There are plenty of good pieces on the Internet about how to build a good board of advisors.  Go ahead, Google them.  There is one super post about why you shouldn’t bother to build an advisory board by the smart guys at 37Signals.  Essentially, they’re saying that too many supposedly critical things are myths that keep you from building the company and products.  But what if someone has approached you to be an advisor to his company?  There aren’t very many pieces about how to be a good advisor.  So how do you provide value as an advisor?

1. Don’t be a professional advisor.  Don’t go seeking to sit on a bunch of advisory boards.  Few things deserve your time and attention so be selective – get involved only with companies where you have unique insight and passion to contribute.  And I mean don’t be a professional advisor. If you ask for cash compensation, you’re a problem and not a solution, especially for young startups with limited resources.  If the management team desperately wants to compensate you, accept a fraction of a fraction of a fraction of equity in stock options that vest over time.  Don’t be a resource drain.

2. Get out of the way.  Too many advisors want to get actively involved in a company’s operations and tell management what to do.  The management team should know more about its business than you do and if it doesn’t – you’ll never be an effective advisor for the company anyway.  Being an advisor should never be an exercise in ego.  If you have to insert yourself to feel valuable, you’re the wrong guy.  Only get your hands dirty if the management team asks you to dive in.

3. Challenge convention.  Unlike members of a formal board of directors, you as an advisor cannot be held liable for the company’s actions.  This allows you to be more objective and give uncensored advice.  This freedom is probably the most enjoyable thing about being an advisor.  You don’t have to have all the right answers, you just need to be gutsy enough to question everything the company does and how it goes about doing it.  This is where you can have the most impact on the company by helping management to consider different strategies.  Focus on strategy, not tactics.

4. Open up your network generously.  You’ve spent your whole career cultivating valuable relationships.  Connect the company to potential investors, partners, and customers.  Of that list, customers rank supreme.  Investors and partners will show up if the company has a growing customer base.  But potential customers could care less who a company’s investors or partners are.  So if you know someone or some organization who could use the company’s products or services, be the leadoff hitter on the sales team.  But hold the management team to high standards.  Make sure milestones are being met and progress is being made before you haphazardly make introductions.  Let management know that if they do their job, you’ll be their biggest evangelist.

5. Get out of the way.  Did I mention that already?  This time what I mean is to know when the company has outgrown your expertise and ability to contribute.  There is a lifecycle to all engagements and you don’t want to be the person to outlast your welcome and usefulness.

So I asked Dan if he thought the Pareto Principle, also known as the 80-20 Rule, might apply to his personal situation. The Pareto Principle states that for many events or outcomes, 80% of the effects come from 20% of the causes. Economist Vilfredo Pareto observed many years ago that 80% of the national income in Italy went to 20% of the population. I shared with Dan my belief that the Pareto Principle might apply not only to theories concerning the distribution of wealth in nations but also to jobs, learning curves, and career growth.

I’ve long believed that, especially in the case of naturally motivated and high-performance individuals, it only takes 20% of X amount of time to learn 80% of the job. The remaining 20% of job-specific development requires the other 80% of time investment to learn what I like to think of as the nuances of the job.

Some jobs allow fast individuals to excel almost immediately out of the gate and other jobs take a long time to master. Salespeople can fairly quickly learn the key attributes of the products they are selling, the markets that most need those products, and the selling techniques that work best. The rest of the time is spent prospecting, qualifying, and closing. Medical professionals spend years in school and residency to perfect their knowledge and skill because they cannot afford to make mistakes; patients’ lives depend on their near-flawless execution.

Mark Bonham at Ray Quinney & Nebeker, one of the top venture and securities lawyers in the country, once shared with me that he needed to “bat 1.000″ in his job everyday. Every legal document that he crafts must be perfect because the negative ramifications of a poorly written contract are extreme. Attorneys spend years in law school and as junior associates to become adept in the law. That’s why any entrepreneur who thinks he can just take a legal document template off the Internet and write his own contracts is playing with fire.

Since we’re on the topic of batting averages, baseball has long been considered the hardest sport. A professional baseball player can fail to get a base hit 70% of the time and still be considered for the Baseball Hall of Fame. If a quarterback failed to complete 70% of his pass attempts, he would soon find himself out of a job.

By that logic, venture capitalists have one of the toughest jobs of all. The success ratios of typical VCs are abysmal when compared to baseball hitters. The average venture firm’s portfolio will witness failure rates between 70% and 90% in its investments in startups. Only about 10% of investments will succeed meaningfully. That dynamic brings decision-making pressure most people are not wired to handle.

