Secrets

The importance of secrets in creating and capturing value has had no more vocal champion recently than Peter Thiel. In last year’s brilliantly distilled and somewhat controversial book Zero to One, Thiel builds a well-argued case for the importance of monopoly profit and power-law thinking for innovation and business that is well worth reading, even if you disagree with his conclusions. One central theme of the book is the value of secrets: not secrets that you hide and tell no one, but rather things that you know to be true even though others think you’re crazy. Thiel’s main point is that if you want to build a company that can capture a substantial portion of the value it creates, you’ll need to know something important on which few other people agree with you initially:

“What valuable company is nobody building? Every correct answer is necessarily a secret: something important and unknown, something hard to do but doable. If there are many secrets left in the world, there are probably many world-changing companies yet to be started.” –Peter Thiel, Zero to One

In Thiel’s view, in order to be profitable in any meaningful sense you have to know things that others don’t – otherwise you’ll be perpetually at war with rival after rival as your profits get competed down to zero. He breaks down secrets into two categories: secrets about the natural world (more or less things you can patent, be they chemicals, compounds, or algorithms), and secrets about people (aspects of our behaviour and desires that remain unacknowledged or misunderstood). Both can be important vehicles to building durable, profitable companies, although in Thiel’s view secrets about people tend to be more interesting and relatively undervalued.

“Great companies can be built on open but unsuspected secrets about how the world works. Consider the Silicon Valley startups that have harnessed the spare capacity that is all around us but often ignored. Before Airbnb, travelers had little choice but to pay high prices for a hotel room, and property owners couldn’t easily and reliably rent out their unoccupied space. Airbnb saw untapped supply and unaddressed demand where others saw nothing at all. … The same reason that so many internet companies, including Facebook, are often underestimated – their very simplicity – is itself an argument for secrets. If insights that look so elementary in retrospect can support important and valuable businesses, there must remain many great companies to start.” – Thiel

If we accept Thiel’s argument at a basic level – that secrets are important for profitability, and are therefore desirable – then I’ve got a few follow-up questions. What is the cash value of a secret, and how could one be priced fairly? Is there a market for secrets, and what’s the opportunity for brokerage? And finally, can such a market ever theoretically be made efficient? In this post, I’ll go through my thoughts on each, and reach a somewhat provocative conclusion that prior to writing this post I had never considered.

First of all: how can you price a secret? This is a tricky problem, particularly for secrets about people, because by definition a secret is something that few individuals will initially understand or appreciate.1 I propose the following basic principle: the fair value of a secret is the sum of all future net earnings this secret will generate for its owner, discounted for time and risk.

The major obstacles towards converging on a fair price for a secret are two-fold. First of all, it’s impossible to practically forecast the sum of all future earnings a secret is capable of generating for anyone, and even the most well thought out confidence interval for that sum will be severely wide. So that’s one issue. Second of all, discounting for risk is going to be really tricky- it’s difficult to evaluate a business model based on something that by definition very few people understand and appreciate. So in our three-variable equation (future net earnings, time discount and risk discount) at least two of them are very difficult to nail down. We’re off to a good start!

Yet the fact that secrets are hard to price has not prevented people from appreciating their utility, nor from investing into their potential. Large and famous secret-discovery factories like Bell Labs and Xerox Parc were built for exactly this purpose: to uncover new secrets in the search of renewed competitive advantage and long-term profitability. The problem with these discovery labs is that it’s hard to systematically uncover secrets, and many of the best opportunities today concern the ones about people anyway. Could there be another way for large companies, with future profitability at stake, to ensure a steady flow of new secrets that have high value and have been sufficiently de-risked?

