcoins as high-powered money with distinct advantages. Bitcoins, like cash, are irrevocable. Merchants don’t have to worry about shipping a good, only to have a customer void the credit card transaction and charge-back the sale. Bitcoins are easy to send – instead of filling forms with your address, credit card number, and verification information, you just send money to a destination address. Each such address is uniquely generated for that single transaction, and therefore easily verifiable. Bitcoins can be stored as a compact number, traded by mere voice, printed on paper, or sent electronically. They can be stored as a passphrase that exists only in your head! There is no threat of money printing by a bankrupt government to dilute your savings. Transactions are pseudonymous – the wallets do not, by default have names attached to them, although transaction chains are easy to trace. It has near-zero transaction costs – you can use it for micropayments, and it costs the same to send 0.1 bitcoins or 10,000 bitcoins. Finally, it is global – so a Nigerian citizen can use it to safely transact with a US company, no credit or trust required.

Even more importantly, Bitcoin the protocol will enable financial services transactions that are not possible today or require expensive and powerful third-parties.

Bitcoin has a scripting language which enables more than a “send money from X to Y” transaction. A Bitcoin transaction can require M of N parties to approve a transaction. Imagine Wills that automatically unlock when most of the heirs agree that their parent has passed, no lawyer required. Or business accounts that require two of any three trusted signatures to approve an expenditure. Or wire escrows that go through when any arbiter agrees that the supplier sent the goods to the buyer. Or wallets that are socially secured by your friends and family. Or an allowance account accessible by the child and either of two parents. Or a crowdfunding of a Kickstarter project that pays out on milestones, based on the majority of the backers approving the next payment. The escrow in each case can be locked so that the arbiters can’t take the money themselves – only approve or deny the transaction.

The scripting language can also unlock transactions based on other parameters. Unlocking them over time can enable automatic mortgage, trust, and allowance payouts. Unlocking them on guessable numbers creates a lottery auditable by third parties. One can even design smart property – for example, a car’s electronic key so that when and only when a payment is made by the car buyer to the seller, the seller’s car key stops working and the buyer’s car key (or mobile phone) starts the car. Imagine your self-driving car negotiating traffic, paying fractional bitcoin to neighboring cars in exchange for priority.

Everyone has a copy of the Bitcoin block chain, so anyone can verify your transactions. You can write software that will crawl the block chain and generate automatic accounting histories for tax and verification purposes. You can engaged in “Trusted Timestamping” – take a cryptographic signature of any document, timestamp it, and put it into the block chain. Anyone can verify that the document existed at a given time. If you sign the document with your private key and another party signs it with theirs, it becomes an undeniable mutually-signed contract. This entirely eliminates notaries and websites like https://www.proofofexistence.com/ are showing the concept. The Namecoin project is building a distributed Domain Name System that allocates and resolve Domain Names without needing ICANN or Verisign, by using the block chain to establish proof-of-ownership. Similarly, look for entrepreneurs to apply this authoritative proof-of-ownership to built P2P Stock and Bond Exchanges – at least one Bitcoin site, “Satoshi Dice,” has sold shares and issues dividends without using a stock exchange. The ownership and dividends are easily verifiable by anyone who wants to look inside the block chain. Predictious.com is combining the transaction scripting and the verifiability to create a prediction market in which you cannot be cheated and third-party arbiters can allocate the winnings.

Bitcoin’s “send-only” and irreversible nature makes it much less vulnerable to theft. Today, anyone with your Credit Card or E-Checque (ACH) information can pull money from your account. This creates chargebacks, expensive dispute resolution and merchants double-checking your identity. Bitcoin is send only. Anyone who has received bitcoins from you can’t request or pull more money from your account.

