One of the things that annoys me so much about the tech industry these days is the rampant arrogance. I’m certainly not one to begrudge someone a moderately over-inflated sense of self-importance. But I think it’s long left the bounds of reasonable self-confidence and entered the realm of self-aggrandizing stupidity.
The most telling sign is the way that the tech industry seems to deem itself immune from the basic laws of economics. Out is the 80/20 rule; in is the long tail. Out are revenues; in are page views and subscriber counts. And I think we’re seeing them both come crashing down, just like we did seven years ago.
This time it’s going to be much slower and less remarkable, because the action is not taking place in the public markets. Startup exits morphed from IPOs to acquisitions, eliminating much of the speculators’ irrational exuberance of the late ’90s. Now we’ve only the exuberance of venture capitalists, and while still probably on the high end of reasonable (or the low end of unreasonable) it’s a far more educated one than that of any Joe Blow with an E*TRADE account.
But the web has, in the years since the first bubble, shifted almost entirely to a culture of free, and I don’t think it can last. Free services, free (in multiple senses of the word) software, free everything. This is a combination of “The Penny Gap” and a shift to a focus on user stats rather than profits, immediate or potential. Say what you want about Webvan or Pets.com, but they had real revenues, and real business models. Their bottom line spending was clearly out of line, their optimism about the growth of the net turned out to be unfounded, and they too ignored certain fundamental principles of economics. They were different principles, and were no less bankrupted when reality came crashing down, but at least they got step 1 right, which is to make something that someone will pay for.
I think that at the end of the day, much of our new free culture is going to turn out to be just plain unsustainable. I’m predicting that we’re going to see a large number of high-flying startups crash, just like we did before. They aren’t currently flying as high or as conspicuously as last time, so the crashes will be much more graceful, but crash they will. This time they won’t depress the public markets, at least not directly, just hedge funds and private equity.
Free software, for the most part, will endure for ages. I’m convinced that businesses attempting to profit from free software (Red Hat, Sun with their MySQL acquisition, WordPress, Mozilla, etc.) will have a mixed record. Some will do well (Mozilla for instance) and some will not.
But in the end, free software is all about hackers making tools for hackers. They do it out of love. Only a small percentage of people who contribute to open source products ever make any profit from it (or expect to) so it doesn’t need revenue (beyond hosting costs, which are frequently donated) to endure. Hell, with Bittorrent and other forms of p2p distribution, they could probably reasonably reduce their infrastructure costs to nearly nothing.
For-profit websites, on the other hand, are another story. They have to make money, or they will eventually go out of business. They aren’t passion projects, not entirely at least, and they can’t exist forever without income. Even if they’re acquired, the same is largely true. They’ll have to pull their weight (not necessarily in terms of profits, but usually so) or they will be shut down by their corporate owners.
Oddly, I think the general public perception is exactly backward. They think YouTube will exist forever, no matter how much of a money pit it remains going forward, and that Linux is disreputable because it’s free. Don’t believe me? Try to explain to someone in a bar (outside of San Francisco) or at your family reunion that there’s an operating system that’s better than Windows for many purposes, and that it’s made largely by volunteers who donate their time to the project, largely for nothing more than the pleasure of doing so. Average people just can’t understand how Windows could make trillions of dollars while a better OS is offered for free, and think you’re crazy for even suggesting it.
And in reality, they shouldn’t believe it, because in almost any other part of life (the parts they’re familiar with) someone telling you that something is both cheaper and better than what most people pay good money for is generally trying to scam you. It’s as if someone were saying “Sure, we’ll sell you a brand new car as nice as a Cadillac for $10,000.” Software is, of course, much different than a car because a collection of ones and zeros can be copied at a very tiny cost, while an automobile cannot. But most people never feel that distinction in their everyday life, and they think that if Windows is a Cadillac, surely Linux must be, at best, a Kia. So even though they’re largely incorrect, their logic is not.
But, as far as for profit-websites (which have not-insignificant expenses) are concerned, since user base is the new revenues, startup founders who want an exit down the line and easy access to funding along the way have little choice but to play the free game. The Penny Gap is a very real and very powerful effect. Because of it, people gravitate to services that are free, and acquirers gravitate to large user bases.
This cannot last forever though. It’s just a game of mutually assured destruction. Let’s take the personal financial software industry as a hypothetical example. You have Quicken, the old-fashioned, balance your checkbook, downloadable GUI we all know and despise, and that costs money. And you have Mint.com, the newer, slicker, less featured (but in a good way) and totally free web-based version.
