Facebook and the Feed

In a week where much of the Internet was all atwitter about Mobilegeddon, Google’s pre-announced algorithm change that will favor mobile-friendly sites in mobile search results, a potentially far more impactful announcement was much more of a surprise: Facebook is tweaking the News Feed algorithm.

This is a big deal for publishers in particular: according to Shareaholic, social referrals passed search referrals last summer and are now up to 31% of site traffic as of December, and Facebook is responsible for an incredible 79% of those social referrals.1 What is perhaps more interesting though, is what these changes mean for Facebook itself.

Understanding Facebook’s Dominance

It is increasingly clear that it is Facebook — not iOS or Android — that is the most important mobile platform. Facebook’s family of apps account for 24% of time spent on mobile, and the main Facebook app is responsible for 75% of that. Mobile apps thrive on “found time” — moments in line, or on the bus, or even on the couch where people simply want to look at something interesting — and Facebook consistently delivers for an increasing number of users all over the world. More impressively, Facebook isn’t just increasing its user base: its existing users continue to deepen their engagement with the app over time.

In this respect Facebook really is the new AOL: in the 1990s the service provided a far easier and more accessible way to get online, and by 1997 nearly 50% of all Americans got online via the service. And, just as publishers and anyone else eager for people’s attention flocked to get their content on AOL, the same is the case for Facebook: as I discussed last month publishers like the New York Times and BuzzFeed are reportedly on the verge of placing their content directly on Facebook. As long as Facebook is the easiest way to access content on mobile, publishers have little choice but to go where their readers are.

The problem with this comparison — at least from Facebook’s perspective — is that 1997 was AOL’s peak. North America’s first broadband service had launched the year previously, and as more and more customers got online through their phone or cable providers, AOL’s moat — dial-up access — evaporated away. And in the end, AOL’s content, compelling though it may have been, simply couldn’t compete with the breadth of the entire Internet.2

Facebook’s Moat

This is where, to my mind, the AOL comparison falls apart. AOL provided an essential utility that was far easier-to-use than the alternatives, but that utility was obsoleted by broadband. Facebook, on the other hand, is built on the social graph: its users’ relationships. And given that the very nature of humanity is to connect and communicate with other humans, the need that Facebook has traditionally met will be with us forever. The only danger is that another service somehow takes Facebook’s place as the Rolodex of the world.

I simply don’t see that happening. At this point, my most extreme Facebook bear case is that the service is the equivalent of an email address: something nearly everyone has because you can’t function without it, even if it’s not their preferred means of communication.

However, I say “extreme” for a reason: for many Facebook is much more than that. Here in Asia, for example, Facebook is LinkedIn: it is standard for an introductory business meeting to conclude with Facebook friend invites. Facebook is also the homepage for the vast majority of businesses: a page is much more discoverable and much easier to maintain, and most don’t even bother with a website.3 A significant amount of e-commerce happens on Facebook as well, and most celebrities and well-known bloggers post primarily or exclusively on Facebook (although Instagram is increasingly important as well). True, messaging services like WhatsApp and LINE increasingly handle one-on-one or private group conversations, but in country after country that I visit or research the social paradigm is Facebook + X social network; the X changes (and is often a Facebook property), but Facebook is the constant.4

Still, the argument I just made is about the ongoing usefulness of having a Facebook account. What about engagement?

What Drives Facebook Engagement?

This is the central question facing Facebook, and a fascinating way to think about yesterday’s News Feed changes. The Verge has a good summary:

Facebook has announced it’s twisting the knobs that control what content you see in your News Feed to favor more content from your close friends. In a post titled “News Feed FYI: Balancing Content from Friends and Pages,” Facebook said it’s making three changes. The first is that it won’t let people reach the “end” of a News Feed as easily, because it will be willing to show more content from the same publisher than it was before. Previously, you wouldn’t be likely to get two posts from the same Page. But the other two changes are more ominous for publishers, but potentially great for users who actually want to see content from their friends: “content posted by the friends you care about” will be “higher up in the News Feed.” Also, if a friend interacts with a post from a brand or publisher page, it will be less likely to show up in your News Feed.

