Value Myths of Platform Businesses

by Rick Hansen

The Chicken-Egg Problem

The current obsession among tech start-ups is driving user adoption.  The emergence of social networks and platform-based businesses has pushed it to a fever pitch.  But which is more important: growth or profitability?  How do you value services that presumably become more valuable with network effects?

 

The first lesson in investing is that if a value proposition appears to be too good to be true or really hard to understand, then it’s probably not true.  Recently John Pestana came to speak at HBS in an informal setting.  He’s semi-famous in tech circles as a co-founder of Omniture, which was acquired about a year and a half ago by Adobe for nearly $2B.  He mentioned that if ten years ago he had to list companies who might potentially buy Omniture, Adobe wouldn’t have cracked the top 50.  But John built a business which made money.  He didn’t want to worry about strategic buyers or synergies.  The point he focused most on was this: if you build a business which makes money, everyone will want to buy you.

 

I can’t help but challenge the conventional wisdom that users = value, and profitability is inevitable with scale.  There are clearly some outstanding success stories.  Google has generated huge cash flows, and it appears that Facebook is finally about to turn the corner.  This has inspired more VC funding and high valuations in the past year:  foursquare = $20m raised, ~$100 pre-money; Twitter = $200m (after $100m in 2009), ~$3b pre-money.  But there are just as many carcasses on the side of the road: MySpace is dead, YouTube has claimed to be “close to profitability” for several years.  Even more puzzling about these pre-revenue valuations is that there are some amazing social success stories that have learned to monetize early and often; Groupon, Zynga, and LivingSocial are prime examples. 

Why Wait for a Good Thing?

Perhaps I’m too much of a disciple of Joe Lassiter, who never fails to impress that “cash sooner is better than cash later”.  I believe the main reason to start monetizing early is to utilize the “shield of the chasm”.  Eric Ries argues that the chasm between early and mass adoption creates an opportunity for businesses to iterate and refine products.  That’s only half the story.  Even more crucial is market design and business model refinement. 

The chasm allows start-ups to experiment with monetization strategies – what revenue model works, what doesn’t – before the mass adoption crowd grows accustomed to the launch product.  This is important for two reasons.  First, you don’t want mass consumer to start expecting free goods if you aren’t sure the product should be free.  As soon user expectations are set, it is very difficult to alter or re-establish behavior.  The recording industry knows this pain all too acutely: with the advent of free music via file-sharing, and low cost music via iTunes, music recording studios have found it impossible to reinstate former prices for consumer retail music.  Although the wallet share for music has not declined, the value chain has been dramatically altered to the detriment of recording studios.  Start-ups can’t waste the opportunity to influence and shape the value chain.

Secondly, monetization may alter the user experience.  This can be either good or bad.  Google got lucky.  When Google finally realized how to monetize their product through sponsored advertising, consumers often found the advertisements to be adding value; consumers were searching for products, and were more than happy to find an eager seller. 

I’m a little jaded by some recent personal experience.  In my spare time, I’m working with a mobile group messaging start-up, and their growth has just sky-rocketed over the past month.  But continued rapid growth is my biggest fear.  Right now the company has tens of thousands of users and no revenue.  I believe that there are several options to pursue, including paid services, promotion, advertising, and content partnerships.  But now adoption is becoming mainstream, and we may be past the point of rapid and easy experimentation with revenue models.

If you buy Clay Christensen’s theory of disruptive innovation (which I generally do), then understanding how a new technology fits in the market (or new market) and its value to consumers is crucial to extracting value.  I’m just not convinced Twitter, foursquare, and others have figured that out.