The Cost of Developers

Yesterday saw three developer-related announcements, two from Apple, and one from Microsoft. The former came as part of Apple’s annual Worldwide Developers Conference keynote:

  • The iOS App Store, which turns 10 next month, serves 500 million weekly visitors, and as of later this week will have earned developers over $100 billion.
  • Sometime next year developers will be able to write apps for the Mac using iOS user interface frameworks (known as UIKit).

Microsoft, meanwhile, for the second time in three years, outshone Apple’s keynote with a massive acquisition. From the company’s press release:

Microsoft Corp. on Monday announced it has reached an agreement to acquire GitHub, the world’s leading software development platform where more than 28 million developers learn, share and collaborate to create the future. Together, the two companies will empower developers to achieve more at every stage of the development lifecycle, accelerate enterprise use of GitHub, and bring Microsoft’s developer tools and services to new audiences.

“Microsoft is a developer-first company, and by joining forces with GitHub we strengthen our commitment to developer freedom, openness and innovation,” said Satya Nadella, CEO, Microsoft. “We recognize the community responsibility we take on with this agreement and will do our best work to empower every developer to build, innovate and solve the world’s most pressing challenges.”

Under the terms of the agreement, Microsoft will acquire GitHub for $7.5 billion in Microsoft stock.

Developers can be quite expensive indeed!

Platform-Developer Symbiosis

Over the last few weeks, particularly in The Bill Gates Line, I have been exploring the differences between aggregators and platforms; while aggregators generally harvest already produced content or goods, developers leverage the platform to create something entirely new.

Platforms facilitate while aggregators intermediate

This results in a symbiosis between developers and platforms: from a technical perspective, platforms provide the fundamental building blocks (i.e. application program interfaces, or APIs) necessary for developers to build new experiences, and from a marketing perspective, those new experiences give customers a reason to buy the platform in the first place, or to upgrade.

The degree to which applications drive adoption of the underlying platform can, of course, vary; unsurprisingly the monetization potential of the platform relative to developers varies in a correlated way. Traditional Windows, for example, provided very little end user functionality; what made it so valuable were all of the applications built on top of its open platform.

Windows was an open platform

Here “open” means two things: first, the Windows API was available to anyone to build on, and two, developers built relationships directly with end users, including payment. This led to many huge software companies and, in 2003, to the creation of a platform on top of Windows: Valve’s Steam.

What Valve realized is that playing a game is only one part of the overall customer experience; the experience of discovering and buying the game matters as well, as does the installation and upgrade process. Moreover, these customer pain points were developer pain points as well; the original impetus to develop Steam, for example, was the difficulty in getting players to upgrade en masse, something that was essential for games in which players competed online. And, while Valve is a private company and has never announced Steam’s revenue numbers, reports suggest the platform generates billions of dollars a year.

Even that, though, pales in comparison to the iOS App Store: Apple took Steam’s app store idea and integrated it with the platform, such that iOS users and developers had no choice but to use Apple’s owned-and-operated distribution channel, with all of the various limitations and costs — 30%, to be precise — that that entailed.

The iPhone platform with an intermediation layer

Apple was able to accomplish this first and foremost because the underlying products — the iPhone and iPad — inspired demand in their own right, independent of applications. Apple had the users that developers needed to make money.

Second, the App Store, like Steam before it, really was a better experience that drove more downloads and purchases by end users. This meant that developing for iOS wasn’t simply attractive because of the number of users, but also because those users were willing to buy more than they would have on another platform.

Third — and this applies to Steam as well — the App Store dramatically lowered the barriers to entry for developers; this led to more apps, which attracted more users, which led to more apps, both locking in apps as a competitive advantage and also ensuring that no one app had outsized power (leaving Apple free to restrict Steam-like competitors by fiat).

Apple’s Platform Announcements

This frames the two Apple announcements I noted above. Start with the news of $100 billion for iOS developers: that means that Apple has collected around $40 billion, and at a very high margin to boot.

Moreover, the vast majority of Apple’s announcements were, if anything, about competing with those developers: the first new app announced, Measure, should immediately wipe out the only obviously useful Augmented Reality apps in the store. Apple also announced a new Podcasts app for Watch, update News, Stocks, and Voice Memo apps, and the only third party demos were about how one of the largest software companies there is — Adobe — would be supporting Apple’s preferred 3D-image format. And why not! The implication of owning all of those high-value users is that, on iOS anyways, developers are cheap.

The Mac, though, is a different story: the platform is far smaller than the iPhone; that there remain a number of high quality independent software vendors supporting the Mac is a testament to how valuable it is for developers to be able to build direct relationships with customers that can span years and multiple transactions. Still, there seems little question that the number of Mac apps is, if not trending in the wrong direction, certainly not growing in any meaningful way; there simply aren’t enough users to entice developers.

That means Apple’s approach has to be very different from iOS: instead of dictating terms to developers, Apple announced that it is in the middle of a multi-year project to make it easier to port iOS apps to the Mac. This is, in a fashion, Apple paying for Mac apps; no, the money isn’t going to developers, but Apple is voluntarily taking on a much greater portion of the porting workload. Developers are much more expensive when you don’t have nearly as many users.

The Cost of GitHub

Still, whatever it is costing Apple to build this porting framework, it surely is a lot less than $7.5 billion, the price Microsoft is paying for GitHub. Then again, at first glance, it may not be clear what the point of comparison is.

Go back to Windows: Microsoft had to do very little to convince developers to build on the platform. Indeed, even at the height of Microsoft’s antitrust troubles, developers continued to favor the platform by an overwhelming margin, for an obvious reason: that was where all the users were. In other words, for Windows, developers were cheap.

That is no longer the case today: Windows remains an important platform in the enterprise and for gaming (although Steam, much to Microsoft’s chagrin, takes a good amount of the platform profit there), but the company has no platform presence in mobile, and is in second place in the cloud. Moreover, that second place is largely predicated on shepherding existing corporate customers to cloud computing; it is not clear why any new company — or developer — would choose Microsoft.

