Twitter’s blog is generally a cheery place, with one big exception from 2012: the innocuously named Changes Coming in Version 1.1 of the Twitter API, and in particular, the section called “Changes to the Developer Rules of the Road” that attempted to put the kibosh on 3rd-party Twitter clients:¹

If you are building a Twitter client application that is accessing the home timeline, account settings or direct messages API endpoints (typically used by traditional client applications) or are using our User Streams product, you will need our permission if your application will require more than 100,000 individual user tokens.

As you might expect, as with any decision by a big company to lock out 3rd-party developers, people were upset. Twitter’s move, though, cut far more deeply: it wasn’t just that people really loved their 3rd-party apps; rather there was a deep sense of betrayal because 3rd-party app developers were unusually responsible for Twitter’s success up to that point.

A Brief History of Twitter and 3rd-Party Developers

Twitter launched as an SMS service, but quickly the web app became the company’s primary focus. No surprise: at that time, the conventional wisdom was that websites would be the dominant interaction layer for a good long time. Of course that idea seems positively quaint: we now know that on phones, the platform with by far the largest share of both computers and attention, apps are far more important than the web, and the companies that recognized that shift early have benefited tremendously. Twitter is on that list, but not by their own doing.

Just months after the first iPhone’s release Craig Hockenberry built Twitterrific, the first mobile Twitter client, and the use case was so compelling that all sorts of people who would normally not consider jailbreaking did it anyway just for his app. In fact, I would not be surprised if Hockenberry’s app had a direct impact on Apple’s decision to open up the App Store. The impact on Twitter was just as profound: it turned out that character-limited tweets and a timeline focused on the here-and-now were a brilliant match for a computer that was in your pocket and thus available in found moments and unusual happenings. Over the next few years Twitterrific and a host of competitors honed the Twitter user experience, and these developers — and users — pioneered many of Twitter’s most important features, making the company, by 2011, worth $8 billion and on the road to a 2013 IPO. And Twitter was slamming the door in their face!

Twitter’s Mistake

In fact, I think Twitter’s decision was absolutely justified: in April 2010 Twitter launched promoted tweets on their website, but as just noted, it was already clear that for most users the website was a secondary platform for consuming Twitter. If Twitter were to succeed in advertising it needed to place those promoted tweets and any other advertising inventory it might devise into Twitter apps. The problem, though, was that by definition Twitter had little control over how its content was presented in apps built by 3rd-party developers. And so, three days before the promoted tweets announcement, Twitter bought Tweetie, an app many (including myself) thought was the best 3rd-party Twitter app of all.

This was the context for the aforementioned post: advertising works best at scale but 3rd-party apps were peeling away too much of Twitter’s audience. That is why the company made such a big mistake: they didn’t kill 3rd-party apps completely. The post noted:

We will not be shutting down client applications that use those endpoints and are currently over those token limits. If your application already has more than 100,000 individual user tokens, you’ll be able to maintain and add new users to your application until you reach 200% of your current user token count (as of today) — as long as you comply with our Rules of the Road. Once you reach 200% of your current user token count, you’ll be able to maintain your application to serve your users, but you will not be able to add additional users without our permission.

The funny/sad thing about this entire episode is that Twitter was clearly trying to bend over backwards for its 3rd-party developers: it was strategically stupid and financially unwise to let them continue to exist, but Twitter left this massive loophole open that limited growth but didn’t kill successful apps like Twitterrific or Tweetbot. And yet, the company was pilloried and tarred with a reputation for being especially unfriendly to developers, a reputation that strongly persists to this day.

Meerkat and Datasift

The reason this history matters is that Twitter has spent the last month cracking down once again. The first target, famously, was Meerkat, an app that allows you to stream live from your phone to anyone else with the Meerkat app. Within days of its release the app was a huge hit in tech circles, aided by its use of the Twitter graph: you signed in with your Twitter login and were immediately able to follow anyone you already followed on Twitter. Just two weeks after its launch, though, and on the eve of South-by-Southwest, Twitter cut them off.

The second target was more surprising, but in retrospect — like the app situation — telegraphed by Twitter. A year ago Twitter acquired Gnip, at the time one of only four companies with access to the full Twitter firehose of every tweet passing through the service. And then, over the weekend, came the other shoe: Twitter is going to cut off Gnip-competitor Datasift and everyone else.

Twitter’s Justification

Both of Twitter’s decisions are correct, albeit for different reasons:

• The most obvious justification for killing Meerkat was that Twitter was on the verge of launching Periscope, an app that does basically the exact same thing (Periscope has since launched). Why should Twitter be expected to give its direct competitor a leg up?

