The Dangerous Seduction of the Lifetime Value (LTV) Formula

Posted on September 4, 2012. Filed under: advertising, Internet, Uncategorized, Venture Capital, Web/Tech | Tags: , , , , , , , |

Many consumer Internet business executives are loyalists of the Lifetime Value model, often referred to as the LTV model or formula. Lifetime value is the net present value of the profit stream of a customer. This concept, which appears on the surface to be quite benign, is typically used to compare the costs of acquiring a customer (often referred to as SAC, which stands for Subscriber Acquisition Costs) with the discounted positive cash flows that will come from that customer over time. As long as the sum of the discounted future cash flows are significantly higher than the SAC, then people will argue it is warranted to “push the accelerator,” which typically means burning capital by aggressively spending on marketing.

This is a simplified version of the formula:

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The key statistics are as follows:

  • ARPU (average revenue per user)
  • Avg. Cust. Lifetime, n (This is the inverse of the churn, n=1/[annual churn])
  • WACC (weighted average cost of capital)
  • Costs (annual costs to support the user in a given period)
  • SAC (subscriber acquisition costs, sometimes refereed to as CAC = customer acquisition costs)

The LTV formula, when used correctly, can be a good tactical tool for monitoring and comparing like-minded variable market programs, especially across channels. But like any model, its proper use is entirely dependent on the assumptions used in that model. Also, people who have a hidden agenda or who confuse a model with reality can misuse it. For many companies that subscribe to its wisdom, the formula slowly takes on more importance than it should. Seduced by the model, its practitioners often lose sight of the more important elements of corporate strategy, and become narrowly fixated on the dogmatic execution of the formula. In these cases, the formula can be confused, misused, and abused, much to the detriment of the business, and in many cases the customer as well.

Here are ten reasons to avoid worshiping at the LTV altar:

  1. It’s a Tool, Not a Strategy.  Heavy LTV companies forget that the LTV model does not create sustainable competitive advantage. You shouldn’t’ confuse output with input. The LTV formula is a measurement tool to be used by marketing to test the effectiveness of their marketing spend – nothing more and nothing less. If one asserts that buying customers below what they charge them is a corporate strategy, this is in essence an arbitrage game, and arbitrage games rarely last. Too many of the variables (specifically ARPU and SAC) are outside of your control, and nothing would prevent another player from executing the exact same strategy. It’s not rocket science; it’s a formula that any business school graduate can calculate. Do not fool yourself into believing it creates a proprietary advantage.
  2. The LTV Model Is Used To Rationalize Marketing Spending.  Marketing executives like big budgets, as big budgets make it easier to grow the top line.  The LTV formula “relaxes” the need for near term profitability and “justifies” the ability to play it forward – to spend today for benefits that are postponed into the future. It is no coincidence that companies that put a heavy emphasis on LTV are also the ones that have massive losses as they scale, frequently even through an IPO. Consider that most companies limit any “affiliate fee” they would be willing to spend to 5-10% of sales. Yet when they are marketing, they use different math. They use LTV math, and all the sudden it’s acceptable to spend 30-50% of revenue on customer acquisition. Find the most boisterous executive recommending excessive spending, and you will usually find a loyal servant of the LTV religion.
  3. The Model is Confused and Misused. Frequently the same group that is arguing for more spending is the same one that “owns” the LTV calculation. (This is a mistake – finance should monitor LTV).  As a result, it is not uncommon for one to see shortcuts taken that allow for greater freedom. As an example, marketers often divide spend by total customers to calculate SAC rather than just those customers that were “purchased.” If you have organic customers, they shouldn’t be included in the spend calculus. They would have arrived regardless of spend. Also, many people discount “revenues” rather than marginal cash contribution. It is critical to bundle all future variable costs of supporting the customer in order to fairly estimate the future contribution. As an example of the sloppiness that exists around the formula, consider this blog post (http://blog.kissmetrics.com/how-to-calculate-lifetime-value/) from KISS metrics, a company whose aim is to “help you make smarter business decisions.” Not only do they include a version of the model that specifically ignores future costs, but also they recommend taking an average of three different results, two of which are clearly flawed. This voodoo-math has no place as part of a multi-million dollar marketing exercise.
  4. Business Isn’t Physics – The Formula Is Not Absolute. LTV zealots often hold an overly confident view of the predictive nature of the formula. It’s not “hard science” like say predicting gravity. It’s at best a “good guess” about how the future will unfold. Businesses are complex adaptive systems that cannot be modeled with certainty. The future LTV results are simply predictions based on many assumptions that may or may not hold. Yet the LTV practitioner often moves forward with a brazen naiveté, evocative of the first time stock buyer who just found out about the price/earnings ratio, or the newcomer to Vegas who has just been taught the basics of twenty-one. LTV models win arguments because executives perceive them to be grounded in science. Just because its math, doesn’t mean its good math.
  5. The LTV Variables “Tug” at One Another. This may be the single most important issue and it lies at the heart of why the LTV model eventually breaks down and fails to scale ad infinitum. Tren Griffin, a close friend that has worked for both Craig McCaw and Bill Gates refers to the five variables of the LTV formula as the five horsemen. What he envisions is that a rope connects them all, and they are all facing different directions. When one horse pulls one way, it makes it more difficult for the other horse to go his direction. Tren’s view is that the variables of the LTV formula are interdependent not independent, and are an overly simplified abstraction of reality. If you try to raise ARPU (price) you will naturally increase churn. If you try to grow faster by spending more on marketing, your SAC will rise (assuming a finite amount of opportunities to buy customers, which is true). Churn may rise also, as a more aggressive program will likely capture customers of a lower quality. As another example, if you beef up customer service to improve churn, you directly impact future costs, and therefore deteriorate the potential cash flow contribution. Ironically, many company presentations show all metrics improving as you head into the future. This is unlikely to play out in reality.
  6. Growing Becomes a Grind. Let’s say you have a company that estimates it will do $100mm in revenue this year, $200mm the next, and $400mm the year after that. In order to accomplish those goals it is going to invest heavily in marketing – say 50% of revenues. So the budget for the next three years is $50mm, $100mm, and $200mm. How realistic is it to assume that your SAC will drop as you 4X your spend? Supply and demand analysis suggests the exact opposite outcome. As you try to buy more and more of a limited good, the price will inherently increase. The number one place on the planet for marketing spend is Google Adwords, and make no mistake about it, this is an increasingly finite resource. Click-outs are not growing at a meaningful pace, and key word purchases are highly contested. Assuming you will “get better” at buying while trying to buy more is a daunting assumption. The game will likely get tougher not easier.
  7. Purchased Customers Underperform Organic on Almost Every Metric. Organic users typically have a higher NPV, a higher conversion rate, a lower churn, and more satisfied than customers acquired through marketing spend. LTV heavy companies are in denial about this point. In fact, many of them will argue until they are blue in the face that the customer dynamics are the same while this is rarely the case. A customer that “chooses” your firm’s services will be much more staisfied than one that is persuaded to buy your product through spend. Find any high-marketing spend consumer subscription company, and I will show you a company with numerous complaints at the Better Business Bureau. These are companies that make it almost impossible to terminate your subscription. When you are scheming on how to trap the customer from finding the exit you are not building a long-term brand.
  8. The Money Could Go to the Customer.Think about this. If you are a company that spends millions and millions of dollars on marketing, wouldn’t you be better off handing that money to the customer versus handing it to a third-party who has nothing to do with the future life-time value of the customer? Providing a better value-proposition to the customer is much more likely to endure goodwill than spending on marketing. A heavy marketing spend necessitates a higher margin (to cover the spend), and therefore a higher end user price to the customer! So the customer is negatively impacted by the presence or “need” of the marketing program. Plus, a margin umbrella now exists for competition that chooses to undercut your margin model with a more efficient customer acquisition strategy (such as giving the customer the money).“More and more money will go into making a great customer experience, and less will go into shouting about the service. Word of mouth is becoming more powerful. If you offer a great service, people find out.” – Jeff Bezos
  9. LTV Obsession Creates Blinders. Many companies that obsess over LTV, become overwhelmed by LTV. In essence, the formula becomes a blinder that restricts creativity and open-mindedness. Some of the most efficient forms of marketing are viral, social, and effective PR (public relations). Most companies that obsess about LTV are less skilled at these more leveraged techniques. Ironically, it’s the scrappy and capital starved startup with absolutely no marketing budget that typically finds a clever way to scale growth organically.  I love this historic slide from Skype comparing their SAC with that of Vonage, an iconic disciple of LTV analysis.

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10. Tomorrow Never Arrives.  The Utopian destination imagined by the LTV formula is a mirage. It almost never works out as planned in the long run. Either growth begins to slow, or you run out of capital to continue to fund losses, or Wall Street cries uncle and asks to see profitability. When this happens the frailty of the model begins to appear. SAC is a little higher than expected. You met your growth target, but the projected loss was bigger than expected. Wall Street is hounding you for churn numbers, but you are reluctant to give them out. The lack of transparency then leads to cynicism, and everyone assumes the worse. It turns out that the excessive marketing spend was also propping up repeat purchase, and pulling back to achieve profitability is increasing churn. Moreover, a negative PR cycle has ensued as a result of your stock decline, and the press’ new doubts about your model. This also impacts results, and customer perception of your brand. The bottom line is that “one day we can stop spending and be remarkably profitable” rarely comes to fruition.

It is not impossible to create permanent equity value with the LTV approach, but it’s a dangerous game of timing – you don’t want to be the peak investor. Let’s say a new business starts with an early market capitalization of A (see graph below). Through aggressive marketing techniques, and aggressive fund raising, the company is able to achieve amazing revenue growth (and corresponding losses), but nonetheless creates a rather sizable organization. At this point, the company is value at point B. Eventually, however, gravity ensues and the constraints outlined herein raise their head, resulting in a collapse to point C.  For early founders and investors at point A, they may do OK (as long as C>A), but it will be accomplished on the backs of later stage investors that helped fund the unsustainable push to point B. This is the story of many a telecom and cable provider expansion history, as well as a few recent Internet companies.