This is the context for thinking about the acquisition of GitHub: lacking a platform with sufficient users to attract developers, Microsoft has to “acquire” developers directly through superior tooling and now, with GitHub, a superior cloud offering with a meaningful amount of network effects. The problem is that acquiring developers in this way, without the leverage of users, is extraordinarily expensive; it is very hard to imagine GitHub ever generating the sort of revenue that justifies this purchase price.

Again, though, GitHub revenue is not the point; Microsoft has plenty of revenue. What it also has is a potentially fatal weakness: no platform with user-based leverage. Instead Microsoft is betting that a future of open-source, cloud-based applications that exist independent of platforms will be a large-and-increasing share of the future, and that there is room in that future for a company to win by offering a superior user experience for developers directly, not simply exerting leverage on them.

This, by the way, is precisely why Microsoft is the best possible acquirer for GitHub, a company that, having raised $350 million in venture capital, was possibly not going to make it as an independent entity. Any company with a platform with a meaningful amount of users would find it very hard to resist the temptation to use GitHub as leverage; on the other side of the spectrum, purely enterprise-focused companies like IBM or Oracle would be tempted to wring every possible bit of profit out of the company.

What Microsoft wants is much fuzzier: it wants to be developers’ friend, in large part because it has no other option. In the long run, particularly as Windows continues to fade, the company will be ever more invested in a world with no gatekeepers, where developer tools and clouds win by being better on the merits, not by being able to leverage users.

That, though, is exactly why Microsoft had to pay so much: buying in directly is a whole lot more expensive than using leverage, which can produce equivalent — or better! — returns for much less investment.

The Bill Gates Line

Two of the more famous military sayings are “Generals are always preparing to fight the last war”, and “Never interrupt your enemy while he is making a mistake.” I thought of the latter at the conclusion of last Sunday’s 60 Minutes report on Google:

Google declined our request for an interview with one of its executives for this story, but in a written response to our questions, the company denied it was a monopoly in search or search advertising, citing many competitors including Amazon and Facebook. It says it does not make changes to its algorithm to disadvantage competitors and that, “our responsibility is to deliver the best results possible to our users, not specific placements for sites within our results. We understand that those sites whose ranking falls will be unhappy and may complain publicly.”

The 60 Minutes report was not exactly fair-and-balanced; it featured an anti-tech-monopoly crusader1, an anti-tech-monopoly activist, an anti-tech-monopoly regulator, and Yelp CEO Jeremy Stoppelman. And, in what seems highly unlikely to have been a coincidence, Yelp this week filed a new antitrust complaint in the EU against Google. To be sure, just because a report was biased does not mean it was wrong; while I am a bit skeptical of the EU’s antitrust case against Google Shopping, the open case about Android seems pretty clear-cut. Neither, though, is Yelp’s direct concern.

Yelp’s Case Against Google

This is from a blog post about the 60 Minutes feature:

Yelp did participate in the piece because Google is doing the opposite of “delivering the best results possible,” and instead is giving its own content an unlawful advantage. We’ve made a video to explain exactly how Google puts its own interests ahead of consumers in local search, which you can watch here:

Yelp’s position, at least in this video, appears to be that Google’s answer box is anticompetitive because it only includes reviews and ratings from Google; presumably the situation could be resolved were Google to use sources like Yelp. There are three problems with this argument, though:

  • First, the answer box originally included content scraped from sources like Yelp and other vertical search sites; under pressure from the FTC, driven in part by complaints from Yelp and other vertical search engines, Google agreed to stop doing so in 2013.2
  • Second, in a telling testament to the power of being on top of search results, Google’s ratings and reviews have improved considerably in the two years since that video was posted; this isn’t a static market (to be sure, this is an argument that could be used on both sides).
  • Third — and this is the point of this article — what Yelp seems to want will only serve to make Google stronger.

No wonder Google declined the request for an interview.

The Bill Gates Line

Over the last few weeks I have been exploring what differences there are between platforms and aggregators, and was reminded of this anecdote from Chamath Palihapitiya in an interview with Semil Shah:

Semil Shah: Do you see any similarities from your time at Facebook with Facebook platform and connect, and how Uber may supercharge their platform?

Chamath: Neither of them are platforms. They’re both kind of like these comical endeavors that do you as an Nth priority. I was in charge of Facebook Platform. We trumpeted it out like it was some hot shit big deal. And I remember when we raised money from Bill Gates, 3 or 4 months after — like our funding history was $5M, $83 M, $500M, and then $15B. When that 15B happened a few months after Facebook Platform and Gates said something along the lines of, “That’s a crock of shit. This isn’t a platform. A platform is when the economic value of everybody that uses it, exceeds the value of the company that creates it. Then it’s a platform.”

By this measure Windows was indeed the ultimate platform — the company used to brag about only capturing a minority of the total value of the Windows ecosystem — and the operating system’s clear successors are Amazon Web Services and Microsoft’s own Azure Cloud Services. In all three cases there are strong and durable businesses to be built on top.

A drawing of Platform Businesses Attract Customers by Third Parties
From Tech’s Two Philosophies

Once a platform dips under the Bill Gates Line, though, the long-term potential of a business built on a “platform” starts to decline. Apple’s App Store, for example, has all of the trappings of a platform, but Apple quite clearly captures the vast majority of the overall ecosystem, both because of the profitability of the iPhone and also because of its control of App Store economics; the paucity of strong and durable businesses on the App Store is a natural outgrowth of that.

The App Store intermediates 3rd parties and users

Note that Apple’s ability to control the economics of its developers comes from intermediating the relationship of those developers with customers.

Aggregators, Not Platforms

Facebook and Google take this intermediation to the extreme, leveraging their ability to drive discovery of the sheer abundance of information on their network and the Internet broadly:

A drawing of Aggregators Own Customer Relationships and Suppliers Follow
In the aggregator business model the aggregator owns customers and suppliers follow

It follows that Facebook and Google’s “platforms” not only don’t meet the Bill Gates Line, they don’t even register on the graph: they are the purest expression of aggregators. From my original formulation:

The fundamental disruption of the Internet has been to turn this dynamic on its head. First, the Internet has made distribution (of digital goods) free, neutralizing the advantage that pre-Internet distributors leveraged to integrate with suppliers. Secondly, the Internet has made transaction costs zero, making it viable for a distributor to integrate forward with end users/consumers at scale.