The venture capital model is one example of a real world phenomenon where the 80-20 Rule cannot be taken literally. The 10% of successful ventures that provide an exit account for probably 90% of the profits. In fact, batting average isn’t nearly as important as slugging average. The 10% of successful ventures need to be homeruns and not just singles and doubles in order to compensate for the frequent failures in the portfolio.

My friends Jared Hutchings and Mark Campbell at Peer Venture Partners understand the Pareto Principle well. Since I first worked with them years ago at the University Venture Fund, I’ve observed that they excel at the 20% of the job that bring about 80% of the rewards. They are maestros at networking for good deal flow, judging the character and appropriateness of management teams, and connecting the dots that help their portfolio companies find the right partners, investors, suppliers, board members, advisers, customers, and business models.

Since personalities and passionate entrepreneurs are involved, venture investment is more art than science. Jared and Mark don’t get bogged down by the mental masturbation that is building complex and inevitably inaccurate financial projections and other time drains that some contemporary venture analysts are apt to giddily do. An old-school focus on the basics also allows them to make quicker, and no less accurate, decisions. This speed is something entrepreneurs appreciate, whether Peer’s answer is yes or no.

I subscribe to Charlie Munger’s Latticework Model of looking at the world. Charlie Munger is Vice-Chairman of Berkshire Hathaway (BRK-A) and Warren Buffett’s long time business partner. The Latticework Model is essentially about approaching life, investing, and problem-solving by weaving multidisciplinary models of knowledge. I don’t want to be an expert in any one specialty or field. If I aspire to be an expert at anything, it would be to master connecting the dots in many different fields of knowledge to bring about new innovations and solutions. That’s why the Pareto Principle works well for me as a way to approach the world and allocate my time. I can take intense deep dives in relatively short bursts of time to learn about the bulk of different subjects and challenges. Perhaps we’ll see a rise of the generalists – people who can straddle the right brain and the left brain with aplomb, people who are “whole-brainers.”

Back to my friend Dan who has hit the diminishing returns part of the Pareto Principle. I told him that if the money is not good enough to compensate for his boredom, he should find another challenge. Life is too short.

This post is not really about politics. Sure the presidential campaign continues marching towards an exciting conclusion. Sure a sudden bevy of vocal, cynical, and amateurish political observers and bloggers are loudly decrying the two presidential candidates as basically undifferentiated “clowns.” There are major differences between the two parties and the two candidates – would we really be so divided as a nation and would our political debates be as heated if they are essentially the same? Please people, let’s be respectful of our diverse differences and acknowledge that there are a mosaic of opinions on how best to govern this country. Often, these opinions diverge widely.

The Left vs. Right Phenomenon
This post is actually about the dichotomy of “right-brained” people who think intuitively and creatively vs. “left-brained” people who think analytically and logically. There are proponents on both sides who contend that their side is better (not unlike our political pundits). Books such as A Whole New Mind: Why Right-Brainers Will Rule the Future and The Rise of the Creative Class make a forceful case for the right-brainers. Other books such as Building Left-Brain Power and Being Logical make an equally convincing case for the left-brainers.

We are Divided
In my work at Design Engine Lab, I interact with designers who believe that creativity and art reign supreme. They dismiss “soulless” businesspeople and “middle-managers” who think logically. When I interact with businesspeople in the venture capital or private equity worlds, they pay little attention to “frivolous” artists who speak in soft language and cannot deliver against measurable hard metrics and milestones. Both sides contain some truth but they are more wrong than right.

Connecting the Dots
The fervent advocacy of the different hemispheres of thinking by their respective fanatics threatens to create a shortage of generalists or whole-brainers. In this increasingly competitive world, we need generalists who can traverse both sides of the fence with aplomb and deft agility. The ability to communicate and “connect the dots” or weave multi-disciplinary fields of knowledge will emerge as the premium skills of this century. Effective communication has always been a desired skill but we will increasingly need leaders who can communicate with engineers and financial analysts on the left side along with artists and storytellers on the right side. Leaders will need to tell compelling stories and extract critical analytic insight from a swamp of data with equal mastery.

Mental Agility
This video makes a quick and fun exercise to explore whether you are right-brained or left-brained. How does the figure rotate? Do you see it rotating clockwise or counter-clockwise? I can make it spin either way in my vision.

