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  • Why Uber Fights

    In his, to my mind, fair defense of Uber, Mark Suster made a very important observation about the reality of business:

    Let’s put this into perspective. As somebody who has to rub shoulders with big tech companies often I can tell you that there is much blood spilled in the competitive trenches of Apple, Twitter, Facebook, Google and so on. Changes to algorithms. Clamping down on app ecosystems. Changing how third-parties monetize. Kicking ecosystem partners in the nuts.

    Be real.

    It’s a brutally competitive world out there because there are extreme amounts of money at stake. I’ve been on the sharp end of it and it doesn’t feel nice. And I pick myself back up, dust off and think to myself that I need to think through the realpolitik of power and money and competition and no matter how unpleasant it is – it’s a Hobbesian world out there. It ain’t pretty – but it’s all around us.

    This is particularly relevant to Uber: the company is looking to raise another $1 billion at a valuation of over $30 billion, and, as I wrote when the company raised its last billion, they are likely worth far more than that. Still, though, skeptics about both the size of the potential market and the prospects of Uber in particular are widespread, so consider this post my stake in the ground1 for why Uber – and their market – is worthy of so many sharp elbows. I expect to link to it often!

    There are three perspectives with which to examine the competitive dynamics of ride-sharing:

    1. Ride-sharing in a single city
    2. Ride-sharing in multiple cities
    3. Tipping points

    I will build up the model that I believe governs this market in this order; ultimately, though, they all interact extensively. In addition, for these models I am going to act as if there are only two players: Uber and Lyft. However, the same principles apply no matter how many competitors are in a given market.

    Ride Sharing in a Single City

    Consider a single market: Riderville. Uber and Lyft are competing for two markets: drivers and riders.

    uber

    There are a few immediate takeaways here:

    • The number of riders is far greater than the number of drivers (far greater, in fact, than the percentage difference depicted by this not-to-scale sketch)
    • On the flip side, drivers engage with Uber and Lyft far more frequently than do riders
    • Ride-sharing is a two-sided market, which means there are two places for Uber and Lyft to compete – and two potential opportunities for winner-take-all dynamics to emerge

    It’s important to note that drivers in-and-of-themselves do not have network dynamics, nor do riders: Metcalfe’s Law, which states that the value of a network is proportional to the square of the number of connected users, does not apply. In other words, Uber having more drivers does not increase the value of Uber to other drivers, nor does Lyft having more riders increase the value of Lyft to other riders, at least not directly.

    However, the driver and rider markets do interact, and it’s that interaction that creates a winner-take-all dynamic. Consider the case in which one of the two services – let’s say Uber – gains a majority share of riders (we’ll talk about how that might occur in the next section):

    • Uber has a majority of riders (i.e. more demand)
    • Drivers will increasingly serve Uber customers (i.e. more supply)
    • More drivers means that Uber’s service level (i.e. car liquidity) will improve
    • Higher liquidity means that Uber has a better service, which will gain them more riders

    In this scenario Lyft by necessity moves in the opposite direction:

    • Lyft has fewer riders (i.e. less demand)
    • Drivers will face increasing costs to serve Lyft riders:
      • If there are fewer Lyft riders, than the average distance to pick up a Lyft rider will be greater than the average distance to pick up an Uber driver; drivers may be better off ignoring Lyft pickups and waiting for closer Uber pickups
      • Every time a driver picks up a rider on one service, they need to sign out on the other; if the vast majority of rides are with one service, this, combined with the previous point, may make the costs associated with working for multiple services too high2
    • Drivers will increasingly be occupied serving Uber customers and be unavailable to serve Lyft customers (i.e. less supply)
    • Fewer drivers means that Lyft’s service level (i.e. car liquidity) will decrease
    • Lower liquidity means that Lyft has an inferior service, which will cause them to lose more riders

    The end result of this cycle, repeated over months, looks something like this:

    uber2

    There are three additional points to make:

    • It doesn’t matter that drivers may work for both Uber and Lyft. If the majority of the ride requests are coming from Uber, they are going to be taking a significantly greater percentage of driver time, and every minute a driver spends on a rider job is a minute that driver is unavailable to the other service. Moreover, this monopolization of driver time accelerates as one platform becomes ever more popular with riders. Unless there is a massive supply of drivers, it is very difficult for the 2nd-place car service to ever get its liquidity to the same level as the market leader (much less the 3rd or 4th entrants in a market)

    • The unshaded portion of the “Riders” pool are people who regularly use both Uber and Lyft. The key takeaway is that that number is small: most people will only use one or the other, because ride-sharing services are relatively undifferentiated. This may seem counterintuitive, but in fact in markets where:

      • Purchases are habitual
      • Prices are similar
      • Products are not highly differentiated

      …Customers tend to build allegiance to a brand and persist with that brand unless they are given a good reason to change; it’s simply not worth the time and effort to constantly compare services at the moment of purchase3 (in fact, the entire consumer packaged goods industry is based on this principle).

      In the case of Uber and Lyft, ride-sharing is (theoretically) habitual, both companies will ensure the prices are similar, and the primary means of differentiation is car liquidity, which works in the favor of the larger service. Over time it is reasonable to assume that the majority player will become dominant

    • I briefly mentioned price: clearly this is the easiest way to differentiate a service, particularly for a new entrant with relatively low liquidity (or the 2nd place player, for that matter). However, the larger service is heavily incentivized to at least price match. Moreover, given that the larger service is operating at greater scale, it almost certainly has more latitude to lower prices and keep them low for a longer period of time than the new entrant. Or, as is the case with ride-sharing, a company like Uber has as much investor cash as they need to compete at unsustainably low prices

    In summary, these are the key takeaways when it comes to competition for a single-city:

    • There is a strong “rich get richer” dynamic as drivers follow riders which increases liquidity which attracts riders. This is the network effect that matters, and is in many ways similar to app ecosystem dynamics (developers follow users which which increases the number and quality of apps which attracts users)

    • It doesn’t matter if drivers work for both services, because what matters is availability, and availability will be increasingly monopolized by the dominant service

    • Riders do not have the time and patience to regularly compare services; most will choose one and stick with it unless the alternative is clearly superior. And, because of the prior two points, it is almost certainly the larger player that will offer superior service

    Ride Sharing in a Multiple Cities

    It is absolutely true that all of the market dynamics I described in the previous section don’t have a direct impact on geographically disperse cities, which is another common objection to Uber’s potential. What good is a network effect between drivers and riders if it doesn’t travel?

    There is, however, a relationship between geographically disperse cities, and it occurs in the rider market, which, as I noted in the previous section, is the market where the divergence between the dominant and secondary services takes root. Specifically:

    • Pre-existing services launch with an already established brand and significant mindshare among potential riders. Uber is an excellent example here: the company is constantly in the news, and their launch in a new city makes news, creating a pool of riders whose preference from the get-go is for Uber

    • Travelers, particularly frequent business travelers, are very high volume users of ride-sharing services. These travelers don’t leave their preferences at home – when they arrive at an airport they will almost always first try their preferred service, just as if they were at home, increasing demand for that service, which will increase supply, etc. In this way preference acts as a type of contagion that travels between cities with travelers as the host organism

    Most important of all, though, is the first-mover effect. In any commodity-type market where it is difficult to change consumer preference there is a big advantage to being first. This means that when your competitor arrives, they are already in a minority position and working against all of the “rich get richer” effects I detailed above.

    uber3

    This explains Uber and Lyft’s crazy amounts of fundraising and aggressive roll-out schedules, even though such a strategy is incredibly expensive and results in a huge number of markets that are years away from profitability (Uber, for example, is in well over 100 cities but makes almost all its money from its top five). Starting out second is the surest route to finishing second, and, given the dynamics I’ve described above, that’s as good as finishing last.

    Tipping Points

    What I’ve described up to this point explain what has happened between Uber and Lyft to-date. Still, while I’ve addressed many common objections to Uber’s valuation in particular, there remains the question of just how much this market is worth in aggregate. After all, as Aswath Damodaran, the NYU Stern professor of finance and valuations expert detailed, the taxi market is worth at most $100 billion which calls into question Uber’s rumored $30 billion valuation.

    However, as Uber investor Bill Gurley and others have noted, Damodaran’s fundamental mistake in determining Uber’s valuation is to look at the world as it is, not as it might be.4 Moreover, this world that could be is intimately tied to the dynamics described above. I like to think of what might happen next as a series of potential tipping points (for this part of the discussion I am going to talk about Uber exclusively, as I believe they are – by far – the most likely company to reach these tipping points):

    • Tipping Point #1: Liquidity is consistently less than 5 minutes and surge pricing is rare – Once Uber becomes something you can count on both from a time and money perspective, rider behavior could begin to change in fundamental ways. Now, Uber is not just for a business meeting or a night out; instead, Uber becomes the default choice for all transportation. This would result in dramatically increased rider demand, resulting in complete Uber domination of driver availability. This would have several knock-on effects:
      • Driver utilization would increase significantly, increasing driver wages to a much more sustainable level
      • Competitor liquidity would decrease precipitously, leading to rider desertion and an Uber monopoly; this would allow Uber to raise rates to a level that is more sustainable for drivers, further increasing supply and liquidity

      By all accounts Uber is already close to this level in San Francisco, and there are lots of anecdotes of people all but giving up cars.5 The effect of this change in rider behavior cannot be overstated, especially when it comes to Uber’s potential valuation: taxis have a tiny share of the world’s transportation market, which means to base the company’s valuation on the taxis is to miss the vast majority of Uber’s future market opportunity

    • Tipping Point #2: Uber transports not just people – Uber has already done all kinds of experiments with delivering things other than people, including Christmas trees, lunch, a courier service, even drugstore items. However, any real delivery service would need to have some sort of service-level agreement when it comes to things like speed and price. Both of those rely on driver liquidity, which is why an Uber logistics service is ultimately waiting for the taxi business to tip as described above.