Most importantly, Bitcoin offers an open API to create secure, scriptable e-cash transactions. Just as the web democratized publishing and development, Bitcoin can democratize building new financial services. Contracts can be entered into, verified, and enforced completely electronically, using any third-party that you care to trust, or by the code itself. For free, within minutes, without possibility of forgery or revocation. Any competent programmer has an API to cash, payments, escrow, wills, notaries, lotteries, dividends, micropayments, subscriptions, crowdfunding, and more. While the traditional banks and credit card companies lock down access to their payments infrastructure to a handful of trusted parties, Bitcoin is open to all.

Silicon Valley knows a platform when it sees it, and is aflame with Bitcoin. Teams of brilliant young programmers, entranced by the opportunity, are working on Exchanges (Payward, Buttercoin, Vaurum), Futures Markets (ICBIT), Hardware Wallets (BitCoinCard, Trezor, etc), Payment Processors (bitpay.com), Banks, Escrow companies, Vaults, Mobile Wallets, Remittance Networks (bitinstant.com), Local Trading networks (localbitcoins.com), and more.

Looming over them is how governments view Bitcoin and the entrenched financial powers it threatens. The last few decades have seen a move towards a cashless society, where every transaction is tracked, reported, and controlled. Bitcoin takes powers from the central actors and returns it to merchants and consumers, savers and borrowers. Bitcoin brings back some pseudonymity in the transactions, and can be irrevocably traded like cash. And finally, it points a way towards a single currency – it is a bug, not a feature, that we have multiple global currencies with exchangers and transaction fees in between.

Governments have been cracking down on the bitcoin exchanges, making it harder to obtain and slowing its development. Strict and expensive Money Transmitter regulations, designed to slow terrorist and child porn financing, threaten the next great technological revolution – never mind that terrorists can use cash just fine, the means of terror are cheap, and that they account for an infinitesimal fraction of global commerce. The development and innovation in Bitcoin has already begun the move to friendlier jurisdictions, where its innovation can continue un-impeded. Regulators in the US and UK would be wise to proceed with a light touch, lest they push the development of Bitcoin and its entrepreneurs to places like Canada, Finland, and the Sino-sphere. The United States has benefited enormously from being home to the majority of global companies driving the Internet revolution. The country that is the home to the Internet of Money could one day end up as the guardian of the new Reserve Currency and the Global Money Supply.

Thanks to Shawn O’Connor, Lucas Ryan, Paul Bohm (@enkido), and Oleg Andreev (@oleganza) for feedback. Follow me at @naval

A Venture SLA

There is an opportunity for a new VC Firm to brand itself. Recent brands in Venture Capital arose from transparency and founder-friendliness. YCombinator gives new, young, technical talent an entry into Silicon Valley. 500 Startups does it globally. Fred Wilson blogs the business. Marc Andreessen and Ben Horowitz back Founders to be Public Company CEOs. Ron Conway tirelessly connects his investments to his huge personal network. AngelList gives away investor and talent introductions for free. Founders Fund explicitly cashes out Founders. First Round Capital builds and operates an internal platform. Brad Feld, Mark Suster, Floodgate, Felicis, Freestyle, Softech, Harrison Metal, Baseline all have transparent, founder-friendly philosophies.

That’s not how most VCs work. Imagine if a young entrepreneur were to walk into a VC firm and say:

"We help our customers but don’t tell them exactly how. Our core product is a commodity, yet we don’t disclose pricing. Even when we do, there are substantial hidden costs. It has to be bought in bulk, more than they want. We can take months to onboard a customer. We reject most of them but don’t actually give them a straight answer. They don’t get dedicated support. They don’t get to choose or replace their representative. We don’t commit to serve them in the future. We have hundreds of competitors with the same strategy. Now where’s my check?"

Not even the DMV could get away with this. It’s only possible when the supplier has power over the buyer. As companies get cheaper to build, that power is eroding. Most great VC firms know this, and have built reputations to counter much of the above. That’s what "smart money" means.

But there’s the opening. No one quantifies it or promises it. A few are beginning to – Passion Capital has a Termsheet in Plain English. The accelerators of course do this.