  Still, I think that Twitter’s decision would have been justifiable even if they weren’t about to launch Periscope. A fundamental part of Twitter, first established by Twitterrific on a jailbroken iPhone, was its sense of immediacy and incredible ability to broadcast information about what was happening right now from anywhere in the world to anywhere in the world. That, though, is exactly what makes Meerkat/Periscope so amazing: immediate access to what is happening anywhere in the world is exactly what they provide, but in a superior format: video. Twitter risked being unbundled, and given their floundering user growth, the company simply can’t afford to lose its claim on its most marketable attribute.²

• Datasift is a little more troublesome. For one thing, in the same post where Twitter announced the 3rd-party app limitation, the company promoted data analysis as an opportunity for 3rd parties to build on the platform:

  Today on Twitter we see a broad and deep variety of individual developers and companies building applications using data and content from the Twitter API…with our new API guidelines, we’re trying to encourage activity in the upper-left, lower-left and lower right quadrants, and limit certain use cases that occupy the upper-right quadrant.

  

  Datasift falls squarely in the lower-left bracket, which means Twitter’s decision is a complete reversal of their previous stated stance, a stance that led to investments worth hundreds of millions of dollars. It’s an ugly move.

  The problem for Twitter is the aforementioned user growth: it’s even uglier. Last quarter the company was celebrated for adding 13~16 million users, but I was far more troubled by the company’s explanation that it lost 4 million users because of iOS 8. What actually happened was that if you ever signed up for Twitter on iOS 7, Safari kept syncing your tweets whether or not you used the service. iOS 8 fixed that, which means those 4 millions users were only counted as active because of an iOS bug! Given that Twitter’s reported metric is monthly active users, how many of their 288 millions active users are actually humans reading their timeline as opposed to randomly updating apps or visits by an abandoned user to a page with an embedded tweet?

  The company has responded by doubling down on monetization, and that’s where this decision makes sense. Wall Street actually loved last quarter, because Twitter monetizes so well, and in the absence of user growth the company is clearly focused on growing revenue per user instead, and data is a low-hanging fruit.

Still, even though all of Twitter’s decisions are understandable, I can’t shake the feeling that the company could have chosen a very different path.

What Might Have Been

It’s interesting to ponder why it is that Twitter is able to monetize effectively – and if they can keep it up – even as they are surpassed in active users by social networks like Instagram and (soon-if-not-already) Snapchat, never mind Facebook. I made this argument at the time of Twitter’s IPO offering:

Whereas Google is valuable because it knows what I want, when I want to get it, Facebook knows who I am, and who I know. Ideally, they also know who and what I like, but it’s a much weaker signal. Twitter, on the other hand, knows exactly what I like and what I’m interested in. It’s obvious both from what I tweet about, but especially based on who I follow. If an advertiser wants to reach someone like me – and they certainly do, given my spending habits – Twitter is by far the best way to find me. Were Twitter able to consistently capture this signal and deliver effective ad units that caught their user’s attention, they could command some of the highest average revenues per user on the Internet.

Indeed, I would argue that what makes Twitter the company valuable is not Twitter the app or 140 characters or @names or anything else having to do with the product: rather, it’s the interest graph that is nearly priceless. More specifically, it is Twitter identities and the understanding that can be gleaned from how those identities are used and how they interact that matters.

If one starts with that sort of understanding — that Twitter the company is about the graph, not the app — one would make very different decisions. For one, the clear priority would not be increasing ad inventory on the Twitter timeline (which in this understanding is but one manifestation of an interest graph) but rather ensuring as many people as possible have and use a Twitter identity. And what would be the best way to do that? Through 3rd-parties, of course! And by no means should those 3rd-parties be limited to recreating the Twitter timeline: they should build all kinds of apps that have a need to connect people with common interests: publishers would be an obvious candidate, and maybe even an app that streams live video. Heck, why not a social network that requires a minimum of 140 characters, or a killer messaging app? Try it all, anything to get more people using the Twitter identity and the interest graph.

As for monetization, Twitter actually already nailed it: that’s exactly what MoPub should have been focused on. I hoped at the time of the acquisition:

I think it’s very likely MoPub is Twitter’s AdSense: Twitter has a great signal about its users — whom I follow is a great approximation for what I’m interested in. That’s even more valuable than whom I know. However, Twitter is not a great platform for any sort of display advertising; the targeting would have to be much more precise than what is possible with current technology for users to tolerate anything more than promoted tweets. MoPub solves this riddle; Twitter can serve up highly targeted ads everywhere but Twitter proper. It’s a great acquisition.

Mostly right, I think, except for the focus on display ads: native advertising is exactly what works best on mobile, which is why Twitter bought native advertising company Namo last summer. Twitter’s offering is an attractive alternative for mobile publishers in particular, it’s just a shame that all those publishers aren’t building on top of Twitter’s identity, but then again, who can trust the company? The past is not dead…

Twitter and Google

Twitter’s story in many respects makes me think of Google: both companies started out benefiting greatly from openness and the power of both connecting users to what they were interested in and opening up powerful APIs to developers. The monetization model is even similar: note the AdSense reference above. Over time, though, Google has pulled more and more of its utility onto its own pages (and the revenue balance in the company has followed), just as Twitter focused on its own apps, and now Google is even starting to eat its best customers like travel websites and insurance agents (members-only), just like Twitter ate Datasift.

