ThinkFlood Blog

A lot of stuff today is free, and I love it. From open source to Google, from free Wi-Fi to various promotions and add-supported broadcasting and Internet content, we get a lot of great stuff for free. In fact, we’ve become accustomed to it.

I’m convinced that someone could write an interesting sociology PhD thesis by examining comments on the iTunes App Store. With something like 20,000 applications and counting, there are a lot of duplicate efforts, and it is not uncommon to see three, four, five, or more versions of similar applications. Invariably, some of these are available for free, and some cost money. Anecdotally, it seems that consumer preference is for the free applications — these have the most downloads, and they tend to get higher “star” ratings. In fact, I have seen cases in which commenters have disparaged paid applications which are functionally superior simply because they feel $4.99 is too much to pay for something they can get for free somewhere else.

To me, this is fascinating. It’s almost as if we have come to see free things as an entitlement. We want our music, our TV, our movies, our books, our software — everything we can get — free. Of course we do. Who wants to pay money if we don’t have to?

The thing is, free creates some problems. First, usually there is some sort of cost to produce these things. The Internet and the digital revolution have certainly reduced the cost of many things, but none of these is completely free to produce. That is particularly true if we consider the time spent in creating this content. Yes, it is possible that someone coding up an iPhone application during nights and weekends can offer that software for free (primarily because Apple subsidizes its distribution 100%). But I find that most things of value require more effort than this, and it is hard to make a living when you do not charge for your product somehow.

Of course creative people have come up with solutions to this problem. Some rely on advertisements to support their work. Others sell related services, or gather data from their users and sell that. However, generally speaking even these approaches cannot sufficiently subsidize physical products where the cost of materials and manufacturing is more than a few pennies per unit. For this reason, we don’t see successful free business models outside of software and media — they just are not viable.

But I think there is a more fundamental problem with free stuff, and that problem is the sense of entitlement we develop when we receive something through no effort on our part. When we receive things for free, we take them for granted. We tend to waste them. Our perception of the value of those products and services — and their paid competitors — actually decreases.

In my last post, I mentioned that we will be launching our product in April as a public beta. While many beta tests are free to participants, ours will not be. What we will do is offer a discount to our beta testers. They will be able to pick up our final, production hardware roughly at cost. This enables us to continue to function as a company — which is in the best interest of all of us, as it means we can keep our jobs and they can get product support and new software with new features. Since the hardware is not “beta hardware,” it seems reasonable to us that we offer a discount now, as they will end up with the full production version once we release our software updates.

But perhaps more important than recouping production and distribution costs on our hardware, it is critical that those who participate in the beta test actually care enough about the product to use it and to give us feedback. After all, the reasons we are bothering with the beta test are to ensure that the product works in a wide variety real world situations, and to understand what features and changes are most valuable to our customers. If those customers receive the product for free and then leave it to collect dust on the shelf, then we cannot accomplish those goals.

So, dear beta testers: we love you. But even if we could afford to give you the hardware for free, we wouldn’t.

Daniel-san, must talk. Walk on road, hmm? Walk left side — safe. Walk right side — safe. Walk middle — sooner or later, get squish just like grape.

©John G. Avildsen, Columbia Pictures Corporation

Ah, the immortal words of Mr Miyagi (Pat Morita) from The Karate Kid, cherished movie of my youth. My ears ring as I say this, but…

…sometimes it’s okay to go halfway. In my post from yesterday I consider how to answer the question, “When Are We Ready?” Well, we have done this with regard to the launch of our first product, and the answer is: we are ready now. But the answer is also, “We will launch first as a public beta.”

Yup. We’re going to launch next month, but we’re also going to call this version a “test” — i.e., not the final product.

So, what could possibly possess us to make like grapes and walk down the middle of the Interstate? The answer came as we considered those two questions: 1) is it valuable enough? and 2) can we afford to fix it?

The answer to the first question is yes. We think we have a really fun product that will be valuable to people every day. But the answer is also that we feel that a subset of the overall population will find its problems more tolerable than others early on. These are people who are willing to dive into a setup process that will be slightly more involved and tedious than what we have planned for the “final” product.