I’ve tried all my life to expose myself to a myriad of wide-ranging experiences. If you look at my diverse background of life and career experiences, you’ll find it very difficult to typecast me in any single role. My goal is to be able to add value and lead whether I’m in a crowd of industrial designers or a crowd of database programmers.

The ability to synthesize disparate fields of knowledge leads to innovative thinking and innovative breakthroughs. Innovation arises strongest as a result of the combination of logical and intuitive thinking models. Thus, engineers can think innovatively, think creatively, and make beautiful things. Artists can use logic to create works of art that are beautiful and structured at the same time. The ultimate goal is innovation, not the singular domination of left or right brain modes of thinking.

To conclude, enjoy this painting by Georges Seurat. A Sunday Afternoon on the Island of La Grande Jatte was painted entirely in dots, what is known as pointillism or divisionism. This was a drastic departure from the tradition of painting in strokes. Today, the pixels in our computer screens follow Seurat’s original insight.

Georges Seurat – A Sunday Afternoon on the Island of La Grande Jatte

The Web is changing. The current Web is designed to allow computers to retrieve and deliver documents from other computers for the end user to view, read, and interpret. As anyone who has used Google’s (GOOG), Yahoo’s (YHOO) and Microsoft’s (MSFT) search engines can attest, sometimes the retrieval of desired documents and information is accurate and sometimes it is way off base. The Semantic Web, others prefer to call it Web 3.0, has the potential to change the game completely. In the Semantic Web, computers have the ability to understand the meaning of things, content, and documents. In essence, computers can read and interpret information, thereby lightening or shortening one of the steps human users have to perform in order to obtain, discover, and understand information online.

The game is changing but it has just begun.
The transition to Web 3.0 is in its nascent stages. Much work remains before it becomes a widespread reality but the promise is enormous. Some potential breakthroughs include a deeper understanding of user behavior, understanding what matters to them, and a revolutionary improvement in search. A lot of my work centers around health informatics, privacy of data, and multi-dimensional messaging. Much of it would be helped tremendously with the more intelligent approach promised by the Semantic Web.

Everyone is a publisher.
Google made a quantum leap over existing search engines when it launched. As the Web grows and everyone has become a publisher, I’m sure you’ve noticed that the search results have deteriorated in quality. This is because Google’s search engine cannot extrapolate or extract meaning from the web pages it scans and indexes. It can only match the words you type into the query field with the millions of web pages or documents that contain those same words. The next great search engine will be a semantic search engine. This could still be Google, but it will be a completely different Google from what we’re used to now.

Learning more about the Semantic Web.
Jupitermedia Corporation (JUPM) is producing the first ever Web 3.0 Conference & Expo this October in Silicon Valley. Some of the cutting edge companies pioneering advances in attendance include Dapper, Delve Networks, Metaweb Technologies, Powerset (recently bought by Microsoft – maybe Gates and Company get it after all, despite the bad Seinfeld commercials), Hakia, Peer39, and Zemanta. It’s exciting to see significant sums of venture capital being devoted to this opportunity to radically change search and the Web in general. I will be speaking in the Enterprise Information Management session.

Success breeds competition. My previous post also mentioned the formation of the Allied Security Trust, a consortium of large technology companies pooling money together to buy up key intellectual property in order to preempt the threat of patent infringement lawsuits. Members of the trust include Google (GOOG), Verizon Communications (VZ), Cisco Systems (CSCO), Ericsson (ERIC), Hewlett-Packard (HPQ), and many others. Former Intellectual Ventures executives have formed a competing fund called RPX Rational Patent. RPX’s investors include premier venture firms Kleiner Perkins Caufield & Byers and Charles River Ventures. The market for intellectual property assets continues to evolve but I believe this new level of competition will introduce efficiencies and is ultimately good.

At Design Engine Lab, we are affected everyday by intellectual property. We are actively creating new intellectual property; we have dozens of patents and patents pending as a result of our product development efforts. We must carefully research prior art and avoid infringing other innovators’ existing patents. We circumvent other innovators’ patents whenever we can can by designing different or better solutions. Our ability to circumvent adds value not just to our own IP portfolio but also to our client’s products. Clients come to us with a certain design or product specification and oftentimes, we are able to bolster their idea with a stronger workaround design or implementation. Since joining Design Engine Lab, I’ve instituted an IP mining strategy. We actively search for interesting patents and improve upon them with stronger implementations. We also approach patent owners to partner with them and create great products.

