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The Birth of The Startup Through PayPal of The Early Days

by Gennaro CuofanoMarch 8th, 2022

Too Long; Didn't Read

PayPal is one of the companies that built the startup playbook of the last decades. The company built a valuable company in an industry where the Internet was not necessarily a native technology. The first killer commercial applications comprised browsing, searching, media, and e-commerce. The story of PayPal has so many turns of events, that seem so improbable it survived in the first place, in hindsight. We can argue that PayPal (and a few other companies of the early Internet) built what we call today "a startup"

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When I interviewed Jimmy Soni, author of The Founders (major research and book about PayPal of the early days), a few key points came up about the PayPal story, which made it one of the companies that built the startup playbook of the last decades.

We can argue that PayPal (and a few other companies of the early Internet) built what we call today "a startup."

The reason why I picked PayPal as an example it's because it tried to build a valuable company in an industry (that of payments) for which the Internet was not necessarily a native technology (as we'll see the first killer commercial applications comprised browsing, searching, media, and e-commerce) and not necessarily payments.

The story of PayPal is so interesting, for a few reasons that we can sum up below.

The story of PayPal has so many turns of events, that seem so improbable it survived in the first place, in hindsight.

To give you a bit of context, we are in the late 1990s, and Internet startups were proliferating. We are in the midst of the dot.com bubble.

This bubble opened up in full swing with the IPO of Netscape IPOing in 1995. Netscape was the first commercial web browser (Mosaic was not commercialized initially), and it was built by James H. Clark, Marc Andreessen (now in charge of venture capital fund a16z), and the development team that had also coded the Mosaic browser (the founding team).

In fact, Andreessen, called up by entrepreneur James H. Clark, built the team to put together Netscape. It was a massive success. Netscape figured that if they took over the whole browsers' market, they could leverage overtime on their platform, to make wide margins and eventually be profitable (Netscape never reached profitability, until it sold to AOL in 1998).

Browsing turned out to be a killer application of the Internet, as explained in the History of AOL.

The Original Sin of The Internet

Thus, the Internet at the time had turned pretty interesting for commercial applications related to browsing, searching, and e-commerce.

While payments represented another area where the Internet could innovate, the commercial applications that were developing behind that were way more complex to implement. In fact, while it was possible to build a valuable Internet business based on media, entertainment, and e-commerce.

It was way more complex at the time to enable the Internet to be a breakthrough when it came to payments. That's because in order for it to succeed you needed the involvement of the legacy system comprised of banks, credit cards, and traditional institutions that didn't want to be part of that game at all.

Later on, Marc Andreessen called that "The Original Sin of The Internet" (we edited the text below to make it more readable). As Andreessen explained:

We tried to build payments in the browser and it was not possible...we made a huge mistake, we tried to work with the banks, and with the credit cards companies, and let me start by saying that those organizations have come in a long way...

He went on with the story. He explained how also Microsoft was working for a solution to embed payments into the browser and they also had failed. As Andreessen further explained:

We allied with MasterCard, Microsoft allied with Visa.

We [at Netscape] sat down and had our first meeting with MasterCard in 1994, and they want to work with us, and we asked whom from MasterCard should we meet with, and they said we got this guy, 'our technology visionary', we sat 'Joe' down in front of a PC, hooked up the Internet with the browser and we said 'click on this link' and he takes his finger and push it into the screen. It's 1994, it's nine years since Apple has invented the Macintosh, and he's never seen a mouse! And he's the technology visionary at MasterCard, oh god, we're completely hosed!

I'm telling you the story above to have you understand the context of the last 1990s, where the Internet was taking over media and e-commerce but was still far from taking over payments (it would still take one decade for this commercial use case to become fully viable).

In that context, two startups, in 1999, were trying to do just that, enabling the Internet to become a native place for payments. Yet they did it with two completely different approaches.

Tackling The Hardest Commercial Application on The Internet: Payments

In 1999, two startups (Confinity and X.com) were operating in the internet payment industry.

Yet, while they were neighbors (initially their offices were in the same building), they also recognized how different they were from each other. Musk (founder of X.com) thought Confinity was "dumb" and Confinity thought X.com hadn't a chance to make it!