This has fundamentally changed the plane of competition: no longer do distributors compete based upon exclusive supplier relationships, with consumers/users an afterthought. Instead, suppliers can be aggregated at scale leaving consumers/users as a first order priority. By extension, this means that the most important factor determining success is the user experience: the best distributors/aggregators/market-makers win by providing the best experience, which earns them the most consumers/users, which attracts the most suppliers, which enhances the user experience in a virtuous cycle.

The result is the shift in value predicted by the Conservation of Attractive Profits. Previous incumbents, such as newspapers, book publishers, networks, taxi companies, and hoteliers, all of whom integrated backwards, lose value in favor of aggregators who aggregate modularized suppliers — which they often don’t pay for — to consumers/users with whom they have an exclusive relationship at scale.

This is ultimately the most important distinction between platforms and aggregators: platforms are powerful because they facilitate a relationship between 3rd-party suppliers and end users; aggregators, on the other hand, intermediate and control it.

Moreover, at least in the case of Facebook and Google, the point of integration in their respective value chains is the network effect. This is what I was trying to get at last week in The Moat Map with my discussion of the internalization of network effects:

  • Google has had the luxury of operating in an environment — the world wide web — that was by default completely open. That let the best technology win, and that win was augmented by the data that comes from serving an ever-increasing portion of the market. The end result was the integration of end users and the data feedback cycle that made Google search better and better the more it was used.
  • Facebook’s differentiator, meanwhile, is the relationships between friends and family; the company has subsequently integrated that network effect with consumer attention, forcing all of the content providers to jostle for space in the Newsfeed as pure commodities.

It’s worth noting, by the way, why it was that Facebook could come to be a rival to Google in the first place; specifically, Facebook had exclusive data — those relationships and all of the behavior on Facebook’s site that resulted — that Google couldn’t get to. In other words, Facebook succeeded not by being a part of Google, but by being completely separate.

Succeeding in a World of Aggregators

This gets at why I find Yelp’s complaints a bit besides the point: the company seems to be expending an awful lot of energy to regain the right to give Google the content Yelp worked hard to acquire. There is revenue there, of course, just as there is in the production of commodities generally, but without a sustainable cost advantage it’s not the best route to building a strong and durable business.

Of course that is the bigger problem: I noted above that Google’s library of ratings and reviews has grown substantially over the past few years; users generating content are the ultimate low-cost supplier, and losing that supply to Google is arguably a bigger problem for Yelp than whatever advertising revenue it can wring out from people that would click through on a hypothetical Google Answer Box that used 3rd-party sources. And, it should be noted, that Yelp’s entire business is user-generated reviews: they and similar vertical sites are likely to do a far better job of generating, organizing, and curating such data.

Still, I can’t help but wonder whether or not Yelp’s problem is not that Google is using its own content in the Answer Box, but rather the Answer Box itself; which of these set of results would be better for Yelp’s business, even in a hypothetical world where Answer Box content comes from Yelp?

Yelp would get more visitors without the answer box

Presuming that the answer is the image on the right — driving users to Yelp is both better for the bottom line and better for content generation, which mostly happens on the desktop — and it becomes clear that Yelp’s biggest problem is that the more useful Google is — even if it only ever uses Yelp’s data! — the less viable Yelp’s business becomes. This is exactly what you would expect in an aggregator-dominated value chain: aggregators completely disintermediate suppliers and reduce them to commodities.

To that end, this is why the best strategies entail business models that avoid Google and Facebook completely: look no further than Amazon, which last month stopped buying Google Shopping ads, something the company can afford to do given that half of shoppers start their product searches on Amazon. To be sure, Amazon is plenty powerful in its own right, but it is a hard-to-ignore example of Google’s favorite argument that “competition is only a click away.”

Yelp Versus Google

Still, I have sympathy for Yelp’s position; Stoppelman told 60 Minutes:

If I were starting out today, I would have no shot of building Yelp. That opportunity has been closed off by Google and their approach…because if you provide great content in one of these categories that is lucrative to Google, and seen as potentially threatening, they will snuff you out.

Stoppelman is right, but the reason is perhaps less nefarious than it seems; the 60 Minutes report explained why in the voiceover:

Yelp and countless other sites depend on Google to bring them web traffic — eyeballs for their advertisers.

Yelp, like many other review sites, has deep roots in SEO — search-engine optimization. Their entire business was long predicated on Google doing their customer acquisition for them. To the company’s credit it has become a well-known brand in its own right, and now gets around 70% of its visits via its mobile app. Those visits are very much in the Amazon model I highlighted above: users are going straight to Yelp and bypassing Google directly.

That, though, isn’t great for Google! It seems a bit rich that Yelp should be free to leverage its app to avoid Google completely, and yet demand that Google continue to feature Yelp prominently in its search results, particularly on mobile, where the Answer Box has particular utility. I get that Yelp feels like Google has changed the terms of the deal from when Yelp was founded in 2004, but the reality is that the change that truly mattered was mobile.

What I do find compelling is a new video that Yelp put out yesterday; while it makes many of the same points as the one above, instead of being focused on regulators it is targeting Google itself, arguing that Google isn’t living up to its own standards by not featuring the best results, and not driving traffic back to sites that make the content Google needs (by, for example, not including prominent links to the content filling its answer boxes; Yelp isn’t asking that they go away, just that they drive traffic to 3rd parties). Google may be an aggregator, but it still needs supply, which means it needs a sustainable open web. The company should listen.

Facebook and Data Portability

Facebook, unfortunately for its suppliers, faces no such constraints: the content that is truly differentiated is made by Facebook’s users, and it is wholly owned by Facebook. Facebook is even further from the Bill Gates Line than Google is: the latter at least needs commoditized suppliers; the former can take or leave them on a whim, and does.