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This should not be misconstrued as a eulogy for the LTV formula. It has a very important place in business as a way to contrast and compare alternative marketing programs and channels. It is a tactical marketing tool that requires candor and thoroughness in its implementation. The fundamental reason that it is so amazingly dangerous and seductive is its simplicity and certainty. Generic marketing is conceptual. LTV marketing is specific. Building a plan to grow to a million users organically is an order of magnitude more difficult than doing it with the aid of the LTV formula. There is comfort in its determinism, and it is simply easier to do.

Some people wield the LTV model as if they were Yoda with a light saber; “Look at this amazing weapon I know how to use!” Unfortunately, it is not that amazing, it’s not that unique to understand, and it is not a weapon, it’s a tool. Companies need a sustainable competitive advantage that is independent of their variable marketing campaigns. You can’t win a fight with a measuring tape.

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Social-Mobile-LOCAL: “Local” Will Be The Biggest of the Three

Posted on June 25, 2012. Filed under: android, Internet, iphone, Uncategorized, Venture Capital, Web/Tech | Tags: , , , |

“Well I was born in a small town
And I live in a small town
Prob’ly die in a small town
Oh, those small – communities”
— Small Town, John Mellencamp

While “Social-Mobile-Local” is certainly an overused buzz phrase, most of the attention has been placed on the “social” and “mobile” parts of the phrase. In social, the spectacular rise of Facebook and Twitter is clearly a disruptive and critical trend. In mobile, the adoption of the smartphone (led by Apple’s iPhone and now catapulted forward by Android) is also a fundamentally important platform transition. Much less attention has been paid to the third concept, “local,” which is ironic since it may be a much larger real business opportunity than either social media or Smartphone application revenue. Over the next five years, this massive opportunity will come into focus as local businesses embrace the Internet and adopt new interactive technologies that increasingly automate the connections between their customers and themselves.

A Huge Opportunity

The attached slide will look familiar to readers in Silicon Valley. It appears to be a disruptive, up-and-to-the-right graph that we normally associate with break-out technology companies. This slide, however, maps the rise of the Yellow Pages industry in North America from 1920 to 2007. As you can see, the Yellow Pages business saw incredible revenue growth as the phone became the key point of connectivity for interaction with local business. At its peak in 2007, the North American Yellow Pages business topped out somewhere between $14-16 billion, depending on the source.

Total local advertising and promotion is much larger than just the Yellow Pages. A separate analysis done by Advertising Age, suggests that in 2007, local U.S. businesses spent around $123 billion annually on local media. However, starting in 2008, this market began to materially erode. Why? Newspapers, magazines, local radio, and Yellow Pages represent about 80% of this spend, and the rise of the Internet is unquestionably undermining the  core structure of these industries. Since 2007, Yellow Pages revenues have fallen in half in five years, after taking 87 years to reach their peak. Many newspapers have closed, and others teeter on the edge of bankruptcy. This is not at all shocking. We  know that consumers are using these products less frequently every day. The Yellow Pages business itself suffers from a terminal disease.

If you think back to five years ago, the small business owner was clearly an Internet skeptic. People would say things like “you should have a web site,” but for most local business owners — like a pet-shop or a locksmith — this didn’t mean anything. They had a phone, it was listed in the Yellow Pages – and people could find them. And if the potential consumer went online, the phone number could be found there as well. No problem. For those that did put up a web site, it was, in many cases, a non-event. Some customers might find it, but only the ones that were already looking for them. What’s the big deal?

An Online Awakening

Two things then happened. The first is the critical success of Yelp. Local merchants were suddenly profiled in an environment where the consumer, not the business owner, controlled the copy and the narrative. At first, it was easy to disregard this thing called Yelp as a passing fad. But the voices  got louder and louder – both the happy and the unhappy ones. Accountability and transparency had arrived at the local level. One has to suspect that Facebook’s pervasiveness played a roll in awakening the small business owner too.  By 2011, Facebook had reached 71% penetration of all 221mm U.S. Internet users. Regardless of  industry, when the small business owner now went home, his or her family was constantly on the Internet – playing games, doing research, connecting with friends. The Internet’s pervasiveness could no longer be denied.

Today, the small business owner’s attitude has shifted from denial to anxiety, and, as a result, these local business owners are rushing to the Internet in droves. In Benchmark’s own portfolio, we have eight companies (OpenTable, Uber, Zillow, Yelp, DemandForce, GrubHub, 1stdibs, and Peixe Urbano, *) that generate the majority of their revenue directly from local businesses. Based on estimates, these companies will represent approximately $735mm in revenue in calendar year 2012. Four of these companies have already seen a liquidity event (OpenTable, Zillow, and Yelp have had successful IPOs, and DemandForce was recently purchased by Intuit for $425 million). As small business owners embrace the Internet, the local Internet is firing on all cylinders. Not bad for a customer segment that was once considered a “do not enter” zone for venture capitalists.

The Smartphone as a Catalyst

If the decay of the Yellow Pages was a catalyst for the local Internet, then the rise of the smartphone is an accelerant. Smartphone adoption is staggering. Today, there are over 1 billion smartphone users worldwide, and in the U.S., smartphone penetration recently passed 50%. Google has announced that Android is activating over 850K new users a day. These mobile devices are frequently the preferred device (vs. a personal computer) when a consumer looks to interact with local businesses. For the eight companies mentioned above, mobile usage already represents between 25-50% of overall customer usage depending on time of day and day of week. And mobile usage looks destined to increase from here: DigitalBuzz predicts that mobile Internet users will pass desktop Internet users within the next 3 years.

The rise of the Smartphone as a new platform is a huge benefit for entrepreneurs. Simply put, large incumbents are typically slow to make shifts to new platforms. This is either because they are overly focused on their current strength, or simply too large and bureaucratic to move quickly. Often, it is a combination of both. Startups on the other hand are eager to find a point of leverage or advantage, and rush to new platforms. New platforms typically have  “hooks” that enable features that never existed on the previous platform, further differentiating the startups offerings. A great example on the Smartphone is using GPS for one button local search. New platforms also require new distribution techniques, and in such a “jump ball” scenario the incumbent’s advantage evaporates. One could argue the incumbents are even at a disadvantage as they are less likely to have the cutting edge technical employees who understand the new platforms.

Changing the Game: Going Deep

But there is an even greater limitation on the power of incumbents than their discomfort with new platforms. As the market moves away from Yellow Pages-like listings and directories as a proxy for advertising, many young companies, taking a page out of the playbook of data-driven software-as-a-service companies, have created deep vertical integration within their spaces in order to drive traffic and enable services. By organizing small business owners, supplementary service providers, and customers on a single canonical set of data, these companies are not only providing new ways for customers to discover local businesses: they are creating new ways for local businesses to interact with customers. They are moving from “listing” services to “automation” services, and they are stitching these Internet services deep into the nervous system of the target industry.

For example, a company like OpenTable provides, on a stand-alone basis, a premises based computer that is an extremely effective tool for restaurants to manage their tables — a digital version of the reservation book on the maitre d’s desk. By connecting that same data on the Internet, and aggregating that data from other restaurants, you have OpenTable’s incredible online reservation system. Along that same data spine, customers can add reviews, limousine services and florists can enhance the dining experience, and a location-aware Smartphone app can tell you what restaurant within walking distance of where you are has a table available right now. The “offering” is the complete network, not just one specific piece, and the pieces alone are less compelling.

Going “deep” like this is a significant challenge for larger incumbents. The playbook requires a deep understanding of the industry, access to all the key content and its structure, a targeted and experienced sales structure, and a willingness to invest in a market that may seem “niche” to the broader service provider. You have to be willing to get your hands dirty. These large companies favor a horizontal, one-size-fits-all approach, offering a widget that all local companies would potentially use (such as virtual loyalty cards). But these lightweight offerings from the incumbents will fall well short of the “automation” features and functionality enabled by the innovators digging deeper into the vertical.

We’ve already seen a couple of recent examples of this with Google. In mortgages, Google launched a product but ultimately retreated, citing prioritization concerns and “taking a hard look at products that haven’t been as successful as we had hoped.” A seemingly simple category like mortgages proved difficult to nail within the overall Google strategic framework. Likewise, in order to gain a foothold in travel — a space where deep verticals thrived for many years —Google ultimately realized they had to pay $700mm for ITA Software in order to acquire the vertical tools they needed to be successful.

The Real Winner: The Customer

If you look closely at many of the leading companies developing these deep verticals, like Zillow or OpenTable or Uber or AirBnB, they are providing far more than just advertising opportunities for local businesses. These companies are using new technologies like mobility and location to improve communication, interaction and overall customer experience.

The amazing thing about these new local Internet companies is how much value the consumer gets from this data-driven, vertically-integrated experience. Watching your Uber driver approaching your location on GPS forever alters your experience of taxis and limos, while at the same time providing total transparency up and down the value chain, from dispatcher to driver to fleet manager.

But the really exciting part is that we are still really early in this process of transformation away from listing/directory advertising to a local Internet.  By way of comparison, in the fourth quarter of 2011, Southwest Airlines reported that 86% of its revenue was booked online.  By comparison, only 12% of US restaurant reservations are booked online. Only 15% of dentists are connected to customers through services like DemandForce.  Only 3% of takeout orders are processed through online offerings like GrubHub. And less than 1% of realtors are premier agents on Zillow.

We all know intuitively where those numbers are headed in the future.

*Benchmark Capital is also super excited about its investment in Nextdoor, the leading social network for local neighborhoods and communities. Join 3,000 other local communities who have revolutionized how neighbors interact online. Check it out at www.nextdoor.com.

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Intuit to Acquire Demandforce for $424MM

Posted on April 27, 2012. Filed under: advertising, Internet, Uncategorized, Venture Capital, Web/Tech | Tags: , , |

This morning, Intuit announced its agreement to acquire one of Benchmark’s portfolio companies, Demandforce, for $424mm. As with Instagram, Benchmark Capital is the largest institutional investor in Demandforce. Unlike Instagram, which is a consumer application and is extremely well known, Demandforce focuses on local professional businesses and has chosen to keep an intentionally low profile – a strategy that has served them well.

