On Due Diligence and Decision Making: Venture Capital

This week, I am continuing a series of posts on due diligence and decision making across different asset classes. Here’s the link to see the first post in the series on poker as an asset class: Link

Due diligence varies substantially across asset classes, and I believe that different investors are better or worse suited for investment in different assets based on how characteristics of asset class decisions match an individual’s personal preferences. I will continue to use the overall framework developed in the last post in order to analyze the decision characteristics of venture capital (VC) against that framework. I’ll end with analysis of the due diligence performed in VC, and discuss the typical investor traits necessary to be successful in VC.

Framework 

Based on my experience, there are 7 decisions characteristics that I believe inform how these decisions are made and subsequently whether you are suited for due diligence of an asset class:

  1. Frequency of Decisions: How often are decisions made?
  2. Distribution of Outcomes: How good or bad can the outcome be? Do outcomes follow a normal distribution or a power law distribution?
  3. Length of Decision Impact: How long lived is the decision? (e.g., venture capital firms might hold a company for a decade, while high frequency traders might hold an equity for a fraction of a second)
  4. Decision Uniqueness: How similar is this decision to other decisions?
  5. Stakeholders: Who benefits or loses from this decision, and how are their motives aligned?
  6. Accessibility to the Public: How easy is it for someone to access this asset class?
  7. Ownership of Outcomes: Who is taking the risk?

Decision Characteristics of Venture Capital

My analysis will center on early-stage venture capital, which is the only segment I’ve had experience in. The later stage you go in VC, the more the asset class looks to private equity, and eventually public equity investing.

Frequency of Decisions: Sourcing decisions happen daily for VCs, whereby they say no to spending time on startups. Actual investment decisions are relatively few, with most partners leading an average of 1-2 investments per year.

Distribution of Outcomes: Venture capital investments exhibit power law behavior, as pointed out by many prominent VCs such as Peter Thiel. I am not privy to VC returns, although some such as the Kauffman Foundation have published copious data on returns to help triangulate. Below is my approximation of how outcomes look in VC as compared to poker for an individual professional poker player or a partner at a VC firm.

There are several conclusions and assumptions embedded in this drawing:

  • Assumption: The Y axis is not drawn to scale. Professional poker players have hundreds of thousands of hands to draw from, while VCs might reach 100 investments over a very long career. If plotted on the same Y axis, the VC distribution would be barely visible, since there are so few actual investments
  • Assumption: The X axis is logarithmic
  • Assumption: The distribution I’ve drawn is a somewhat idealized view of VC that follows a J-curve. Some critics of venture capital including the previously linked Kauffman report have shown that there are a variety of variables that can have strong impacts on return distributions, including things like vintage year, fund quartile ranking, and others. It’s likely that many VC funds out there do not exhibit the positive power law behavior distribution illustrated above, and have instead a somewhat negative normal distribution.
  • Assumption: These are only the company outcomes, not the VC partner’s actual outcome distribution
  • Conclusion: While poker exhibits negative power law distributions, VC exhibits much more of a normal distribution on the downside, and a power law distribution on the upside. VCs have relatively frequent, large, negative outcomes due to the fact that so many startups fail
  • Conclusion: VCs (or at least ideal VCs) have a longer positive tail of outcomes than poker players do, with several orders of magnitude larger positive outcomes ($1B+ vs. $1M+)

Length of Decision Impact: Active VC investors may live with their investment decisions for a very, very long time. Good VCs with a board seat are engaged with their portfolio companies on a day-to-day basis beyond attending meetings once a quarter. The Kauffman Foundation reported many funds have not fully unwound positions more than a decade into the future. Thus, the impact of an investment decision is substantially longer than say poker or sales and trading.

Decision Uniqueness: Decision Uniqueness is extremely high for VC, with each investment having different people, products, and industries. While some VC firms try to specialize to some extent, the decisions still look very different from one deal to the next. It’s incumbent upon VCs to do their own homework and be familiar with a portfolio company’s industry if they hope to have even a chance of adding value.