The rapidly evolving market for intellectual property raises many questions. I’m especially concerned about the Allied Security Trust (a horrible marketing and branding execution). Will a combination of such heft invite antitrust attacks? Certainly, if only large, well-funded technology companies that already dominate their respective industries can join the trust while keeping small innovators off the membership rolls and at an unfair disadvantage, a case for antitrust actions can be made. Will the stalled Patent Reform Act of 2007, which would have curbed the ability of patent trolls to extract large monetary settlements through patent infringement litigation, find fresh support? Does the renewed focus on innovation and intellectual property that permeates the environment represent a new economic opportunity for an enterprising entrepreneur? Can someone create a new marketplace or exchange where patents can be bid upon by competing players, much like how stocks are traded today? It sounds like an immense challenge and undertaking – which smells to me like great value and profits.

Umair Haque’s An Open Challenge to Silicon Valley put it in even stronger terms as he labels the current crop of Web 2.0 startups and their incrementalist approach “trivial” and “banal.” I certainly could see the banality of the Web 2.0 echo chamber. Say a company creates a service for users to share picture slideshows online. The next competitor provides a widget for picture slideshows with better transition effects. Then the next entrant will provide the ability to incorporate simple audio effects into slideshows.

Haque’s answer to “what’s next?” is to challenge revolutionaries or entrepreneurs to solve bigger problems. What are some huge problems facing this world? Haque mentions skyrocketing food prices, unstable financial systems, and a worsening energy crisis. To this list I would add terrorism, a deteriorating and increasingly costly healthcare system, global warming, and war.

Pieter van der Heyden – Sloth

The incrementalism Nolan and Haque decried is alive and well. Petty, self-appointed social networking gurus argue about the incremental virtues of Identi.ca over Twitter, Facebook over Myspace (NWS-A), FriendFeed over Twitter, Twitter over Facebook, and countless other variants of this rock-paper-scissors silliness. The other 99.9% of the world’s population couldn’t care less.

At the time I read Nolan’s and Haque’s posts, I was mired at SocialOptimize creating social networking applications for clients. My former partner and I collected exorbitant dollars per hour for our work but I felt as if we drastically overcharged for our services. I came to realize that what we produced were inconsequential products that added little to no value to the economy and society. Even the companies that employed SocialOptimize derived scant value from the apps we delivered. Don’t get me wrong – I enjoy games and distractions as much as anyone but these apps constituted neither good games nor good distractions. They were merely companies’ halfhearted and “me too!” attempts at having a presence on social networks. The companies didn’t really even want these apps; they just got caught up in all the Web 2.0 hype.

As an investor, I’ve always been a contrarian but my entrepreneurial endeavors started to look like a vapid run with the herd. Haque’s and Nolan’s posts landed profound psychological kicks to my posterior. So I immediately interrupted my usual programming and have since been obsessed with searching for opportunities to address bigger problems.

My search for meaning has turned out to be fortuitous and delightful. It has taken me many months as I tried to vigorously filter noise from signal, short-term cash grabs from sustainable opportunities. Opportunities never appear scarce; the trick lies in carefully identifying and selecting the ones I can have the most impact on and the most fun with.

So I was ecstatic when I decided to join Design Engine Lab, a leading industrial design firm, as partner and chief strategist. Industrial design is an entirely new world to me and I’ve jumped in with complete enthusiasm. I am steering the firm gradually away from servicing clients and toward developing our own internal products and spin-off companies.

We have designed a new, patented interface technology that we will first apply to the lighting market. Our technology has the potential to curb energy usage drastically wherever it is installed. Some of Haque’s big problems are beyond the scope of my circle of competence, but global warming is one which Design Engine Lab’s greener and cleaner technology can have a very positive impact. Our technology will also affect the delivery and efficacy of healthcare, another big problem, by mitigating the environmental risk factors attendant in hospitals and other healthcare facilities. Our technology will be used in hospitals across the United States and that specific segment alone represents a multi-million dollar market.

We’re also forming a joint venture with another company to develop a portable landing zone that will dramatically improve the success rate of emergency extractions of injured people via helicopter. I’ve accompanied helicopter pilots on test flights and have received nothing but the most eager feedback. I’m very excited about this product because it will actually save lives in the real world.

At Design Engine Lab, we conduct serious play looking for ideas that have global implications. Sometimes, that means huge ideas requiring complex execution. But we also engage in what I coined Bite-Sized Innovation®. Small does not have to mean incremental if the result is drastic. We attempt to make small changes that lever up to create huge consequences. Some of our upcoming medical device projects will reflect this Bite-Sized Innovation model. The best part of all this is the intensely joyful feeling of play that permeates all our brainstorming and experimentation sessions.