They are also people who are willing to deal with a few warts that will surface. This goes to the answer to the second question. This product is a new kind of accessory for the iPhone and iPod touch. At this point we are comfortable that the hardware design is solid. But the nature of this accessory is that it must interact with literally thousands of other kinds of devices, and there is no way that we could test all of the possible combinations beforehand. Therefore we anticipate that we will need to update the software to improve compatibility and squash a few bugs.

Actually, this last part is one of the most exciting things for us, because the ability to roll out software updates with new features and tweaks will be groundbreaking. We have many ideas of ways that we can make the product more fun and elegant. But what we want the most is to hear what other people think after using our product. We are launching in “beta mode” because we want the chance to hear our customers’ ideas about how the product can be better. We expect that they will have suggestions that we would not have considered otherwise.

And so that is the real value of going halfway — at least in this case. We can offer something useful as early as possible, and we can give our customers the chance to influence the design of the product so that it can be even more useful to them in the long run. I suppose some people might see that as a dangerous proposition. But for us, it’s mostly just exciting.

This is a basic question that we all ask ourselves at one time or another. Am I ready to drive a car? Leave home (for school, a job)? Enter into this relationship? Hold this responsibility?

Lately at ThinkFlood, we’ve been asking ourselves the same question — about our product. It seems that there are two opposing forces here. On the one hand, we are eager to get going, to do new things, and to test ourselves. On the other hand, we are apprehensive. We wonder whether our preparations are enough, and whether we are up for the task.

Some will say that the latter is just fear of the unknown. I’m not so sure. Certainly there is an element of unfamiliarity. But there are also good reasons that we may pause. For example, as a young company preparing to launch our first product, we want to make the right first impression. We believe that marketing — not technology — is our biggest challenge, and we need to make sure that when we “go live” the general perception is positive, or we will be digging ourselves out of a deep hole for some time.

Of course this being a business, there are some additional factors in the equation. For example, where are our competitors? For the moment, we seem to be in the lead, but there may be another company out there that is keeping as quiet as we are who sneaks up and surprises us. Another question many companies face is short term cash flow. Thankfully our non-development expenses are basically zero. (This is not true of our personal finances, and I know that my family is dying for this thing to hit the market.)

I think a lot of these factors — on both sides of the issue — are basically irrelevant. Let’s consider a few:

1. Competitors. Let’s face it — we have just about as much clue as to what our competitors are cooking up as we do about how the stock markets are going to move. In fact, that’s a pretty good analogy — timing the market is impossible. Instead, we have to focus on fundamentals (as a product company, that is creating something valuable for other people), make it as good as it can be, and settle in for the long haul.
2. Preparations. There is always more that we can do, and there will always be hiccups along the way. The fact of the matter is that it is impossible to be prepared for everything, and incredibly hard to know how to prepare until you start.
3. Cash position. A lot of people will argue that this is an absolute — no cash, no company. I won’t argue with the last statement, but limited cash on hand is not the same thing as saying there is no cash available. The other day, Jason Calacanis made a pretty compelling argument that entrepreneurs can survive if they want to.
4. Excitement. It’s generally easier to find reasons not to do something than to do something, but let me at least address one reason why people rush into things: excitement. It’s thrilling to do new stuff, particularly if you have identified something at the heart of the latest fad. But enthusiasm alone cannot create real value.

Now, I’m sure that you can come up with a bunch of other reasons to take the plunge or to hold back — I can’t possibly address all of those concerns in this post. Even so, I believe that there are only two questions to consider when planning to start something new:

1. Is it valuable enough?
2. Can I afford to fix it?

The order of these questions matters. First, whatever you are going to do, it has to be valuable to someone. In fact, it needs to be valuable enough that the cost of doing it is less than the value it delivers. As long as this is true, it is worth doing. The second question is related: when it breaks, can I afford to fix it. In other words, is the fully-loaded cost still less than the value you can deliver? You have to assume that whatever you do will fail sometimes — this is particularly true since you are about to start something new. So the question is not whether it will break, but whether you can afford to fix it if it does. If so — if the cost of producing it and fixing the failures is still less than the value you get from it — then there is no reason to wait.