But where’s the venture capital with a strict, quantified promise? A Service Level Agreement?

Imagine this pitch:

"Hello, we’re Founder Friendly Capital. We

• Give you a quick and clear answer. 3 meetings, 2 weeks, yes or no.
• Sign up to a plain-English, Founder-Friendly Termsheet. We pay our own legal costs.
• 1x Liquidation Preference, no veto on Arms Length transactions. Four weeks to decide. No one-way NDAs.
• We’ll always do our pro-rata in the future or sell you back our stake.
• Will never bring in an outside CEO without at least 50% Founder consent.
• You’ll get access to the following resources. X hours of our recruiter time. Access to Y network. Office hours with your Partner.
• Board Seat above $X, Board Observer below that, no Board Control
• No Option Pool Shuffle – the Pre-Money is the true Pre-Money
• Minimum investment amount is $__; Minimum ownership percentage is __%
• Choose your Partner – don’t be embarrassed to ask
• 10% of the Round can be used for Founder Liquidity
…"

Change the numbers. Change the terms. It’s the transparency that matters. Instead of leaving every option open and wiggle room on everything, make hard choices up front. A Venture Capital Firm that voluntarily constrains itself will be viewed as Founder Friendly, Smart Money, and will never be short of opportunity.

Build a Team that Ships

I started my first company 15 years go, and I still can’t manage. I suspect that very few people can. With AngelList, we want a team of self-managing people who ship code.

Here’s what we do:

  • Keep the team small. All doers, no talkers. Absolutely no middle managers. All BD via APIs.
  • Outsource everything that isn’t core. Resist the urge to pick up that last dollar. Founders do Customer Service.
  • People choose what to work on. Better they ship what they want than not ship what you want.
  • No tasks longer than one week. You have to ship something into live production every week – worst case, two weeks. If you just joined, ship something.
  • Peer-management. Promise what you’ll do in the coming week on internal Yammer. Deliver – or publicly break your promise – next week.
  • One person per project. Get help from others, but you and you alone are accountable.

If they can’t ship, release them. Our environment is wrong for them. They should go find someplace where they can thrive. There’s someplace for everyone.

It’s not perfect. We ship too many features, many half-baked. The product is complex, with many blind alleys. It’s hard to integrate non-engineers – they aren’t valued.

But, we ship.

Why You Can’t Hire

There isn’t a shortage of developers and designers. There’s a surplus of founders.

The cost of starting a company has collapsed. It’s now just (minimal) salaries. For entrepreneurs, desks are free, hosting is free, marketing is online, and company setup is cheap.

Raising the first $25K for product development is easy – join an incubator. Raising the next $100K is easy – investors are following the incubators with automatic notes. Building a product and launching a product are easy – develop on Open Source Stacks, host on Amazon, launch on Facebook, Android or iOS, get your early traction.*

Getting real traction is hard. Raising millions of dollars is hard. Building a sustainable, long-term company is hard.

Yammer can hire. Square can hire. Twitter can hire. These companies have achieved product / market fit. Your pre-traction company has not, and so it has a hard time hiring.

If the costs of founding a pre-traction company have gone down, then returns to pre-traction founders must go down.

Throw out the old cap tables. A founder doesn’t get 30% and an early engineer shouldn’t get 0.25%. Those are old numbers from when you had to raise VC capital before you could build a product. Before everyone could and did start a company.

Post-traction companies can use the old numbers – you can’t. Your first two engineers? They’re just late founders. Treat them as such. Expect as much.

Your next five designers and developers? Your cap table probably can’t even afford them until you have traction, and the cash that follows it.

Close the equity gap, and hiring will get a lot easier.


* Of course nothing is ever “easy” – but it’s a lot easier than it used to be.

** This is just my opinion, not that of my employer. But you can see what they’re doing to help at AngelList Talent. Coincidentally, the lead hacker on that project put up this related must-read post on his own blog yesterday.

