Cowboys Like Us: Investor Nick Hanauer on How to Think About Breakthroughs in Business and Society (Part 1)

3/29/10Follow @gthuang

Last week was a pretty good one for Nick Hanauer. When I visited his office, he was basking in the glow of the mid-afternoon sun—and the afterglow of President Obama’s signing of the much-ballyhooed healthcare reform bill. (Yes, he’s a staunch Democrat.)

But I wasn’t there to talk politics. Hanauer is one of the Seattle area’s most successful investors and businessmen, and one of its most influential thinkers. He is a founder of Second Avenue Partners, an investment group focused on early-stage companies. He was the first non-family investor in Amazon.com (and a board advisor until 2000); the founder of Avenue A Media (which became aQuantive and was sold to Microsoft for $6.4 billion in 2007); and an investor in such diverse companies as Insitu (sold to Boeing for some $400 million in 2008), Newsvine (sold to MSNBC.com in 2007), Market Leader (formerly HouseValues), Modumetal, and Qliance.

He is also a political activist, a die-hard science buff, and an amateur astronomer. And he’s giving the opening keynote today at our Xconomy Forum (“What’s Your Breakthrough Idea?”) at the University of Washington at 1:30 pm. He will set the table by discussing where “breakthrough ideas” fit into the overall taxonomy of startups and entrepreneurship, and he’ll give examples of some transformative ways of thinking from his own experience.

To whet my appetite, and those of our readers, I sat down with Hanauer for an extensive and wide-ranging chat. I should have known better; it was like partaking in a 15-course dessert buffet just before the main meal. But it was vintage Hanauer—talking in depth about not conforming to societal expectations and how to think creatively about new ideas and metaphors, reflecting on why venture capital doesn’t work as a sector, quoting famous philosophers, and discussing the one area in which he would seek omniscient advice if he could. All of that sprinkled with insights from Amazon, Insitu, and other prominent companies.

Here is an edited transcript of the first part of our interview:

Xconomy: You’ve talked about the importance of new metaphors in thinking about potential breakthrough ideas. What do you mean by that?

Nick Hanauer: OK, here’s a non-business example of what I mean by that: The entire edifice of modern economic theory—Chicago school, efficient-market hypothesis, market fundamentalism, that has dominated our political discourse for 30 to 40 years—is based on the understanding of the world as a linear system. Modern economic theory requires the system to be linear in order to make the numbers add up. It requires humans to be rational calculators of their self-interest. The only way it works is if you assume every human can make an instantaneous net present value calculation about what they should do at every moment. What that does is it creates this idea in your mind that the market is this perfectly efficient machine.

The dominant narrative has been that markets are perfectly efficient. If it’s perfectly efficient, then the market is always right. And if it’s always right, you also have to believe, among other things, that the rich deserve to be rich, and the poor deserve to be poor. How could it not be, if the market is always right? You have to believe that any civic intrusion into market constructs is an abomination, because the market is always right. These things have to be true if that’s your metaphor for understanding how the economy works. But if you understand the economy for what it is—it is a complex, adaptive system. Our market isn’t just like an ecosystem, our market is an ecosystem. It’s complex, it’s adaptive, and it is shaped by the evolutionary forces identical to the forces that are at work in Puget Sound.

X: So what’s the breakthrough here?

NH: If you understand the market in that way, then it forces you to reckon with it like a giant garden. In that garden, we get to make choices about what’s going to grow, what we’re going to eat, and so on. All of a sudden, a civic intrusion into that structure doesn’t become an abomination, it becomes an obligation. No thoughtful person lets nature take its course with their garden. Otherwise all you get is dandelions. Now in the meantime, the dandelions are making this rocking case for dandelions—go yellow! dandelion wine! whatever—but if the dandelions overrun the potatoes, carrots, and celery, you’ve got a problem. And it’s not just your right, it’s your responsibility to make sure that doesn’t happen.

In a garden, the dandelions don’t deserve to be rich. You may choose to create a circumstance in which they become rich, but they don’t deserve it. Their situation was a consequence of the situation in which you put them. The rich are usually rich as a consequence of the circumstances in which they were put. Those changes in metaphorical understanding of how the world works cascade into fundamentally new ways of understanding how we should arrange society. They can translate into completely new ways of seeing the world that opens you up to transformation.

X: How does all of this translate to the business world?

NH: One of the ways that you know an idea is transformational in business is if the metaphor you use to describe it is new—if people don’t have a ready metaphor for understanding it. “Online” was this weird thing—it came along and, what do you mean, “online,” what do you mean “virtual world,” what are you talking about? And boom, here we are, able to conceive of an entire sort of universe that takes place in this “cloud.” I don’t know where it is, but it is a whole place where we spend most of our time today. People are super comfortable with that.