Confinity had started to build a valuable company by looking at a narrow application: enabling payments through the PalmPilot.

As Jimmy Soni explained in our interview:

PalmPilots are maybe the distant ancestors of your iPhones, and they were handheld devices that were very popular in the mid-1990s and they had introduced an infrared port as one update in the latest series of PalmPilots and Max Levchin’s idea was we can do cryptographically secure transactions between this. So if I’m sitting at lunch with you and I want to send you $10, how cool would it be if I could do that through the infrared port on my PalmPilot?

On the other side, X.com wanted to be a financial institution. As Jimmy Soni further highlighted in our interview:

The other side of the origin story, which is really never really gotten truly, I think explored is Elon Musk had successfully built and then sold a company called Zip2. And he was thinking about what would come next for him. And from his days as an intern at a bank in Canada, he had thought a lot about how the financial system was running on old technology and that there were unnecessary fees, unnecessary bloat, middlemen, bureaucracy within that financial system.

And he thought, well, look, the internet is fundamentally reducing a lot of that in other industries, it should do so in finance, so he built and found three co-founders for a site that was X.com and X.com was going to be a revolution in finance; banking, insurance mortgages. It was going to do everything. At one point I had employees tell me he would say, “We’re going to be the federal reserve. We’re going to be the world’s financial system.” It was a vast ambition, certainly different from beaming money, but those were the two predecessor companies of the company that becomes PayPal.

Therefore, the two companies not only had a fundamentally different vision, but they also had a different philosophy in terms of the underlying technological infrastructure they had developed (X.com leveraged the Microsoft stack, where Confinity leveraged Linux, open-source software).

Eventually, those two companies ended up merging to become one: PayPal.

The Merger: From Grandiose Vision To Commercial Killer Application

Elon Musk and Peter Thiel, the founding members of two Internet startups, who were trying to redefine banking, were going to the meeting that sealed the two companies as one: PayPal.

In 2000, the meeting was at Sequoia Capital, one of the most influential VC firms in the Valley.

Elon Musk was driving his McLaren F1 (a one-million-dollar car) up Sand Hill Road. He was with Peter Thiel, as they were going to seal the merge between X.com (the company Musk had founded a year earlier) and Confinity (the company Thiel had established a couple of years before) to create PayPal.

As the story goes, Peter Thiel asked Musk, "what can this do?" (referring to the McLaren F1).

Musk replied, "watch this!"

Musk floored the car and did a sudden lane change. Yet he lost control of the vehicle, which started spinning until it hit an embankment on Sand Hill Road, thus wrecking it off!

Musk and Thiel were ok, and Thiel had a lift to Sequoia offices. Musk waited for the car to be picked up and met at Sequoia.

Pretending as if nothing had happened, they closed the deal!

While both companies had some grandiose visions, the market also turned out in a direction that none of them had foreseen. Enabling email payments which were supposed to be a “side feature” became the killer commercial applications for both companies.

They also figured that their tools had become extremely relevant on eBay. This triggered an irreversible journey. Where both startups understood the path to growth, leveraged virality to get there, and eventually decided to merge to tackle the market.

So Different And Yet Running According To The Same Business Playbook

As the two companies merged, and became officially PayPal, dramas didn't end up there.

As the companies merged, in the coming months, PayPal faced many near-death experiences.

Among these is the fact that they completely depended on a platform, eBay, which while could not shut them down, as the PayPal service was such a great product for eBay power users, the company was trying to build and launch (unsuccessfully) its own payment service.

And the drama only got worse, when Musk who had led the company since the merger, eventually got ousted with a coup from Thiel, Levchin, and Sachs (and this happened Musk was on honeymoon, and on an airplane, thus it was impossible for him to rebuke).

As an interesting side note, as Musk was hosted (we are in September 2020), this gave Musk the freedom to start thinking about his next startup, which would later become the space exploration company: SpaceX! (here is the full story).

Eventually, PayPal would be bought by eBay in 2002, for $1.5 billion.

The money from the purchase gave to the early founders, what later was called The PayPal Mafia, the resources, know-how, and understanding of the tech world that gave them the bandwidth to build up what today we call Web 2.0.

Founding Web 2.0

The founding members of PayPal would go on to build many other valuable companies and found the next wave of the Internet, what we now call Web 2.0 or Web2.