That is why I’ve come to realize a popular prescription for Facebook’s dominance, data portability, put forward this week by a coalition of progressive organizations under the umbrella Freedom From Facebook, is so mistaken.3 The problem with data portability is that it goes both ways: if you can take your data out of Facebook to other applications, you can do the same thing in the other direction. The question, then, is which entity is likely to have the greater center of gravity with regards to data: Facebook, with its social network, or practically anything else?

Facebook at the center of data exchange
From The Facebook Brand

Remember the conditions that led to Facebook’s rise in the first place: the company was able to circumvent Google, go directly to users, and build a walled garden of data that the search company couldn’t touch. Partnering or interoperating with companies below the Bill Gates Line, particularly aggregators, is simply an invitation to be intermediated. To demand that governments enforce exactly that would be a mistake that only helps Facebook.4

The broader takeaway is that distinguishing between platforms and aggregators isn’t simply an academic exercise: it should affect how companies think about their competitive environment vis-à-vis the biggest companies in tech, and, just as importantly, it should weigh heavily on regulators. The Microsoft antitrust battles of the 2000s were in many respects about enforcing interoperability as a way of breaking into the Microsoft platform; today antitrust should be far more concerned about aggregators capturing everything they touch by virtue of their control of end users.

That’s the thing about the “Generals fight the last war” saying; it’s usually applied to the losing side that made mistake after mistake while the victors leveraged the new world order.

I wrote a follow-up to this article in this Daily Update.

  1. I’ve discussed why I disagree with Gary Reback’s views on monopoly and innovation in this Daily Update [↩︎]
  2. With regard to that FTC decision, yes, as the Wall Street Journal reported, some FTC staff members recommended suing Google; what is not true is that the recommendation was unanimous, or that FTC commissioners ultimately deciding to go in another direction was unusual. In fact, other staff groups in other groups recommended against the suit, and the decision of the FTC commissioners was unanimous. Again, that is not to say it was the right decision, but that the popular conception — including what was reported in that 60 Minutes piece — is a bit off [↩︎]
  3. To be fair, I’ve made the same argument previously, but I’ve changed my mind [↩︎]
  4. The group’s demand that Facebook be forced to divest Instagram, WhatsApp, and Messenger makes much more sense in terms of this framework (with the exception of Messenger, which has always been a part of Facebook). I strongly believe that the single best antitrust remedy for aggregators is limiting acquisitions [↩︎]

The Moat Map

A subtext to last week’s article, Tech’s Two Philosophies, was the idea that there is a difference between Aggregators and Platforms; this was the key section:

It is no accident that Apple and Microsoft, the two “bicycle of the mind” companies, were founded only a year apart, and for decades had broadly similar business models: sure, Microsoft licensed software, while Apple sold software-differentiated hardware, but both were and are at their core personal computer companies and, by extension, platforms…

Google and Facebook, on the other hand, are products of the Internet, and the Internet leads not to platforms but to aggregators. While platforms need 3rd parties to make them useful and build their moat through the creation of ecosystems, aggregators attract end users by virtue of their inherent usefulness and, over time, leave suppliers no choice but to follow the aggregators’ dictates if they wish to reach end users.

The distinction wasn’t entirely satisfying; first and foremost the power of both aggregators and platforms, however defined, ultimately rests on the size and strength of their userbase. Moreover, Google and Facebook have platform-type aspects to their business, and Apple has aggregator characteristics when it comes to its control of the App Store (that Microsoft does not is a symbol of the company’s mobile failure).

Moreover, what of companies like Amazon, or Netflix? In a follow-up Daily Update I classified the former as a platform and the latter as an aggregator, but clearly both have very different businesses — and supplier relationships — than either Google and Facebook on one side or Apple and Microsoft on the other, even as they both derive their power from owning the customer relationship.

Make no mistake, that bit about owning the customer relationship remains critical: that is the critical insight of Aggregation Theory. How that ownership of the customer translates into an enduring moat, though, depends on the interaction of two distinct attributes: supplier differentiation and network effects.

The Supplier Differentiation Spectrum

Consider the six companies I mentioned above: Facebook, Google, Amazon, Netflix, Apple, and Microsoft.1

The degree of differentiation of tech company suppliers varies

These companies exist on a spectrum in terms of supplier differentiation (and, by extension, supplier power):

  • Facebook has commoditized suppliers more than anyone: an article from the New York Times is treated no differently from a BuzzFeed quiz or the latest picture of your niece or an advertisement.
  • Google gives slightly more deference to established content providers, but not much; search results are presented the same regardless of their source (although Google increasingly presents results differently depending on the type of content).
  • Amazon is a little harder to classify — that’s kind of entailed in the name The Everything Store — but generally brands are much less important than they are in a world of limited shelf space, and few people even realize they are buying from the 3rd party merchants that make up over half of Amazon’s sales.
  • Differentiation matters more for Netflix, particularly when it comes to acquiring new users; still, users are transacting with Netflix and, the longer they stick with the streaming service, first opening Netflix and then looking for something to watch, as opposed to the other way around.
  • Apple first and foremost attracts and retains users through its integrated experience, but that experience would quickly be abandoned were there not third party apps.
  • Microsoft traditionally succeeded entirely because of its ecosystem, not just applications but also the entire universe of value-added resellers, systems integrators, etc.

The extremes make the point: Facebook could lose all of its third party content providers overnight and still be a compelling service; Microsoft without third parties would be, well, we already saw with Windows Phone.