The other thing that’s happening that’s radical and will have terrific business implications is going from understanding the world atomically, to understanding the elements of the world as networked. For a very long time, we’ve had this atomic world view, that things are atomized, disconnected. The political instantiation of that is to say every man is an island; or I should be able to do whatever I want to do so long as it doesn’t hurt anybody else. Those statements make perfect sense if you understand the world as atomized.

But if you come to understand the world as networked, if you understand every human being as a node on a network, then you have to account for the fact that everything you do affects other people. There’s this landslide of research to show, among other things, behaviors are contagious. If I’m happy, you will be happy. If I’m sad, you will be sad. If I’m a smoker, you will be a smoker. It’s unbelievably predictive. By the way, if I’m poor, you will be poor. If I’m rich, you will be rich.

The network effects overwhelm almost everything else. Now you can’t say I should be able to do whatever I want so long as it doesn’t hurt someone else, because in fact whatever you do affects them. Now we have a mutual responsibility to behave in ways that make our lives better. Courtesy is a great example. If I’m courteous, you will be courteous. If I’m not courteous, that sets off a cascade of discourteous behavior. Society becomes how you behave—this is one of the central findings of understanding complex, adaptive systems. This idea of emergence, that the interaction of the parts create patterns that essentially describe the system. Show me turbulence, and I’ll show you a whirlpool. It’s an emergent property of turbulence.

X: Let’s talk about healthcare for a moment, as it relates to your political activism and one of your recent company projects, Seattle-based Qliance (which delivers primary care without health insurance companies).

NH: I’m super psyched about the healthcare bill. For almost two years I’ve been in Washington DC slagging the healthcare bill as a half-measure and a step that actually doesn’t fix the problem. We’ve taken a broken system and made it bigger. But I think it’s a great step for the country, if you start with the fact that you have an insurance-based system and you’re probably not going to get rid of it anytime soon. Having an insurance-based system that doesn’t include one in five families in America—stupid—that allows insurance companies to kick you off if you get sick—criminal—that allows insurance companies to not take you if you need it—what?! Fix it. It’s crazy to not fix that stuff.

Something Americans have to reckon with is that despite having average incomes on the order of 50 percent higher than many other industrialized countries, by any other measure we’re doing worse. Every health measure, virtually every happiness measure, violence, incarceration, education—pick it—we’re behind. All of this has to do with this radical income inequality we’ve allowed to seep into our society, this giant distance between the rich and the poor. I think at this stage, anything we can do to enfranchise people, to make them part of us, makes us a better country. Will it be more expensive than they say? Yeah, but we spent $1 trillion in Iraq. Let’s spend $1 trillion making our fellow citizens healthy. You could spend the money in worse ways. Because I’m an optimist, I think there is hope to fix the system. I think our message about how to fix the thing—if you push the insurance companies out from in between doctors and patients for all the stuff where they don’t belong, everything gets better—people are beginning to grok that. Now they’ve really got to solve the cost problem.

X: So how does this affect Qliance?

NH: It doesn’t, at least not in the near term. But long term, it’s very good news for Qliance, because we worked super hard to get language in the legislation which permits people in the insurance exchanges to buy primary care without going through insurance. So we were very successful in our lobbying efforts to get our model baked into the legislation. But at the end of the day, it’s years out; there’s no effect in the near term. Although redoubling of focus on how to get costs under control will probably benefit us asymmetrically.

There’s a bunch of venture activity in the healthcare space. There are all these venture firms focused on healthcare because people see it as a huge opportunity. We’ve been in discussion with a large VC whose sole focus is healthcare and is trying to go find ways to bring healthcare costs down, because it’s such a disaster, particularly in places like California.

X: Can you talk a bit about Modumetal and why you invested in this far-out nanomaterials company?

NH: Modumetal is one of these amazingly big swings where if they can crack the engineering challenges, they really can transform the world. That idea that you can grow completely new kinds of metal things in solution using metal salts, some liquid, and a tiny bit of electricity, is a huge, huge idea. Getting them to scale it up industrially is a great challenge that we’ve not yet cracked. But we’ve certainly made some really interesting stuff, and have gotten a lot of interest from a lot of people. It’s a great example of a thing which has almost infinite promise but is incredibly hard to get funding for. If something is truly new, venture firms don’t have a partner who can evaluate it at a level of granularity that gives them comfort. You have this weird Catch-22 where they say they’re all about the new, but actually if it’s really new, they don’t want to look at it because it sounds crazy, or they can’t carefully evaluate it. In the interest of serving the fiduciary responsibility to their investors, they screen out the stuff they can’t understand.