Stakeholders: VC investments have a very complex set of stakeholders. VCs have both a fiduciary responsibility to the investors (also known as limited partners or LPs), and a fiduciary responsibility to the shareholders of the companies (including founders, employees, and other investors) whose boards they sit on. These stakeholders tend to be more aligned when things are going well, but things can get more complicated if things are going poorly.

Accessibility to the Public: Most VC deals are extremely proprietary, and limited to a small handful of investors. Prior to the adoption of Regulation A+, investing for individuals was limited to accredited investors. Although Regulation A+ has expanded accessibility to venture capital, it’s likely that the best deals will still be proprietary to a handful of VC firms, and mostly inaccessible to the public.

Ownership of Outcomes: Traditional VCs invest someone else’s money, typically money from their Limited Partners (LPs). Although management fees can help reduce VC reliance on carried interest as a salary, Jason Lemkin and others have written about how the capital contributions that General Partners (GPs) are required to put in to help align incentives with the LPs can nullify the salary you get through management fees. This means that VCs have relatively large ownership of outcomes, since they are giving up a substantial amount of immediate cash flow for hopefully large, future carried interest cash flows.

Due Diligence and Investor Traits in Venture Capital

Although venture capital is often compared to poker, there are a number of decision characteristics that dramatically affect how due diligence is performed, and what traits to look for in investors. The relatively small number of investment decisions coupled with the very long 10+ year decisions means that VCs are very “all-in” with individual investments, much more so than a poker player who plays many hundreds of thousands of hands a year. Thus, VCs must be very long-term focused, and willing to be patient and wait for out-sized results far in to the future.

The distribution of outcomes for VC investments also has a substantial impact. Because so many startups ultimately fail, and the fact that 1 or 2 portfolio companies could make or break a fund, VCs really have to swing for the fences with every deal they take. This is in heavy contrast with poker, where professional players are focused on squeezing small edges over a large number of hands. On a day-to-day basis, sourcing tends to be focused on finding reasons to say yes, with a key question being whether or not a startup can make it to the far right end of the power law tail. VCs attempt to filter through hundreds of startups and founders a year to get to 1-2 ultimate investments. As a result, VCs say no to spending more time on startups on a daily basis, often with only a light amount of diligence. While this does mean that they sometimes say no to great deals, this is largely a function of the frequency of decisions and distribution of outcomes.

For those startups that DO make it through the sourcing funnel, VCs perform due diligence in a very different manner than later stage private equity investors.  Because the decision uniqueness is so high in VC, there are usually few if any comparable companies or products. This makes it nearly impossible to accurately forecast the future trajectory of the company. This stands in stark contrast to later stage private equity deals, which generally involve companies with tens or hundreds of millions of dollars a year in real revenues and profit. Private equity stage companies have a relative dearth of information available to analyze to assess the potential of an investment. Little data usually exists for many startup markets, and VC diligence tends to be relatively qualitative as a result.

While people of many backgrounds ranging from finance to journalism have succeeded as VCs, I have seen a few common traits among the VCs I’ve met:

  • Long-term optimism: While some like Founders Fund push the envelope on the pessimistic side, allocation of capital in wait of very long-term, future outcomes requires a high degree of optimism. The way the numbers work out, VC partners are very all-in
  • People-focused: The challenge of filtering through hundreds of startups and founders a year to invest in 1 or 2, means that VCs speak with tons of people on a daily basis. This task is not onerous given that most of the people you are speaking with are bright, passionate founders, but it’s certainly not for everyone
  • 80/20: Despite only making 1 to 2 investments per year, VCs tend to make very frequent decisions on a daily basis, about where to invest their time. In addition, because the outcomes being chased are so far in the future, it’s near impossible to get 100% of the truth today. Thus, VCs are constantly trying to filter between signal and noise, and they need to be able to get to 80% of the “truth” quickly to decide whether they should continue to invest time in a startup or a founder.

It’s clear that while there is overlap between poker and VC, there are some decision criteria that dramatically change how due diligence is performed, and subsequently who is best suited for each. For more insights specific to VC, check out my previous post, What I Learned About Venture Capital This Summer, which goes more in-depth into who is best suited for VC. Next week, I’ll dive into private equity to attempt to tease out why it looks so different from both VC and poker, despite the fact that VC is technically a subset of private equity.