What do you do if you cannot answer yes to both these questions? The answer is simple: 1) either increase the value of the thing by adding more features or (my favorite) streamlining to make it more useful, or 2) reduce the costs to produce and to repair until the answers change.

Today I spent a couple of hours compiling and cleaning up financial statements in preparation for talks with investors. Whenever I do this, all I can think about is how glad I am that I did not pursue a career as a financial analyst or an accountant.

So, it’s probably pretty obvious that I have some bias against jobs in finance. It’s not that I distrust people in finance, or that I think finance and accounting are useless. On the contrary, there is certainly a place for them as management tools in business. However, I think the problem is that finance is so abstract that we tend to separate it from the fundamentals of business.

In some ways, finance and academics are similar. Both are necessary for an informed picture of the world — they help us develop the critical thinking and language we need to understand and to communicate important concepts. However, if pursued without a regular and solid grounding in real world experience, they can create false pictures and lead us into some sticky traps.

I think this separation from reality is what has happened in the current financial meltdown. For example, one of the basic goals in finance is to reduce risk. We have many vehicles to do so — we share risk through insurance, we minimize the impact of risk through hedges, we evaluate risk by marking assets to market, and so forth. However, one dimensional risk management does not make a good financial instrument. There are other factors, such as transparency. It seems to me that credit default swaps and collateralized debt obligations played up the risk management idea, but completely ignored the importance of transparency. As a result, we no longer know who owns what, whether terms are negotiable, or what the “real” value of the assets are. Throwing money at the problem reduces leverage — and therefore mitigates certain kinds of risk — but it does not provide any greater transparency, and so other types of risk linger.

I don’t say these things to point blame or to criticize well-meaning actions already taken. Rather, I point out the difficulty in constructing things like financial models and forecasts. Yes, we can analyze this or that historical trend and come up with some estimates. But in the end we don’t really know. At best, finance is a guide that helps us determine what to look out for — we cannot afford to depend on it as a primary means of creating wealth, because so much of it is speculative.

This attitude has dictated many of my practices in business. First, I prefer to work in a company that provides an actual product. Sure, there is a room for services, but ultimately I feel that products have a more sure foundation — they are real creations, not just virtual reshuffling. Second, I do not see much point in playing games with payables and lines of credit. These things have their place, but if used too extensively they create race conditions which can make a business insolvent. They also create internal conflict between debtors and creditors — I much prefer equity ownership, which aligns investor and company interests. Finally, I like to get out into an operation to see what is going on. Numbers are useful, and I enjoy looking at things in different ways. But unless I can tie those numerical conclusions back to real-world observations, I refuse to accept those conclusions as fact.

In some ways, we have a credit problem – though it’s not the same one that the larger economy faces.

While we haven’t gone public with what we are working on, it is no secret that ThinkFlood is a small startup. Right now, there are three of us on the team (an early founder jumped ship when we changed products back in April). We are gearing up for our first product launch this coming April — a hardware accessory for the iPhone and iPod touch — so we currently have no revenues. In addition, we have worked with a handful of service providers over the past few months, but our expenses have been relatively low and so we do not have a lot of payment history. Finally, early last year we made the decision to stay away from VC funding, so we don’t have gobs of cash in the bank (although we do have enough to get going).

With all this in mind, it’s not surprising that we have a credit problem. It’s not so much that our credit is problematic — we pay all of our bills quickly and reliably — more that we just don’t have much of a history. So, last summer when we were lining up contract manufacturers, we were not surprised that most of these potential partners wanted us on secured terms — or at least a very short leash (e.g., Net 15 days).

No problem. When we walked in the door, we expected a bit of pushback (being young and small and everything), and we were ready to work with them. Cash up front? Sure, for the first few months. Our only expectation was that once we established regular sales that we might be able to get standard industry terms (e.g., Net 30 days). But no rush — we have some cash, and an existing line of credit at the bank can finance our inventory purchases well enough. What mattered more to us was the level of service and flexibility that we could get from these partners.

We distributed our initial bid package in mid-August, and then we waited. Our first order of business was to find a place to build our prototype devices, so when the one month mark rolled around and we hadn’t received any responses, we started calling to ask for at least a quote on the prototype work. A couple of weeks later we finally received some bids.

