Innovation in Software

If you need any proof that we’re in a bubble around Web companies, the valuation of Facebook at $15 billion thanks to the $240 million Microsoft just paid for a 1.6% share, must be it. Even the TechCrunch guys seem a little flummoxed by it – the comments are worth a scan.

To put that into perspective, if we assume $150 million in revenues next year is solid we’re talking about 100:1 price-to-earnings ratio there. If you’re the kind of person who normally yawns when hearing about P/E, here’s why it’s important.

There are lots of reasons a company might be valued with a high P/E. The six most common are:

• The market expects earnings to rise rapidly in the near future. This is normally the case with oil or gold companies who have little in the way of earnings right now, but who have secured income in terms of drilling/mining rights
• The company makes piles of cash normally but has had to take a one-time hit on something showing earnings being lower for this year
• The company has a business advantage that guarantees revenue for low risk. Think “monopoly”.
• Investors need to shove a large amount of money into the market to get it out of other vehicles, so the law of supply and demand means prices go up
• High demand for a particular share for some reason, for example a takeover bid
• The company is hyped, and we’re in a bubble

Going through each of these in the case of Facebook:

• Facebook’s revenues are not going to rise dramatically any time soon. They have not suddenly secured a huge pot of advertising revenue they have yet to “mine”, and my P/E is based on next year’s optimistic revenue figures, not past figures.
• They’re not making a lot of cash at all, and they’re not taking any major hits in terms of infrastructure, so that’s not it.
• Whilst everybody is raving about them, they don’t have a monopoly. It would be relatively easy to replicate the Facebook platform in open source (in fact, that’s an idea going onto the site tomorrow – unless you now put it up first and claim credit), so it’s hard to see how this sticks. The value is in the user base, but talk to MySpace if you want to hear about how fleeting they can be.
• Microsoft are in no hurry to diversify risk or in need to get money out of other “vehicles” – they might need to show their shareholders they’re hitting hard with their new advertising-driven model, but that doesn’t justify the expense
• 1.6% is no basis for an immediate takeover bid

That leaves us with…

• We’re in a bubble

It’s not like Microsoft are going to miss $240 million. It’s not that we’re in big trouble if this doesn’t hold up when Facebook floats in a couple of years.

It’s the mindset that bothers me.

People are no longer looking at figures. They’re thinking irrationally. They’re buying shares because they want to hold a chip. I’m not an IFA or your banker, but I suggest you make sure you don’t pay too much for any chip you want to hold on to yourself.

This article at Dead 2.0 makes an interesting point about some stuff kicking around over Paul Graham’s comments in what is quickly becoming an infamous interview.

Paul Graham is a smart man, of that, there is little doubt. Seek out his essays, and you will be confronted with insight that it is rare in terms of its raw power.

But if his recent advice to start-ups is anything to go by, Dead 2.0 has called it, and he’s going to see a lot of disappointed kids in the near future. He will drive a bubble to bursting point, it will pop, and everybody will be covered with another 4 years of misery.

Look, I was coming out of a job in 2002 with nothing, just after the bubble burst. Because people with stupid, frothy, moronic thinking like “Business plans don’t matter” had just destroyed an industry I’d given my all to, I, a qualified and experienced developer and systems administrator, ended up having to wallpaper bathrooms for money to eat. I’m not making this up. Idiotic bubble-pushing statements like that almost killed the industry and almost killed me.

I am no longer going to listen to business advice from Paul Graham. Not that I was massively tuned into his ideas on business in the first place – his more interesting work came from his thinking on innovation.

Of course you need a business plan, you just don’t need a very advanced one. You don’t need to spend thousands of man-hours perfecting it. But what you need more than anything, more than any business plan, any seed funding, anything at all that Graham might tell you that you need is much harder to get:

A paying customer.

What Graham was trying to say, I suspect, but not very elegantly was this simple truth. Find a person with money who is prepared to exchange it for something, and then find them that something. If you can do that, you have a business.

I learnt this, what now seems obvious, lesson in business after picking up this book: Bootstrapping your Business. I discovered it about a year ago when Greg Gianforte (one of the authors) visited the University I was working with at the time – Manchester Metropolitan University – to talk to a group of Business Studies students.

The points he makes are simple – it’s not the read of the century, but it’s OK – and he makes more sense than Paul Graham’s frothy, silly nonsense. Start small, find something people want, sell it to them, find out what features they need, improve what you’ve got. If one guy wanted it, chances are other people want it too. Well done: you’ve just created a successful business, and you did it with nothing else other than a phone.

It sounds like a ridiculous way to do business, because it doesn’t involve years and years of R&D, but because it doesn’t involve all that expense, and because you deliver what somebody is prepared to pay for, you are able to fail cheaply. You are also more likely to succeed.

Saying that your business plan should respond to a clearly identified group of customers (Gianforte’s stance) is one thing, but to say don’t have a plan at all is just outright dangerous.

I really hope I’m not going to have to get my overalls out again.