Frankly, the arc of both companies is simultaneously understandable and saddening to me. I’ve loved them both for the ways they have connected me to truly new ideas and new people, and it’s frustrating to see the growth imperative push both companies to turn increasingly inwards. One does wonder if they might find salvation in each other.³

The question of whether or not we are in a tech bubble has been raised regularly for years now; 2012, particularly Facebook’s acquisition of an app¹ called Instagram for a ridiculous² $1 billion, was a particular high point. The fact that Instagram is now valued at $35 billion suggests the 2012 doomsayers were just a bit off.

Still, it’s possible to be off in timing but right in meaning; in retrospect Alan Greenspan was correct to, at the end of 1996, characterize what we now call the dot-com bubble as a period of “irrational exuberance”; the correction just took a few extra years to materialize, and it was all-the-more painful for having taken as long to arrive as it did. Might the tech industry be facing a similar reckoning?

I don’t think so.³

Changing Markets

If you’ll forgive a brief diversion, a pet peeve of mine is when people analyze the mobile phone market, particularly iOS versus Android, through the lens of Apple versus Microsoft in the 80s and 90s. The issue is not the obvious differences — this time Apple was first, the absolute numbers are much larger, etc. — but rather the fact that many of these commentators simply have their facts wrong. Windows didn’t win because it was open or all the other nonsense that is ballyhooed about; it won because MS-DOS was the operating system for IBM PCs, and at a time when personal computers were sweeping corporate America, “no one got fired for buying IBM.”⁴ By the time the Mac arrived in 1984, the battle was already over: businesses, the primary buyers, were already invested in MS-DOS (and, over time, Windows), and not many consumers were buying PCs. Today, of course, the situation is the exact opposite: consumers vastly outnumber business buyers. Thus, the chief reason iPhone/Android is not Windows/Mac is because the market is fundamentally different.

I tell this story because I think a similar mistake is made when comparing today’s funding environment to the dot-com era: it’s easy to look at numbers, whether that be valuations, revenue multiples, or simple counting stats, but any analysis is incomplete without understanding markets. In 1999 most consumer markets were simply not ready, whether it be for lack of broadband, logistics build-out, etc., while most enterprise opportunities were in selling licensed software to CIOs. And, in this latter market especially, the competition was other tech companies.

Today, by contrast, many of the most valuable unicorns are consumer-focused companies like Uber or Airbnb. Moreover, these companies are competing not with other tech companies⁵ but rather with entirely new (to tech) industries like transportation or hospitality. And, even for more traditional pure software plays like Snapchat or Stripe the implications of mobile-everywhere means a whole lot more time — and contexts — to reach consumers. In short, the size of the addressable market for tech companies has exploded — why shouldn’t valuations as well?

Changing Business Models

Today’s startups also have very different business models than companies did in the dot-com era (to the extent they had business models at all, of course). The difference is the most stark when it comes to enterprise software: back in the late 90s enterprises bought software licenses that were usually paid for up-front. Thus, when a company closed a sale, they would get paid right away.

Today, on the other hand, most enterprise startups sell software-as-a-service (SaaS) which is paid for through subscriptions. In the long run this is a potentially more lucrative business model, as the startup can theoretically collect subscription revenue forever, but it also means revenue is much slower to arrive as compared to the old software licensing model. For example, suppose you spend $100⁶ to acquire a customer who pays $35/year: in year one, for that customer, you will lose $65, but then profit $35 every year thereafter. It’s a great model, but it looks bad, especially when you consider growth:

Year	New Cust	Growth	CAC	Total Cust	Total Rev	Annual Profit/Loss
1	1	–	$100	1	$35	($75)
2	2	100%	$200	3	$105	($95)
3	3	100%	$300	6	$210	($90)
4	6	100%	$600	12	$420	($180)
5	12	100%	$1200	24	$840	($360)

No company, though, can double forever, so watch what happens when the growth rate slips to, say, ~30%:

Year	New Cust	Growth	CAC	Total Cust	Total Rev	Annual Profit/Loss
6	7	29%	$700	31	$1085	$38
7	9	29%	$900	40	$1400	$500
8	12	30%	$1200	52	$1820	$620
9	15	29%	$1500	67	$2345	$845
10	20	30%	$2000	87	$3045	$1045

This is a simplistic example: there is no churn on one hand, and no decrease in CAC (which usually happens at scale) or increase in revenue/customer via add-on services on the other. The takeaway, though, is that particularly during a period of hyper-growth, SaaS companies need a lot of capital, and more pertinently, a lot more capital than a company that monetizes through up-front software licenses.

There is a similar dynamic for many consumer companies, particularly companies that monetize through advertising. Advertising works at scale, which in today’s world means hundreds of millions of users; getting all of those users requires years of operating without revenue, which means a lot of capital. All of this is magnified for companies that operate in markets that include network effects: network effects translate into winner-take-all opportunities, which significantly increases the growth imperative, requiring, again, significant amounts of capital.

Changing Nature of Capital

The question, then, is where does all that capital come from? Traditionally, from one place: the public markets.