Suppose Mint starts making serious inroads into Quicken’s user base (and it very possibly will). Intuit (in a hypothetical world where that was their only product) would now become virtually worthless to acquirers. Who wants to buy a company whose user base is flocking en masse to a rival? Never mind the fact that Mint is hemorrhaging money (theoretically, of course) because Quicken’s makers will soon be too as their subscribers jump ship.
I realize this example is largely contrived, but I think it communicates the point which is that the culture of free, seductive as it is, is destructive to everyone involved. Everyone is undercutting everyone, until nobody is making a profit. At best, the winner is the group that can survive off of (usually meager) ad revenues.
This isn’t new. This happens in almost every burgeoning industry. The automotive industry once had over a hundred Amercian manufacturers engaging in such warfare, until consolidation reduced them to three American companies and a handful of foreign ones. The same thing happened recently in the cell phone and PC industries (much faster than it did with cars), is happening currently in the airline industry currently, and soon is going to happen in many segments of the web.
In my above example, both Mint and Quicken are going to be long term losers. Everyone will jump ship from Quicken to Mint, who, eventually, will have to start making money or be faced with intolerable server and payroll bills. But they won’t be able to charge users, or they’ll just jump to Wesabe or whoever the next free personal finance management software provider is. The Penny Gap ensures that as long as customers have a free choice available to them, that’s where most of them will end up.
And suppose they can’t make money off of advertising. (Again, this is theoretical, Mint might be one of the sites for which an ad-supported model, or maybe something like freemium or credit card affiliates, actually makes sense. But let’s suppose it is not.) What happens then? Both it and Quicken are driven out of business. And in the long term what happens? Providers in this industry drop like flies, and new ones stop popping up because eventually they realize they can’t make money. And eventually we’re left with one or two who have a business model either of actually charging a healthy markup.
This cycle has to end somewhere. It always does. The internet makes some things possible that aren’t in the physical world. For instance, a team of a few people can make a product used by millions in a matter of a few months and with little or no capital expenditures. But it doesn’t circumvent fundamental laws of economics, and it certainly doesn’t mean that a company that loses money can go on doing so forever. And acquirers can’t indefinitely support them and continue to face their board members in meetings.
Of course, as David Heliocentricity Hansson will point out, a small company doesn’t need to make hundreds of millions per year. If a team of 5 people makes $5 million per year in profit, that’s a pretty damn good life for those 5 people, and the angels who backed them for a couple hundred grand in the early years. And at the end of the day, when all of the cards are turned over, that’s where we’re going to end. The web, I think, will be populated with lots of small teams of people making relatively focused websites, and making relatively small (compared to Google) amounts of money off of them, often by charging customers small amounts of money.
Most of them won’t crack the Alexa 100. As Mike Maples once told me, only 100 can at any given time. But they won’t need to. A hundred thousand customers paying you $5 a month is a fortune, both to them and to their investors.
The problem, in the mean time, is the VC funding system. The large amounts of money injected into companies by these firms gives them a large temporary edge. Go down the Alexa 100 (removing adult sites, who operate in a largely separate sphere from the rest of the net, and even then are generally well-funded, just not by VC firms) and you’ll notice a tremendously large amount of companies funded by VCs or publicly traded companies, most of which were, at one point, funded by private equity. Only a very tiny percentage of total websites fall into either of those two groups, but probably the majority of the Alexa 100 does. If that’s not evidence of the value of money and connections, what is?
The reason of course is that money still talks, even on the web. We want to believe that the internet is fundamentally Darwinian and democratic, and that everyone has an equal shot and the cream will rise to the top. But it just isn’t true. It’s more true than it might be in the automotive or casino industries, but it’s far enough from absolute that the balance of power is still largely determined the same way it was twenty years ago. The fact that Craigslist, Wikipedia, and Plentyoffish exist shows that it can happen. But the fact that they’re the only three I can name shows that it’s still exceedingly rare.
A very good site can earn billions of users without spending a dime in advertising, and possibly without raising large amounts of funding. But at the same time, give me a few million bucks to throw into advertising, and I could turn this blog into an Alexa Top 100 site, at least for a little while. And even if it didn’t last, other blogs of similar genre and quality would be permanently left in the dust.