Great entrepreneurs often blaze their own trails, and the founder and CEO of Demandforce, Rick Berry, is no different. In a day and age of social media, where many companies project a persona much larger than reality, Demandforce chose instead to focus on its customers and its products. We never even announced Benchmark’s funding of the company, which I believe is unprecedented. The Demandforce team always felt that the attention should be focused on the customer rather than the company.

Demandforce’s customer mission has always been the same – to help small businesses thrive in an evolving and increasingly complex connected world. Today, they are the leading provider of interactive “front office” SAAS services to thousands and thousands of professional small business owners. The Demandforce product is a powerful web-based application that seamlessly integrates with existing workflow systems, works automatically, and delivers guaranteed results. Through this, Demandforce provides local businesses – like salons, auto shops, chiropractors, dentists, and veterinarians – with affordable and easy access to the tools and platforms that large enterprises use to communicate with customers, build a strong online reputation and leverage network marketing. It you have ever received an automated communication from your dentist, it was likely sent through Demandforce.

Demandforce’s success puts it at the forefront of the burgeoning “Local Internet” wave. The combination of Internet pervasiveness and smartphone penetration has led to a complete reconfiguration with regard to how local businesses interact with their customers. These local businesses have traditionally spent over $125B/year on traditional media, and this is only in the U.S. But the channels they have historically used, such as the newspaper and the yellow pages, are increasingly compromised. These business owners know they need new solutions, and these dollars will be reallocated to these exciting new platforms. Benchmark believes this “Local Internet” wave is many times larger than the “social” and “mobile” themes with which it is often contrasted. In addition to DemandForce, Benchmark is fortunate to have backed such “Local Internet” market leaders as OpenTable (OPEN), Zillow (Z), Yelp (YELP), Peixe Urbano, GrubHub, Uber, and Nextdoor.

It has been an honor and a pleasure to work with Rick Berry, Patrick Barry, Hoang Vuong, Mark Hale, Sam Osman and Annie Tsai at Demandforce. This is truly one of the best teams ever assembled. It was also a pleasure to work with Steve Kostyshen as well as Mike Maples of Floodgate and Peter Ziebelman of Palo Alto Venture Partners, all of whom preceded us in their investment, and all of whom are passionate fans of the company.

It is certainly thrilling to see a team of entrepreneurs reach a significant milestone such as this.  That said, it is equally bittersweet as it means we will no longer be working directly with them on this incredibly compelling mission. Our loss is unquestionably Brad Smith and Intuit’s gain. Combining the leading “front office” small business SAAS vendor with the iconic Silicon Valley small business company is an incredibly compelling combination.

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Why Youth Has an Advantage in Innovation & Why You Want To Be a Learn-It-All

Posted on March 26, 2012. Filed under: Internet, social networking, Uncategorized, Venture Capital | Tags: , , , |

[Follow Me on Twitter]

A few relevant scenes from the recent blockbuster Moneyball:

Peter Brand: Billy, Pena is an All Star. Okay? And if you dump him and this Hatteberg thing doesn’t work out the way that we want it to, you know, this is…this is the kind of decision that gets you fired. It is!
Billy Beane: Yes, you’re right. I may lose my job, in which case I’m a forty four year old guy with a high school diploma and a daughter I’d like to be able to send to college. You’re twenty five years old with a degree from Yale and a pretty impressive apprenticeship. I don’t think we’re asking the right question. I think the question we should be asking is, do you believe in this thing or not?
Peter Brand: I do.
Billy Beane: It’s a problem you think we need to explain ourselves. Don’t. To anyone.
Peter Brand: Okay.

———————————

Grady Fuson: No. Baseball isn’t just numbers, it’s not science. If it was then anybody could do what we’re doing, but they can’t because they don’t know what we know. They don’t have our experience and they don’t have our intuition.
Billy Beane: Okay.
Grady Fuson: Billy, you got a kid in there that’s got a degree in Economics from Yale. You got a scout here with twenty nine years of baseball experience. You’re listening to the wrong one. Now there are intangibles that only baseball people understand. You’re discounting what scouts have done for a hundred and fifty years, even yourself!

These two scenes from Moneyball illustrate something that may be essential to modern business: the incredible value of youth and innovative thinking relative to traditional experience. It turns out that the Moneyball character Peter Brand’s real name is not Peter Brand (played by Jonah Hill), but rather Paul DePodesta. And he didn’t go to Yale, but instead Harvard. He was indeed young – twenty-seven when he went to work for Billy Beane – and he did have an actual degree in Economics. What’s more, as you can see in the interaction above, Billy valued Paul’s (Peter Brand’s) opinions and decisions – despite the fact that he was a complete novice with respect to baseball operations.

A month or two ago, I had the unique opportunity to share the stage with Billy Beane at a management offsite for one of the leading companies in the Fortune 500. We were both fielding questions about innovation, and what one can do to keep their organization innovative. I talked about how many of the partners that have joined Benchmark Capital have been extremely young when they joined, including our most recent partner Matt Cohler who joined us at the age of 31. At Benchmark, we believe that young partners have many compelling differentiators. First, they will ideally have strong connections and compatibility with young entrepreneurs, who are frequently the founders of the largest breakout companies. They are also likely to be frequent users of the latest and greatest technologies (all the more important with today’s consumer Internet market). Like the “Moneyball” situation described herein, young VCs are open to new ways of doing things. This form of “rule-breaking,” or intentionally ignoring yesterday’s doctrine, may in fact be a requirement for successful venture capital investing.

When I mentioned this intentional bias towards youth, Billy Beane abruptly concurred. He noted that injecting youth into the A’s organization is also a key philosophy of his. Paul DePodesta may have been the first young gun that Billy hired, but he was far from the last. Billy continues to recruit young, bright, talented people right out of college to help shake up the closed-minded thinking that can develop with an “experience only” staff. Also noted was the fact that if a certain “experience” is shared by all teams in the league, then it is no longer a strategic weapon. You can only win with a unique advantage.

The impact of youth on the technology scene is undeniable. The included table lists the founding age of some of the most prominent founders of our time. The facts are humbling and intimidating, especially for someone who is no longer in their twenties or early thirties. Can someone in their forties be innovative? Or, do the same things that produce “experience” constrain you from the creativity and perspective needed to innovate?

Lets look at some of the specific advantages of youth. First, as mentioned before, without the blinders of past experience, you don’t know what not to try, and therefore, you are willing to attempt things that experienced executives will not consider. Second, you are quick to leverage new technologies and tools way before the incumbent will see an opportunity or a need to pay attention. For me this may be the bigger issue. The rate of change on the Internet is extremely high. If the weapon du jour is constantly changing, being nimble and open-minded far outweighs being experienced. Blink and you are behind. Youth is a competitive weapon.

The point Billy raised regarding the fleeting value of experience is also important to consider. As the world becomes more and more aware of a trick or a skill, the value of that experience begins to decay. If word travels fast, the value of the skill diminishes quickly. Best practice becomes table stakes to stay-afloat, but not to get ahead. We see examples of this every day with Facebook application user acquisition techniques. Companies find a seam or arbitrage that creates a small window of opportunity in the market, but quickly others mimic the same technique and the advantage proves fleeting.

Back before the Yahoo BOD hired Carol Bartz, there was much speculation about the important traits for Yahoo’s next CEO. Most of the analysis honed in on two key traits for the company’s next leader – the ability to lead and the ability to innovate. I remember trying to think about leaders that I thought would have a chance at having a measurable impact. On one hand, you could put a very young innovative executive into the role, but it is hard to imagine handing a $15B public company over to someone remarkably inexperienced. The other side of the coin is equally difficult – thinking of a seasoned executive who has the ability to dramatically innovate Yahoo’s products and business model.

There were only a handful of people (as few as three) that I could think of at the time that fit this second profile. Thinking back now, they all shared the following characteristic: despite being experienced CEOs, these individuals all “thought young” i.e. they were open-minded and curious. And they did not believe that experience gave them all the answers. These type of executives love diving head-first into the latest and greatest technologies as soon as they become available.

If you want to stay “young” and innovative, you have no choice but to immerse yourself in the emerging tools of the current and next generation. You MUST stay current, as it is illusionary to imagine being innovative without being current. Also realize that the generational shifts are much shorter than they were in the past. If you were an innovative Internet company five short years ago, you might have learned about SEM and SEO. Most of the newly disruptive companies are no longer using these tools as paths to success – they have moved on to social/viral techniques. The game keeps changing, and if you are not “all-in” in terms of learning what’s new, than you may be falling rapidly behind.

Consider these questions:

  1. When a new device or operating system comes out do you rush out to get it as soon as possible – just because you want to play with the new features? Or do you wait for the dust to settle so that you don’t make a mistaken purchase. Or because you don’t want to waste your time.
  2. Do you use LinkedIn for all of your recruiting, or do you mistakenly think that LinkedIn is only for job seekers? How many connections do you have? Is your profile up to date? (When Yahoo announced Carol Bartz as CEO, I did a quick search on LinkedIn.  She was not a registered user.)
  3. When you heard that Zynga’s Farmville had over 80MM monthly users, did you immediately launch the game to see what it was all about, or do you make comments about how mindless it is to play such a game? Have you ever launched a single Facebook game?
  4. Do you have an Android phone or do you still use a Blackberry because your Chief Security Officer says you have to? I know many “innovators” who carry an iPhone and an Android, simply because they know these are the smartphones that customers use. And they want exposure to both platforms – at a tactile level.
  5. Do you use the internal camera app on your iPhone because it’s easy, or have you downloaded Instgram to find out why 27mm other people use that instead?
  6. Do you leverage Twitter to improve your influence and position in your industry or is it more comfortable for you to declare, “why would I tweet?,” before you even fully understand the product or why people in similar roles are leveraging the medium? Do you follow the industry leaders in your field on Twitter? Do you follow your competitors and customers? Do you track your company’s products and reputation?
  7. How many apps are on your smart phone? Do you have well over 50, or even 100, because you are routinely downloading each and every app from each peer and competitor you can to see how others are exploiting the environment? Do you know how WhatsApp, Voxer, and Path leveraged the iphone contact list for viral distribution?
  8. Do you know what Github is and why most startups rely on it as the key center of their engineering effort?
  9. Have you ever mounted an AWS server at Amazon? Do you know how AWS pricing works?
  10. Does it make sense to you to use HTML5 as your mobile solution so that you don’t have to code for multiple platforms? Does it bother you that none of the leading smartphone app vendors take this approach?
  11. When you are on the road on business, do you let your assistant book the same old car service, or do you tell them, “I want to use Uber just to see how it works?”
  12. When Facebook launched the new timeline feature did you immediately build one to see what the company was up to, or did you dismiss this as something you shouldn’t waste your time on?
  13. Have you been to Glassdoor.com to see what employees are saying about your company? Or have you rationalized why it’s not important, the way the way the old-school small business owner formerly dismissed his/her Yelp review.

The really great news is that being a “learn-it-all” has never been easier. With the Internet, high-speed broadband, SAAS, Cloud-services, 4G, and smart-phones, you can learn about new things, 24 hours a day, no matter where you are or what you do. All you need is the internal drive and insatiable curiosity to understand why the world is evolving the way it is. It is all out there for you to touch and feel. None of it is hidden.

There are in fact many “over 30” executives who can go toe-to-toe with these young entrepreneurs, precisely because they keep themselves youthful by leaning-in and understanding the constantly evolving frontier. My favorite “youthful” CEOs are people like Marc Benioff and Michael Dell, who frequently can be found signing up for brand new social networking tools and applications. Reed Hastings has more than once answered Netflix questions directly in Quora.  Jason Kilar frequently communicates directly with his customers through Hulu’s blog. Rich Barton, the co-founder of Expedia and Zillow is one of those people carrying both an Iphone and an Android, and is constant learning mode. I would also include Mark Cuban, whose curiosity is voracious. The other NBA owners never saw him coming. And lastly, there is Jeff Bezos, who seems to live beyond the edge, imagining the future as it unfolds. Watch the launch of Kindle Fire in NYC, and you will have no doubt that Jeff plays with these products directly and frequently.

Our last table highlights the stats from the Twitter account of some of these “youthful,” learn-it-all executives (sans Mr. Bezos – we all wish he tweeted). If you don’t find this list interesting, think about the thousands and thousands of executives out there who are nowhere to be found with respect to social media. They take the easy way out, likely blaming their legal department. They intentionally choose not to learn and not to be innovative. And they refuse to indoctrinate themselves to the very tools that the disrupters will use to attack their incumbency. That may in fact be the most dangerous path of all.

[Follow Me on Twitter]

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You Don’t Have to Tweet to Twitter

Posted on November 15, 2011. Filed under: advertising, Facebook, Internet, IPO, social networking, Twitter, Uncategorized, Venture Capital, Web/Tech | Tags: , , , , |

Frequent comparisons to Facebook leave many confused about the true value of Twitter.

[Follow Me on Twitter]

“In a brand new direction
A change of perception
On a brand new trajection”
UB40

[Disclosure: Benchmark Capital is a major investor in Twitter, and my partner Peter Fenton sits on the Twitter BOD.]

Twitter is having a remarkable year. Active users have soared to over 100 million per month, with daily actives now above 50 million. Tweets per day are over 250 million. Most top actors, athletes, and artists are all active on Twitter. Every news and sports program proudly advertises its Twitter account handle. No one would consider running for public office without a strong Twitter presence. Global news in any region breaks first and spreads fast on Twitter. Even uber-socialist Hugo Chavez of Venezuela has 2.24 million followers (which puts him slightly behind Mandy Moore, but just ahead of Queen Latifah).

So, Twitter’s traffic has been growing in leaps and bounds. It has become an indispensable tool for managing personal and corporate brands. And Twitter, along with its verb form “tweet”, have become words in everyday usage all over the world. Yet despite these impressive strides, Twitter’s upside is far, far greater and its user base will expand by an order of magnitude – as soon as the service can overcome a major perception problem.

Twitter suffers from two key misperceptions that need to be resolved before the business can reach its true potential. The first misperception is that Twitter is simply another social network, like Facebook. People commonly think of Twitter as a variant of Facebook. The press frequently positions the two together as “leaders in social networking.” This pairing erroneously implies that the two services are used for the exact same thing, even though the two platforms are very different. Facebook is a few-to-few communication network designed for sharing information and life events with friends. Twitter, on the other hand, is a one-to-many information broadcast network. The only way magic happens on Facebook is through reciprocity: I friend you and you friend me back – then information flows. But on Twitter, I can get something out of following Shaquile O’Neil who has no social obligation to follow me back.

As its roots are in communication, a key part of the Facebook value proposition is sharing information. Any potential anxiety with regards to Facebook sharing is reduced by the fact that these communications are generally seen only by one’s friends. In fact, users react quite negatively when this information is unknowingly shared more broadly. For the people who view Twitter as a Facebook variant, they immediately assume the platform’s core purpose is for the user to broadcast his or her own thoughts and personal information (like Facebook), but to a much broader public audience. For those with this perception, the notion of potentially exposing their own private thoughts to the broad public Internet is overwhelming and uninteresting.

The second, and more critical, Twitter misperception is that you need to tweet, to have something to say and broadcast, for the service to be meaningful to you. For many non-Twitter users, Twitter is an intimidating proposition. “Why would I tweet?,” and “…but I don’t want to tweet” are two common refrains from the non-adopter that highlight this key misperception. But this completely misses the point as to why Twitter has become such an amazingly powerful Internet destination for 100 million others. For the vast majority of Twitter’s next 900 million users, the core usage modality will have very little to do with “tweeting,” and everything to do with “listening” or “hearing.”

Twitter is an innovative and remarkable information service. While it is amazingly democratic and allows literally anyone to broadcast publicly as a “tweeter,” the core value in today’s Twitter is the amazing flow of curated and customized information that emanates from its crowd-sourced user feeds. Other Internet networks like to keep the user “inside.” Much like Google, Twitter points out to the world. It’s a “discovery engine” and an “information utility” rolled into one. With Twitter, you get news faster, you see updates from your favorite artists, you hear directly from key politicians, and gain insights from influencers in a wide variety of specializations. Just as Facebook is symmetric in terms of its poster-reader relationship, Twitter is highly asymmetric. The majority of the tweets on Twitter are posted by a small sub-set of the users. And the majority of the users get value from “reading” or “listening” to the tweets from these core influencers. Once again, for most users it’s more about what you hear, learn, and find than the fact that you can tweet.

In many ways, Twitter is much more of a competitor to other “discovery tools” and “information sources” than it is to Facebook. Facebook is unquestionably the number one resource for “sharing with the people in your life.” From this perspective, Facebook competes (extremely well) with email, instant messengers, and certainly other symmetric social networks like MySpace. Twitter, on the other hand, competes most directly with other tools that help you find important links, news, and information. It is in this broad, non-friend based crowd-sourcing and speed of discovery where Twitter truly shines. A recent Tweet by famed sci-fi author William Gibson highlights this point. Having become accustomed to the non-linear speed of information flow on Twitter, Gibson grew frustrated watching news of the Osama bin Laden killing on TV: “Network news feels like trying to suck cold tar through a milkshake straw.

Some who understand this point have suggested that Twitter is merely a “Better RSS reader.” While this analogy is directionally more accurate than the Facebook comparison, it greatly underestimates the power and value of Twitter. RSS feeds are simply computerized information “routers” that require complex setup, initialization, and maintenance. Twitter has three breakthroughs that make it dramatically more powerful than simple RSS. First and foremost, your personalized Twitter feed is human-curated by a potential universe of millions of curators. When you “check Twitter” you are looking at the specific articles and links purposefully chosen by people you have chosen to follow. That is powerful leverage. Second, it is easily extensible. Due primarily to the concept of “retweeting,” the simple act of using Twitter exposes you to new and interesting sources to follow. It evolves into a richer and more customized offering over time. You discover new people as well as new information. Lastly, Twitter’s unique handles and follower networks create a strong-form network effect that has high lock-in and high switching costs. Twitter and its top tweeters have a deeply symbiotic relationship.

So what can Twitter do to solve this misperception problem? The first thing they can fix is the new user registration flow, a process that has already begun. Earlier this year, a new user would be encouraged to “tweet” very early in the registration process, basically reinforcing the perception problem. Today’s “first 60-second” Twitter experience is quite different and revolves around choosing the influencers you will follow. You should expect even more evolution in this direction in the future. Next, Twitter must make it crystal clear to the press and prospective user that there is an amazingly powerful value proposition for non-broadcasting users. This will not be easy, as it requires a reprogramming of perception across a broad audience. Not only will this aid in incremental adoption, but it will also help subdue the confusion with respect to Facebook.

Twitter is on an amazing trajectory and will continue to increase in usage and influence.  However, the power of this discovery platform is much more about the tweets themselves, and not simply about every single user having the ability to tweet.

[Follow Me on Twitter]

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Google’s Acquires ITA: Will Deeper Vertical Integration Lead to Higher Revenues?

Posted on July 8, 2010. Filed under: advertising, Internet, Uncategorized, Web/Tech | Tags: , , , , , |

“It’s funny how fallin feels like flyin,
for a little while…”

– Jeff Bridges, Crazy Heart Soundtrack

On July 1st, Google announced its intention to acquire ITA Software. ITA owns a primarily B2B airfare search and pricing system called QPX. Several of the leading online travel sites, like Orbitz, Kayak, and Bing Travel, use information from QPX to power their airfare search. Many in the industry view this move as a seminal event in Google’s history, as the company makes a decisive step from being a general search engine, into more structured vertical search. Certainly, Google already offers vertical search in Images, Videos, Maps, News, and several other categories. Despite that, ITA feels different. Perhaps the difference is that this is a step into a vertical where many independent incumbents, like Priceline and Expedia, who are material customers of Google, have large established businesses.

There are two reasons mentioned for why Google feels compelled to dive deeper into verticals. The most straightforward explanation is competitive pressure. Following its own acquisition of Farecast, Microsoft has subsequently launched Bing Travel, a much richer travel search product than offered on Google today. The second argument given for the move is that by moving deeper into verticals, and closer to the actual transaction that Google can actual make more money per visit. This argument suggests that CPA (cost-per-action) is a fundamental improvement over Google’s current business model, CPC (cost-per-click). The competition argument seems obvious and accurate. However, it is not at all clear that going deeper in verticals will raise Google’s revenues. In fact, there are several scenarios where they could actually go down.

Let’s first address the easy part – competition. Bing buys Farecast and Google needs to respond. This make sense, but it is not the whole story. If you are searching for a book or an author you go to Amazon, or at the very least you do a search like “Man in Full Amazon” so that you go directly to the page you want on Amazon. The same is true for hotels with TripAdvisor and for restaurants with OpenTable. These sites offer deeper and richer experiences for a vertical searcher precisely because they incorporate deep meta-data, faceted search, transaction connectivity, and typically a form of community or UGC (user generated content). These things simply do not exist in the simple but limited Google user interface that Om Malik affectionately refers to as “10 blue links.”  So Google has competition in verticals not just from Microsoft, but also from best of breed vertical sites offering users a richer, deeper experience.

Some have suggested that Google’s move into a deeper vertical experience is more about greed (more money) than fear (competitive) response. The argument voiced by Barclay’s analyst Douglas Anuth and others, is that by moving closer to the transaction, Google can ask for CPA fees, which naturally carry higher margin. Clearly, a single CPA fee will be much higher than a single CPC fee, but you will also have much fewer of them. The variable that links the two is conversion. One can certainly argue that Google can drive higher conversion if they can help drive the customer closer to the actual result they need. This will require a materially better product. Even then, however, there are two key reasons Google may not see higher revenue with deeper vertical integration.

Reason #1: Irrational CPC Pricing on Google Today, “Uber-Optimization”

Some might argue that Google’s current bid-based CPC model results in “optimal” pricing. The argument would be that the market-clearing price settles out at the precisely rational price for each and every keyword pair. A market-place model naturally results in efficient pricing. While this makes logical sense, we all know that there are companies participating in the CPC purchasing game who simply are less sophisticated than others. Moreover, many of these buyers win bids and have huge CPC budgets. The point is that there are plenty of startups, arbitragists, and even large companies “experimenting” with CPC purchasing in an attempt to gain an edge. The winner in this bidding game isn’t the most rational, but simply the one with the highest price. Certainly, over the long run if a company irrationally pays too much for CPC ads, they will eventually go out of business. But the key word here is eventually. For a long period of time, they are paying an “uber-optimized” price for their keywords.

If there are enough of these players in the market, then Google’s CPC prices aren’t economically rational. Rather, they live slightly above that level driven by irrationality and experimentation in the market. If you have a hard time with this theory try typing a search term like “laser treatments” in Google and look through the list of CPC purchasers on the right side of the screen. Would you put money in these companies?  Do you have confidence they will be around in ten years?  Have you ever heard of them? It gets even better. Many believe that Google uses a low quality rating score on these “middle-men” to force them to pay a higher fee for a single CPC, thus getting an even higher price than previously discussed. That’s right, for certain CPC buyers, Google has a mechanism for extracting an even higher price, even if the buyer is already the high bidder!

As Google moves past its “10 blue links” model and connects directly to airlines, hoteliers, etc, it will be removing the irrational and arguably temporary middle-man from the system. This fleeting but determined participant, very likely has a negative long term ROIC, and Google, riding the brilliance of the CPC model, stands as the beneficiary. With this player out of the system, and with the connections directly to the service provider, the model will naturally trend to a more efficient pricing.  You will have fewer larger players, who are all more rational, and all more experienced. As such, you would have to expect more rational, and therefore lower, pricing. Building a better product could actually result in less lead-generation revenue.

Reason #2:  Moving from a Marketing Channel to a Transaction Channel

If you have ever sold anything on the Internet, ask yourself the following question. What is the maximum amount you would want to pay for a transaction fee?  5%?  10%? There is data in looking at typical affiliate fee percentages, which can range from say 4-15%. Amazon charges 6-15%. Ebay charges about 11% (with Paypal).  Comparison shopping engines make even less. When an etailer assumes they are “always going to pay” for something on every single transaction, they are very sensitive to the % of revenues, as this payment will always reduce their margin. One could assume the general average for all affiliate fees or similar distribution type arrangements is around 10%.

Now, ask someone in your marketing department how much they are willing to pay to “acquire a customer.” While I don’t pretend to support this logic, the Lifetime Value of the Customer (LTV) model depicted herein mesmerizes many marketing managers. Using this simplistic but highly regarded model, many marketers justify “acquiring a customer” not as a percentage of revenue, but as a percentage of life-time value. The key to reaching this Zen state of marketing awareness is to believe that Google is sending you this customer only this one time, but for here ever after this customer is going to come directly to your own site, bypassing Google. This logic supports a much larger denominator, known as LTV. With LTV, ad buyers are easily willing to spend 25-50% of a first purchase in order to “acquire a customer.”

We could talk forever about the LTV formula, and we could argue back and forth about its efficacy, but that would miss the point. Consider the following assertion. People that are buying CPC ads are frequently marketers, and marketers are much more likely to think in terms of LTV. When you enter into a CPA deal it feels very transactional. When you do deep integration it feels very transactional. And, if Google is building a deep vertical site in travel that will pass leads to companies like American Airlines it will feel very transactional. It will be harder and harder to assume that you are “acquiring a customer,” and it will feel more and more like you are paying a distribution fee to a channel. As such, it may turn out that moving deeper into a vertical will puncture the illusion that marketers are “acquiring a customer” from Google, and get them in touch with the fact that they have a permanent CPA “transaction fee” they need to “pay” to Google. The end result is a lower overall rake for Google with the per transaction model.

Could this be wrong? Absolutely. Perhaps conversion rates will triple due to the incredible design, implementation, and ease of use of the Google’s new product, more than offsetting the two points we just mentioned. Or perhaps, Google will have such a powerful place in the travel ecosystem that travel companies will simply be “price-takers.” If this is the case then Google will once again find the exact right way to optimize their business model. It is equally likely, however, that Google’s current business model is highly, highly optimized and tweaking it may have as much risk as upside.

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When It Comes to Television Content, Affiliate Fees Make the World Go ‘Round

Posted on April 28, 2010. Filed under: Internet, online video, Uncategorized, video, Web/Tech | Tags: , , , , |

“The clock on the wall’s moving slower
My heart it sinks to the ground
And the storm that I thought would blow over
Clouds the light of the love that I found”

Fool in the Rain, Led Zeppelin

More often than not, we here in Silicon Valley are prone to idealism. We see a scenario the way we want to see it, and make predictions that fit our view of how we think the world should work, or perhaps even how we would like the world to be. This is especially true when it comes to technology. Outsider “luddites” who do not immediately grok the remarkable disruptive power of our latest and greatest technologies are doomed to the business trash heap – driven there by obsolescence and an obstinate refusal to accept their fate. Often times, our version of them “accepting their fate” would require them to abandon everything they know, walk away from the majority of their revenue, and terminate 80% of their employees. But hey, that’s their problem, not ours. We love disruption. It serves our purpose.

One often discussed target of such criticism is the media industry. There is a widespread belief that Hollywood now faces the same digital threat that has plagued the music industry over the past ten years. The argument goes something like this: There is nothing Hollywood can do to stop this train. The problem, you see, is that technology is merciless, impersonal, and unforgiving. Video can be turned into bits; Moore’s Law will make a pile of bits smaller and smaller over time; and efforts to erect pay walls will prove fruitless and even Quixotic. Studio heads should simply throw in the towel now and take what’s coming to them. Denial equals delay, and delay costs you time away from learning how to execute within your new constraints. All content will be free, and you simply have to live with that fact. The sooner you get in touch with it the sooner you will learn to execute in the new reality.

There are three key reasons why Hollywood is under less duress than Silicon Valley wants to believe. For starters, the leaders are wide-awake. Ever since Boxee offered Hulu (and were told to stop), the executive ranks at the major cable companies have been alert and engaged. Second, Hollywood has a solid track record of enforcement. They understand the stakes are high, and they are willing to invest in lobbying, regulation, litigation, and enforcement. They are also unafraid to throw around their weight (witness Viacom vs. Google). The final and most significant reason is that this is a massive, massive business, and it is critically important to understand where the money flows (most people don’t). You can spend plenty of time talking about other issues, but when it comes to understanding the key factor at play in nearly every major business decision in television, you will find affiliate fees – all $32 billion of them.

For those who do not know, affiliate fees are the primary revenue stream that funds today’s mainstream television content development. These are basically a “share” of the subscription fee you pay to your cable or satellite operator that is then shared back to the content owner/distributor (typically on a per subscriber basis). As an example, you will hear that some less notable cable-only channel was able to negotiate $0.25/sub/month, or that ESPN can negotiate $2.00/sub/month, because any aggregator would be afraid to market a television package without ESPN. Over the past 30 years, these fees have become the lifeblood of the TV content business – affecting how the major aggregators think and operate, and also affecting how content is produced, financed, and packaged.

Here are some specifics to help frame the issue. According to Matthew Harrigan at Wunderlich Securites, in 2009 DirecTV paid approximately $37/sub out of an ARPU of $85/sub to content owners for programming costs (i.e. affiliate fees). In this case, affiliate fees represent roughly 43% of total revenue for DirecTV. Similarly for Comcast, Matthew estimates programming costs at 37% of video revenue (Comcast has high-speed data and voice revenue that are separate). These are just two examples, but to give you a sense of scale these numbers represent around $7-8 billion/year each for Comcast and DirecTV. The recent, and very well written Business Week cover story on this same topic pegs the aggregate fees of all content providers at $32B per year. These are big, big numbers. To put things in perspective this is about 33% higher than Google’s annual global revenues including revenues for its advertising network.

These affiliate dollars flow through to the content producers. Estimates suggest that the annual affiliate fee revenue at companies like Viacom and Disney is around $1.5B and $2.0B respectively. On their own, numbers this large would obviously be motivational to corporate executives. But the reaction is even more intense because affiliate fees “feel like” 100% gross margin revenue. From a cost accounting perspective, a studio should allocate these fees across the content development costs, and therefore, they are not explicitly 100% GM. But as there are no significant variable costs related to the deployment of these programs to the carrier, most content owners cannot help but think about affiliate fees as 100% gross margin and therefore the key contributor to overall profitability.

Affiliate fee optimization is the key objective behind many of the industry’s most high profile strategic moves.  Here are a few examples.

  1. Cablevision vs WABC. Recently, there was a high profile stand-off between WABC in New York City and Cablevision. As is often the case, the content owner here was threatening to cut-off access to their content precisely before a very high profile and high demand piece of content was set to air. This particular piece of content was the Oscars. A cable channel owner holds up a cable company to extract a higher per-sub affiliate fee for the next contract. They always put the customer in the middle, and both sides try to argue that they are virtuous and that the other is greedy. There have been numerous examples like this over the years, and it is common to see one of these showdowns each and every year.
  2. Modern Day Cable Channel Strategy. Today’s most typical cable strategy is built entirely around profit maximization utilizing affiliate fees. If you own a cable channel, your goal is to develop one or two key, hit programs, and fill the rest of the linear lineup with very inexpensive content. The “hits” make you a “must have” for any cable or satellite carrier – granting you the right to ask for fees. Too many hits drive up costs. This is why you will see more and more hit shows on the less well-known cable channels. Mad Men on AMC is a perfect example. How can a cable company not offer Mad Men? Once you nail the single channel game, you immediately try to proliferate that into multiple channels a la MTV and ESPN.
  3. Comcast Acquires NBC. Why would a cable distribution network want to own content?  First, it’s a hedge against rising content costs (affiliate fees).  Second, it offers leverage vis-à-vis their competition.  DirecTV needs NBC.  DirecTV will have to negotiate affiliate fees for NBC with Comcast (Comcast also owns other channels like E! Entertainment, The Golf Channel and Versus).  This helps keep Comcast’s business model in check.  It’s also why Comcast made a huge play for Disney in 2004. Affiliate fees have been rising for some time.
  4. Networks Ask for Fees. For the longest time, the major networks were not part of the affiliate fee gravy train. In fact, due to “must carry” laws, most networks never considered intentionally restricting their own distribution. They were simply pleased to get redistributed over cable and satellite. As these fees have grown in size and importance, the networks have changed their position and have come to the table asking for affiliate fees also. The WABC case above is one such example.
  5. Oprah Asks for Fees. Many people seem confused by Oprah’s decision to abandon her network television show after 25+ years of unquestionable success and relaunch it within her own cable network. Why would she do such a thing? Because she can. When Oprah launches her own network (with the help of Discovery), she will get per sub affiliate fees. Which cable company is not going to carry Oprah?  What programs will be on during the other 23 hours? As stated in #2, it really doesn’t matter. They still need to carry the Oprah channel. That said, Oprah has proven she can launch other personalities (Dr. Phil), and one would suspect that any new celebrity she “launches” will be tied to the Oprah network, increasing her leverage and her affiliate fees.
  6. Sports Networks Ask for Fees. Affiliate fees are driving an endless supply of channels for anyone that has “must see” content. The NFL has a channel, and had some high profile disagreements with the carriers over the “need” for its affiliate fee. You also see an NBA channel, an MLB channel, and pro wrestling is vying for one as well. If you own exclusive content, you might as well build a channel around it. This endless proliferation of channels will one day reach a limit, but for now it’s the game on the field.
  7. Hulu/Boxee. Many people blamed Hulu for its decision to block access on the Boxee platform. These users simply didn’t understand the power of affiliate fees. Comcast told NBC/Fox that if Hulu could distribute their content for free, then they would like to take their own affiliate fees (the newly negotiated ones in #4) to $0.00. This caused NBC/Fox to tell Hulu that maybe Boxee isn’t such a good idea.

In addition to not appreciating these money flows, most of the digerati in Silicon Valley have huge misperceptions about the content owner’s preferences. They assume that content owners would like to distribute directly to consumers precisely because the Internet allows them to do so. They would no longer  be in the “death grip” of the content packager (cable and satellite companies) who take an unreasonable fee for their services. This is simply not how these content owners view the world.

Content owners absolutely prefer to be aggregated in a bundle of channels and, as a result, to receive affiliate fees. They also have little interest in “a la carte” packaging, a concept dreamed up by regulators in Washington but not desired by the heads of the content studios. Simply put, there is adequate value provided in distribution and revenue collection. To launch a direct channel (and forgo these fees), and then attempt to regain your customers one by one is a harrowing experience. Why earn your customers one by one when you can get to mass volumes, and a fixed amount of recurring revenue, through a distribution partner? If you create a new piece of camping equipment would you sell it online or try to obtain distribution through REI?

ESPN360 is a solid example of content owner’s preference for the affiliate fee driven/ distribution partner model. As the Internet became fast and pervasive, ESPN (owned by ABC/Disney) saw a clear opportunity to deliver more programming to their users and launched an online-only product called ESPN360 (recently renamed ESPN3). This on-demand, “over the top” offering is a killer product for the true sports fan, offering access to significantly more live games that was ever possible on a traditional linear cable channel. Despite the fact that ESPN has the brand, the reach, the market power, and the technology to charge users directly for this new product, they chose a different path. ESPN sought out distribution partners to bundle ESPN360 in with their standard video television packages, even though this was confusing and even baffling to most Internet users.

So against this backdrop, the cable companies have developed a remarkably shrewd strategy to simultaneously leverage their broadband infrastructure and affiliate-fee money flows. This concept, known as TV Everywhere, has two main components (once again, this move by the cable companies is extremely well articulated in the recent Business Week cover story on the same subject). First, you tell your customers that you want to provide them with a killer new service. They are already paying for all the content they receive through the linear channel stack. What if that same content could be viewed at any time “on-demand” and also through multiple devices (TV, PC, and mobile)? Sounds great so far. Who wouldn’t want this? And “everything” on a service like Comcast is more than any digital aggregator has yet even dreamed of aggregating. Ignore for a moment that this is not completely working just yet and focus on what they will “eventually” deliver. It’s also helpful to show the FCC you are being innovative, and not resting on your laurels the way a true monopolist would. Check.

Next comes the clever part.  The cable companies go to the content owners and make the following argument. With Internet-connected TVs on the horizon, you can no longer separate the Internet from the TV or the office from the living room. We pay you an affiliate fee to distribute your content to the homes we serve. We understand you have multiple distribution partners. What we don’t understand is why you would give content to some of them for free, and still expect us to pay our feesCheck-mate. This is the move that forced Hulu to a subscription model. The content owners, struggling with depressed advertising rates as a result of the global recession, quickly acquiesced to Rupert Murdoch’s assertion that maybe all their content should have a price.  Disruption disrupted.

Some have even suggested that Comcast has approached the large networks and offered an “extra” affiliate fee of around $0.50/sub to pay for over-the-top rights. Proactively increasing your own costs is a fairly unique business strategy. But this move also increases the costs for the disrupters, who are far less likely to be able to afford it.

As a result of these maneuvers, the current trend in the market is for less rather than more prime-time content to be openly available for free on the Internet.  Do you remember when South Park boldy made all episodes available for free on the Internet? Check out where things are today.  Try to watch the recent Facebook parody “You Have 0 Friends,” and you will receive the official message “DUE TO PRE-EXISTING CONTRACTUAL OBLIGATIONS, WE CANNOT STREAM THIS EPISODE UNTIL 05.08.10.” They may have wanted it to be free, until someone threatened to take their affiliate fees away. Viacom also recently removed shows like “The Daily Show” and “The Colbert report” from Hulu noting that “we could not agree on a price.” Suggesting there is a “price” at all would indicated they were discussing affiliate fees, as opposed to ad splits.

While this likely enrages the disruption enthusiasts, expect this trend to continue over the next year. More and more content owners will rip their shows “over the paid wall” as they get reacquainted with their own affection for affiliate fees. There is much speculation about Hulu’s forthcoming subscription launch with many journalists hopefully optimistic that Hulu as we know it will remain free and that all sorts of new features (TV support, iPhone support) and content (movies, back catalog) will be behind the paid wall. They may be surprised to find that “paying” may be necessary just to obtain what users see today. Affiliate fee parity may demand it.

So does this imply the end of all digital packagers? Not at all. Most clearly, NetFlix has successfully built a hybrid physical/digital strategy while maintaining its “all you can eat” model. It is also going toe-to-toe with other packagers by striking deals to lock up digital content (including TV programming). Furthermore, Hulu has executed well beyond anyone’s original expectation, and there is no reason to expect that to change as they move to a new model. One would expect them to continue to lead in terms of ease-of-use and simplicity even within a new model. Also keep in mind that Amazon has a strong VOD offering integrated into its overall purchasing experience, and many suspect both Apple and Google will enter the game as well. Despite this level of competition, all of theses vendors will need to find unique ways to compete against TV Everywhere. And with “free” off the table, the dimensions of competition will be inherently less disruptive.

There are two other potential challenges for non-facilities based content aggregators. First, as was the case with Satellite radio, we may see a “no holds barred” price war break out in an attempt to grab “exclusive” content to distinguish one’s package. As we all know, exclusive deals with the likes of Howard Stern nearly killed XM and Sirrus. DirecTV already pays $700 million per year to the NFL to have an exclusive offering of every NFL game on every weekend (NFL Sunday Ticket), and they recently coughed up over $4 billion to extend this deal. Wow. What if other digital “packagers” look for unique differentiation by leveraging the cash on their balance sheet? If this happens, any digital aggregator without deep pockets will be holding a knife at a gun fight.

The second externality that could cause trouble is “bandwidth limits” or “metered usage” on the Internet. While some people assume this will never happen (especially the idealist in Silicon Valley), the quiet momentum is building. There are continuing tests at AT&T and Time Warner, and AT&T’s president Randall Stephenson spoke openly about metered Internet pricing as recently as a month ago. Also, the Supreme Court recently put the kibosh on the FCC’s deliberate effort to make net neutrality one of its defining policies. This is perhaps an entirely separate post, but one should be confident that the rate charged the consumer by the owner of the transport for one hour of Internet video would be quite a bit higher than that for one hour of the same video over their own “optimized” TV infrastructure (backed up with an ample helping of technical analysis and white papers).  The fox isn’t just guarding the henhouse, he designed it.

There are still two legitimate arguments that trump all these discussions of affiliate fees and deft corporate strategy – piracy and content democratization.  Let’s start with piracy.

What if “BitTorrent 2.0” in whatever form it takes is just blatantly unstoppable?  No matter what you do, content has become too small relative to the big broad pipes and storage devices.  Technology trumps determination, and the minute something has been shown once, it will be free for all takers.  Isn’t this true in China today? It’s a big leap from expecting this to happen “someday” to expecting a content creator/owner to throw caution to the wind and immediately adopt a strategy that is congruent with unlimited free distribution (what is this strategy by the way?  can’t ads be removed also?). Technology is inevitably a tough competitor, but so is regulation and enforcement, and you should expect that a mighty effort on the part of a multi-billion dollar industry would mute any expectation of an overnight transformation. In her latest post at All Things Digital, Kara Swisher suggests that a recent increase in the number of intellectual property enforcement officers at the DOJ may be a direct response to the immediate needs of the entertainment industry.

Other cheerleaders of the disruption bandwagon point to the undeniable future where the availability of low-cost, high-feature camcorders at BestBuy will lead to a mass democratization of content creation. In this brave new world, the bloated and lavish infrastructure of Hollywood will give way to thousands of mini-Tarantinos who produce hit after hit on shockingly low new-world budgets that redefine the content creation business. This is the video equivalent of the infinite monkey theorem.  While this may be true when it comes to low-budget formats like game shows, talk shows, and reality television, today’s fussy television viewer has come to expect a product that is much more equivalent to feature films than home movies. Each episode of Lost costs well over $1mm to produce. Cheap cameras do not disrupt “production quality”. And let’s not forget that The Blair Witch Project was over ten years ago, and desperately stands alone as an exception and not a rule.

In the long run, the disruption zealots may be right. It may all come undone in the unstoppable Armageddon of unlimited “all you can eat” content enabled by the undeniable liberation of all bits big and small. But with $32 billion on the line, don’t expect it to happen overnight. You will be sorely disappointed.

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Android or iPhone? Wrong Question

Posted on January 5, 2010. Filed under: iphone, Mobile, Uncategorized, Venture Capital, Web/Tech | Tags: , , , , , |

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In a recent New York Times article, Kathryn Huberty, a Morgan Stanley analyst was quoted suggesting that Apple’s iPhone is the key catalyst for an important new technology trend. “Applications make the smartphone trend a revolutionary trend – one we haven’t seen in consumer technology for many years.” This argument rings true in that the “after iPhone” smartphone market is dramatically more interesting than the “pre-iPhone” smartphone market. Later, Ms. Huberty made an even bolder statement, “The iPhone is something different. It’s changing our behavior…The game that Apple is playing is to become the Microsoft of the smartphone market.”  Or perhaps not.

Many analysts and bloggers have worked hard to position “iPhone vs. Android” as the title fight of the decade in the technology industry. It is an easy comparison to want to make. Both phones use rich microprocessors, are graphical, both have GPS and Wifi. They both run a sophisticated operating system, and they both give you access to thousands and thousands of third party applications. In most practical ways, they seem similar. However, there is one fundamental difference – business model choice.

When Apple launched the iPhone, it was able to secure an unprecedentedly strong business relationship with AT&T. Not only did Apple want control over the user interface, something carriers had been extremely reluctant to cede, it also wanted previously unrealized economics for a handset or OS designer. Apple insisted on upfront revenue dollars as well as a cut of the cellular service stream. AT&T, desperate for a win vs. Verizon, acquiesced.  The product was launched to rave reviews from analysts and consumers alike. It really was a brand new market and a brand new product. As noted earlier, we only “thought” we had seen smartphones before the iPhone. This market, as Ms. Huberty notes, looks like one that is Apple’s to lose.

With the iPhone’s massive success, it would be hard in retrospect to challenge the thinking behind Apple’s business model choice. After all, it will always be true that Apple was the company that “cracked open” the famed Walled Garden of carrier-land. They also did it with style, demanding golden economics as it disrupted a previously obstinate industry. And although AT&T may have become “comfortable” with its choices as a result of the iPhone’s success, other carriers suddenly had an “iPhone problem.” Enter Google.

If Apple’s business model is aggressive relative to the carriers, in contrast Google’s seems unrealistically accommodating. You want to control the user interface? No problem. Want access to the code? We’ll make it open source. What kind of economics do we want? Nothing at all.  What the hell, we will pay you!  That’s right.  Google will give the carrier ad splits that result from implementing the Google search box on any Android phone. FBR Capital Markets suggests that Google is taking this idea one step further in its November 24, 2009 report titled Implications of a Potential Share Shift to Android-Based Wireless Devices. “Recent support for Android-based devices appears to be correlated with significant up-front financial incventives paid by Google to both carriuer and handset vendors.” FBR goes on to suggest that these incentives may be as high as $25-50 per device. This is simply an offer that no carrier can refuse, particularly when U.S. carriers are currently in the habit of paying $50-150 per handset sold in subsidies.

While Apple may have opened the proverbial Walled Garden, it is Google, with its aggressive Android offering, that aims to obliterate it. Make no mistake about it; Apple was the pioneer with the amazing revolutionary product. Also, with no iPhone, there is no Android. This is not to say that Android copied iPhone, but rather the impetus to adopt and trust Google’s Android offering was driven by a market dynamic that resulted directly from the iPhone’s success.  Without the iPhone, it is possible that most carriers might have opted not to use Google’s OS solely for the reason that letting a powerful company like Google in the front door can be a risky strategic bet.

All of this is now history. The iPhone does exist, and it is wildly popular. There are an estimated 55 million iPhones in use around the world. Despite this remarkable success, history will also show that Apple intentionally chose a business model with plenty of room for disruption underneath its pricing structure. It also chose a single carrier as a partner, which resultantly threatened others. Then Google built a product and a strategy that allayed the carrier’s relative fears. Google gave them what they wanted, and then even gave them money. It could afford to do this because Google aims solely to protect the great business they already have in advertising, not to make money directly from the product (HW or SW in this case). Microsoft Windows, Internet Explorer, and Mozilla’s Firefox represent choke points on the personal computer whereby Google could lose search share, or at least be forced to pay a toll. In mobile, they see a chance to potentially eliminate the toll-takers.

With a business model that allows for much broader distribution and price points that are well beneath the iPhone, Google’s Android won’t compete directly with the iPhone.  For the iPhone loyalist, like Stewart Alsop who railed against Android, Android is simply not an option.  This price insensitive user demands the very best experience they can possibly have and this is still the iPhone. Users won’t switch in mass from the iPhone to the Android. It’s the other 3.95 billion cell phone users that are highly likely to consider Android a step up from their current feature phone. The Android strategy results in phones at much lower prices with much more diversity which will hit a braoder set of demographics. Apple can and will quintuple its current market share and still have a small portion of the overall cell phone market.

This is why the two products do not compete head to head. With its super aggressive model, Android will be the choice of the masses, and with its sleek design and non-compromising price point, Apple will rule the high end. Many have suggested that Apple is perfectly happy with its high-margin spot at the top of the food chain. They are doing exceptionally well with that position in the personal computer market – in fact, they are currently gaining share at an accelerating pace. So no need to worry about Apple, they are doing just fine (as their stock price suggests). They are just not currently executing a model to become the “Microsoft” of the smartphone market.

Some will argue that the best product will win the market and that Apple will still dominate the smartphone market. The history of the personal computer market is no omen for this thesis. If you think about it, the people that know this better than anyone are the exact Apple loyalists who have been frustrated for years at Apple’s lack of dominance in the PC market. Disruptive business strategies can and have trumped better products. And with no change to the current market, the Android leveraged position in the market could result in staggering unit share gains. This is not to say that the Google Android is better than or as good as the Apple iPhone. The key point is that it does not have to be. It only needs to be dramatically better than the current feature phone. Which it is.

While Apple will be fine as Android gains steam, the amount of shrapnel flying around this new marketplace is immense, so expect innocent bystanders to be compromised.  Recognize that as Google’s play here is as much defense as offense, they have less of a need to “make a profit,” at least right out of the gate.  This type of attitude always makes for a messy competitor.  Also, because of the sheer breadth of the effort in terms of number of handset makers and number of carriers, Android will be marketed extremely aggressively.  Lastly, the early application leaders are beginning to believe it’s a two horse race.  Currently the iPhone is priority number one.  That said, increasingly these application vendors are seeing Android as the primary second platform to support.  Others are falling further and further behind.

Also, Android doesn’t appear to be an OS that stops at the smartphone market.  Expect much experimentation with a variety of hardware manufactures and almost any and every embedded device market from navigation devices to e-readers to tablets and beyond.  Android gives every Korean, Taiwanese, and Chinese manufacture whoever wanted to approach these markets a huge head-start.  Additionally, the more of these vendors that build on Android, the more Android will evolve for the better.  The number of applications will increase, and the problems will get worked out.  Just like Microsoft worked its way from Windows to Windows 3 and eventually to Windows 7, Android will improve with time as well.

With its disruptive and leveraged strategy, it is Google that is attempting to be the Microsoft of the smartphone market.  Perhaps ironically, Apple is well positioned to be the “Apple” of the smartphone market.

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Google Redefines Disruption: The “Less Than Free” Business Model

Posted on October 29, 2009. Filed under: Internet, Uncategorized, Venture Capital, Web/Tech | Tags: , , , , , , , , |

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I like to think of myself as an aficionado of business disruption. After all, as a venture capitalist it is imperative to understand ways in which a smaller private company can gain the upper hand on a large incumbent. One of the most successful ways to do this is to change the rules of the game in such a way that the incumbent would need to abandon or destroy its core business in order to lay chase to your strategy. This thinking, which was eloquently chronicled in Clay Christiansen’s The Innovator’s Delimma, is the key premise behind recently successful business movements like SAAS (Software as a Service), open source software, and the much-discussed Freemium Internet model.  And while each of these disruptions are impressive in their own right, when I read this week that Google was including free turn-by-turn navigation directions with each and every Android mobile OS, I had an immediate feeling that I was witnessing a disruptive play of a magnitude heretofore unseen.

google_maps_logoGoogle has long had an interest in maps. Early in its history, the company added “Maps” as one of the coveted tab alternatives offered at the top of the screen above its famed search box. At that time, Google did what many others did to enter the mapping business – they licensed data from the two duopolists that ruled the mapping business – Tele Atlas and NavTeq. Over the years, as these two companies gained more and more power, and larger and larger market capitalizations, Google’s ambitions were growing too. Google wanted to spread its maps across the web, and to allow others to build on top of its mapping API.  The duopolists, recognizing a fox in the henhouse, were apprehensive to allow such activity.

Logo NAVTEQIn the summer of 2007, excitement regarding the criticality of map data (specifically turn-by-turn navigation data) reached a fever pitch.  On July 23, 2007, TomTom, the leading portable GPS device maker, agreed to buy Tele Atlas for US$2.7 billion. Shortly thereafter, on October 1, Nokia agreed to buy NavTeq for a cool US$8.1 billion. Meanwhile Google was still evolving its strategy and no longer wanted to be limited by the terms of its two contracts. As such, they informed Tele Atlas and NavTeq that they wanted to modify their license terms to allow more liberty with respect to syndication and proliferation. NavTeq balked, and in September of 2008 Google quietly dropped NavTeq, moving to just one partner for its core mapping data. Tele Atlas eventually agreed to the term modifications, but perhaps they should have sensed something bigger at play.

teleatlasRumors abound about just how many cars Google has on the roads building it own turn-by-turn mapping data as well as its unique “Google Streetview” database. Whatever it is, it must be huge. This October 13th, just over one year after dropping NavTeq, the other shoe dropped as well. Google disconnected from Tele Atlas and began to offer maps that were free and clear of either license. These maps are based on a combination of their own data as well as freely available data. Two weeks after this, Google announces free turn-by-turn directions for all Android phones. This couldn’t have been a great day for the deal teams that worked on the respective Tele Atlas and NavTeq acquisitions.

To understand just how disruptive this is to the GPS data market, you must first understand that “turn-by-turn” data was the lynchpin that held the duopoly together. Anyone could get map data (there are many free sources), but turn-by-turn data was remarkably expensive to build and maintain. As a result, no one could really duplicate it. The duopolists had price leverage and demanded remarkably high royalties, and the GPS device makers (TomTom, Garmin, Nokia) were forced to be price takers. You can see evidence of this price umbrella in the uniquely high $99.99 price point TomTom now charges for its iPhone application. When TomTom bought Tele Atlas, the die was cast.  Eat or be eaten. If you didn’t control your own data, how could you compete in the GPS market?  This is what prompted the Nokia-NavTeq deal.

garmin_stockGoogle’s free navigation feature announcement dealt a crushing blow to the GPS stocks. Garmin fell 16%. TomTom fell 21%. Imagine trying to maintain high royalty rates against this strategic move by Google. Android is not only a phone OS, it’s a CE OS. If Ford or BMW want to build an in-dash Android GPS, guess what? Google will give it to them for free. As we noted in our take on the free business model, “if a disruptive competitor can offer a product or service similar to yours for ‘free,’ and if they can make enough money to keep the lights on, then you likely have a problem.” It would be one thing if this were merely a mean-spirited play by Google to put an end to the GPS data duopoly. But it is not. There are multiple facets to this remarkably disruptive move.

While it is obvious that this maneuver creates a problem for the multi-billion dollar GPS market, it also poses real challenges for the leading smart phone players – RIM’s Blackberry and Apple’s iPhone. Without access to their own mapping data, these vendors now face an interesting dilemma. Do you risk flying naked without free navigation or do you suck it up and swallow the above average royalty fee for each and every handset? Neither option is stellar. This problem isn’t nearly as daunting as the one now faced by the Windows Mobile and Symbian teams.  As software providers, they are lucky to get a per unit royalty equal to that extracted by the GPS data guys. If they are now forced to integrate this data merely to keep their product competitive, their gross margin just went negative. Ouch!

This is not just incredible defense. Google is apt to believe that the geographic taxonomy is a wonderful skeleton for a geo-based ad network.  If your maps are distributed everywhere on the Internet and in every mobile device, you control that framework. Cash starved startups, building interesting and innovative mobile apps, will undoubtedly build on Google’s map API.  It’s rich, it is easy to use, and quite frankly the price is right. In the future, if you want to advertise your local business to people with an interest in your local market, chances are you will look to Google for that access.

Introducing the “Less Than Free” Business Model

android logoGoogle’s brilliance doesn’t stop there. It is hard not to have been surprised by the rapid rise in recent buzz surrounding the Google Android Smartphone OS. When I asked a mobile industry veteran why carriers were so willing to dance with Google, a company they once feared, he suggested that Google was the “lesser of two evils.” With Blackberry and iPhone grabbing more and more subs, the carriers were losing control of the customer UI, which undoubtedly represents power and future monetization opportunities. With Android, carriers could re-claim their customer “deck.” Additionally, because Google has created an open source version of Android, carriers believe they have an “out” if they part ways with Google in the future.

I then asked my friend, “so why would they ever use the Google (non open source) license version.”  (EDIT: One of the commenters below pointed out that all Android is open source, and the Google apps pack, including the GPS, is licensed on top.  Doesn’t change the argument, but wanted the correct data included here.)  Here was the big punch line – because Google will give you ad splits on search if you use that version!  That’s right; Google will pay you to use their mobile OS. I like to call this the “less than free” business model. This is a remarkable card to play. Because of its dominance in search, Google has ad rates that blow away the competition. To compete at an equally “less than free” price point, Symbian or windows mobile would need to subsidize. Double ouch!!

lessthanfree“Less than free” may not stop with the mobile phone. Google’s CEO Eric Schmidt has been quite outspoken about his support for the Google Chrome OS. And there is no reason to believe that the “less than free” business model will not be used here as well. If Sony or HP or Dell builds a netbook based on Chrome OS, they will make money on every search each user initiates. Google, eager to protect its search share and market volume, will gladly pay the ad splits. Microsoft, who was already forced to lower Windows netbook pricing to fend off Linux, will be dancing with a business model inversion of epic proportion – from “you pay me” to “I pay you.”  It’s really hard to build a compensation package for your sales team on those economics.

Naysayers of these assertions will likely have the same retort – quality is key. They will argue that Google’s turn-by-turn apps are inferior to their well honed market leading products. With regard to Android, Google will lack the user interface or embedded software expertise necessary and will deliver a subpar product.  Plus, because the Android OS will be so splintered, QA testing will be difficult and incompatibility issues will abound. In the short run, these issues will exist.

Despite these challenges, it would be a dangerous strategy for any of the many threatened players in these markets to hang on to this “quality” rationalization for very long. First, Google’s products will get better over time. The sheer volume of the Android phones in the market will give them new data feeds to complement their own mapping effort. Also, they can create UGC hooks for users to embellish their own maps (like in Google Earth), offering themselves further differentiation.  With regard to Android, version 3 will be better than version 2 will be better than version 1.  Microsoft knows this game well.

Another perhaps even more important factor is that when a product is completely free, consumer expectations are low and consumer patience is high. Customers seem to really like free as a price point. I suspect they will love “less than free.”

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Want To Know More About the Future of Internet TV?: Let’s Look to Korea

Posted on September 29, 2009. Filed under: Internet, online video, Uncategorized, video, Web/Tech | Tags: , , , , |

megatv

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We are clearly at a very important point in time when it comes to Internet video, especially video that is served to your television, but over the Internet (also known as “over-the-top” Internet video). Christmas of 2009 and Christmas of 2010 will mark the point in time that Internet menus began to show up in-mass on televisions, DVD players, and game machines. That said, one would be hard pressed to predict exactly how this market will evolve.  There are simply way more questions than answers. For example:

  • Who will own the operating system layer?
  • Who will own the menu “stack” which dictates discovery?
  • What will be the key features of this menu system, and which applications will be most useful and successful?
  • What type of programs are most popular in this format?
  • What are the typical pricing/product offerings?
  • Will this product live inside the carrier set-top box or outside?
  • Will the carriers that control the pipe also control this interface (either directly or indirectly)?
  • Are these systems selling at rates that are above or below expectation?  Why or why not?
  • Is it considered a viable alternative to cable or satellite?

One way to have an advantage in “predicting” what will happen is to look at other countries that are further evolved in terms of broadband. The most obvious of these, with over 90% broadband penetration, is South Korea. Three providers in Korea offer an over-the-top Internet set-top box, and recent press suggests that there are now just over 800,000 subscribers of these services (out of roughly 16-17mm South Korean HHs).  The leader is KT with their Mega TV offering, followed by  LG Dacom, and then SK Broadband.  While these numbers are certainly impressive, if memory serves, the estimates from a few years back were for multiple-millions at this point, so for some reason the roll out has not gone exactly as planned.

According to this article from January, MegaTV has 38 live channels and 85,000 episodes in VOD format.  Also, the video included immediately after this paragraph shows an integration of the Mega TV service on the Playstation 3 (unfortunately its not in English).  This highlights the complexity of the “who owns the menu” question. Mega TV is a set-top box as well as service offering on other boxes.

Unfortunately, outside of what is shared here, I do not have much detail on exactly how this market is evolving. If any readers have more data, or have perspectives or answers to any of the questions listed above, add them to the comments or send them to me at bgurley@benchmark.com with “Korea IPTV” in the subject, and I will incorporate the responses into this post. In other words, I will try to make it a living blog post with the latest and greatest on the Korean “over-the-top” video market.  Thanks a ton – I look forward to hearing from you!

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    …focusing on the evolution and economics of high technology business and strategy. By day, I am a venture capitalist at Benchmark Capital.

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