David Piccione.com

Yesterday, I wrote that the current boom being experienced in the tech sector is about to come crashing down around us. To be honest, I didn’t anticipate the level of passion the article would stir up. There were a good deal of experienced opinions shared at ycombinator, and I may revisit the topic again soon.

For now, indulge the point I was making; is there anything that founders can do to isolate themselves as much as possible from the negative effects? Is it possible that even in a downturn, a particular company could find a level of success?

Of course it is. Back when the sector was hit hard in 2000, there were companies that managed to survive and grow. Even in a full on recession, the economy doesn’t stop. Knowing how to position yourself to take advantage of change will be key to your startup’s success in 2008. Even if I’m wrong, and the expected bust fails to materialize, following the advice here will give your organization better resistance to changing realities.

Understand Your Market

In a downturn, what will happen to the way your customers think? If you take a look at what’s happened in previous recessions, you can accurately predict the effects on your company. Traditionally, the mindset of a consumer changes in the following ways:

1. People pay more attention to purchases - Your consumer will be more critical of the value received from your product. This is especially true if your consumer is an advertiser. What you’ll need to demonstrate is a value for money that places your product high on the “need” list; the less likely your product - or the price of the product - is classified by consumers as a luxury they can’t afford.
2. People look for optimization rather than expansion - Your consumer is going to start looking to get more use out of what they currently pay for. It’s going to be difficult to launch a new product that requires a large investment. Instead, take a look at ways you can improve something a customer already uses for a smaller investment. Now is the time to check out the competition and see where you stand compared to them.
3. People act like the recession will last forever - Your customer will start to look at buying things in smaller amounts and lower price points. It’s more attractive to buy less of a product than more, even if buying more is a better value. Retaining the money in hand is a more pressing concern.

Play the Right Hand

If this is how your customer is thinking, you’ll need to position your startup to take advantage of their concerns. You can do this by adjusting your company as such:

1. Make sure your product is “real” - “Real” products address “real” needs. You’ll need to establish that your customer can’t live without your product - especially not now! Chances are, if you have end users that are already paying to use your product, this is a matter of perception. It’s time to focus on marketing: what does your product offer that others do not? What will the customer lose if they stop using your product? If you look at a company like 37signals, their products address needs that are perceived as essential. It’s doubtful that a Basecamp customer will cancel their subscription when they’re worried about their own sales. If you make your money from advertisers, take a look at what attracts them to your site specifically. How will you be able to prove to them that $10 spent with you is worth more than $10 spent with a competitor?
2. Offer efficiencies and savings instead of new features - Show the actual value in your product to your customers. How much time is it saving them? How much more expensive would it be for them to go elsewhere? If you know, spell it out for them. If you don’t, find out. Even better, look at your own efficiencies - are you doing things as best you can? Can you do them cheaper? Now is a great time to look inward and improve processes.
3. Focus on retention - In a down cycle, it’s difficult to translate a stay and hold mentality into a new sale. Because of this, put some extra effort into those customers that aren’t as happy with your service as they should be. Don’t let them become someone else’s win. Solve their issues, address their concerns, and put them back in your safe column. It’s the easiest sale you’ll make, and it’ll be easier to do now than when the market is up.

Things to Avoid

There are certain sure fire ways to ensure your company will implode as soon as people start to get jittery about their money. When you’re adjusting to survive, be sure to stay well clear of the following traps below. A special note however: If you happen to fall into one of these categories as a result of your deliberate strategy, it doesn’t need to be lights out. You just happen to be in a space that is particularly vulnerable, and you’ll need to be extra careful at the moves your organization makes.

1. Ad-based revenue models - One of the easiest cost savings a company can make is to cut its advertising budget. When this happens, you better be sure ads aren’t your only source of revenue. In 2000, almost all of the companies that went out first were those that relied on pay-per-click banner ads as their only source of income. It would be very optimistic to assume that more than one or two of our favourite multi-million dollar sites will be around in five years. Odds are that your startup is nowhere near their level. You may be able to mitigate the loss of ad revenue from switching to a pay-per-action model,- since the advertiser can then see real numbers - but overall it’s not a situation you want to be in.
2. Being recreational or “fun” - When people start to worry about their money, they reduce spending on leisure activities. In the depression, people were so concerned about making money that they actually took on extra jobs instead of having fun, which as seen as frivolous and risky. I’m not suggesting recessions are that bad, but staying out of this market is a good way to avoid being hurt unnecessarily by a slowdown. Admittedly, this isn’t a huge concern, but it’s something to keep an eye on.
3. Innovate at your own risk - In general, innovative ideas are going to be a tougher sell. The one area though where innovation will work is where it provides measurable efficiency improvements to the consumer. Case in point: Google. Releasing a search engine that provided a better result to the end user - saving them time - allowed Google to ignore - even capitalize during - the last market slip.