This is hardly the first major change to Facebook’s News Feed algorithm:5 consider, for example, this major update from December 2013:

We’ve noticed that people enjoy seeing articles on Facebook, and so we’re now paying closer attention to what makes for high quality content, and how often articles are clicked on from News Feed on mobile. What this means is that you may start to notice links to articles a little more often (particularly on mobile)…

While trying to show more articles people want to read, we also don’t want people to miss the conversations among their friends. So we’re updating bumping to highlight stories with new comments…With this update stories will occasionally resurface that have new comments from friends.

This December 2013 change had a huge effect, crushing viral sites like Upworthy while bumping up traffic for sites like BuzzFeed, Business Insider, and The Guardian. What is perhaps more interesting, though, is that yesterday’s changes seem to run in the opposite direction: prioritizing friends, when 2013’s update prioritized news; and deprioritizing friends’ comments and likes, when 2013 bumped them up.

Here’s the thing: I’m quite sure the 2013 changes weren’t arbitrary. Facebook is a very data-driven company, and all available evidence suggests that the changes had their intended effect: as I noted above Facebook is not only increasing users but also deepening the engagement of their existing users quarter after quarter. That’s why I’m curious just how important data was in yesterday’s changes compared to the personal preference of Facebook founder and CEO Mark Zuckerberg and his belief about what makes Facebook valuable.

Facebook’s Vision and Potential

Zuckerberg is quite clear about what drives him; he wrote in Facebook’s S-1:

Facebook was not originally created to be a company. It was built to accomplish a social mission – to make the world more open and connected.

I am starting to wonder if these two ideas — company versus mission — might not be more in tension now than they have ever been in the past. I’m increasingly convinced that Facebook has an absolutely massive business opportunity on its hands: to capture, almost completely, the imminent wave of advertising dollars deserting TV for digital. To do so, though, will require an embrace of Facebook’s status as the “homepage of the Internet” (on mobile in particular), and an abdication of sorts of the social interactions that built the company.

For several years now the percentage of people’s attention devoted to digital has far outstripped the percentage of advertising devoted to the medium. Television and (especially) print, on the other hand, keeps a far greater share of advertising than it seems they deserve:

via BuzzFeed

via BuzzFeed

A big reason for television’s dominance in particular is that it is simply the easiest way to reach a large audience. Twitter may offer interest-based targeting, for example, but your typical brand manager simply doesn’t have the time or expertise to optimize every dollar across a broad array of platforms. Efficiency is just as much a feature of advertising as is targeting capability, conversion tracking, or price.

Still, as I wrote in Old-Fashioned Snapchat, advertisers care above all about attention, and there’s no question that television is losing it both to alternative video services like Netflix but also to digital services, especially Facebook. Last year the average user gave Facebook over 40 minutes of attention a day (and another 20 minutes to Instagram, a property capable of supporting a very Facebook-like advertising unit), and that number continues to grow. Given Facebook’s excellent targeting capabilities and aspirations for Atlas’s ability to provide conversion tracking (members-only), it’s not inconceivable that, at some point in the relatively near future, it is Facebook that is the default advertising medium, commanding dollars that exceed its already dominant share of attention. Still, this outcome depends on Facebook driving ever-more engagement, and I’m not convinced that more “content posted by the friends [I] care about” is the best path to success.

What Matters to Users?

Everyone loves to mock Paul Krugman’s 1998 contention about the limited economic impact of the Internet:

The growth of the Internet will slow drastically, as the flaw in “Metcalfe’s law”–which states that the number of potential connections in a network is proportional to the square of the number of participants–becomes apparent: most people have nothing to say to each other!

It’s worth considering, though, just how much users value what their friends have to say versus what professional media organizations produce. Again, as I noted above, Facebook made the 2013 decision to increase the value of newsworthy links for a reason, and in the time since, BuzzFeed in particular has proven that there is a consistent and repeatable way to not only reach a large number of people but to compel them to share content as well. Was Krugman wrong because he didn’t appreciate the relative worth people put on what folks in their network wanted to say, or because he didn’t appreciate that people in their network may not have much to say but a wealth of information to share?

I suspect that Zuckerberg for one subscribes to the first idea: that people find what others say inherently valuable, and that it is the access to that information that makes Facebook indispensable. Conveniently, this fits with his mission for the company. For my part, though, I’m not so sure. It’s just as possible that Facebook is compelling for the content it surfaces, regardless of who surfaces it. And, if the latter is the case, then Facebook’s engagement moat is less its network effects than it is that for almost a billion users Facebook is their most essential digital habit: their door to the Internet.