The price spread on the prototype bids we received was nothing less than astounding. While fixed costs (setup, stencils, etc.) were fairly comparable ($1,000 to $2,000), the per piece costs were all over the map. Our high bidder came in at just under $400 per device, while the low bidder was $65. We had a cluster around $300, and a few others scattered across the range. This despite the fact that we were providing all the prototype material on a consignment basis — leaving only the cost of labor in the final total. When the production bids started coming in we saw a similar spread: the high bidder was more than twice as expensive as the low bidder, and even the low bidder was offering to do the work at a 100% markup over the bill of materials cost (we had expected a markup in the 30-35% range).

Of course it was obvious to us that the high bids were essentially a rejection of our business. These companies were happy to take our money if we were foolish enough to give it to them, and their high prices were a vote of no confidence in our future. But why? It couldn’t be a concern over our finances, because we were willing to pay up front (in fact, the low bidder was one of the companies that gave us a line of credit). Could business be so good that they don’t need the work? On the contrary, these were all local New England contract manufacturers — an industry largely down on its luck since the bursting of the telecom bubble a decade ago. When we were touring their facilities, most looked uncomfortably quiet — here and there a medical device build, but honestly nothing too impressive.

Now our goal all along had been to keep production local as long as possible. While it is nice to be able to print “Made in USA” on a label, there are other reasons — the ability to drop in to monitor production, a closer working relationship with plant management, reduced shipping costs, etc. In fact, while labor costs are an issue, electronics manufacturing today is highly automated, so the real pricing differences between domestic manufacturing and production in a low cost region are small. Moreover, because our product is aimed at the consumer market, we designed it to snap together quickly to minimize these costs.

Frustrated, we decided to broaden our net. The response was incredible. Within a couple of weeks of releasing our bid package to contract manufacturers in Asia (Taiwan, mainland China, Thailand, etc), we received responses. And the price? 25-30% markup over our bill of materials cost — or just about what we had expected. In fact, one of the manufacturers even offered us Net 45 terms. And all this despite the fact that we had relatively weak connections to these companies before we contacted them — whereas most of the manufacturers we contacted in New England had done work for one or more of us when we were with prior employers.

We had a similar experience trying to find a plastics manufacturer for our device enclosure. Local US firms took 6-8 weeks to respond to our requests, and then were 2-4 times as expensive as their Asian competitors, who typically responded within 1-2 weeks. For example, we ended up paying $19,000 for two, dual-cavity injection molding tools to a company in China (which incidentally also has electronic assembly capability and is FDA-certified to make medical devices for Procter and Gamble), while a local US manufacturer wanted to charge us $67,000 for single-cavity tools. The quality of these tools coming out of China is just as good as what we would get here, and the service we are getting is fantastic — in spite of time zone, cultural, and language differences.

Here is what I don’t understand: where is the sense of hunger in US manufacturing today? I would think that given the state of the economy — not just now, but over the last decade or more — these companies would be itching for new work, and happy to find new companies to supply them with jobs in the future. Sure, some startups will fail, but they can manage the risk and still be successful. We would have been happy to pay in advance for a few months. But we can’t afford to pay 100% markup (much less 300% markup) over our component costs and have a viable business. No wonder so many startups fail — if they cannot get the support they need from established manufacturing partners.

Now, in the end everything is working out for us. We can get what we need at prices that make our business viable. But we aren’t going to be doing much production here in the US, and it’s not for lack of trying on our part. Why does an Asian company on the other side of the globe show more interest and confidence in us than the guy down the street? As a rule, the Asian companies have bigger manufacturing facilities, newer equipment, and cheaper labor costs, so we expected to go there eventually. But I was surprised how quickly the US manufacturers pushed us there with their own disinterest. Is it surprising that our manufacturing output is declining at an alarming rate, or that US businesses are losing to competition overseas? To me, the reasons don’t seem to have anything to do with NAFTA or any of the other demons that Lou Dobbs tries to summon in his tirades. Outside of a few entrepreneurs, it seems to me that US business just isn’t as hungry as it needs to be. The fact that so many companies are looking for a piece of the government bailout pie is just evidence to support my theory.