It’s About Good Business

An economic downturn is a time to separate the wheat from the chaff in business. Your startup will need to survive the harsh realities of stingy consumers and ruthless competition. You’ll do it by focusing on real needs, and improving results to the problems that don’t go away.

Recessions and crashes don’t do much except eliminate ideas that are purely based on speculation. If you can ensure your startup focuses properly, you’ll have no problem building a solid organization. If anything, you can rest assured that if your idea can survive and be fruitful in a recession, it will most certainly cruise through an upswing.

Over the next couple of days, I’ll be talking about the fact that it looks like we’re heading into another technology crash. With all the hoopla around the current business activity on the internet, that opinion is sure to be unpopular. Nonetheless I believe it to be correct.

Today, I’ll tell you why I think that way, and tomorrow, I’ll give you my thoughts on how entrepreneurs can best avoid being left in the pile of 2.0 refuse.

A Tail of Two Corrections

First off, a caveat - Crash 2.0 will be nowhere near as bad as 2000 was. The hype back then was outrageous IPO’s based on unrealistic profit expectations. Now, we have private acquisition based on unrealistic profit expectations. The VC’s are still there, but they’re pitching to a different audience. It’s a different environment within our industry.

It’s also a different market overall. In 2000, the market was dominated by tech. The rampant speculation that was occurring had an effect on the average investor because there was no way for him to avoid being a part of the industry - dot coms were everywhere. Today, tech is only a segment of a market that is structured differently. This means that our little piece of over-valuation and acquisitions matter less to the average man on the street; he’ll be affected likewise.

The problem for those of us who are directly involved in web 2.0 is that we are now part of a market that we have less control over. Regardless of how secure our sector is, we’re going to be affected by the events in other areas. These events, as witnessed over the last week or so aren’t all that encouraging, to say the least.

Are we staring into a recession, or even something more serious? It’s possible, but still subject to healthy debate. Even the most optimistic however, don’t suggest that we are heading into anything but a bear market. Even the slightest correction in the index however will be magnified in effect in our sector - one built on speculation and venture capital almost exclusively. When the VC’s other earnings dry up, they’ll be less likely to take a chance on your latest Facebook app.

For comparison, 1987; a strong housing sector was destroyed by a correction in a market dominated by industrials. That’s very simplistic, but it serves to illustrate the point. At the end of the day, it was better to be a part of the index than a part of a booming sector within it.

Icing on the Cake

Given the conditions outside of web 2.0, what kind of security do we have within that will shelter us from a market correction? The truth is, our industry is speculative right now - as it was in 1999. Look at the leaders - Facebook, mySpace, Digg, YouTube. Being ad based, each of these companies generate no income from those actually consuming the product.

Consumer loyalty is directly linked to the amount the consumer invests out of pocket. Apple has a fiercely loyal base partly because they feel really stupid spending an extra $300 on a product that isn’t something special. With social networking sites the amount spent is zero - and the loyalty corresponds.

Facebook and mySpace are only as valuable as the next big thing. In other words: they are fads. Now, fads can be successful if they’re managed right, but they all share one thing in common - they won’t be around tomorrow. If you need proof, look no further than Frendster. In 2003 they had 20 million users. Today, they have less than 1 million die hards. Those are fickle crowds.

So, why is this a problem? Because eventually investors - be they VC’s or acquiring organizations - want to see some growth in their investment. With a fad-based industry, all value becomes speculative and opinion based. In order to make money, investors need to assume that tomorrow, the perceived worth of the product will be higher. Let’s pick on Facebook a little. Facebook now needs the next investor to believe it’s worth $2 billion at least. - invest $1 billion, recoup $1 billion. Sorry if I laugh a little.

This whole thing works until there is a measurable instance of a product demonstrating its actual value. It doesn’t have to be the product itself, just something close enough. If, for example, it came out that Digg was in the red, or not nearly worth as much as the $200 million BusinessWeek thought, Facebook would have a tougher time convincing potential investors of its value.

Any industry built on such rampant speculation is doomed to be as temporary as boy bands and leg warmers.

Facebook Apps - Beyond Madness

Bubble 2.0 takes things a step further. Not only do we have the general investor speculation in copycats (quick, how many Technorati clones can you name in 15 seconds?) but we have investor interest in products built upon other products. Ladies and Gentleman, the folly of the Facebook application.