There are multiple advantages to an IPO, for all of the various stakeholders in a startup:

• The company gets additional capital to fuel growth, non-dilutive shares to use for acquisitions, and a bit of added prestige that can help with sales, particularly to enterprises
• Founders and employees can finally be fully compensated (by selling shares) for their years spent building the company
• Venture capitalists get a return on their investment that they can distribute to their limited partners

There are downsides, though, as well. The run-up to an IPO is very difficult, and requires a lot of attention from senior management, the disclosure of a lot of information, and a large expense that has only increased because of recent legislation. The disclosure and expense continues, too, on a quarterly basis, which brings its own pressures and risks, including activist shareholders and SEC oversight.

On the flip side, a number of IPO advantages have been peeled away:

• The most important has been the emergence of a new type of capital: growth capital. Growth capital is less speculative than traditional venture capital; it seeks to make relatively larger investments for relatively smaller stakes in companies with provably viable businesses that are seeking to grow for all of the reasons listed above. Now an IPO is no longer necessary for growth
• Secondary markets and special purpose vehicles that buy stock from founders and early employees give founders and early employees a way to realize some of their gains, again, without an IPO. This too removes a previous forcing condition for an IPO
• Finally, more and more early investors have determined that doubling down on winners often provides a better return than spreading bets widely; indeed, an increasing number of venture funds are explicitly marketed to limited partners as a combination of venture and growth capital

Just as Arthur Rock and Fairchild Semiconductor birthed venture capital, Yuri Milner and Facebook deserve the most credit for the development of growth capital.⁷ In 2009 Milner and Facebook shocked the Valley with a $200 million investment that valued the company at $10.2 billion. This investment was the growth capital archetype: a large amount of money in absolute terms for a surprisingly small stake in a provably viable business, and it paid off handsomely. Facebook would go on to further expand the growth capital market, first to private equity (Elevation Partners in 2010) and then to Wall Street (Goldman Sachs in 2011): Facebook was clearly a winner, and if Goldman Sachs’ clients wanted in, then growth capital was the answer. Since then nearly every huge startup has followed the same path, and Wall Street especially has responded: growth is no longer found by investing in IPOs, but in private companies that need the money but not the hassle of an IPO, and any qualms have been drowned in an environment where multiple countries are issuing negative rate bonds (a big contrast from 1999) — growth is hard to find!⁸

What’s the Downside

So to recount:

• Today’s startups have massively larger markets than in 1999
• Today’s business models require significantly more capital than ever before
• Thanks to Facebook, funding this growth via Growth Capital has been established as a viable alternative to an IPO

In short — and I’m not the first to say this — it’s less that valuations are unnaturally high than it is the fact that there is a completely new capital market — the growth market.

There are, though, some downsides and new risks:

• The most obvious downside is that the best growth opportunities are increasingly out of the reach of retail investors like you or I. Goldman Sachs Facebook Special Purpose Vehicle (SPV), for example, required a minimum $2 million buy-in
• Companies like Facebook, Uber, or Palantir may be obvious winners, but the difficulty in investing in them creates a powerful sense of FOMO — Fear of Missing Out. This has the potential of pushing less sophisticated investors desperate for growth towards higher-risk companies
• Relatedly, there is very little oversight around these investments, particularly when it comes to the disclosure of audited financial information. A lot of these growth investors are plunging in a bit blind

Bill Gurley, an investor I greatly admire and have learned a lot from (his blog is a must-read), is worried the last two points in particular are leading to a risk bubble:

All of this suggests that we are not in a valuation bubble, as the mainstream media seems to think. We are in a risk bubble. Companies are taking on huge burn rates to justify spending the capital they are raising in these enormous financings, putting their long-term viability in jeopardy. Late-stage investors, desperately afraid of missing out on acquiring shareholding positions in possible “unicorn” companies, have essentially abandoned their traditional risk analysis. Traditional early-stage investors, institutional public investors, and anyone with extra millions are rushing in to the high-stakes, late-stage game.

Read that carefully: much of the media has adopted Gurley as the apostle of the “here we go it’s 1999 all over again” mantra, but that was a valuation bubble. Companies simply weren’t worth what they were priced at. Gurley is arguing that the private market with its limited information and oversight is producing something very different: investors putting too much money in companies without enough information or enough potential upside to justify the risk.

This though, is why concern one — the lack of access for retail investors — is arguably a firewall against this truly being a bubble. For one, if everything goes sour, the folks taking a hit can very much afford it. More importantly, a bubble is less about companies than it is a bet on euphoria — the assumption that no matter how nonsensical your investment, there will always be someone on the other end ready-and-willing to buy. While many of these growth investors are arguably making such a bet on a future IPO that may or may not materialize, there is no question the combination of increased investor sophistication necessary to participate in this market and the lack of liquidity makes betting on euphoria a far more risky — and thus far more unlikely — outcome.

Or, to put it another way, bubble talk is less 1999 than it is Y2K: a potential problem, and some people will lose money, but in all likelihood a far smaller deal than many in the media are making it out to be.