I don’t want to stray too far from the software world. So I’ve been fortunate to have also gotten involved with Sendside Networks as a consultant helping with research, marketing, business development, and fundraising. Sendside is creating technology that will change the way companies communicate with their customers. It is a highly risky strategy as we are trying to forge a brand new category in the Enterprise 2.0 market. But highly risky strategies are the ones that capture or create enormous value if executed well. In this case, the risk is vastly mitigated by a fantastic executive team and boards of directors and advisers filled with quality individuals. The team is the primary reason I wanted to get involved in the first place.

Without giving away the recipe for the secret sauce, Sendside has the potential to replace a sizable portion of the physical mail stream. In our vision, at its most revolutionary extreme, only junk mail and parcels will flow through the mail stream. Successfully bringing about this vision would make Sendside one of the greenest companies in the world, lightening the global burden on our forest lands forever. I have to give a shout out and thank my friend Jeff Barson, Sendside’s evangelist, for turning me on to this opportunity.

I’ve been lucky to have had the luxury of putting a halt to my daily grind to look for game-changing opportunities. I was especially lucky to have come across the two thought-provoking and ego-shattering pieces by Haque and Nolan. Umair Haque wrote in the end of his post that he’d put his money where his mouth is and advise five organizations trying to solve big problems. Umair, if you’re reading this, please get in touch with me. If not, I’ll be in touch shortly.

When Microsoft (MSFT) bought a small stake in the wildly popular social network, the price paid implied an overall value of $15 billion. The rumored prices at which Facebook insiders are trying to unload some shares carry an implied overall value of as low as $3.75 billion to $5 billion.

It is clear that Facebook currently cannot be worth $15 billion. The Facebook Apps platform that attracted so much attention from independent software developers has lost a lot of momentum. Independent developers who invested a lot of time, money, and energy into creating Facebook Apps have found it increasingly difficult to attract a significant audience. While finding users has been tough, monetizing their creation has proven to be a Herculean task. Special venture funds created to fund Facebook apps have not been able to deploy much of their capital as most Facebook apps are ill-conceived or frivolous with no clear business model. I would return that money to limited partners rather than hope a genius comes along to battle for market share owned by early movers like Slide and RockYou!

Advertising, the main business model of free social networking platforms, continues to disappoint, with click-through rates and conversion rates declining alarmingly. While international growth remains strong, domestic growth is decelerating noticeably. This could be spun as a positive, but I don’t think the youth of other countries have spending power approaching anywhere near that of American youth.

Will this mark the end of the current cycle of funding exuberance on the part of venture capital firms for all things Web 2.0 or social? The pace of venture funding in this sector of the Internet really picked up when Myspace sold for close to $600 million to News Corporation (NWS-A). Since then, millions have been poured into all flavors of social networks and social networking apps. It reminded me of the fin de siècle bubble that burst so painfully for all involved. Below is an essay I wrote for an investment letter published in June 2007 distributed high net worth clients.

Irrational Exuberance 2.0

We are not calling a bust of the current bull market. As much as we admire Barron’s editor Alan Abelson’s wit and literary style, we are cognizant of the ravages that might befall our track record if we were permanent bears. Still, we can’t help but imitate his dour tone of the 1990s when he repeatedly called too early for the bursting of the dot com bubble. Mr. Abelson eventually got it right when we entered the new century and collectively blinked at the stratospheric levels we had taken the market to. Then as now, venture capital funding of cockamamie business ideas served as a reliable indicator of an impending rinsing out of “frothiness.”

As we once again witness new highs in the stock market, it may be wise to examine the shenanigans our friends in the venture capital world are participating in. Are they helping to start companies “built to last” or are they throwing money at silly business ideas “built to be sold?” After a quick survey of recent startup financings, we think a strong sense of déjà vu might visit us.

While yesteryear’s absurd venture deals were justified as the obsolescing of brick and mortar business models by an online nirvana fueled by UPS (UPS) and FedEx (FDX) trucks, today’s venture activity centers around “social networking” and the wisdom and power of crowds, also known as Web 2.0 in geeky circles.

Take NaturallyCurly.com for example. It proclaims itself as the social network for people with curly hair. Purportedly, individuals with curly locks need an online support network for all their hair maintenance difficulties. Don’t forget the most important feature of any social networking community, the ability to make friends with similar interests. We delight at the prospect of spending all our time discussing hair. A technology industry veteran who sold his company to Compaq invested $600,000 into this dandy of a site.