Please tweet me and let me know if you liked this post or have any comments – I’d love to hear from you!

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Startup School 2012 Themes

After having some time to decompress and re-digest my notes from Startup School 2012, I’ve collected my primary takeaways in the form of themes echoed by multiple speakers. There were many interesting anecdotes and nuggets of advice that I have not attempted to list. Note that these are my subjective views and it’s likely different people gained different insights from the speakers.

1.   There are still many opportunities for startups to leverage the Internet

Ron Conway believes that the Internet is still in its infancy. When asked about whether he felt Facebook could have been founded earlier, Mark Zuckerberg pointed to university e-mail addresses as necessary to its early success. Zuckerberg speculated that there is some social-networking equivalent of Moore’s Law that dictates the long-term, exponential growth of sharing. Mark pointed to Wikipedia as an example. In his eyes, Wikipedia was able to achieve success earlier than Facebook because it needed less sharing to sustain itself. Thus, as more sharing occurs in the future, there will be new opportunities for startups that did not exist before.

2.   Big growth opportunities in eCommerce

A few speakers pointed at eCommerce as an example of a space now reaching the sustainable sharing threshold necessary for success. Hiroshi Mikitani cited Rakuten’s rapidly growing mobile revenue, currently growing 300 to 400 percent year-over-year. This point should certainly be taken with a grain of salt, as several of the speakers addressing this topic have vested interests in this industry that could affect their objectivity. Both Mikitani and Ron Conway have made substantial investments in Pinterest, whose success is certainly tied to the success of eCommerce. On the other hand, the fact that Mikitani and Conway have made a number of substantial investments in eCommerce shows that they are willing to put their money where their mouth is when it comes to eCommerce.

3.   Technology as an extension of fundamental human wants and needs

To Mark Zuckerberg, Facebook is a natural extension of the fundamental human need to connect with other people, noting that humans are highly geared toward social interaction. To that end, Facebook extends the number of meaningful social relationships humans can maintain beyond the Dunbar number of 150. In the same vein, Ben Silbermann stated that Pinterest is not just about eCommerce; Pinterest is about helping people find others that have similar interests and helping them find their passion. Ben Horowitz noted that the line between wants and needs is not real. Many people have made statements to the effect that technology development was at its end as people’s needs had been fully met. Ben pointed out that over time “wants become needs.”

4.   Startups are difficult

Many speakers described long, arduous journeys to success. Ben Silbermann challenged the commonly used maxim that startups are like running a marathon, stating that there was much more uncertainty in a startup than a marathon. Speakers identified several common difficulties:

i.  Gaining traction. David Rusenko related how weebly did not really gain traction until 48 months after the first line of code was written, in spite of early publicity from TechCrunch, Newsweek, and Time. Patrick Collison of Stripe recounted long hours spent coding and an alert system that guaranteed someone would be available to provide customer support at all hours. Ben Silbermann stressed how important it was for startups to “be great one thing,” and to ship when they have their “one thing.” He also related how long finding that “one thing” can take.

ii.  Funding. Many speakers including Ben Silbermann and David Rusenko related personal stories of investor rejection.  Jessica Livingston of YCombinator and others described a common “herd mentality” problem whereby investors refused to fund “ugly duckling” startups due to other investors not having funded them already. Ron Conway acknowledged this challenge and cited several successful startups he had failed to fund when given the opportunity including salesforce.com, Pandora, Palantir, and Kickstarter. Amusingly, even Mark Zuckerberg said that Facebook’s early growth was limited by the number of $85 servers they could afford.

iii.  Unique problems. Several founders described non-technical problems that were crucial to the success of their startups. Travis Kalanick of Uber discussed process management and operations problems that required logistics expertise not typically necessary for most startups. In addition, he touched on the regulatory issues facing Uber, stating that all truly disruptive startups would face resistance from entrenched, outdated industries, and the governments supporting them. Ben Silbermann described how Pinterest focused on marketing campaigns like “Pin it Forward” and user meetups to tackle non-engineering problems necessary for Pinterest’s success. Patrick Collison said he feels empathy for business people attempting to break into tech because he felt similarly out of his element working with the financial industry to build Stripe.