As it turns out, there is: Venture Capital. The market for secrets today is Sand Hill Road, and its currency is the term sheet. While VCs everywhere preach about all of the value they bring to companies that help change the world, what they really do is act as secret brokerage firms. When a VC invests in a startup, they are placing a bet on the likelihood of 10x return on investment- the kind of profits that are only possible when valuable secrets are involved.2 By purchasing an initial stake into a secret at Series A, they are betting that they have invested at a lower price than the fair value of this secret: the sum of all future net earnings it will generate for an acquisition target – or the public, in the case of an IPO – discounted for time and risk. Whenever a VC gets an exit, they have successfully participated in the brokerage of a secret between its discoverers and its new owners, and their return on investment represents a broker’s fee of sorts – distributed between the LPs and the partner in question.

If this all sounds lovely, be aware that there’s a catch: the market is really inefficient. Most VC firms fail to beat the market these days, and there are more than a few Zombie firms sitting around sucking management fees while their portfolio companies die. Meanwhile, VCs are getting a stupidly good deal- if their investments pay off, they make twenty; if they lose everything, they still make two. But there’s good news – the old school VC model is starting to get attacked from all sides, with early stage financing (Angellist), network & prestige (Y Combinator) and many of the other value-add components of traditional VC getting unbundled, re-thought and optimized. As Marc Andreesen of a16z mused in a recent New Yorker profile, “What if we’re the most evolved dinosaur, and Naval [Ravikant, of Angellist] is a bird?” Yet for all of the value that Angellist, YC et al. provide, they’re not truly participating in secret brokerage in the same way that an established VC firm can. So long as they hold onto this function, there will always be opportunity to make money for them and their LPs.

However, a few particularly innovative large companies have begun to outmanoeuvre the rest of us when it comes to secret acquisition. When Facebook rolled out Messenger as a Platform a few months ago, we saw a glimpse of the future: by opening its most lucrative asset (their social graph) to developers everywhere, Facebook is attempting a brilliant move. Whereas in the past, as new companies emerged with powerful and desirable secrets, Facebook has simply purchased them (Instagram and Oculus come immediately to mind; Snapchat was a notable failure of this strategy). Now Facebook no longer needs to outright buy these secrets – if the next Snapchat is built on Messenger platform, with Facebook’s users, they’ve already captured 80% of the value of the secret with a small fraction of the effort and cost. (That’s some Tim Ferriss shit right there!) If this works, and other large companies manage to build their own equivalents, the impact of this ‘secret hijacking’ plus the new incentives to delay IPOs for long periods of time may well lead to a crisis in VC where the opportunities for fund-returning exists are restricted – potentially to the point where the traditional 2-and-20 management fee becomes untenable. Should this happen, a new secret brokerage model will inevitably emerge. What will it look like? I have a few ideas, but I’ll save them for a future post.

Finally: can a market for secrets ever, in theory, be made efficient? I’m not sure it can: a genuinely valuable secret’s true worth is almost inversely proportional to its publicly perceived value, so true competition cannot really occur. Secrets have the exact opposite problem of the auction-winner’s curse: a genuine secret marketplace is one where consensus value and true value are perfectly uncoupled. If this is true, then the secret trade is therefore the most theoretically profitable industry that can exist! That’s an eye-opener alright.3

I will admit that my closing conclusion about the secret trade’s theoretical profitability has left me deep in thought. I hope it has done the same for you. I will revisit this topic in the near future once I have given it further consideration, and very much look forward to where this thinking exercise might lead.

  1. Yes, I am aware that people regularly evaluate and put prices on patents. But I would argue that the majority of patents are not truly secrets, but rather derivative extensions that don’t require any particular illumination to appreciate. The truly innovative ones – admittedly a small subset – are those I’m interested in, and I’m sure they are the hardest to price accurately.
  2. “We invest in great founders!” They say. Yeah, you invest in founders who know a secret and have de-risked that secret somewhat with early traction. That’s what ‘being a great founder’ means. Let’s call a spade a spade.
  3. Who could’ve foreseen that? Well, a certain company with a certain founder does come to mind.

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out / Change )

Twitter picture

You are commenting using your Twitter account. Log Out / Change )

Facebook photo

You are commenting using your Facebook account. Log Out / Change )

Google+ photo

You are commenting using your Google+ account. Log Out / Change )

Connecting to %s