The Network Effect Spectrum

Another way to consider this spectrum is in terms of user-related network effects. The idea of a network effect is that an additional user increases the value of a good or service, and indeed all of these companies depend on network effects. However, the type of network effect differs considerably, as well as the extent to which the network effect directly improves a company’s core product (what I am calling an “internalized” versus “externalized” network effect):

The internalization of network effects varies by tech company

Again there is a spectrum:

  • For Facebook the network effect that matters is users — a social network’s most important feature is whether your friends and family are using it. This network — given it is the product! — is completely internal to Facebook.
  • Google has network effects of its own, but they are less about users and more about data: more people searching makes for better search results, because of the system Google has built to relentlessly harvest, analyze, and iterate on data. Like Facebook, Google’s network effect is largely internal to Google.
  • Amazon’s network effect is more subtle: there is an aspect where your shopping on Amazon improves my experience through things like rankings, reviews, and data feedback loops. Just as important, though, are two additional effects: first, the more people that shop on Amazon, the more likely suppliers are to come onto Amazon’s platform, increasing price and selection for everyone. In other words, Amazon, particularly as it transitions to being more of a commerce platform and less of a retailer, is a two-sided network. There is one more factor though: Amazon’s incredible service rests on hundreds of billions of dollars in investments; that fixed cost investment has to be born by customers at some point, which means the more customers there are the less any one customer is responsible for those fixed costs (this manifests indirectly through lower prices and better service).
  • Netflix is a hybrid much like Amazon: there are certainly data network effects when it comes to what shows are made, what are cancelled, recommendations, ratings, etc. An essential part of Netflix’s competitive advantage going forward, though, rests on its differentiated ability to invest in new shows; this investment capability is driven by the company’s huge and still-growing user base, which is the biggest way that additional users benefit users already on the service.
  • Apple certainly benefits from a large user base over which to spread the significant fixed costs of its products, but on this end of the spectrum it is the two-sided network of developers and users that is most important. The more users that are on a platform, the more developers there will be, which increases the value of the platform for everyone.
  • Microsoft, befitting the point I made above about the expansiveness of its ecosystem, has the most “externalized” network effect of all: there is very little about Windows, for example, that produces a network effect (Office is another story), but the ecosystem on top of Windows produced one of the greatest network effects ever.

At this point, you may have noticed that these two spectrums run in roughly the same order: I don’t think that is a coincidence.

The Moat Map

Here are these two spectrums laid out on two orthogonal axis:

The Map Moat represents the relationship between supplier differentiation and network externalization

This relationship between the differentiation of the supplier base and the degree of externalization of the network effect forms a map of effective moats; to again take these six companies in order:

  • Facebook has completely internalized its network and commoditized its content supplier base, and has no motivation to, for example, share its advertising proceeds. Google similarly has internalized its network effects and commoditized its supplier base; however, given that its supply is from 3rd parties, the company does have more of a motivation to sustain those third parties (this helps explain, for example, why Google’s off-site advertising products have always been far superior to Facebook’s).
  • Netflix and Amazon’s network effects are partially internalized and partially externalized, and similarly, both have differentiated suppliers that remain very much subordinate to the Amazon and Netflix customer relationship.
  • Apple and Microsoft, meanwhile, have the most differentiated suppliers on their platforms, which makes sense given that both depend on largely externalized network effects. “Must-have” apps ultimately accrue to the platform’s benefit.

It is just as useful to think about what happens when companies find themselves outside of the Moat Map.

Missing Moats

Start with Apple and apps: in August 1997, Steve Jobs, having just returned to Apple, took the stage at Macworld Boston and proceeded to humble himself: first, he talked about how much Apple needed Adobe, and then he announced a settlement with Microsoft that entailed Microsoft investing in Apple and developing Office for Mac for at least five years. That was followed by Bill Gates’ grinning visage appearing via satellite over Jobs’ head:

An image from MacWorld Boston when Microsoft invested in Apple

I wrote in 2013 that I believe this experience resulted in Apple making poor strategic choices with the iPhone and iPad: the company never again wanted to have its suppliers become too powerful. The way this played out, though, is that Apple for years neglected the business model needs of developers building robust productivity apps that could have meaningfully differentiated iOS devices from Android.

To be sure, the company has been more than fine: its developer ecosystem is plenty strong enough to allow the company’s product chops to come to the fore. I continue to believe, though, that Apple’s moat could be even deeper had the company considered the above Moat Map: the network effects of a platform like iOS are mostly externalized,2 which means that highly differentiated suppliers are the best means to deepen the moat; unfortunately Apple for too long didn’t allow for suitable business models.

Some company's and models outside of the Moat Map

Another example is Uber: on the one hand, Uber’s suppliers are completely commoditized. This might seem like a good thing! The problem, though, is that Uber’s network effects are completely externalized: drivers come on to the platform to serve riders, which in turn makes the network more attractive to riders. This leaves Uber outside the Moat Map. The result is that Uber’s position is very difficult to defend; it is easier to imagine a successful company that has internalized large parts of its network (by owning its own fleet, for example), or done more to differentiate its suppliers. The company may very well succeed thanks to the power from owning the customer relationship, but it will be a slog.

On the opposite side of the map are phone carriers in a post-iPhone world: carriers have strong network effects, both in terms of service as well as in the allocation of fixed costs. Their profit potential, though, was severely curtailed by the emergence of the iPhone as a highly differentiated supplier. Suddenly, for the first time, customers chose their carrier on the basis of whether or not their preferred phone worked there; today, every carrier has the iPhone, but the process of reaching that point meant the complete destruction of carrier dreams of value-added services, and a lot more competition on capital-intensive factors like coverage and price.

Direction or Context?

It’s worth noting that maps can take two forms: some give direction, and others provide context for what has already happened; I’m not entirely sure which best describes the Moat Map. In the case of Apple and apps, for example, I absolutely believe the company could have made different strategic choices had it fully appreciated the interaction between supplier differentiation and network effects.

On the other hand, one could make a very strong case that the degree of supplier differentiation possible flows from the network effect involved: perhaps it was inevitable that Facebook and Google commoditized suppliers, for example, or that Amazon and Netflix would have to simultaneously pursue differentiated suppliers even as they sought to suppress them. What is always certain, though, is that there is no one perfect strategy: as always, it depends.

Thanks to James Allworth, my co-host on the Exponent podcast, for helping me conceptualize this framework

I wrote a follow-up to this article in this Daily Update.