Facebook’s Choice

I’ve written previously about publishers and the smiling curve, the idea that value is increasingly flowing to aggregators on the right and differentiated content creators on the left; publishers are being left in the cold.

Publishers and the Smiling Curve

Publishers and the Smiling Curve

Facebook is slowly but surely building a bridge between the left and right sides of that curve: publishers are being invited into a revenue-sharing content-on-Facebook deal now, but what is to stop the program from extending to individuals? Same thing with Facebook’s video unit, which is on pace to attract more advertisers than YouTube. Were this to happen, it’s easy to see Facebook as a one-stop shop for even more users than today, and were that to happen, advertisers would inevitably follow to an even greater degree.

This course, though, depends on Facebook giving users exactly what they want, or at least a good enough mix, in their news feed, and as I noted, I’m not convinced personal updates is enough. Moreover, while Facebook may view “the network” as their differentiator, the fact is that a lot of “friend” sharing is indeed moving to alternative networks like Snapchat and LINE and WhatsApp. With this News Feed update I am concerned that Facebook is limiting itself and committing to a battle — the private sharing of information — it can’t necessarily win.

Consider Facebook’s smartest acquisition, Instagram. The photo-sharing service is valuable because it is a network, but it initially got traction because of filters. Sometimes what gets you started is only a lever to what makes you valuable. What, though, lies beyond the network? That was Facebook’s starting point, and I think the answer to what lies beyond is clear: the entire online experience of over a billion people. Will Facebook seek to protect its network — and Zuckerberg’s vision — or make a play to be the television of mobile?

I will admit, I write this analysis with mixed feelings: from a strategic perspective, I think Facebook should go for it — be the dominant interaction model on mobile for every user on earth (outside of China). On the other hand, as an advocate and beneficiary of the open web, I do fear this future and wonder: What might be the broadband to Facebook’s dial-up?

  1. Pinterest is second, with 16% of social referral, and Twitter a distant third, with only 3% of social referrals
  2. AOL — now Aol — still exists of course, but it’s basically another Yahoo; relatively high-traffic sites monetized through relatively undifferentiated advertising. That said, it is more profitable…thanks to dial-up!
  3. As I’ve written previously, WeChat fills these roles in China, where Facebook is banned
  4. That is why I was not surprised to see this month’s Pew Research report that showed that Facebook was still the dominant social networking service amongst teenagers, past scaremongering notwithstanding
  5. Buffer’s blog has a running list

Twitter and What Might Have Been

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

  1. The introduction originally read as follows:

    Clearly, Twitter would like you to forget one particularly controversial moment in its history:

    Screenshot 2015-04-15 at 8.43.34 PM

    In case you can’t make out the URL, the page in question is a blog post entitled “Changes coming in Version 1.1 of the Twitter API”, and the most upsetting news was in the section called “Changes to the Developer Rules of the Road”. From The Internet Archive:

    It turns out the blog post was moved, not deleted. I apologize for the mistake

  2. That’s why I don’t really object to the celebrity pressure either.
  3. This eternal rumor was repeated this week; for the record, I think it’s highly unlikely, first and foremost because Twitter is simply too expensive now. And, I might add, I think Twitter will be ok for now; missed potential doesn’t mean outright failure. The long-term danger of slowing user growth is real though: advertisers will want to consolidate

Podcast: Exponent 041 – Bubbles

On the newest episode of Exponent, the podcast I co-host with James Allworth:

In this week’s episode Ben and James discuss whether or not there is a bubble, as well as a bit on the Apple Watch. Please note this was recorded before the Apple Watch reviews were released.


  • Ben Thompson: It’s Not 1999 – Stratechery
  • The Unicorn List – Fortune
  • Ben Thompson: The Multitudes of Social – Stratechery
  • Bill Gurley: Investors Beware: Today’s $100M+ Late-stage Private Rounds Are Very Different from an IPO – Above the Crowd
  • Turd on the Front Porch – The Talk Show
  • Ben Thompson: Apple Watch’s Bad Messaging – Stratechery (members-only)
  • David Pierce: iPhone Killer: The Secret History of the Apple Watch – Wired
  • Last Week Tonight with John Oliver: Government Surveillance – YouTube
  • Ben Thompson: Apple Watch: Asking Why and Saying No – Stratechery

Listen to the episode here

Podcast Information: Feed | iTunes | SoundCloud | Twitter | Feedback

It’s Not 1999

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.