I noted some below. And beyond the people below, it's worth mentioning that many of the PayPal employees that stayed at eBay helped its further growth and many others flew to many tech companies in Silicon Valley:

The new Internet business playbook

While Confinity and X.com were completely different companies, from a philosophical standpoint. They were similar in the kind of business playbook to follow.

They understood continuous iteration vs. perfectionism. They knew how to balance vision with short-term goals. They knew how to build distribution into their products.

All these things that we give for granted at the time, didn't exist in theory back then. They were figuring things out on the fly!

During this process, a new business playbook has been developed.

Again, today we give some of those methodologies, frameworks, and ideas for granted but at the time they didn’t exist.

This playbook comprised concepts like:

And entire business disciplines, based on growth marketing, network effects, and much more.

That is why PayPal's history is so instrumental to the commercial Internet.

Let's explore some of these frameworks, tools, and the mindset that connected them all.

Viral growth

In the Lean Startup, Eric Ries defined the engine of growth as "the mechanism that startups use to achieve sustainable growth." He described sustainable growth as following a simple rule, "new customers come from the actions of past customers." The three engines of growth are the sticky engine, the viral engine, and the paid engine. Each of those can be measured and tracked by a few key metrics.

When PayPal's growth exploded it did that through two-sided viral loops.

The company sent $10 to both invitees and the inviters if the former signed up. Thus, both sides got incentivized.

This might seem a trivial strategy now, but at the time it was quite counterintuitive and seemingly expensive.

Many other startups (Dropbox and a bunch of other startups would use this as the main growth driver).

Product-Market Fit

Marc Andreessen defined Product/market fit as "being in a good market with a product that can satisfy that market." According to Andreessen, that is a moment when a product or service has its place in the market, thus enabling traction for the company offering that product or service.

Andy Rachleff who cofounded the firm Benchmark Capital, and also a co-founder and CEO of Wealthfront in an interview with Mike Maples explains the origin of the term. As Andy Rachleff explained:

I learned it from Sequoia Capital. Don Valentine really invented it.

Don used to say, “I’m looking to invest in companies that can screw everything up and still succeed because the customer pulls the product out of their hands.”

I’m paraphrasing. I’m not sure I got that exactly right. He felt that way because the startup will screw everything up. I want a company that has such demand from the market that they can literally screw everything up and still succeed.

Don Valentine was an American venture capitalist, founder of Sequoia Capital, who shaped Silicon Valley and helped build companies like Oracle, LSI Logic, and Cisco Systems.

In an article entitled “The only thing that matters” Andreessen popularized the term:

At any given startup, the team will range from outstanding to remarkably flawed; the product will range from a masterpiece of engineering to barely functional; and the market will range from booming to comatose.

In other words, Andreessen takes into account three major factors for the success of any startup:

The team.
The product.
And the market.

He argues that if you asked Entrepreneurs and VCs of the three elements what mattered the most, they would have picked the team.

On the other hand, if you asked engineers about the most crucial element, they would argue that the product matters the most (Andreessen mentions Apple and Google as an example of that).

He takes a third path though. Rather than the team or the product, what matters is the market!

In a great market — a market with lots of real potential customers — the market pulls product out of the startup.

From here he introduces the concept of MVP or minimum viable product.

He defined it as:

The market needs to be fulfilled and the market will be fulfilled, by the first viable product that comes along…

…The product doesn’t need to be great; it just has to basically work. And, the market doesn’t care how good the team is, as long as the team can produce that viable product.

From here it is essential to understand two concepts that help startups and entrepreneurs in general to launch successful products:

The lean startup methodology.
And the MVP.

We’ll also see a third element that has become critical even before an MVP can be developed: the problem/market fit.

In other words, where the lean methodology is the “How,” the MVP becomes the “What” and the problem/market fit becomes the “Why.”

Freemium

The freemium - unless the whole organization is aligned around it - is a growth strategy rather than a business model. A free service is provided to a majority of users, while a small percentage of those users convert into paying customers through the sales funnel. Free users will help spread the brand through word of mouth.