Towards a Literate Nation

“Give me a lever long enough, and a place to stand, and I will move the earth”

- Archimedes

To reduce unemployment, we need to lever up.

Not like Wall Street did, through debt, but like Silicon Valley does, with tools.

Leverage magnifies your actions and increases your productivity. You can get leverage through:

  • labor (people work for you)
  • capital (money works for you)
  • tools (machines work for you)

We’re trying to help labor. We don’t have much capital. We must give tools to the people.

All of the great modern tools for productivity – the printing press, the factory, the movie studio – require capital and coordination to use. The computer is the first tool since maybe the stone axe, that an individual can use to gain massive leverage, without permission from anyone else.

The modern computer can help in every endeavor – even if you don’t use a computer at work, you’ll soon carry a $50 smartphone in your pocket. You’re banking online, learning online, communicating online. The computer, and now the smartphone, make everyone more productive.

This is why Silicon Valley doesn’t have enough people, when the rest of the nation doesn’t have enough jobs.

Now computers are simpler. More ubiquitous. Cheaper. More accessible.

And we can teach people how to use computers, through computers, using tools like ShowMe, CodeAcademy, Bloc, and so on.

Let’s create the world’s first, completely Digitally Literate Society. Not a nation of programmers (maybe someday) but a nation of people who are comfortable with the most powerful tool ever invented by mankind.

Let’s do it quickly – train them in three months from start to finish. And cheaply – for free.

We can create the program at Stanford, MIT, Berkeley, Harvard, etc. We can teach basic proficiency – use online applications like Google Apps, Search, DropBox, Email, Online Banking, Travel, Ordering supplies, etc. Some basic creation – create your own web-site. Research questions. Solve problems. Learn to learn.

Google, Amazon, and Apple will loan us the tablets. Companies will pay us to have people learn to use their apps. An app marketplace where companies pay society to educate society.

Apple, Square, DropBox, Twitter have created beautiful software interfaces. iPad and Android have made the hardware accessible. Today, it is not just cheap to build a company. It is cheap to re-build a person.

Let’s create the world’s first digitally literate society. The world’s most desirable workforce. If that won’t generate employment, nothing will.

Google should pull an Android on Facebook

Android’s best weapon against iOS is that it’s a much more open platform. iOS’ elegant user experience comes at a cost – developers have to suffer through approval delays, rejections, private APIs, rules against advertising, and shutdowns. Android, on the other hand is open to carriers, users, and developers.

Facebook developers face two major problems. Firstly, to attract them, Facebook concocted and gave the developers access to artificial virality channels. Then, to prevent spam, they had to take them back. But the enforcement seems capricious and arbitrary to developers, with some (i.e., the offerwall providers) being punished, and some (check a certain game company’s S-1) being rewarded. Secondly, Facebook is still figuring out its own business model, so what’s allowed and what’s not is subject to change – look at the graveyard of social ad companies and payments companies, and the recent introduction and mandates on Facebook credits.

Google should tell developers – “Here’s a simple set of rules that will never change. Here’s a simple API that we will always keep backward compatibility with. Here’s an incentive and a reward for creating an application that brings more users into G+. Here’s a simple and clear way for users to export their information and their social graph. Here’s the standard small cut that we take on everything – it will never go up.”

Right now, the only true open platforms for any startup are email and the web. Android is a close third. Facebook, iOS, SMS, etc., while beautiful and elegant, forget at their peril that there was a time when AOL, Compuserve, WAP, and other walled gardens were beautiful and elegant too.

An army of 100,000 developers is Google’s best chance against Facebook.

There is No Angel Bubble. There are Many Angel Bubbles.

A common meme floating around right now is that there is an Angel investing bubble.

In the sense that an enormous amount of capital is being placed at risk, and its popping will have grave macro-economic consequences, No.