But in the end the little guys will win out over the big ones more often than not, because their economics are fundamentally viable. The big VC funded companies who are forced to scale beyond their profit potential just to justify the millions they raised, just like Webvan was by their investors, will go bankrupt. And they might take a lot of little guys down in the process, but in the end, it will be little guys who pop back up and fill the void. After the nuclear winter, the cockroaches will rule the Earth.
I think what we’re going to see happen is a lot fewer large, YouTube like acquisitions, and a lot more little ones. Google, with one or two notable exceptions, has pioneered this brilliantly. Acquire 100 small companies, and only a few have to be a smash hit. And if you get 20 moderately profitable subdivisions, you’ve made out like a bandit. You just shut the underperforming ones down.
Big companies like Google can acquire some companies that they know will directly lose money, so they won’t cut out large acquisitions entirely. One of the incredibly valuable things about Gmail, to them, is that it gives people a reason to log in. Even if it were fairly unprofitable in and of itself (and I have no idea if it is, so I’m not trying to imply that) giving Google the ability to track its customers as they move around the web might make it worth the subsidy. Google Docs might make serious inroads into Microsoft’s profits (though I don’t think it will) making it easier for Google to compete with them in other areas, and worth the relatively small expense of trying.
But most businesses don’t have this working in their favor. Even if they’re lucky enough to be acquired, they’ll have to pull their weight at some point or they’ll get dropped. I think YouTube is in that category, and I’m uncertain if it will ever change. I definitely won’t count out the possibility, but I’d bet against it.
This line of thinking has made a lot of difference in how I’ve chosen and operated my current fantasy sports startup, Draftmix. The beautiful thing about gaming is that it requires a buy-in, and so The Penny Gap is essentially irrelevant. A lot of the reason Craigslist has crushed so many competitors is that they don’t require someone to cross the gap. They can provide the same service, minus that necessity, and that’s a compelling alternative.
With gaming that’s not the case. Playing a game of skill like fantasy sports or poker becomes so much different when money is involved that you can’t even compare it to the free versions. It’s not the same game. It’s the difference between playing putt-putt and golfing 18 holes at Pebble Beach. And therefore, when you’re running a gaming site that allows people to play for money, you’re really not even competing with the free sites.
For a very long time Yahoo offered free poker but nowhere to play it for money. I remember asking a Party Poker executive on one of their cruises who he thought his chief competitors were, and he named about 5. Yahoo, despite being (back then) by far the most trafficked site on the net was nowhere to be found. As far as he was concerned, they weren’t even in the same industry.
So what happens is that competition is not about undercutting each other by making the service free, or even cheaper (since the house fee is well-disguised) but rather by building the most compelling site possible. And they had to do it, in the early days, with small marketing budgets (compared to what came later, when you would regularly see their ads on general programming like CNN) and an audience that was hard to reach due to poker having not yet made it into the mainstream.
As such they developed a lot of very innovative features and practices. What they are is beyond the scope of this article, and I wouldn’t want to give them away even if they weren’t, but suffice it to say the industry became incredibly efficient. In only a few cases did a player even try to compete by undercutting the majors, and never successfully.
I should mention that I’m not suggesting that the advertisement-supported business model won’t ever work. It clearly has its place. It’s just not going to be the economic panacea that a lot of people seem to expect, and that a lot of startups have depended on to justify that $10 million Series C. It’s going to be fairly rare that it builds the sort of home-runs that VCs and publicly traded companies need to recoup the sort of investments we’re seeing now.
The last bubble seemed to be all about people thinking that the top line potential was higher than it really was, because everyone would be doing all of their shopping on the net. This one is all about thinking advertising revenue will take its place.
Facebook, on the merits of current ad revenue alone, would still be a successful company, as they could probably slow down growth, scale down their employee base, and make $100m a year in profit pretty easily. But it’s debatable if it could ever hit the $15 billion valuation it currently commands. And it’s undoubted that its investors won’t let that happen.
So when people ask me if I think we’re in a bubble, I say probably, but not a very big one. People are still, I think, a little overly-optimistic, but nowhere near as much so as last time. And the top line still isn’t higher than the bottom one in most cases, but the gap is a lot smaller.
But I think we’re nearing the end of the free economy of the venture funded internet. I expect to see a lot of the free services we like that aren’t offered by the bigger corporations (and even some of the ones that are) to start charging, offering premium services, or just plain closing down. Some of them will find their way to profitability, others will be replaced by high-flying competitors due for a crash. But in the end it will be the little guys, the only ones who can afford to live off of a few million a year in ad revenue or subscription fees, and the ones that can offer a compelling premium service that survive.