In March 2006, venture capitalist Fred Wilson wrote an article entitled “My Favorite Business Model” which said:

Give your service away for free, possibly ad supported but maybe not, acquire a lot of customers very efficiently through word of mouth, referral networks, organic search marketing, etc, then offer premium priced value added services or an enhanced version of your service to your customer base.

He mentioned examples of this successful business model at Skype, Flickr, and a few others.

According to Fred Wilson, the core advantage of a “Freemium business model” is fast customer acquisition. But he made clear that it had to be as frictionless as possible: A customer is only a click away and if you can convert them without forcing them into a price/value decision you can build a customer base fairly rapidly and efficiently. It is important that you require as little as possible in the initial customer acquisition process. Asking for a credit card even though you won’t charge anything to it is not a good idea. Even forced registration is a bad idea. You’ll want to do some of this sort of thing once you’ve acquired the customer but not in the initial interaction.

The main aim was to “eliminate all barriers to the initial customer acquisition.” He didn’t have yet a name for this kind of revenue model.

At the end of his article, Fred Wilson had clear in mind what the Freemium business model looked like. However, he didn’t have a name for it.

That is why he invited people to comment and to come up with a proper name for this business model A commenter, Jarid Lukin suggested the name Freemium model.

Thus, service and product are wholly free and frictionless, where most users don’t pay, and a small base of users pay for a product that has premium features.

Over the years Fred Wilson kept emphasizing the importance of freedom. Today the freemium business model has taken over also the gaming industry. But it has also become the most debated business model in the software industry.

Building a free product and making it available to anyone and then expecting to make money isn’t the right strategy.

Instead, the “free” within the freemium, if appropriately used, can be a lever for quick success.

As Fred Wilson pointed out in October 2008 “freemium is far from dead, in fact, it may be the business model de rigueur.“

What did he mean? He recounted in a later article:

Facebook is a perfect example of freeconomics at work. A woman who works for a major media company was in my office recently. She quoted her CEO as saying “why doesn’t Facebook just charge a monthly subscription fee, they’d be making money hand over fist?”. Well I believe that if Facebook did that, they’d be vulnerable to other networks offering a free service. And certainly not every one of those 200mm+ users are going to cough up a monthly subscription. But by offering a friction free service, they have built a powerful and growing network that they are now starting to monetize in various ways and that they will monetize even further in additional ways. And they are super hard to compete with because they are free.

Agile methodology and MVPs

Agile started as a lightweight development method compared to heavyweight software development, which is the core paradigm of the previous decades of software development. By 2001 the Manifesto for Agile Software Development was born as a set of principles that defined the new paradigm for software development as a continuous iteration. This would also influence the way of doing business.

Back in 2009, Eric Ries defined MVP as:

The minimum viable product is that version of a new product which allows a team to collect the maximum amount of validated learning about customers with the least effort.

And he continued:

MVP, despite the name, is not about creating minimal products. If your goal is simply to scratch a clear itch or build something for a quick flip, you really don’t need the MVP. In fact, MVP is quite annoying, because it imposes extra overhead. We have to manage to learn something from our first product iteration. In a lot of cases, this requires a lot of energy invested in talking to customers or metrics and analytics.

Ash Maurya also described it as:

The smallest thing you can build that delivers customer value(and as a bonus captures some of that value back).

As pointed out by Eric Ries, a minimum viable product is that version of a new product that allows a team to collect the maximum amount of validated learning about customers with the least effort through a cycle of build, measure, learn; that is the foundation of the lean startup methodology.

Continuous innovation

That is a process that requires a continuous feedback loop to develop a valuable product and build a viable business model. Continuous innovation is a mindset where products and services are designed and delivered to tune them around the customers' problems and not the technical solution of its founders.

On FourWeekMBA I had Ash Maurya explain why continuous innovation matters so much.

Let’s start with the key principles!

As Ash Maurya has highlighted continuous innovation is a set of mindsets moving along ten key principles:

Love the problem not the solution

Talking about problem-solution fit Ash Maurya highlighted how:

One of the biases that that many entrepreneurs fall run into is this premature love of the solution. Like the first principles in science, you almost have to deconstruct an idea. We have to start with the basics. In this case**, when we look at our business, we have to break it down into customers and problems.**

If you don’t have the right customers who are trying to get sorted and problem solved, and no matter what solution you build, it doesn’t matter because we know that unless you’re solving a problem, customers are not going to use it.