X: How is Second Avenue Partners different from a venture capital firm? (Hanauer and his partners invest their own money.)

NH: We can do whatever we want—because we don’t have to prove to somebody that we made the right decision. You can’t make an investment in something like Modumetal when we did and defend that to a fund manager, other than “we thought it was cool.” That’s all you can say. Imagine if this all works out, it’ll be huge. There’s no business model proof. There’s no technical proof. It’s just a flyer. It’s a bet based on instinct and perspective on what can be big. And it’s indefensible in the context of that [VC] environment. They [fund investors] would say, what do you know about metallurgy? Answer: nothing. What experience do you have? None. We liked them and we thought it was a good bet. That’s a whole different thing from talking to somebody from the Washington State Pension Fund where they’re [pounding the table] saying, are you doing your due diligence?

It’s a very difficult problem for that business. I mean, people do surmount it, like Vinod Khosla and John Doerr [from Kleiner Perkins Caufield & Byers], who have such a track record, and where “if John thinks it’s good, I’m in.” You can get to that point, I suppose. But most VCs don’t have that track record, and certainly John didn’t start there.

X: What are your most notable failures as an investor?

NH: I put $150,000 into Pets.com. It was one of these “Wahoo, we’re going public, we’re all going to make a lot of money” bets. I think that’s a $150,000 sock puppet [points to a puppet in the corner]. We made some early bets on technology— Terabeam was a technology that looked promising. That was a bet we made that didn’t turn out. We had some early Web tools companies, a couple of tries at building technology that would enable people to build websites more easily. They just didn’t execute terribly well.

My partners give me [grief] about one thing we did. I had a friend from Texas, he’s this super fast-talking, really glib, good-looking guy. He couldn’t talk without including five buzzwords in a sentence. He was Mr. Technology. I can’t even tell you what the business was, some platform network, blah blah blah… it was called Agillion. I was really smitten because he seemed so smart and had this big track record in the bubble that looked really good. He called us from a G-4 flying across the country where he described the business plan. We put $400,000 in this thing, and 10 minutes later it was gone. My partners have always called it “a gillion ways to lose money.” We couldn’t even describe what the hell the money went for. That was 1999-2000.

X: So how do you manage the risk of investing in projects that could, if they work, change the world—when in fact they probably won’t?

NH: We want to help people at the earliest stages do the newest and most interesting things. We want to take as much risk as there is to take, and we also want to get rewarded as much as possible for taking that risk. Lots of people don’t like to take risk. We had a VC come out to look at Qliance. He called me later and said, “Fabulous meeting. Let me tell you about the things we’d like to see progress on before we feel like we could make big investment.” He proceeded to list every single business risk—literally every possible risk, every sales risk, every operational risk, every legislative risk, everything—as a threshold for where they’d be super interested in investing. That’s not venture investing—I’m not sure what that is. I think that’s banking. Unless you’re prepared to take risk, you’re a banker.

X: But were VCs ever all that different from that, in truth? What are your broader thoughts on the venture model?

NH: I suspect that in the very early days, they were mostly cowboys like us who met people working on interesting problems and said, “Yeah, to heck with it, we’re in.”

A very successful venture capitalist was in the office the other day. He said, “Venture used to be a cottage industry, and it’s turned into a sector. It should never have been a sector.” Venture doesn’t work unless it’s a cottage industry. Once you professionalize it, you’ve taken the life out of it. The business model is toxic to risk-taking, because it’s so unbelievably profitable for the partners just if it doesn’t fail. They get these 2 percent fees on these giant funds; you raise $1 billion or $2 billion, pay yourself 2 percent on that a year, split between six guys? All you want to do at that point is not screw up. It’s crazy how much money these guys make to produce nothing, for zero return. Now you can argue, if you don’t produce returns, you’re going to lose your fund—yeah, in 20 years when you’re retired. These things hang on forever. It’s a gravy train for partners, I think it’s unconscionable. They are so massively overcompensated for the value they create. To me, it should be [two tenths of a percent]—you should earn a fee enough to keep the lights on.

[Stay tuned for Part 2 of the Q&A tomorrow, where Hanauer talks about Seattle's innovation culture, how to change people's minds, and how to think about solving the big problems in business and society---Eds.]

Gregory T. Huang is Xconomy's Deputy Editor, National IT Editor, and the Editor of Xconomy Boston. You can e-mail him at gthuang@xconomy.com or call him at 617-252-7323. Follow @gthuang

By posting a comment, you agree to our terms and conditions.