5.   People are important to a startup’s success

Ron Conway described how he funds people and not startups. His practice of following founders regardless of whether or not their last startup succeeded allowed him to get in on the ground floor of Twitter after following Evan Williams from Odeo. Unfortunately for most, Ron also said that within 10 minutes of meeting someone, he has already decided whether he would invest in them. Tom Preston-Werner described how a company’s people, product, and philosophy were all interconnected and necessary for success. Jessica Livingston stated that incompatible co-founders was a common reason for startups to fail. Ben Horowitz said he looks for “Founders with courage and skill to build.”

6.    There’s more than one path to success

While founders described common themes, their startups addressed very different needs and markets. Joel Spolsky related two very different personal success stories in Stack Exchange and Fog Creek Software. He described a dichotomy of startup growth options:

i.  Get Big Fast. These are startups like Facebook and Stack Exchange, which rely on network effects and lock-in to be successful. Because success is market dependent, it is important to grow rapidly. As a result, problems are solved with money from venture capitalists. Quantitatively, expected value could be viewed as a 1% chance of a 10 billion dollar valuation.

ii.  Organic Growth. These are startups like Ben & Jerry’s and Fog Creek software, which develop products that are valuable to even just one customer. These companies must focus on being frugal because mistakes can kill you. For these startups, it’s important to bootstrap and break even quickly, rather than taking outside funding. Joel expressed the expected value of an organic growth company as a 90% chance of a 10 million valuation.

While the media focuses on the success of “Get Big Fast” companies, millions of companies go the route of “Organic Growth.” Ultimately, Joel said said that failure to choose one of the two methods of growth kills startups.

The US needs a Department of Nerds

During the recent House Judiciary Committee hearings, it seemed every other statement began with the following disclosure: “I’m not a nerd, but I think…” Through the course of the hearings, the word “nerd” was used quite often. Some were derisive. Others, respectful. However in all cases, it was an assertion of general ignorance about the matter at hand.

It has become painfully obvious that our US representatives fundamentally do not understand new technology. But who can blame them? The average age of the 112th Congress was 56.7 years at the start of the term. This demographic was middle-aged and well out of college before the inception of the personal computing era and the Internet. While many in Congress have adopted social media, nobody would expect them to understand the intricacies of IP addresses and DNS servers. Most millennials outside of the technology industry would be hard-pressed to describe these concepts.

So why then are our Congressmen seeking to enact legislation about something they do not understand? While it is certainly impossible for Congressmen to fully understand all the details of every bill they work on, it has always been their responsibility to interface with leaders of respective industries to make the best possible decision with limited information.

The problem is that technology as a whole is moving too quickly for legislators to understand the latest innovations to pass effective legislation. As technology has continued to improve, the knowledge gap between the engineer and the layman has increased. The field has become too specialized for “non-nerds” to understand well, nonetheless our representatives. Furthermore, technology is important to a number of industries, sometimes with conflicting interests. To make effective decisions in this regard would require a very comprehensive understanding of not just technology, but how it is applied in different industries.

The technology industry represents the most significant US innovation in the past few decades. It should be encouraged to grow as quickly as possible, but this growth cannot be unregulated. Nor should those who are unfamiliar with the field be the ones regulating it. 10 years from now, will our Congressmen understand enough about the complex algorithms and programs that operate Google’s self-driving car to make an informed decision about its safety and efficacy for use by the general public? Certainly not. However, this does not mean that this service should be unregulated. As technology is integrated more and more into everyday life, there will need to be people in government that do understand the intricacies of technology.

The US needs a Department of Nerds. Maybe more aptly named, a Department of Technology. This branch of the executive arm should regulate technology as a whole.  It should encourage sustained organic growth of the technology industry. It should help regulate computer security to prevent hackers from attacking America’s public facilities and crucial infrastructure. It should service other departments to improve efficiency of everything from agriculture to veterans’ affairs. Most importantly, it should be run by nerds. The appointed secretary should be someone who understands technological innovation and someone who champions its safe and effective utilization in America.