I’m a couple of days late in writing about Tidal, Jay Z and friends’ new streaming service, so I’ve been saved the trouble of predicting it will fail. The most scathing and, unsurprisingly, best critique was levied by Bob Lefsetz. This is the key paragraph:

Suddenly, just because Jay Z is a famous musician he expects all of his fans to pony up ten bucks a month? Raw insanity. As is the position of the artists on the stage. I’d be much more impressed if they all ankled their deals, got rid of the major labels and went it alone. That’s why they’re not making much money on Spotify, not because of the free tier, but because their deals suck. But these same deals apply on Tidal! They’ve got to license the music from their bosses! It’s utterly laughable, like nursery school kids plotting against the teacher, or a kindergartner running away from home. Grow up!

Lefsetz’s criticism is based on the basic structure of the music industry:

The role of three of the four is obvious:

• Artists make the music
• Distributors (Apple, Spotify, YouTube, Pirate Bay, etc.) get the music to fans
• Fans listen to the music

The more interesting question is about labels: why do they still exist, and why do every single one of the artists behind Tidal remain attached to them?

The Role of Record Labels

In the pre-Internet era (or, to be more precise, the pre-Napster era) one of the roles of labels was obvious: they handled distribution. Actually making and distributing a bunch of records (or 8-tracks or cassettes or CDs) was a capital-intensive task that required significant investment in production lines, channel development, and logistics. As with many such businesses, it was the cost structure of these activities – significant fixed costs, but relatively small marginal costs (a CD costs pennies to make) – that determined the business model: an outsized focus on big hits. The New York Times broke this down back in 1995:

Setting prices “is very arbitrary,” said a top executive at a major label, who described his company’s pricing policies only on condition of anonymity. “We’re trying to raise CD prices,” he said. “The reason for this is that our costs are escalating in such a marginal way, everything from marketing to promoting to signing bands. It costs $400,000 to $600,000 to sign a band. The first video costs a minimum of $50,000. Touring is more expensive, and people’s salaries are a lot higher. Our profit margins are being squeezed.

“It’s a very speculative business that we’re in. If a label can break one new band a year, they’re having a good year. The first 300,000 to 500,000 copies a record label sells of most CD’s don’t make money. That’s 80 percent of all records that don’t make money; the other 20 percent have to pay for the 80 percent.”

There’s a bit of circular logic here – many artists are unprofitable because of marketing and promotional (fixed) costs, but the ever-higher marketing and promotional costs existed because of the pursuit of breakout winners, which are necessary to cover the ever increasing fixed costs.¹ Still, the logic makes sense. The reality is that a Jay Z or Coldplay will more than pay for a whole roster of unprofitable artists, and this has always been the case.

This is why, by the way, I’m generally quite unsympathetic to artists belly-aching about how unfair their labels are. Is it unfair that all of the artists who don’t break through are not compelled to repay the labels the money that was invested in them? No one begrudges venture capitalists for profiting when a startup IPOs, because that return pays for all the other startups in the portfolio that failed.

In fact, this gets to the first reason why labels are still relevant: although the distribution function has gradually gone away (although, CDs still made up over 50% of all album sales in 2014), the venture capital function of record labels remains. Apple, Spotify, et al are not interested in discovering and speculatively funding new artists; it’s a difficult and specialized job and the labels are quite good at it. And, like the best sort of VCs, record labels don’t just provide money but also guidance in both an artist’s sound and their business dealings.

Of course labels don’t just find artists who magically become popular: the record labels also help make them so with the aforementioned marketing and promotion costs. This can be everything from getting artists booked on TV, featured in iTunes, or promoted on blogs, but the biggie, even in 2015, is getting artists on the radio. According to the Nielsen 2014 Year End Music Report radio remains the number one source of music discovery: an amazing 91.3% of the U.S. population listens to the radio at least once-a-week, and 51% of those surveyed based their buying decisions off of what they heard on the radio. Record labels have entire divisions devoted to getting their artists on the radio, and while the old under-the-table payments have been outlawed, there still is no expense spared when it comes to getting in front of listeners. Marketing is expensive, and the competition is steep.

The Motivation of Artists

This is why Jay Z and his chart-topping partners are taking on Spotify, not their labels. Jay Z is the extreme example here: he has his own label that deals with artists directly, but Roc Nation is a part of Universal Music Group, which handles distribution, and is financed by Live Nation (making a move into the record labels business) to the tune of $150 million over 10 years. Jay Z isn’t giving that money back so that he can make his music exclusive to Tidal, nor are any of the other artists.