The total amount of additional capital flowing through the Silicon Valley early-stage ecosystem, thanks to Super-Angels and newly minted millionaires, is on the order of half-a-billion dollars or so. It’s no more than a middling-sized VC fund. Would the emergence of a new VC fund be considered a bubble? Would the collapse of one signal disaster?

Furthermore, most of this capital is replacing traditional Series A deals. As we say around here, “Seed is the New Series A.” The same companies that needed $3M to launch now need $30K-$300K to launch. So, it’s not surprising that there are many more of them.

Ok, but could that mean that the amount of capital for funding startups in the old environment is too much for the new environment? That the total supply of early-stage funding dollars should come down by a factor of ten rather than the number of companies being funded go up by a factor of ten?

This one is harder to ascertain, but my sense is that if there’s too much capital, it’s not an overwhelming overhang. Most of the small companies being funded will fail, but the ones that hit will generate fantastic returns. And because of their small size and operating costs, a greater percentage will be able to get “ramen profitable” than was traditionally possible. Of course, actual exits might still be rare. The volume of small M&A deals hasn’t scaled with the volume of Angel investments in small companies. I think we’re all going to have to become even more comfortable with failures, re-starts, and the kind of team re-combination that one sees from one Y Combinator Demo Day to the next.

One thing that has been happening is that Angel investment valuations have been climbing very quickly – un-sustainably so. Twenty companies in an Investors’ portfolio carried at a valuation of X might now suddenly be twenty small bubbles at a valuation of 2x. They may not be able to clear their valuation in a micro-acquisition, or lead to a down-round in a VC financing, or just give a sub-par return for what might otherwise have been a hit. Prices on the margin *have* been rising, and that will hurt returns.

Prices have been rising not because of a huge influx of money (no big, macro bubble), but because of a modest influx of price-insensitive money. Prices get set on the margin. On Wall Street, it doesn’t take an influx of $5 Trillion into the stock market to move the total market capitalization of all of the companies from $15 Trillion to $20 Trillion. (In fact, money never moves into the stock market – it moves *through* the stock market, but that’s another post). Rather, a small series of secondary transactions at the margin, done by price-insensitive buyers at high prices, can move the quotational value of each stock considerably higher. Similarly, a small number of high-profile Angel investments, moving small amounts of capital but at very high valuations, can make the entire market look overvalued.

So what’s driving the new, price-insensitive bidders? It’s three things:

1) VC Funds – Every VC that announces a $20M seed fund is basically a price-insensitive Super-Angel. They’re buying first looks and options to finance companies in the future, so they’re not particularly price sensitive. When you have $1B under management, $20M is pocket change.

2) Entrepreneurs Set Pricing – Leaderless “party” rounds often end up with the entrepreneurs setting the valuation. And clever entrepreneurs are getting the less price sensitive investors to sign off on the initial terms, and then taking those terms, social proof in hand, to Investors who would have been traditionally more price sensitive.

3) New Angels – People who have had modest exits and are now angels are just building their portfolios. They don’t have enough exits under their belts to understand that price does matter. Not as much as in other businesses, because a Power Law distribution here means that one winner can dominate your whole portfolio. But it still matters because a lower price allows you to pick more startups in the hope of finding that one winner. New angels often hear that “If it’s the right company, price is irrelevant.” That’s true, but that gives too much credence in your own ability to pick the right company. If you’re informed just enough to know how un-informed you are, then you doubt your ability to consistently pick winners, and a low price will give you more attempts to figure it out.

So does this always end in tears?

For VCs, they will look back at these seed funds and find that (a) their seed efforts didn’t have the best returns and that (b) they didn’t always get the first look options that they always wanted. But it will probably still pay off. Seed is the new Series A, and if you don’t do Seed, you’re basically retreating to later stage.

For Angels who are price-disciplined, things will be fine – we are undergoing an incredible renaissance in technology, with smart phones taking computing to local arenas and social networks taking it into the mainstream populace. There’s a lot of opportunity and great companies will be built. For un-discplined Angels, there will be pain (unless they find their one big winner early), but it’s part of the learning curve inherent in the business.

Entrepreneurs win big, all-around. There has been some concern that all of these small companies are going to get orphaned – who will fund them downstream? I don’t necessarily view this as a negative, though. Even failed, these entrepreneurs are going to be much more employable than those who never tried or had the opportunity, and given that the minimum efficient scale of businesses is getting smaller and smaller, more of them will succeed than in any previous generation.

Entrepreneurs sticking to the old model of hiring are getting hurt. The old model used to be that after a Series A, you could hire an engineer and give him 0.25% of the company. Good luck hiring a great engineer for that in Silicon Valley now, for a freshly-minted startup with a small seed round in your pocket. The opportunity cost for that engineer is now to go join a Seed Combinator or raise some Angel funding. So, we’re going to see the equity gap narrow between the founders of raw startups and early key team members. Only the best startups with high valuations and tremendous traction can recruit under the old formulas anymore.

The Unbundling of the Venture Capital Industry

People often mock Super-Angels as being impure because they invest other people’s money. We also often get asked “What are VCs and Seed Funds doing on AngelList?” (They’re clearly marked, by the way, and you can choose who your pitch is visible to.)

I will propose, however, that whose money you’re investing is less relevant than on what terms it comes on. Venture Hacks was created to educate entrepreneurs when the Angel market was much less robust. At the time, if you wanted anything more than $250K, you basically had to go to Venture Capital.

Venture Capital, at the time, was a bundle of three things – Advice, Control, and Money.

The money is obvious – you want money, you go get it. But in the case of VC, it came with control – because the amounts being disbursed were large enough, it made sense that they needed to be actively managed. And finally, because it was actively managed, you cared about how well it was managed, and thus the advice.

Now, thanks to increased dissemination of information on the web, Venture Hacks and many others (Series Seed, A VC, Feld Thoughts, The Funded, etc.) have helped entrepreneurs understand the control layer. Y Combinator and other seed incubators have essentially helped “union-ize” the startup workforce, and via reputation and standardized documents, reduce the control that VCs have over startups. Lower capital requirements have opened up the playing field of investors, and reduced the need or even the ability of early-stage investors to do active portfolio management.

So Angels are investors who leave out the control. They essentially bundle just Advice and Money.

The amount of money invested and whose money it is are factors that play into it, but most Super-Angels eschew control. Similarly, some seed funds (i.e., True Ventures), and some larger funds (i.e., Andreessen-Horowitz) make entrepreneur-friendliness a core part of their ethos, and as such often leave out classic control provisions (M&A vetos) or mechanisms (Board seats). Conversely, you’ll see some Super-Angels or even traditional angels asking for more control if they’re investing a significant portion of their investable capital.

We are also seeing the emergence of Seed Combinators and Pure Money plays. Y Combinator, TechStars, I/O Ventures, AngelPad, Founder Institute, etc., are basically giving advice – if you’re going there for the funding, then you’re not doing the math. DST and later stage funds are pure sources of money.

The net effect is that the Venture Capital is slowly being un-bundled, as mature industries often are.

One side effect of all of this is that reputation matters a lot less. It used to be that VC reputation was built on their ability to pick winners (this has signaling value to other investors and potential employees), the advice that they gave, and how friendly they were to the entrepreneurs, given that they essentially had Board control. Most of this doesn’t matter anymore – it’s only the signaling and advice that carries much value for savvy entrepreneurs, and even the advice part is gradually being augmented and possibly replaced.

There is one thing that the new unbundled model can’t replace – which is the subtle influence of incentives. You may be able to get advice from the best advisors, money from the cheapest source, and keep control for yourself, but the one thing that an experienced VC partner can *uniquely* provide you is someone who has a strong incentive (because they own a lot of your company), and a very different perspective and experience base. That’s the old-fashioned “Investor as a Partner” model. It will always survive, to some extent, but it’s not the model that any but the best firms practice.