While the current Departments manage technology in their respective fields, there are significant inefficiencies that are incurred by this framework. While the Department of Defense has access to highly advanced computer security knowledge, a millennial hacker recently accessed water infrastructure management systems using just a three-character password. While certainly there should be some level of disparity between the two systems, it is clear that the latter industry could use a significant security upgrade. A centralized Department of Technology would allow for more effective distribution of technology to improve efficiency and security of all sectors.

In the future, the balanced implementation of technology will be the hallmark of all successful nations. Technological innovation and development will be necessary across all industries in the public and private sectors. A centralized authority that understands technology is necessary to regulate the introduction of new technologies to different industries. As the integration of technology into our day-to-day lives increases, the more important it will be that this technology is well understood and reviewed.

The present is being built by nerds, but regulated by laymen. The future must be regulated by nerds.

Why I love Facebook’s seamless sharing

Recently a number of articles have decried recent Facebook changes allowing seamless sharing of information. Using Open Graph, several news sites such as the Washington Post and the Guardian have released “social reader” Facebook apps. These apps, once enabled, allow Facebook friends to see the articles you have read in much the same way that Spotify shows friends songs you have listened to.

Molly Wood at CNET released a scathing article entitled “How Facebook is ruining sharing.” Molly insists that sharing and recommendation shouldn’t be passive, and this sort of passive sharing will “overwhelm our interest and deaden us to the possibility of organic discovery.” I would argue that the exact opposite is true, that seamless sharing improves organic discovery.

Seamless sharing improves organic discovery

How many times have you been sitting in a car with a friend and heard them play a song you liked? Prior to the advent of the smartphone, you would have to remember the name of the song, then at a much later point in time, download it… if you could remember the name. Spotify now allows you to see what your friends are listen to and quickly try the song or artist yourself. Spotify for me has quickly become an easy way to explore new music that I never would have heard of without this service. While initially there was a chorus of boos from people complaining about the lack of privacy this spread, this chorus quickly faded as those who demanded more privacy found the option to stop sharing.

How was news promulgated prior to seamless sharing? You might receive an e-mail from a friend with “Fwd: FWD: Fwd: FWD” appended to the front of the title. Often you’d find that some people never shared anything of value. This might be an elderly relative who only sent fake inspirational stories or urban legends. In the end, many drew the same conclusion that I did. These forwarded e-mails were generally marked as unread and never opened.

The new social reader is one of the first things that allows people to catch glimpses outside of the filter bubble described by Eli Pariser in his TED talk. Very quickly, I found myself catching headlines that I normally wouldn’t have read if not for the fact that another friend had checked out the link beforehand. Of course social readers might introduce some level of junk into your feed as certain friends read low-value articles about say Kim Kardashian’s recent divorce. However, just as in the past, these sources will be mentally filtered as you realize that specific friends might not have the most important contributions to your media digest.

The important thing here is that you are seeing things outside of your curated digest. I posit that when people are overly conscious of what they are sharing, in the end you miss out on information. Some of this information may or may not be useful, but with seamless sharing you get to make that decision. With curated sharing and without seamless sharing, people you follow make a decision for you.

Facebook privacy decisions

It is true that the default privacy settings in Facebook have become looser since its inception. As I have argued above, I believe that this creates more organic discovery opportunities. Nonetheless, Facebook has allowed for close management of privacy settings, allowing for users to manage their information in a relatively easy manner.

It seems many Facebook users do not understand the model under which they are using Facebook. As a Facebook user, you are allowed access to a powerful medium that allows you to connect to your social network in a way that has never been possible in history before now. Although you don’t pay any money to use its services, Facebook is not free. The cost is privacy. This is information is sold by Facebook to 3rd parties for cash. You control how much privacy you are willing to give up to use Facebook, and in exchange you get some degree of connectivity to the world.

As a frequent traveler, I am more than willing to give up more of my privacy in order to be more connected to my friends around the world. I love being able to see what my friends are reading and listening to on Facebook, because otherwise I would be totally disconnected from them for months at a time.

Facebook’s seamless sharing is another way for me to remotely participate in the water cooler discussions about recent news, which I would normally not be privy to being overseas. It allows me to be anchored in my life at home within my group of friends while working on the other side of the globe. It allows me to see the introduction of new members of my family when I am unable to be at the hospital for the delivery.