This is a common mistake, happening especially in the startup world, where it becomes easy to focus on providing technical solutions rather than focusing on the problem that might solve.

That is why you need to make sure to understand the problem first.

What problem are you solving? For whom? What alternatives are the people for which you will solve the problem using? Why and what can you do way better than existing alternatives?

Those are the right questions. Yet, many still focus on how to build a feature, product, and service without validating or understanding what problem is solving in the first place.

As Ash Maurya further highlighted when I interviewed him on FourWeekMBA:

They’re not going to pay money. Even if you can reach them.**Even if you have a patent or an unfair advantage, it doesn’t matter at the end of the day because your customers don’t care.**So that is the way we logically break it down, but that innovator’s bias is one of those sneaky things.

Growth hacking

Growth hacking is a process of rapid experimentation, coupled with the understanding of the whole funnel, where marketing, product, data analysis, and engineering work together to achieve rapid growth. The growth hacking process goes through four key stages analyzing, ideating, prioritizing, and testing.

As the story goes, in 2007, Brian Chesky and Joe Gebbia couldn’t afford the rent on their San Francisco apartment that is why they decided to transform their loft into a lodging space.

Yet instead of relying on Craiglist, they built their site, which they called Airbed & Breakfast and leveraged on Craigslist to drive users back to their website.

Source*: GrowthHachers.com*

I wish I could tell you that this is how that idea turned into a multi-billion company, known under the name of Airbnb.

Airbnb didn’t grow in a multi-billion business from one day to the next with a single magic trick. Instead, they had to undertake several experiments before seeing their listings grow.

More importantly, they had to master a process of continuous iteration that spanned across product’s features, to marketing channels which eventually spurred an impressive growth track for the company.

Sean Ellis, one of the fathers of the discipline, called this process of continuous experimentation to achieve exponential growth: growth hacking.

Let me further define what’s not Growth Hacking so we can avoid falling into the trap of a few myths surrounding the discipline; appreciate its full potential.

Growth hacking follows a few key premises. From setting a north start metric to building a multidisciplinary team, and speeding up experimentation through data.

However, there is a key point about growth hacking that made it so important for tech companies. This discipline starts from the premise of wrecking down the walls between marketing, product development/engineering, and distribution.

So that the product itself has built-in distribution mechanisms, to enhance its viral growth and build what we like to call network effects within the product!

Blitzscaling

Blitzscaling is a business concept and a book written by Reid Hoffman (LinkedIn Co-founder) and Chris Yeh. At its core, the concept of Blitzscaling is about growing at a rate that is so much faster than your competitors, that make you feel uncomfortable. In short, Blitzscaling is prioritizing speed over efficiency in the face of uncertainty.

Blitzscaling is prioritizing speed over efficiency in the face of uncertainty.

The name Blitzscaling comes from a World War II association with the term “blitzkrieg” or lightning war, where the attacker risks it all to either win or lose the battle.

Understanding Blitzscaling might mean having a framework that can help your small organization to scale up or your large company to also benefit from a new and reinvigorated acceleration, which is critical to survival in a market that changes at a faster pace.

The Birth of The Lean Startup

It officially started with an HBR article of 2013 that referred to a new phenomenon in the business world “Why the Lean Start-Up Changes Everything:”

However, the origin story started in the late 1990s.

Steve Blank, a retired serial entrepreneur had the time to think through what he had missed in terms of business frameworks, during the years, as he started several high-tech companies.

He had noticed that the only tool available at the time was the business plan. However, not only the business plan was a static document that didn’t survive the first contact with the real world.

That document was also plenty of untestable and untested assumptions.

The patterns he noticed would be all gathered into what became a manifesto, and the foundation for the lean startup movement.

In the 2013 HBR article “Why the Lean Start-Up Changes Everything” Steve Blank defined the lean startup as:

It’s a methodology called the “lean start-up,” and it favors experimentation over elaborate planning, customer feedback over intuition, and iterative design over traditional “big design up front” development.

In a nutshell, the lean startup methodology aims at creating a repeatable process for product development to minimize the time it takes to build a product that the market wants.

This process consists of three phases: