July 11, 2004

It's a business, stupid

Everybody says this but this time we really mean it

Like we said, we really don’t want to be in the platform business. It’s like trying to sell PhD research to kindergartners: it doesn’t matter how smart you are or how great your stuff is, because that’s not what they are about (your competition is SpongeBob; you’re doomed).

When we started Electric Communities, we did understand that we needed to be in business. We wanted to do some awesome stuff, and awesome stuff requires awesome bucks, and awesome bucks generally come from a revenue stream. But the reality is that venture capitalists don’t invest in stuff because it’s awesome. At least not any more. They invest in stuff because they think they’re going to make a lot of money. If your plan is about making awesome stuff rather than about making a lot of money, they don’t want to talk to you. This is business 101, but it’s easy to fall into the following trap: “Here’s some awesome stuff, surely somebody will want to pay us a lot of money for it, it’s so awesome!” This is sort of The Business Plan of The Damned. But this is another one of those You Can’t Tell People Anything things. People were telling us this the whole time, and we didn’t really get what they were talking about. I mean, we thought we did, we thought were in business to make a product and sell it, but really we were more interested in making what we were making because it was what we wanted to make than because it was what people wanted to buy. Eventually we figured this out, but by that time the ride was over. I think I know what to do now, but unless one of you out there has 8 or 10 million dollars you want to bet on another spin of the wheel it may be a little while before we get to try again.

So what we’ve got to show for our troubles is a menagerie of amusing business fallacies whose fallaciousness we understand in an intimate and personal way:

User generated content isn’t free

Who’da thunk? You get a couple million people generating stuff, that’s way more stuff than you could ever afford if you had to actually pay people to create it. What’s not to love? Well, the cost of editing and filtering, for one thing.

Sturgeon’s Law famously says, roughly, that 90% of everything is crap. But that proportion is so low only because most of what we see is highly filtered. Over the centuries, vast industries have evolved to filter most of the crap out. It’s kind of like the mess we face today with spam. It’s not that any individual piece of crap is so hard to deal with, it’s that the producers are so damnably prolific.

Context equals Revenue

Advertising! We were going to make money selling ads. So was everybody else. In the early days of the Internet boom, a lot of the advertising business was basically just startups taking in each others’ laundry. Larry Samuels, one of our CEOs (the good one) at Electric Communities, described the dotcom advertising game this way: “Here is $5 million dollars. Your job is to spend this money in a way that generates $3 million dollars in ad revenues. Think you can do it??

We actually managed see this for the shell game that it was and avoided getting pulled into it for quite a while. We made the plunge into advertising when we took over The Palace, Inc. and unexpectedly found ourselves with a working product on our hands. Faced with the need to now make money from this situation, we talked ourselves into selling ads. In 1999, just as ad prices dropped through the floor.

One of the big things that popped the advertising bubble is that ads need context. Real advertisers, as opposed to dotcoms playing Let’s Pretend We’re A Business, are control freaks. They’re very sensitive to what their ads appear next to (just ask Janet Jackson and MTV). User generated content is unpredictable — not something that gives control freaks that warm fuzzy feeling that encourages them to spend money on you. Context is everything for them. This is one of the reasons why Google has been able to make substantial money selling really quite modest and unintrusive ads: they can deliver killer context.

Another thing about ads is, you’re serving two masters, the advertiser and the end user, and their wants and needs don’t always line up. Getting the value proposition right is tricky. Traditional media businesses generally resolve the conflict of interest by kissing up to the advertisers, but in the online world it’s harder to hold on to fickle users.

Extraordinary Popular Delusions & the Madness of Crowds

For those of you who don’t recognize the heading, it’s the title of a wonderful book by Charles MacKay all about the Internet. It was published in 1841. I wish I had read it in 1995.

A million free users does not a business make

Another business plan: “Hey! We can get millions of people to use our service. Millions of people, that’s a lot! Surely there must be a way to make money from such a large population!” This is another variation of The Business Plan of The Damned.

An important wrinkle on this is: “We’ll get millions of people to start using our service, then, once we have millions of users who know they like our service, we’ll start charging them money for stuff.” In the real world: turn on the money, watch them all go switch to the other free service who haven’t used up all their venture funding yet. Or watch them prove just what a powerful engine for innovation the Internet is, as they figure out countless clever ways to keep using your service while not paying you.

Economists have what they call the Principle of Revealed Preference, which is the idea that the only way to find out what people really think is to watch what they really do, especially when it comes to spending money on something. If you instead simply ask them what they think, you’ll get a different answer, because giving you an opinion does not require them to commit to anything. The same principle explains why it is hard to convert a free beta tester into a paying customer. As long as things are free, the starving student, the middle-class yuppie, and the millionaire are pretty much interchangeable. Once you put a price on things, the student can’t afford it and the yuppie now needs to be persuaded to spend. In fact, it’s worse than that, because the one resource they were expending during the free period was their time, for which their budgets likely follow completely the reverse hierarchy.

Boundless Potential

So we had this myth of the boundless potential of the Internet. I love this quote from the economist Herbert Stein:

“Things which cannot go on forever eventually tend to stop”

First Mover Advantage

Another lie to be suspicious of is the so called “first mover advantage”. This notion was most notably promoted by McKinsey Associates, the business consulting firm whose big Silicon Valley success was Apple Computer (or least, that’s the way it got spun). The idea is that a competitor who gets in first can establish such a dominant position that the barriers to entry to later competitors are huge and so the dominant position is locked in. This is just nonsense. Our experience is, first movers get slaughtered. And we always knew this; back in the days when IBM occupied the post of Great Satan now held by Microsoft, one of their widely quoted mottos was: “Never first. Always second.” The second mover has the advantage of being able to see which of the first movers didn’t get eaten by the sharks.

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