Others choose to severely limit or completely disable their Facebook accounts, as the benefit they gain is not enough to overcome the value of the privacy they give up. If you have never consciously evaluated the value of the Facebook product and how much privacy you are willing to give up to use it, you should. However, I think I and many others will agree that the benefit is significantly greater than the cost.

The True Intent of SOPA

The Great Firewall of China has been an inapt metaphor for the entirety of its existence. Its purpose is to keep its citizens in rather than to keep invaders out like the original Great Wall. Some will point to its exclusion of non-Chinese companies from the Chinese web space, but ultimately, the government was more than willing to play ball with those who were willing to compromise. The only thing the Great Firewall has in common with the Great Wall, is that they were both built to protect the builders.

Reasons Claimed by SOPA Proponents

The Great Firewall of America is no different. It is being built by the people who would benefit most from its construction. Just take a look at the witness list at the House hearing for the Stop Online Piracy Act (SOPA or H.R. 3261). 5 of the 6 witness list are outspoken advocates for SOPA. Most notable is Michael O’Leary, Senior Executive Vice President of Global Policy and External Affairs for the MPAA (Motion Picture Association of America). During the course of the hearings, O’Leary made multiple fallacious claims that googling names of movies such as “J. Edgar” or “The Grinch Who Stole Christmas” would return pirated versions of the movie. According to O’Leary, this link will show you lists of pirated versions of the movie. I’ll let you judge for yourself the veracity of his claim.

Many in support of the SOPA bill will claim that enforcement would be balanced and fair. They would claim that I am exaggerating the effects of the SOPA bill through hyperbole. During the course of the hearing, Michael O’Leary not only showed support for SOPA, but stated that “the Internet isn’t broken” in places like China and Iran. Wait. Isn’t China the home of some of the worst copyright infringement in the world? O’Leary’s statement must be made from either pure ignorance or to fallaciously support legislation that is not truly intended to protect against copyright infringement. When countries notorious for human rights abuse are held up as successful Internet models, it’s quite apparent that the Great Firewall of America is an apt name for the SOPA construct.

Let’s look at other potential motivations for SOPA. While the name of the bill certainly seems reasonable and desirable, how big of a problem is online piracy? The MPAA published this document about piracy in America. If you analyze their claim that there are $58 billion in losses per year from piracy and that 13% of all adults have pirated, you’ll find that the MPAA claims that your average downloader should be buying 200 more DVD’s a year. Lest we forget, the MPAA has a history of using hyperbole to defend its own interests. In his 1982 testimony, Jack Valenti, former President of the MPAA, stated the following to Congress,

“I say to you that the VCR is to the American film producer and the American public as the Boston strangler is to the woman home alone.”

Clearly the effects of the VCR on the media industry was poorly understood and greatly exaggerated by the MPAA. Videotape sales ended up being a significant new revenue stream for the MPAA for many years, even spawning the spinoff media rental industry which still exists today.

Failure to Understand the Internet as as Medium

During the hearing, it became painfully obvious that the proponents of SOPA simply do not understand the Internet as a medium. Representative Ben Quayle expressed concern that there were no successful business models that could survive without SOPA to prevent piracy. Yet services like iTunes, Netflix, and Amazon now represent some of the largest services in media representing billions in revenue every year. Furthermore, there have even recently been disruptive business models like Spotify which have been able to assert themselves in the environment that SOPA proponents claim is not possible to exist in.

It is apparent that proponents of SOPA like the MPAA are simply failing to adapt their business model as technology evolves. In the 1980’s, the MPAA fought against the VCR claiming concerns over about copyright violations. In the 2010’s, the MPAA is fighting against the Internet as a medium. The difference is, this time the stakes are much higher. SOPA’s scope extends far beyond alleged piracy. It creates a web environment almost identical to that of China that restricts internet access, which has recently been declared a human right by the United Nations.

The True Intent of SOPA

If the most recent hearing was any indication, the proponents of SOPA are not interested in working with the technology and Internet industries to find solutions to stem online piracy. When has a fair and balanced discussion ever been held when the debate is stacked 5 to 1? Supporters of SOPA clearly do not understand the Internet as a medium and are constructing a system in which the deck is stacked in their favor. As many tech giants have pointed out, SOPA is devastating to the technology and Internet industries. How long will we suffer the claims that media giants cannot make enough money, even as they are increasing their own compensation?

The Stop Online Piracy Act is being constructed to allow a stranglehold on the American Internet. Make no mistake. Its constructors are building it with this intent in mind. Just like the Great Firewall of China, the Stop Online Piracy Act is a misnomer. Hidden behind an innocuous name, the bill’s intent is not to stem piracy as its proponents suggest, its true intent is to control the Internet itself.

US Bill Creating the Great Firewall of America

History of Chinese Internet Censorship

In the western world, China has long been infamous for its human rights abuses. Prior to Deng Xiaoping’s re-opening of China to the west in the late 1970’s and early 1980’s, these abuses were largely hidden from the West. With the advent of globalization, the PRC quickly realized the dangers of the internet to China’s fragile societal balance. Beginning in 2005, China began enlisting Western aid in Chinese internet censorship. Western companies like Cisco and Google have long abetted the Chinese government in establishing the so-called Great Firewall of China.

As Western social media developed, the PRC quickly recognized the power of these sites and moved to restrict its citizen’s access to these web sites. While some of these actions may appear to be antitrust behavior to allow local Chinese companies a competitive edge, make no mistake that the primary reason for censorship is the ongoing restriction of information from Chinese citizens. Nonetheless, as the Chinese web has developed, Chinese ‘netizens’ actively find ways around the Great Firewall and discuss social issues around the world. Numerous free tools such as Freegate, Freenet, and Vtunnel provide solutions for Chinese netizens to access the internet in the free world. As Chinese netizens find ways around the firewall, China has continued to step up its policing of the Chinese web.

The Power of Social Media in China

Over the past few years, more and more of China’s human rights abuses have come to light through social media. Ai Weiwei’s recent incarceration and the PRC’s bullying of Ai through gigantic back tax charges has resulted in Ai Weiwei speaking out about his incarceration. Using Google+, Ai was able to communicate methods of donation to help fight back against the $2.4 million back taxes claimed by the Chinese government. According to Chinese law, in order to contest tax charges of this nature, half of the sum must be presented as  collateral. In an awe-inspiring demonstration of the power of Chinese social media, Ai’s supporters around the world have already donated more than $1 million in 2 weeks.

Despite the outpouring of support from the West, Ai Weiwei is quick to criticize Western foreign policy.

“Today, the West feels very shy about human rights and the political situation. They’re in need of money. But every penny they borrowed or made from China has really come as a result of how this nation sacrificed everybody’s rights… With globalization and the Internet, we all know it. Don’t pretend you don’t know it. The Western politicians—shame on them if they say they’re not responsible for this. It’s getting worse, and it will keep getting worse.”

Unfortunately, Ai is more than correct in his assessment. Unfortunately, Western politicians’ short-sightedness extends beyond Chinese foreign policy.

Internet Censorship in the United States

On October 26, 2011, the Stop Online Piracy Act (SOPA) was introduced in the House of Representatives. This bill aims to quell loosely defined “online piracy.” I’d like to compare SOPA to the Chinese web landscape by discussing the two major things that SOPA would do if passed.

1. SOPA allows for suspension of service prior to being found guilty

SOPA does away with the “safe harbors” defined in the Digital Millennium Copyright Act (DMCA). These safe harbors allow some degree of protection for providers like Facebook, Youtube, and Google from liability for copyright infringement. SOPA would hold any site with user-generated content responsible. In Lenz v. Universal Music Corp., it was demonstrated that big media corporations have not considered fair use in the past when issuing takedown notices. In the SOPA world, the alleged rightsholder would be able to force former safe harbors to suspend service prior to being found guilty of infringing on rights. None of the sites that rely on user-generated content would be able to survive in this environment.

While China is not as concerned with IP laws as America is, there are obvious parallels here. The major Chinese Twitter-clone, Sina Weibo, is often forced to censor information without proof of guilt. This frequently involves blocking references to activists like Ai Weiwei who are trying to express free speech. The important point to note here is that in Ai’s case, he has not necessarily been proven to be guilty of anything prior to the repression of his speech. Similarly, whether or not the rightsholders’ property is being infringed upon, the alleged infringer would have to suspend services immediately.