  1. In this article when I refer to “Amazon” I am primarily referring to the e-commerce company; Microsoft the PC company. I will cover AWS and Azure in a follow-up in the Daily Update. [↩︎]
  2. iMessage being an instructive exception [↩︎]

Tech’s Two Philosophies

Even though Apple’s developer conference is still a few weeks away, I think it’s safe to say that the demo of Google Duplex at yesterday’s Google I/O keynote will go down as the most impressive of the tech conference season. If you haven’t seen it, it is a must-watch:

Once I picked my jaw up off the floor, though, what struck me about Google CEO Sundar Pichai’s presentation was how he opened the segment:

Our vision for our assistant is to help you get things done.

And how he closed it:

A common theme across all this is we are working hard to give users back time. We’ve always been obsessed about that at Google. Search is obsessed about getting users to answers quickly and giving them what they want.

In Google’s view, computers help you get things done — and save you time — by doing things for you. Duplex was the most impressive example — a computer talking on the phone for you — but the general concept applied to many of Google’s other demonstrations, particularly those predicated on AI: Google Photos will not only sort and tag your photos, but now propose specific edits; Google News will find your news for you, and Maps will find you new restaurants and shops in your neighborhood. And, appropriately enough, the keynote closed with a presentation from Waymo, which will drive you.

The Google and Facebook Philosophy

Rewind a week, and there was a specific section in Mark Zuckerberg’s keynote at the Facebook F8 conference that stuck out to me:

I believe that we need to design technology to help bring people closer together. And I believe that that’s not going to happen on its own. So to do that, part of the solution, just part of it, is that one day more of our technology is going to need to focus on people and our relationships. Now there’s no guarantee that we get this right. This is hard stuff. We will make mistakes and they will have consequences and we will need to fix them. But what I can guarantee is that if we don’t work on this the world isn’t moving in this direction by itself.

Zuckerberg, as so often seems to be the case with Facebook, comes across as a somewhat more fervent and definitely more creepy version of Google: not only does Facebook want to do things for you, it wants to do things its chief executive explicitly says would not be done otherwise. The Messianic fervor that seems to have overtaken Zuckerberg in the last year, though, simply means that Facebook has adopted a more extreme version of the same philosophy that guides Google: computers doing things for people.

The Microsoft and Apple Philosophy

Earlier this week, while delivering Microsoft’s Build conference keynote, CEO Satya Nadella struck a very different tone; after describing how computing was becoming invisible, because it is everywhere, Nadella said:

That’s the opportunity that we have. It’s in some sense endless, but we also have responsibility. We have the responsibility to ensure that these technologies are empowering everyone, these technologies are creating equitable growth by ensuring that every industry is able to grow and create employment. But we also have a responsibility as a tech industry to build trust in technology.

In fact Hans Jonas was a philosopher who worked in the 50s, 60s, and he wrote a paper on technology and responsibility…he talks about act so that the effects of your action are compatible with permanence or genuine life. That’s something that we need to reflect on, because he was talking about the power of technology being such that it far outstrips our ability to completely control it, especially its impact even on future generations. And so we need to develop a set of principles that guide the choices we make because the choices we make is what’s going to define the future…

This opportunity and responsibility is what grounds us in our mission to empower every person and every organization on the planet to achieve more. We’re focused on building technology so that we can empower others to build more technology. We’ve aligned our mission, the products we build, our business model, so that your success is what leads to our success. There’s got to be complete alignment.

This is technology’s second philosophy, and it is orthogonal to the other: the expectation is not that the computer does your work for you, but rather that the computer enables you to do your work better and more efficiently. And, with this philosophy, comes a different take on responsibility. Pichai, in the opening of Google’s keynote, acknowledged that “we feel a deep sense of responsibility to get this right”, but inherent in that statement is the centrality of Google generally and the direct culpability of its managers. Nadella, on the other hand, insists that responsibility lies with the tech industry collectively, and all of us who seek to leverage it individually.

The Bicycle of the Mind

This second philosophy, that computers are an aid to humans, not their replacement, is the older of the two; its greatest proponent — prophet, if you will — was Microsoft’s greatest rival, and his analogy of choice was, coincidentally enough, about transportation as well. Not a car, but a bicycle:

Steve Jobs was exceptionally fond of this analogy: there are multiple clips of him making the point in mostly the same way; I usually link to this one because by the time this video was recorded1 Jobs had his delivery perfectly honed.

Interestingly, though, the earliest known clip of Jobs telling this story, from 1980, doesn’t include the famous phrase “Bicycle of the Mind”; it’s worth watching, though, all the same:

The best analogy I’ve ever heard is Scientific American, I think it was, did a study in the early 70s on the efficiency of locomotion, and what they did was for all different species of things in the planet, birds and cats and dogs and fish and goats and stuff, they measured how much energy does it take for a goat to get from here to there. Kilocalories per kilometer or something, I don’t know what they measured. And they ranked them, they published the list, and the Condor won. The Condor took the least amount of energy to get from here to there. Man was didn’t do so well, came in with a rather unimpressive showing about a third of the way down the list.

But fortunately someone at Scientific American was insightful enough to test a man with a bicycle, and man with a bicycle won. Twice as good as the Condor, all the way off the list. And what it showed was that man is a toolmaker, has the ability to make a tool to amplify an inherent ability that he has. And that’s exactly what we’re doing here.

This is precisely what Nadella was driving at: “to empower every person and every organization on the planet to achieve more” is to “amplify an inherent ability” those people and organizations have; the goal is not to do things for them, but to enable them to do things never before possible. And, I would hasten to add, Apple remains very much on the same side of this philosophical divide.

The Chicken and Egg Question

There is certainly an argument to be made that these two philosophies arise out of their historical context; it is no accident that Apple and Microsoft, the two “bicycle of the mind” companies, were founded only a year apart, and for decades had broadly similar business models: sure, Microsoft licensed software, while Apple sold software-differentiated hardware, but both were and are at their core personal computer companies and, by extension, platforms.

In a platform business model 3rd parties attract customers

Google and Facebook, on the other hand, are products of the Internet, and the Internet leads not to platforms but to aggregators. While platforms need 3rd parties to make them useful and build their moat through the creation of ecosystems, aggregators attract end users by virtue of their inherent usefulness and, over time, leave suppliers no choice but to follow the aggregators’ dictates if they wish to reach end users.

In the aggregator business model the aggregator owns customers and suppliers follow

The business model follows from these fundamental differences: a platform provider has no room for ads, because the primary function of a platform is provide a stage for the applications that users actually need to shine. Aggregators, on the other hand, particularly Google and Facebook, deal in information, and ads are simply another type of information.2 Moreover, because the critical point of differentiation for aggregators is the number of users on their platform, advertising is the only possible business model; there is no more important feature when it comes to widespread adoption than being “free.”

Still, that doesn’t make the two philosophies any less real: Google and Facebook have always been predicated on doing things for the user, just as Microsoft and Apple have been built on enabling users and developers to make things completely unforeseen.

Tech’s Yin and Yang

That there are two philosophies does not necessarily mean that one is right and one is wrong: the reality is we need both. Some problems are best solved by human ingenuity, enabled by the likes of Microsoft and Apple; others by collective action. That, though, gets at why Google and Facebook are fundamentally more dangerous: collective action is traditionally the domain of governments, the best form of which is bounded by the popular will. Google and Facebook, on the other hand, are accountable to no one. Both deserve all of the recent scrutiny they have attracted, and arguably deserve more.

That scrutiny, though, and whatever regulations that result, must keep in mind this philosophical divide: platforms that create new possibilities — and not just Apple and Microsoft! — are the single most important economic force when it comes to countering the oncoming wave of computers doing people’s jobs, and lazily written regulation that targets aggregators but constricts platforms will inevitably do more harm than good.

The truth is that the Divine Discontent that I wrote about last week is not only an antidote to low-end disruption, but also a reason for optimism: companies like Apple and Amazon can, as I noted, win in the long run by offering a superior user experience, but more importantly, the dividend of discontent is a greenfield of opportunities to build new businesses and new jobs alleviating that discontent. For that we need platforms on which to build those businesses, and yes, we will need artificial intelligence to do things for us so we have the time.

I wrote a follow-up to this article in this Daily Update.

  1. 1990 I believe, but I’m not certain [↩︎]
  2. As I’ve written in the past, this is why mobile saved Facebook: the company desperately wanted to be a platform but being “just an app” left Facebook no choice but to be self-contained and thus a better ad company [↩︎]

Divine Discontent: Disruption’s Antidote

It is nothing but a number, no different than 999,999,999,999 for all practical purposes, but we humans are not practical creatures: we attach importance to all kinds of silly things, round numbers chief amongst them. To that end, an increasingly popular parlor question in the stocks as entertainment business is which company will be worth $1 trillion first?

The market caps of the top five companies over time

There are certainly cases to be made for Google and Microsoft and even Facebook, but most of the attention is focused on Amazon and Apple: the latter for being the closest, and the former for growing the fastest, at least recently:

The market cap of Apple and Amazon over time

It is interesting to consider these two companies in conjunction: they couldn’t be more different, but for the one thing that makes them both so valuable.

Apple Versus Amazon

I mean it when I say these companies are the complete opposite: Apple sells products it makes; Amazon sells products made by anyone and everyone. Apple brags about focus; Amazon calls itself “The Everything Store.” Apple is a product company that struggles at services; Amazon is a services company that struggles at product. Apple has the highest margins and profits in the world; Amazon brags that other’s margin is their opportunity, and until recently, barely registered any profits at all. And, underlying all of this, Apple is an extreme example of a functional organization, and Amazon an extreme example of a divisional one.

These points are all, of course, interrelated: Apple’s organizational structure, focus, and release-focused development cycle enable it to create highly differentiated products, even as the exact same structure, focus, and development cycle underly the company’s struggles in iterative services.1 Similarly, Amazon’s highly modular structure, varied businesses, and iterative approach to those businesses enable it to create services with itself as its first, best, customer, and then extend those services to developers and retailers, even as the exact same factors lead to product disasters like the Fire Phone.

Both, taken together, are a reminder that there is no one right organizational structure, product focus, or development cycle: what matters is that they all fit together, with a business model to match. That is where Apple and Amazon are arguable more alike than not: both are incredibly aligned in all aspects of their business. What makes them truly similar, though, is the end goal of that alignment: the customer experience.

The iPhone Versus Disruption

The first time Apple released two different iPhone form factors in the same year was 2013. There the new form factor was the iPhone 5C, but while the industrial design was new, the pricing wasn’t: the 5C slotted into the spot where the discontinued iPhone 5 would traditionally have gone — $100 less than the new flagship iPhone 5S. Analysts and pundits were aghast: how could Apple not produce a truly low-price iPhone? Didn’t they know this guaranteed disruption?

I argued to the contrary in a piece entitled What Clayton Christensen Got Wrong. After recounting the many predictions by the father of disruption that the iPhone would not be a success, I came up with three specific reasons why Apple seemed immune to disruptive gravity:

  • First, it was folly to presume that consumers were rational, at least to the extent that rationality could be reduced to easily articulable features balanced against price (or appreciating that round numbers aren’t anything special).
  • Second, there are many attributes of a product that can’t be easily measured, but only experienced, and that they loom large when the person using the product is the same as the person buying the product.
  • Third, that modular products, by virtue of their prioritization of standardization and interconnectivity, would inevitably fall short on attributes directly connected to the experience of using the device.

The key paragraph is here:

The attribute most valued by consumers, assuming a product is at least in the general vicinity of a need, is ease-of-use. It’s not the only one — again, doing a job-that-needs-done is most important — but all things being equal, consumers prefer a superior user experience. What is interesting about this attribute is that it is impossible to overshoot.

The term “overshoot” is right out of disruption theory. Christensen writes in his seminal book, The Innovator’s Dilemma:

The second element of the failure framework, the observation that technologies can progress faster than market demand…means that in their efforts to provide better products than their competitors and earn higher prices and margins, suppliers often “overshoot” their market: They give customers more than they need or ultimately are willing to pay for. And more importantly, it means that disruptive technologies that may underperform today, relative to what users in the market demand, may be fully performance-competitive in that same market tomorrow.