Let’s put this into perspective: We have a product that has a monetary value of zero to its users being used to build further products of negligible value - and these products are actually being sold or invested in!

Let’s avoid the elephant in the room - putting 100% of your chances of success into the outcome of someone else’s business plan - for a second. There is zero evidence that Facebook users value the site enough to pay to use it. There is zero evidence that Facebook advertisers value the site enough to maintain a long term relationship with it - and thus ensure that any market is there for your application. Somehow though, there’s enough money to be made on a small fraction of that user base to recoup a sizable investment, or so the thinking goes.

I just don’t get it. And Facebook only scratches the surface. I’m sure that some fool, or collection thereof will purchase Twitter - only to lose a heck of a lot of coin - any day now.

How Could This Bubble not Burst?

Let’s take a look then at situation then:

1. We’re heading into a bear market, if we aren’t already there.
2. The boom in our industry is fueled primarily by speculative values and notional potential future revenues
3. The social network audience is fickle, investing little and demonstrating high mobility.
4. We have people investing in products that are naturally restricted by the success of a product that is - as of yet - of dubious long term stability

I’m sorry to those that are caught up in the madness, but you have to have a few screws lose to think that we’re not in the middle of a bubble. There are scary signs all over the place right now, and it seems that many of us won’t be as wealthy this time next year as we are now.

So what do the smart start-up do? Tomorrow, I’ll take a look at some of the ways that an entrepreneur can avoid being left out to dry when the inevitable happens.

One of the blogs I frequent often is JohnChow.com. Normally, this fellow Vancouverite is a wealth of information on using your website to generate income.

This past week however, John’s taken some pot shots on the minimum wage and notion of progressive taxes. John’s pretty conservative in his thinking, so that makes him pretty predictable in is stands; support of a flat tax in place of our current progressive system included.

Of Flat Taxes and Economic Fairies

Flat tax systems suggest replacing our progressive tax brackets (of which Canada now only has four - 15.5%, 22%, 26%, 29%) with a one size fits all rate, usually floating around 15-20%. Benefits often touted are a reduced bureaucracy, and well, less tax for the upper brackets.

John feels that the government currently has it backwards, and that progressive tax policies “reduce economic growth by creating strong disincentives to hard work, savings, and investment.”

Fortunately, the truly innovative aren’t going to let 29% get in their way. “Ernst & Young estimated there were 315,000 millionaires in Canada at the start of 2001…The consulting firm forecast that the number of Canadian millionaires would grow to 900,000 by the year 2010″. Seems like a good deal of us are willing to live with the incentive as it currently exists.

In addition, unprotected capital gains in Canada are only taxable to 50%, a huge incentive for investment and savings.

Gold on the Surface, Green Underneath

Aside from a straight monetary comparison for taxpayers, flat tax systems take a huge amount of flexibility and power away from the government. Libertarians no doubt will argue that this is a good thing in all cases, but those of us who are a little more concerned with the the neighbourhood outside of our walls tend to think a little bigger.

Progressive systems work well because the government can use the built in system of incentives and disincentives to encourage certain behaviour it deems beneficial to the country.

At a time when we will be undergoing massive social, environmental and technological change, this is a key benefit. The Conservative government’s transit pass and child benefits are perfect examples of ways a government can effect positive change using the tax structure. So called “sin taxes” on cigarettes have helped (pdf) lower smoking rates - specifically among teens.

This influence disappears in a flat tax system.

Four Brackets is Simple

The most commonly used argument in favour of flat tax systems is that they bring simplicity. Of course, often left out is the fact that simplicity has absolutely nothing to do with whether you have one rate or four, or fifteen for that matter. It has everything to do with who and what is taxed. New Zealand, for example, has simplified their system a great deal, yet it remains progressive.

On the other hand, a flat tax implementation with certain caveats and incentives remaining will be just as complex and difficult to navigate as our current setup.

Even worse, given government’s pension for staying in power, how long do you think a flat tax system would be “flat” for? How long before one person, one price is replaced with a big asterisk? I don’t know about you, but I’d give it one election.

Want Relief? NIT-Pick

For those (John included) that are serious about tax reform that is more than just getting a bigger refund, I’d suggest exploring some form of Negative Income Tax. Canada, as it stands is in a perfect position to benefit from a NIT policy, since we have already have a generous social net and have mean incomes that are well above the poverty line.

Flat tax is often seen as a cure all every April. Unfortunately, our tax system is complex because our county is complex. Those who would change it hold very different views of what our country should be. Others perhaps just don’t get a chance to look at the negatives. Either way, we’re much better off staying with what we have than looking for a silver bullet in a flat tax system.