  1. Make sure you read this sentence with the proper amount of condescension; if you have forgotten, it was exceptionally heavy
  2. This should be read with disgust
  3. And this is where I desperately hope this article isn’t hung around my neck in a year or two
  4. Moreover, it was IBM, not Microsoft, that made the PC open in order to get it more quickly to market, and it was a decision they came to dearly regret when “IBM-compatible” PCs, led by Compaq, undercut the IBM PC and came to own the growing market (and why were they “IBM-compatible”? Because they ran MS-DOS on Intel chips)
  5. Sorry Lyft
  6. I.e. your customer acquisition cost (CAC) is $100
  7. Although Chris Sacca deserves special credit for coming up with the idea of special purpose vehicles that raise money in order to invest in a specific startup, an increasingly common vector for growth capital
  8. As an aside, this is why I don’t take the relatively poor performance of many recent IPOs as a bubble indicator; increasing stock prices are about an increasing expectation of future growth, but if much of the growth has been realized, then why should we expect stocks to do anything more than hover?

Podcast: Exponent 040 – BuzzFeed and Amazon

On the newest episode of Exponent, the podcast I co-host with James Allworth:

In this week’s episode Ben and James discuss BuzzFeed in the context of the Brother Orange story, the discuss Amazon’s Dash Button and Home Services initiative, along with a dive into the technical details of Amazon’s balance sheet (sorry, it’s a bit dry) and why Ben is nervous.


  • Matt Stopera: I Followed My Stolen iPhone Across The World, Became A Celebrity In China, And Found A Friend For Life – BuzzFeed
  • Ben Thompson: Why BuzzFeed is the Most Important News Organization in the World – Stratechery
  • Matt Stopera: Who Is This Man And Why Are His Photos Showing Up On My Phone? – BuzzFeed
  • Peter Osborne: Why I have resigned from the Telegraph – OpenDemocracy
  • Introducing Amazon Dash Button – Amazon
  • Introducing Amazon Dash Replenishment Service – Amazon
  • Amazon Home Services – Amazon
  • Ben Thompson: Losing my Amazon Religion – Amazon
  • Timothy Green: Inc. Is Losing More Money Than You Think – Motley Fool
  • Marc Bain: Consumer culture has found its perfect match in our mobile-first, fast-fashion lifestyles – Quartz

Listen to the episode here

Podcast Information: Feed | iTunes | SoundCloud | Twitter | Feedback

Tidal and the Future of Music

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

  1. When the unnamed executive refers to costs “escalating in such a marginal way” he is referring to the way marketing spend increases with each artist; marketing, though, is a fixed cost for any one album. The more albums you buy, the less the marketing costs on a per-album sold basis
  2. Longtime readers will make the connection to my arguments as to why Google’s services will always work on the iPhone, and why I was so aghast at Microsoft strategy of using their services to differentiate Windows Phone (since abandoned, thankfully): both companies have horizontal business models that dictate a strategy of reaching as many consumers as possible. This is the case for most services, and Apple’s are the exception that proves the rule: their services serve to differentiate their hardware, which is where they make money, thus the exclusivity
  3. If anything the hi-fi offering has hurt Tidal by anchoring the price at $20/month in too many people’s minds
  4. Some outlets are reporting that Tidal has exclusive rights to Taylor Swift’s back catalog, but that’s incorrect; Swift’s catalog is available on any streaming service that doesn’t have a free tier
  5. This is another potential angle to Apple’s Topsy acquisition
  6. This is the biggest different from video, in my opinion. Quality television is still significantly more expensive than self-produced content; the delta in music is less (and dramatically less when it comes to text)
  7. Which should have gone to Kendrick Lamar, but that’s neither here nor there
  8. Speaking of business models only, mind you! I bet Jay Z, who himself couldn’t get a label at the beginning and who has proven to be a brilliant businessman, would follow the same path were he starting today

Podcast: Exponent 039 – Lando Calrissian Publishers

On the newest episode of Exponent, the podcast I co-host with James Allworth:

In this week’s episode Ben and James follow up on last week’s episode, introduce the Toilet Bowl philosophy of career development, and then dive into the future of publishers in the world of Facebook.


Listen to the episode here

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