Moreover, even if Jay Z and company were truly independent, they would be heavily incentivized to avoid exclusivity as well: remember that music has high fixed costs but (especially on the Internet) zero marginal costs. That means the best way to make money is to sell as many units as possible in order to spread out those fixed costs. That, by extension, means the optimal strategy for whoever owns the music is making it available in as many places as possible – the exact opposite of an exclusive.²

This ultimately is why Tidal will fail: it’s nice that Jay Z and company would prefer to garner Spotify’s (minuscule) share of streaming revenue, but there is zero reason to expect Tidal to win in the market. Not enough people care – or are even capable of appreciating – the hi-fi option,³ and unlike Beats headphones (but like Beats the music service) software isn’t a status symbol. Moreover, Tidal doesn’t have Spotify’s head-start or free tier, it doesn’t have Apple’s distribution might and bank account, and it doesn’t have any meaningful exclusives⁴ — and to be successful, you need a lot of exclusives; it’s too easy and guilt-free to pirate (or simply skip) one or two songs.

Looking Forward

The key to the record label’s resilience is that their role has always been about more than distribution; it has also been about discovery, funding, and promotion. Each of these is under threat in different ways:

• Discovery: A combination of social media and YouTube has made it massively easier for a musician to spread via word-of-mouth. On the back-end, tools like Shazam are providing real data about what artists are blowing up long before a traditional record label would ever notice. Both of these channels are much more actionable for one of the distribution companies (Apple,⁵ Google/YouTube, and Spotify) than a traditional talent discovery process
• Funding: The cost of producing a basic record has come down dramatically over the years. Sure, things like samples and extensive production raise those costs, but those are also often the luxuries of the already-established. Thanks to computers an artist can put together something good enough to get noticed for remarkably little money⁶
• Promotion: The more that distribution moves away from CDs and to online channels, the more valuable those channels become in terms of promotion. iTunes already has significant expertise in this regard, and I wouldn’t be surprised if Apple in particular is considering an acquisition of Pandora to give Beats an even stronger promotional channel

Still, it’s often far easier to theorize an industry’s downfall than it is to actually effect it. The fact remains that the labels can – and do – take just as much advantage of social and Shazam data as anyone else, and they retain a core competency in developing and nurturing raw material into something popular. Moreover, sometimes better music costs money, and the record labels remain the only source. Finally, promotion generally and radio generally remain a big deal: the more noise there is, the more valuable is the ability to break through the noise.

I would again draw an analogy to venture capital: startups can spread via Twitter or new discovery services like Product Hunt; minimum viable products are cheaper to build than ever thanks to Amazon Web Services, Microsoft Azure, etc.; and distribution channels like App Stores have natural promotional channels. And yet the importance – and amount – of venture capital has never been greater. The truth is that because so many folks can now get started it is that much harder – and more expensive – to cut through the noise. Consumer companies need massive growth for many years, and enterprise companies need expensive salesforces, and the only folks enabling both are venture capitalists.

The Exceptions

There is one big problem with this story of continued label importance: Macklemore. The Seattle rap artist made it to the top of the charts – multiple times – and won multiple Grammys⁷ without the help of a label. Techdirt transcribed a podcast where Macklemore explained his path:

With the power of the internet and with the real personal relationship that you can have via social media with your fans…I mean everyone talks about MTV and the music industry, and how MTV doesn’t play videos any more — YouTube has obviously completely replaced that. It doesn’t matter that MTV doesn’t play videos. It matters that we have YouTube and that has been our greatest resource in terms of connecting, having our identity, creating a brand, showing the world who we are via YouTube. That has been our label. Labels will go in and spend a million dollar or hundreds of thousands of dollars and try to “brand” these artists and they have no idea how to do it. There’s no authenticity. They’re trying to follow a formula that’s dead. And Ryan and I, out of anything, that we’re good at making music, but we’re great at branding. We’re great at figuring out what our target audience is. How we’re going to reach them and how we’re going to do that in a way that’s real and true to who we are as people. Because that’s where the substance is. That’s where the people actually feel the real connection.

Macklemore now works with labels on distribution – CDs still sell! – but he hires them, he doesn’t give away everything before he’s even started. Is he an exception that proves the rule, or the start of a wave?

In the short term I think the former, but the long term is very much an open question: there’s no question the world is changing. Returning to Lefsetz, he made a similar observation in an article about BuzzFeed Motion Pictures:

Are you watching this? It’s kind of like digital photography. We heard about it for a decade and then it happened overnight. We heard about internet delivery of television programs and in the last two weeks, it’s arrived.

And what do people want to see? That’s BuzzFeed’s mission. To capture eyeballs. And to replace the cable TV producers. [Head of BuzzFeed Motion Pictures] Ze [Frank] thinks their model stinks. Thinks the music labels’ model stinks. Wherein you throw a ton of money at the wall and hope something sticks to pay for it all. Ze believes you’ve got to pay as you go. Everything’s got to win…

The key is to create content people can identify with, see themselves in, that they can access at any time. Length, story? Irrelevant…Which is why you’d rather work at BuzzFeed Motion Pictures. Where you get to put your hands on the wheel. Where you’re the master of your own domain. Where you can become a star.