2. SOPA allows the US government to blacklist web sites

Under Section 102 of SOPA, the Attorney General could order American companies from doing business with any alleged infringing web site. While proponents of SOPA have avoided using the term blacklist, make no mistake. SOPA allows the US government to blacklist websites.

If alarm bells aren’t ringing in your head yet, they should be. This is exactly what China has done with the Great Firewall. We have seen many times in China and recently in the Arab Spring that the censorship of internet is a strong component of the suppression of human rights. Recently, the UN has declared internet access a human right. SOPA would be infringing on American human rights in order to protect big media companies from infringement on their content.

Ultimately, SOPA attempts to control the American web space in the same way that the PRC suppresses human rights in China in the name of intellectual property protection. Look, at the end of the day, online piracy is a serious problem. However, SOPA is not the way to deal with it. If the DMCA needs to be revised to adjust to today’s web, then so be it. Let’s be clear here. This is not a slippery slope argument. SOPA puts in provisions that allows the US to control the internet the same way that the PRC does in China.

To  help fight this bill,

Contact your Congressmen

AND

visit americancensorship.org and show support for American Censorship Day tomorrow, November 16, 2011.

Chinese Consumerism – Death of the Knockoff Culture

A recent LA Times article explores the phenomenon of plummeting knockoff phone sales as the number of smartphones skyrockets. While this article examines the economics of this shift, it fails to capture the shift in Chinese culture that has led to this outcome.

Anyone who has visited China is familiar with the 山寨 (shan zhai) culture. The clothes that most lower and middle class Chinese wear are simply imitations of Western styles from 5 years ago, made in local shops and sold at significantly lower prices. Popular tourist destinations include places like the Museum of Science & Technology subway station in Shanghai. Here, vendors hawk row upon row of knockoff goods.

“Hello friend! We have special deal for you! Gucci, Prada, whatever you want, we have!”

The products they sell are as fake as their enthusiasm and English abilities. Out of curiosity, I purchased a fake IWC watch for $10. What a surprise it was, when it stopped ticking and the minute hand became dislodged less than a month later.

However, the Chinese knockoff culture extends beyond just fake luxury goods. It permeates throughout the Chinese lifestyle. Fake food scandals are seemingly a daily occurrence, with news stories about tainted milk and reused cooking oil dominating the news. When Chinese people encounter a good deal, it is assumed that the deal is fake in some form or fashion. The inevitability of these scandals in daily life is deeply rooted in the frustration of a populace unable to accomplish social change.

The shift from acceptance to avoidance of the knockoff consumer culture stems from the differing viewpoints of Chinese society. The younger generation, brimming with optimism from increased opportunities, is no longer willing to accept the fake culture their parents resigned themselves to. While the stratified social classes still promote the worship of big brand names, the willingness to accept substitutes has all but disappeared.

I traveled to Shanghai for the first time in 2010. During this trip, it was plain to see the awe on the locals’ faces when they saw my authentic iPhone. When I lost my phone in a cab, I was distraught. However, I was somewhat mollified by the recognition that the relative value for me was significantly lower than its value to whoever found it. For many (such as a taxi driver), the value of this item was equivalent or greater than an entire year’s salary.

When I returned in 2011, I noticed the googly eyes I once got using the iPhone in public had all but disappeared. Many of my friends in Shanghai had purchased their own authentic iPhones and looked forward to their next luxury purposes. One thing the LA Times article fails to capture is the level of sacrifice made by many of these people to afford these items. One lower-middle class friend of mine spent over 1/10th of her annual salary on an iPhone. This shouldn’t come as much of a surprise, as China’s GDP per capita was approximately $7,500 in 2010 according to the IMF.

While it is true that the relative price of smartphones has dropped over time, the insistence of the younger generation for quality over cost is a marked departure from Chinese culture which has dominated in the past. Expect the youth of China to affect social change in all of China over the next decades through traditional capitalist means, their wallets. As China continues to embrace consumerism and capitalism, expect a resurgence in use of the Chinese idiom,

一分錢一分貨。

Simply put, you get what you pay for.