A little less silly but nonetheless vacuous is a website called Flixster. This is the social network for all things cinematic. Users rate movies, join fan clubs celebrating famous thespians, read up on news regarding upcoming films, and make friends.

Websites that allow people to rate movies and chat about their favorite scenes already exist. They just don’t allow people to make friends. This ability to make online friends convinced Lightspeed Ventures, a very reputable venture capital firm, to invest around $2 million into Flixster.

If the dollar amounts involved look nothing like the wasted mega-millions of the late 1990s, we present Geni.com, a website for constructing family trees. The premise revolves around getting relatives to help by emailing them a digital “widget” with which they could plug themselves in the appropriate branch of the family tree. It is the wisdom of crowds, albeit a familial one here, that makes this a very compelling idea indeed. Unfortunately, it occurred to us that great great great grandpa Bob of many years before cannot respond by email from Heaven. That did not prevent Charles River Ventures from injecting $10 million for 10% of the company, effectively valuing the then seven week old company without any revenues at $100 million. We believe the large valuation might have something to do with being able to turn relatives into online friends.

The Big Bang that gave rise to all this Web 2.0 insanity occurred when Rupert Murdoch’s News Corporation bought the top dog of all social networks, Myspace, for $580 million. Users of Myspace could create their own web pages and browse around the online community to make friends. Google (GOOG) soon followed by buying YouTube for $1.6 billion. YouTube users upload their homemade videos for the whole world to watch. One of the key principles of Web 2.0 is getting the community to contribute user-created content. Did we mention that YouTube users could also make friends with fellow wannabe Spielbergs?

Almost overnight, lemming-like venture capitalists funded dozens of Myspace clones with typically cute techie names like Tagworld, Bebo (TWX), Facebook, Facebox, Multiply, and Gather. Of course, all of these allow users to make friends.

YouTube copycats receiving venture funding include Veotag, Kyte, Mogulus, VideoJug, YeboTV, and Brightcove. Although we haven’t used these sites personally, we’re quite sure you could make friends on all these websites. How many News Corporations and Googles remain to stuff the coffers of venture firms by buying their portfolio companies? It seems as if entrepreneurs and venture capitalists in this space are banking on many more buyouts to come.

It isn’t just the private venture capital world that has fallen to the seduction of easy profits. When flimsy businesses with short operational histories try to tap the capital markets by going public through an initial public offering and find a receptive market, we are treated to such delicious examples as GoFish (GOFHE.OB) , a video sharing website in the spirit of YouTube. Debuting last October on the over-the-counter “bulletin boards”, the fishy company achieved a peak market cap of $147 million. With only $45,580 in revenue and no profits to speak of, investors in GoFish are swimming in a foamy sea of hope and greed.

Our favorite new social network? Stockalicious, a website that allows users to keep track of their portfolios and compare their performances against the market and each other. We wonder if Alan Abelson might jump on the Web 2.0 bandwagon and become a member of this Internet community. We could sure use a friend or two.

Patents are notoriously difficult to value but it is clear that patents are becoming a viable asset class in themselves. Taking the cue from many other asset classes, could there be a way to “securitize” a portfolio of assets? This could be a fun and challenging opportunity to address. One approach is Nathan Myhrvold’s Intellectual Ventures, a “venture fund” that invests in patents by acquiring those invented by others and developing some internally. There are many in the technology industry who fear Intellectual Ventures will evolve into the best funded and organized patent troll.

Below is an essay I wrote for an investment newsletter published in February 2007 distributed to high net worth clients.

Patent Bridge is Falling Down

Horror of horrors! We almost lost service for our Blackberry communication devices early last year. Also known as Crackberries for their users’ incessant finger-pounding of emails during company meetings, on the subway, and even on vacations, a patent infringement lawsuit filed against parent company Research In Motion (RIMM), threatened to sever the umbilical cord between the gadgets and their addicted users. NTP, Inc., a patent holding company, claimed that RIM infringed NTP’s wireless email patents. Legions of squinty-eyed telecommuters were relieved when RIM finally settled with NTP by paying an extortionary sum of over $600 million.

The Blackberry episode underscores the growing importance of an emergent business model. Disdainfully described as “patent trolls” by detractors, patent holding companies assemble portfolios of patents and wait for other companies to develop infringing products. Profits are then won in the courts and not in the arena of market competition. This form of intellectual blackmail has the potential of drastically altering the economic landscape and the development of innovative new products.