“Become”, not “are.” This is the biggest problem with Tidal. The stars of today would like a few more pennies-per-stream. It’s the stars of tomorrow, though, that will decide the music industry’s fate, and while I might think Jay Z the better rapper, it’s very much possible that Macklemore is the greater inspiration.⁸

Earlier this week the New York Times reported that Facebook was offering publishers a deal:

With 1.4 billion users, the social media site has become a vital source of traffic for publishers looking to reach an increasingly fragmented audience glued to smartphones. In recent months, Facebook has been quietly holding talks with at least half a dozen media companies about hosting their content inside Facebook rather than making users tap a link to go to an external site.

Such a plan would represent a leap of faith for news organizations accustomed to keeping their readers within their own ecosystems, as well as accumulating valuable data on them. Facebook has been trying to allay their fears…To make the proposal more appealing to publishers, Facebook has discussed ways for publishers to make money from advertising that would run alongside the content.

The prevailing wisdom seems to be that this is a bad idea. The late great David Carr, who first broke the news about Facebook’s initiative last fall, said, “Media companies would essentially be serfs in a kingdom that Facebook owns.” Robinson Meyer at The Atlantic recounted Facebook’s previous efforts in this space, particularly its Social Reader, and concluded:

The company will work very hard to satisfy the altar of engagement—in fact, it’s a business imperative that it always work harder. But history shows just how fickle, and how unpredictable, that idol can be.

Ryan Chittum at the Columbia Journalism Review declared flatly: “The news business should refuse Facebook’s deal,” adding:

The point is not that news organizations and other publishers can ignore Facebook and Google and the like. The point is that it’s intolerably risky to build their business models around them.

Perhaps my favorite warning, though, came from John Gruber:

I can see why these news sites are tempted by the offer, but I think they’re going to regret it. It’s like Lando’s deal with Vader in The Empire Strikes Back.

For those who don’t remember, or who (gasp!) have never seen Star Wars, Darth Vader, thanks to a tip from bounty hunter Boba Fett, arrives at Lando Calrissian’s Cloud City to set a trap for the Millennium Falcon and its crew. We find out later that this is when Vader and Lando made their deal: Vader will get Luke Skywalker, Boba Fett will get Han Solo, while Calrissian can keep the Millenium Falcon, Chewbacca, and Leia. Ultimately, though, Vader intends on keeping everyone, delivering his famous line: “I am altering the deal; pray I don’t alter it any further.”

The problem with Gruber’s criticism is that Lando never really actually had a choice. Vader was far more powerful than he was; taking a chance on a deal was the best of a bunch of bad options. That, I think, is the case with most publishers when it comes to Facebook.

Publications’ Mobile Problem

I’ve written several times about the dramatic impact that the Internet has had on journalism, in particular Newspapers are Dead; Long Live Journalism and just a few weeks ago in Why BuzzFeed is the Most Important News Organization in the World. Succinctly, the Internet dramatically increased competition, not only for readers, but also for advertisers. Many newspapers with obsolete print-centric cost structures were ill-equipped to compete; however, many online-only publications, built from the ground-up for Internet economics, quickly appeared to take their place.

This mixture of online newspapers and online-only publications primarily monetized with display ads that appeared alongside the content, and the results have been decidedly mixed. The problem is that online ads are inherently deflationary: just as content has zero marginal cost, so does ad inventory, which means it’s trivial to make more. A limited amount of total advertising dollars spread over more inventory, though, means any individual ad is worth less and less. This resulted in a bit of a prisoner’s dilemma: the optimal action for any individual publication, particularly in the absence of differentiated ad placements or targeting capability, is to maximize ad placement opportunity (more content) and page views (more eyeballs), even though this action taken collectively only hastens the decline in the value of those ads. Perversely, the resultant cheaper ads only intensify the push to create more content and capture more eyeballs; quality is very quickly a casualty.

What is interesting is the particular impact that mobile has had on this dynamic:

• First, mobile display ads stink. Unlike a PC browser, which has a lot of space to display ads alongside content, content on mobile necessarily takes up the whole screen (and if it doesn’t, the user experience degrades significantly, making quality a casualty once again). This results in mobile ad rates that are a fraction of desktop ad rates (and remember, desktop ad rates are already a fraction of print ad rates)
• Second, on mobile, clicks are expensive from a user experience perspective. Not only do PCs typically have faster broadband connections to download assets and more powerful processors to render pages, they also have multiple windows and tabs. On a phone, on the other hand, clicking on a link means you can do nothing but wait for it to open, and open quite slowly at that. The cost of clicking a link, already quite high because of the deluge of crap content and particularly-annoying-on-mobile ads, is even higher because of the fundamental nature of the device

Note that all of these issues with mobile affect new online-only publications just as much as they do old-school newspapers; the problem stems from the display ad business model.

Enter Facebook.