This was the basis for insisting that the iPhone must have a low-price model: surely Apple would soon run out of new technology to justify the prices it charged for high-end iPhones, and consumers would start buying much cheaper Android phones instead!

In fact, as I discussed in after January’s earnings results, the company has gone in the other direction: more devices per customer, higher prices per device, and an increased focus on ongoing revenue from those same customers. Yesterday’s results were mostly more of the same: wearables were up a lot (more devices per customer); ASP’s were down from last quarter but still 11% higher than a year ago;2 services revenue, meanwhile, shot through the roof for reasons that are still a bit unclear, but impressive nonetheless.

Also the same was a very modest increase in the number of iPhone sold: 3% more than a year ago. Apple seems to have mostly saturated the high end, slowly adding switchers even as existing iPhone users hold on to their phones longer; what is not happening, though, is what disruption predicts: Apple isn’t losing customers to low-cost competitors for having “overshot” and overpriced its phones. It seems my thesis was right: a superior experience can never be too good — or perhaps I didn’t go far enough.

Amazon and Divine Discontent

Jeff Bezos has been writing an annual letter to shareholders since 1997, and he attaches that original letter to one he pens every year. It included this section entitled Obsess Over Customers:

From the beginning, our focus has been on offering our customers compelling value. We realized that the Web was, and still is, the World Wide Wait. Therefore, we set out to offer customers something they simply could not get any other way, and began serving them with books. We brought them much more selection than was possible in a physical store (our store would now occupy 6 football fields), and presented it in a useful, easy-to-search, and easy-to-browse format in a store open 365 days a year, 24 hours a day. We maintained a dogged focus on improving the shopping experience, and in 1997 substantially enhanced our store. We now offer customers gift certificates, 1-Click shopping, and vastly more reviews, content, browsing options, and recommendation features. We dramatically lowered prices, further increasing customer value. Word of mouth remains the most powerful customer acquisition tool we have, and we are grateful for the trust our customers have placed in us. Repeat purchases and word of mouth have combined to make the market leader in online bookselling.

Over the last 20 years Amazon has dramatically changed, but Bezos’ annual focus on consumers has not. This year, after highlighting just how much customers love Amazon (answer: a lot), Bezos wrote:

One thing I love about customers is that they are divinely discontent. Their expectations are never static — they go up. It’s human nature. We didn’t ascend from our hunter-gatherer days by being satisfied. People have a voracious appetite for a better way, and yesterday’s ‘wow’ quickly becomes today’s ‘ordinary’. I see that cycle of improvement happening at a faster rate than ever before. It may be because customers have such easy access to more information than ever before — in only a few seconds and with a couple taps on their phones, customers can read reviews, compare prices from multiple retailers, see whether something’s in stock, find out how fast it will ship or be available for pick-up, and more. These examples are from retail, but I sense that the same customer empowerment phenomenon is happening broadly across everything we do at Amazon and most other industries as well. You cannot rest on your laurels in this world. Customers won’t have it.

Critically, when it comes to Internet-based services, this customer focus does not come at the expense of a focus on infrastructure or distribution or suppliers: while those were the means to customers in the analog world, in the online world controlling the customer relationship gives a company power over its suppliers, the capital to build out infrastructure, and control over distribution. Bezos is not so much choosing to prioritize customers insomuch as he has unlocked the key to controlling value chains in an era of aggregation.

Bezos’s letter, though, reveals another advantage of focusing on customers: it makes it impossible to overshoot. When I wrote that piece five years ago, I was thinking of the opportunity provided by a focus on the user experience as if it were an asymptote: one could get ever closer to the ultimate user experience, but never achieve it:

The asymptote version of the user experience

In fact, though, consumer expectations are not static: they are, as Bezos’ memorably states, “divinely discontent”. What is amazing today is table stakes tomorrow, and, perhaps surprisingly, that makes for a tremendous business opportunity: if your company is predicated on delivering the best possible experience for consumers, then your company will never achieve its goal.

The ever-changing version of the user experience

In the case of Amazon, that this unattainable and ever-changing objective is embedded in the company’s culture is, in conjunction with the company’s demonstrated ability to spin up new businesses on the profits of established ones, a sort of perpetual motion machine; I’m not sure that Amazon will beat Apple to $1 trillion, but they surely have the best shot at two.

The Disruption Antidote

This analysis applies to Facebook and Google, two of the other companies in that chart, more than you might expect. While the two companies’ revenues are based on advertising, the attractiveness to advertisers rests on consumers using both services.3 Both, though, are disadvantaged to an extent because their means of making money operate orthogonally to a great user experience; both are protected by the fact would-be competitors inevitably have the same business model.4

That is why, for all four companies, the first place to look for weaknesses is not in the supplier base or distribution or even regulation: it is with the end users. That is why it matters that Amazon is the most popular company in the United States, why Apple and Google continue to have two of the most respected brands, and why Facebook is right to be more concerned about the PR effect of its scandals than the regulatory ones. Owning the customer relationship by means of delivering a superior experience is how these companies became dominant, and, when they fall, it will be because consumers deserted them, either because the companies lost control of the user experience (a danger for Facebook and Google), or because a paradigm shift made new experiences matter more (a danger for Google and Apple).

In the meantime, though, disruption5 has its antidote.

  1. Yes, the company is crushing it with regards to “Services” revenue; that is mostly from the App Store and also iCloud Storage, that is to say, predicated on iPhone dominance. This reference is to things like Siri and Maps [↩︎]
  2. There was a lot of breathless speculation about iPhone X sales cratering, which clearly didn’t happen. That said, iPhone X sales clearly fell off a bit: iPhone ASP was down 9% sequentially, a much larger drop than the 6% drop a year ago. [↩︎]
  3. Microsoft is an enterprise company, a very different beast [↩︎]
  4. For a social network, the number one feature is how many of your friends are on it, which means a “free” service will always have an advantage; for a search engine, there is a weaker, but still significant, network effect that is based on data, which again augurs for a free service with the maximum number of users that entails. [↩︎]
  5. Low-end disruption, to be clear [↩︎]