Innovation is the Holy Grail. Harvard Business School professor Clayton Christensen assured us of that universal truth with the publication of a couple of business bestsellers. Large corporations pursue innovation with a newfound zealousness. However, the editors of this publication submit that the innovator’s dilemma is no longer about large corporations’ inability to recognize and take advantage of disruptive technology; it is now about navigating the field of patent landmines.

Who takes the risk? Innovation is inherently a risky endeavor. Impactful advances in technology seldom occur at low cost. Invention, experimentation, testing, and prototyping can require large sums of capital. Furthermore, product evangelism often dwarfs the cost of research and development. Thus, the founding fathers created a patent system to reward the risk taker and incentivize risky behavior resulting in benefits to society in the form of improved goods. They must now be spinning in their graves. Patent trolls are, in essence, excellent risk arbitrageurs, because they have found a way to extract profit without undertaking the bulk of the risk. In the case of NTP v. RIM, although Research In Motion incurred the cost of developing the Blackberry device and bringing it to market, the patent troll almost succeeded in removing a winning product from the marketplace. Who loses? Ultimately, the consumer.

How does one spot a patent troll? Like the monsters of childhood tales, they hide and wait under a bridge until someone attempts to cross. Trolls then exact a toll from the weary traveler for use of the bridge. Only in the real world, the bridge or asset was built or developed by the traveler! Patent trolls are, in the words of the legal cognoscenti, “nonpracticing” patent holders. They have no intention of ever developing and commercializing their patents.

“But we are all patent trolls!” Panglossian defenders of the current patent system point to the huge patent portfolios of large corporations like General Electric (GE), International Business Machines (IBM), Intel Corporation (INTC), and even mundane consumer goods powerhouse Procter & Gamble (PG). In this world of limited resources and talent scarcity, even the most imposing corporate behemoths can ill afford to commercialize all their patents. Yet when the blue chips’ patents are infringed, they pursue legal recourse as vigorously as any litigant. Defenders of the status quo place the burden of diligence on manufacturers. All who aspire to make the next iPod (AAPL), Blackberry, Viagra (PFE), or toaster oven must search the United States Patent and Trademark Office archives for all prior art – just as it has always worked for the last two centuries. They have a point. If manufacturers are not thorough with their homework, why shouldn’t they be sued?

The problem is not whether large or small inventors are practicing or not. The editors submit that the problem is what we call the Goldilocks Paradox. Currently, too many overly broad patents are being awarded. When that occurs, it becomes very difficult to innovate around such widely defined intellectual property. When patents are too narrowly defined, it becomes very easy for competition to design around them.

“Yum yum, these patents are not too broad and not too narrow, they’re just right!” To get to this happy equilibrium, we humbly suggest a remedy. To curb trolling behavior, set a time horizon for making infringement claims. The deliberate strategy employed by patent trolls of waiting for another company to develop a market for a product to then sue for damages is diametrically opposite of the approach taken by most large corporations armed to the teeth with attorneys. After a certain amount of time, claims will either have no merit or will win reduced compensation. We believe this would put a significant chill on trolling behavior and allow everyone to get on with the business of making our lives better.

For all the Blackberry users out there, cling tightly to your beloved devices. On May 1, 2006, Research In Motion was sued by another patent troll, Visto. Ah, as Candide implied, “All is for the best in this, the best of all possible worlds.”

A few days ago, I wrote about the commoditization of social networks or rather the social networking feature sets that currently make Myspace and Facebook so unique and neat. Pioneers in social networking like Friendster and Myspace introduced a new data and software architecture that, at the same time clumsily and elegantly, met Internet users’ desire to interact and share content with each other. Finding old friends, connecting with new friends, sharing music and videos, playing collaborative games, and expressing oneself to virtual audiences of thousands all were groundbreaking features or functions that captivated a whole new generation of Web users.

These features generated higher levels of engagement (or stickiness) many times greater than traditional web properties. This stickiness in turn attracted marketers and advertisers who wanted to be where the people were. This stickiness premium netted the founders of social networking startups wealth reminiscent of the dotcom bubble. Myspace sold for nearly $600 million in a buyout by News Corporation (NWS-A), Facebook was valued at $15 billion by Microsoft (MSFT), and Bebo’s owners sold out to AOL (TWX) for $850 million.