Facebook and Native Advertising

There are three ways to combat the deflationary trend in online advertising:

• Sell/display more ads (which is problematic for the reasons listed above)
• Sell more effective ads that better engage the viewer
• Sell better targeted ads that reach the advertiser’s target audience

Facebook, in stark contrast to publishers, is dominant in all three areas:

• Facebook’s fantastic targeting capabilities are well known, and the company is pushing to make tracking, particularly for brand advertising that results in offline purchase, even more effective
• The company is actually selling fewer ads on the desktop – increasing the price per ad – even as it continues to grow its mobile inventory
• Perhaps most importantly, Facebook has an incredibly effective ad on mobile: a native one

Native advertising has a bit of a bad rap thanks to poor executions like The Atlantic’s Church of Scientology disaster, leading to accusations that native advertising only succeeds to the degree to which it “tricks” the reader. And, for the record, I completely agree that this sort of native advertising is a bad idea, particularly for the publications that employ it: not only does it ruin the publication’s credibility, it doesn’t even work that well.

Instead, the sort of native advertising that is interesting is the type that lives in a stream like the Facebook news feed. I detailed a couple of years ago how Facebook had the best digital ad unit in the world:

The Facebook app owns the entire screen, and can use all of that screen for what benefits Facebook…You can’t help but see the advertising, which makes it particularly attractive to advertisers. Brand advertising, especially, is all about visuals and video (launching soon!), but no one has been able to make brand advertising work as well on the web as it does on TV or print. There is simply too much to see on the screen at any given time.

This is the exact opposite experience of a mobile app. Brand advertising on Facebook’s app shares the screen with no one. Thanks to the constraints of mobile, Facebook may be cracking the display and brand advertising nut that has frustrated online advertisers for years.

There’s just one catch to this sort of advertising: it depends on people immersing themselves in the stream. Clearly, that’s not a problem for Facebook; incredibly, despite its dominance both in terms of users and engagement, the company continues to grow both! Twitter, too, although suffering from a small user base, is monetizing very well because of its immersive nature. Similar opportunities await Instagram, Pinterest, and Snapchat. Each of these services has hundreds of millions of users voluntarily opening their app daily.

Destination Sites

That bit about visiting directly is critical: native advertising only really works if customers go directly to your site or app; it’s much less effective if your site is only ever at the end of a link in another stream (which is the case for the majority of publications). It follows, then, that if native advertising is the only truly sustainable advertising on mobile, that the only sites or apps that can succeed with ads are “destinations” – sites or apps that users go to directly.

Most people don’t have many destinations: a few social networks, and maybe a web page or two; I suspect my list is on the high side when it comes to quantity (and truthfully, the news sites are mostly visited via Twitter or Nuzzel):

The problem is that it’s really hard to become a destination: you need compelling content of consistently high quality. Notice, though, that that is precisely the opposite of what most online publications have focused on: in their race for ever more content and ever more clicks most publications have lowered their quality bar and made themselves uniquely unsuited to making money on mobile.

Of course native advertising is not the only option: three of my “destination” sites (The New York Times, Wall Street Journal, and Financial Times) require a subscription. The quality and consistency bar for a subscription is even higher than for a destination site though, because it requires customers to actually pay money.

The Facebook Future

I believe the vast majority of publications, particular newspapers and older online-only outfits, are in serious trouble on mobile. Not only does their chosen business model (display ads) monetize incredibly poorly, but the incentives that model creates work against those sites becoming destinations capable of supporting effective native advertising.

In this light the Facebook offer is a lifeline:

• Facebook will enforce a quality user experience
• Facebook will utilize its superior targeting and ad unit to generate revenue
• Publishers will be incentivized to create content that is shared, not just clicked

In fact, the incentives will look a lot like BuzzFeed’s – and that’s a good thing. As I noted a few weeks ago:

By not making money from display ads, and by extension deprioritizing page views, BuzzFeed incentivizes its writers to fully embrace Internet assumptions, and just as importantly disincentivizes pure sensationalism. There is no self-editing or consideration of whether or not a particular post will make money, or if it will play well on the home page, or dishonestly writing a headline just to drive clicks. The only goal is to create – or find – something that resonates.

As an aside, there should be zero surprise that BuzzFeed is a pilot member of Facebook’s initiative: their entire business is predicated on understanding how to get content shared. The fact that they make money by selling this ability to brands is what makes them independent (and is why they are important).

Of course most publishers won’t replicate that part of the BuzzFeed model, which means by partnering with Facebook they are committing their future to a company that has very different priorities and could change course at any time, just as they did with the old Social Reader. The problem, though, is that while the Facebook path leads to an uncertain future, uncertainty is preferable to what is probably certain irrelevance (and death). After all, there’s little question in my mind that Facebook will over time favor content that is on site, slowly freezing out everyone else; I think this likely explains the New York Times’ involvement: I just noted the New York Times is unique in that it is a destination, and one that can charge a pretty steep subscription fee to boot. Absent Facebook, though, its growth is almost certainly limited.

That said, even with Facebook’s offer, I think the next few years are going to be difficult ones for the journalism industry. Too many sites have bad business models with bad incentives, and there will be a shakeout. I think, though, this will on the whole be a positive transition for consumers especially. Creating a destination,¹ giving customers content that resonates, or building up alternative revenue streams that benefit from a site’s journalism² all argue against the sort of content-farming and click-bait writing that dominates the web today. If it takes Facebook to hasten that shift, so be it.