Redeye VC

Josh Kopelman

Managing Director of First Round Capital.

espite being coastally challenged (currently living in Philadelphia), Josh has been an active entrepreneur and investor in the Internet industry since its commercialization. In 1992, while he was a student at the Wharton School of the University of Pennsylvania, Josh co-founded Infonautics Corporation – an Internet information company. In 1996, Infonautics went public on the NASDAQ stock exchange.

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Nothing to Lose (or Risk Tolerance is a Competitive Weapon)

155890834X.01.LZZZZZZZ I've been thinking a lot about the market/economy lately, and what the economic downturn means for startups.  And I've come to the conclusion that while the economic crisis does present serious challenges to startups, it it might also offer a real opportunity to attack large entrenched players. 

Back in 2000, after I sold to eBay, I remained with eBay for a few years.  And while I was there I was a witness to their battle with (and ultimate defeat by/acquisition of) PayPal.  There are many reasons why PayPal won -- but I think it really came down to the differences in "risk tolerance" between a startup and a large public company.  Let me give two examples:

1.  PayPal had a different risk tolerance level for legal risk.
Around the time that PayPal launched, eBay launched its own payment product called Billpoint.  Paypal's product was widely seen as the better product -- it was easier to use, had less "friction" for sellers, and was well designed.  Billpoint was clunky and forced the seller (and buyer) to go through several additional steps.  The conventional wisdom was that PayPal had a better product team and that eBay was clueless.

From what I saw inside eBay, that wasn't really the story.  I believe that eBay understood everything that was needed to build a great payments product.  They were just unable to do so given the risks involved.  Specifically, I believe that PayPal had a better product than Billpoint because they were willing/able to take risks that Billpoint/eBay was not.  For example, when PayPal first launched, it was pretty clear that their product violated the operating rules for Visa, Mastercard and American Express -- and violated banking regulations is more than 40 different states

PayPal's bet was that they could ultimate resolve these issues after their product had won in the marketplace.  (And that if they didn't win in the marketplace, the legal risks didn't matter).  And they were right.   In late 2000, MasterCard threatened to terminate PayPal's ability to accept MasterCard cards for payment -- and PayPal ultimately worked the issue out.   In 2001, Visa said that PayPal was violating their operating rules -- and PayPal ultimately worked the issue out.  Over a dozen states investigated PayPal and several including Louisiana and New York concluded that PayPal was offering "illegal banking".  Ultimately, PayPal was able to work the issues out (and ended up applying for money services business licenses in more than 25 states).

It was clear to me (from inside eBay), that the Billpoint team knew exactly what they needed to do in order to offer a comparable product to PayPal.  They just were unwilling to accept the risks of doing so.  As a large public company, eBay could not afford to violate the laws of 40 states.  As a small private company, PayPal was willing to take the risk.

2.  PayPal had a different risk tolerance level for financial risk.
PayPal was one of the earliest success stories for online viral marketing.  Every time a user sent money to someone, the recipient had to become a PayPal user in order to access their money.  And to add fuel to the fire, PayPal launched a "refer-a-friend" bounty program, where they gave users $5 everytime they invited a new user -- and gave the new user $5 when they deposited money into their account.  PayPal was willing to invest millions of dollars to acquire new customers.  According to their financial filings with the SEC, PayPal spent over $15M in marketing fees in 2000 and lost over $169 Million that year. 

eBay, on the other hand,  was profitable in 2000 -- with Net Income of $48M.  Given the pressures that Wall Street analysts put on the company, there was just no way that eBay could invest anywhere near as much in the payments space as PayPal.  If eBay decided to spend half as much as PayPal did, eBay would have shifted from a $48M profit to a $37M loss -- a move which would have reduced eBay's market capitalization by billions.

Ironically, eBay was sitting on an enormous amount of cash at the time (over $1B) -- especially when compared to PayPal's $61 million cash reserve.  However, the realities of the public markets prevented eBay from spending/investing their cash to remain competitive with PayPal.  The fact that eBay was a publicly traded company forced them into a diferent risk profile when it came to financial investment.

In both of these cases, PayPal was able to pursue a strategy with a different risk profile because they had nothing to lose (except their venture capital investment dollars) and eBay (with their $20 Billion market capitalization) had everything to lose. 

So, as I look at the markets today, I think I see a similar situation developing.  There are a large number of public companies that have a lot to lose (and are forced to play defense to protect their sagging stock prices).  As they cut their spending (and lay people off), these companies are slashing investment in new projects and new products.  And that makes them vulnerable to scrappy startups with a different risk profile.  Granted, I don't think you're going to be able to burn through $150M (or even $15M) today to "go big" -- but I believe there are other ways to take an aggressive risk posture (as PayPal did with their willingness to accept legal "ambiguities").

Maybe the fact that startups don't have much to lose is a good thing - especially if you're competing with someone who has a lot to lose.