With great rewards come hordes of wannabes and copycats. Many people are staking their future on social networking. Some are attempting to create me-too social networks. Others are pimping themselves as “experts” in social networking and offering their “consulting” services. I did the same with my SocialOptimize startup. Although my now defunct startup was able to deliver good social networking applications to prominent venture-funded startups, I soon realized that social networking would become a game with few winners and many losers. I argued that once Web 2.0 methodologies become widely adopted and social networks become a feature set rather than destinations, those same Web 2.0 methods will become standardized commodities.

That march to commoditization may occur faster than anticipated. Google (GOOG) recently announced its Friend Connect program, which allows virtually any website to plug in a turnkey social networking suite. Owners of websites can, like Google’s AdSense product, embed a snippet of code in their webpages and immediately enjoy the benefits of offering social networking features to their site customers or visitors. Think of Google Friend Connect as a more powerful Google AdSense, but instead of offering relevant text ads it offers your site visitors the ability to connect with their friends, connect with new friends, interact with each other with messages, and share content.

Here are the search engine giant’s stated high-order benefits of Google Friend Connect (GFC):

• Anyone with a basic understanding of the Web can implement GFC, no need to hire an expensive programmer or self-branded “social media guru.”
• Drive traffic: people who discover interesting sites can bring their friends with them, and can opt-in to publish their activities on those sites back into their social network, attracting even more visitors.
• Increase engagement: access to friends and OpenSocial applications provides more interesting content and richer social experiences.
• Less work: any site can have social components without hiring a programming team or becoming a social network.

That last point is key. Google doesn’t want more “social networks” per se – it just wants more websites to have social features. A while ago, it signed a deal with Myspace to serve Google ads. At the time, Google paid a huge premium and there are reports that claim the Mountain View, CA behemoth has not recouped its cost. Signing advertising deals with mass market social networks can be expensive. Helping mom and pop sites to have social networking features will, in the long run, give Google a cheaper alternative. Google is simply facilitating the creation of more web pages (places to serve its ubiquitous ads), pageviews, and advertising inventory.

The message is clear. You don’t need to become a social network; social networking features are a commodity. Here, have a few social networking features for free.

First, Anderson argues that social networking should be a feature, not a destination. I agree wholeheartedly. The ability to interact with friends, share content, and engage in self-expression should be standard features on most websites. The unique methods of encouraging creative online behaviors known as Web 2.0 will filter through the rest of the Internet and, soon, your grandfather’s favorite website will allow him to engage in “social networking.”

Second, Anderson cites stats regarding advertising revenues or costs from Myspace (NWS-A), Facebook, and Ning. He shows that monolithic social networks like Myspace and Facebook, which attempt to be all things to all people, are having immense struggles with selling advertising at worthwhile rates. He also implies that Ning’s niche vertical social networks built by customers command higher advertising rates. Some marketers happily pay the higher rates because the engagement level is greater on these niche vertical networks. Advertisers also prefer the more intelligent targeting of relevant audiences. Myspace, Facebook, Bebo (TWX), and other undifferentiated mass networks are actively trying to improve their targeting abilities so it will be interesting to watch this competition evolve.

Finally, Anderson asks a pointed question about Facebook’s implied $15 billion valuation when Microsoft (MSFT) bought a small percentage of the company a few months ago. If Facebook is struggling to target its advertising and improve its advertising revenues, does its gargantuan valuation make sense? I think Zuckerberg should take the money and run. I also think that Lee Lorenzen, a venture capitalist, and his prediction that Facebook is worth $100 billion is a case of shrewd exaggeration. What I think is most funny is the fact that all of Lorenzen’s fanboys, the self-branded “social app gurus” and developers of tiny Facebook apps are all eagerly drinking the spiked punch. There are few better examples of confirmation bias in action.

My main problem with Anderson’s analysis is his implied assumption that the currently high advertising rates the niche vertical social networks enjoy will stay relatively high. Based on his personal experience, he concludes that Ning’s advertising rates are greater than Facebook’s and Myspace by at least a factor of ten. I don’t think this will last. Web 2.0 methods are precisely that, methods. They can be products, but they are also methods or general, conceptual best practices. As such, the ability to create robust social networks for different verticals will diffuse to a critical mass of software engineers. As that process accelerates, social networks and features of social networking will become commonplace or commoditized. I’ve alluded to the commoditization of social networking applications, which is a related problem. When this process nears its peak, advertising rates for all social networks will have diminished drastically. Self-proclaimed “social app gurus” and “social network gurus” who have staked their futures on social networking will ultimately prove themselves as less than prudent.