      However, once such a delivery service is launched, its effect would be far-reaching. First, driver utilization would increase even further, particularly when it comes to serving non centrally located areas. This would further accentuate Uber’s advantage vis-à-vis potential competitors: Uber service would be nearly instant, and drivers – again, even if they nominally work for multiple services – would be constantly utilized.

      Moreover, there is a very good chance that Uber could come to dominate same-day e-commerce and errands like grocery shopping: most entrants in this space have had a top-down approach where they set up a retail operation and then figure out how to get it delivered; the problem, though, is that delivery is the bottleneck. Uber, meanwhile, is busy building up the most flexible and far-reaching delivery-system, making it far easier to move up the stack if they so choose. More likely, Uber will become the delivery network of choice for an ecosystem of same-day delivery retailers. Needless to say, that will be a lucrative position to be in, and it will only do good things for Uber’s liquidity.

    Why Uber Fights

    The implications of this analysis cannot be underestimated: there is an absolutely massive worldwide market many times the size of the taxi market that has winner-take-all characteristics. Moreover, that winner is very unlikely to be challenged by a new entrant which will have far worse liquidity and an inferior cash position: Uber (presuming they are the winner) will simply lower prices and bleed the new entrant dry until they go out of business.

    To put it another way, I think that today’s environment where multiple services, especially Lyft, are competing head-on with Uber is a transitional one. Currently that competition is resulting in low prices and suppressed driver wages, but I expect Uber to have significant pricing power in the long run and to be more generous with drivers than they are now, not for altruistic reasons, but for the sake of increasing liquidity and consistent pricing.

    In short, Uber is fighting all out for an absolutely massive prize, and, as Suster noted, such fights are much more akin to Realpolitik. As Wikipedia defines it:

    Realpolitik is politics or diplomacy based primarily on power and on practical and material factors and considerations, rather than explicit ideological notions or moral or ethical premises

    It’s ethics – or, to be more precise, Uber’s alleged lack of them – that has been dominating the news most recently, and is what inspired Suster’s post. And, to be very clear, I can understand and share much of the outrage: in my Daily Update I have compared Uber to Wall Street and said that Emil Michael should be fired (both links members-only) for his comments suggesting Uber might investigate journalists – Sarah Lacy in particular – who disparage the company.6

    However – and one of the reasons I’m writing this article – I am also very aware of just how much is at stake in this battle. Lyft has raised $332.5 million from some very influential investors, and I don’t for a minute believe that they don’t want to win just as badly as Uber does. It’s perfectly plausible, if not probable, that Lyft and its backers, overmatched in a head-on battle with Uber, are conducting a guerrilla campaign with the aim of inspiring so much disgust in riders that Uber’s liquidity advantages start to slip (and to be clear, such a campaign – if it exists – is only possible because Uber’s management speaks and acts poorly frequently).7

    To be perfectly clear, I don’t know anything further about this situation – or other recent Uber PR fiascos, like this Verge piece about stealing Lyft drivers – beyond the size of the potential prize, as detailed here, and the reality of human beings and their incentives in the presence of such outsized rewards. In my experience the truth ends up being far more gray than the press – which really hates threats to journalists – has characterized this most recent episode.

    In fact, in some ways I’m actually far more concerned about Uber’s perceived lack of ethics than most, because if I’m right, then Uber is well on its way to having monopoly power over not just taxi services but a core piece of worldwide infrastructure, and nothing about this crisis gives me confidence in the company’s ability to manage that gracefully.8 I get that Uber’s willingness to fight unjust laws is what got them to this point, but as James Allworth and I discussed on the most recent episode of Exponent, there is a deeper moral code that ought to govern Uber’s actions. Moreover, Uber needs rider goodwill to prevail in the many markets where it is facing significant regulatory resistance: it is local citizens who determine whether or not local laws and regulations will be changed to accommodate Uber, and Uber is making it very difficult to rationalize advocating for them, or, if my Twitter account is any indication, to even ride with them.

    Ultimately, this blog generally seeks to analyze business, not render moral judgment or tell anyone what products or services they should or should not use. I myself am mixed: I plan on spending some time in the white part of that graph above, at a minimum. I hope, though, that you now appreciate exactly what is at stake and why so many elbows are being thrown.

    1. I’ve attempted to articulate Uber’s potential multiple times in the Daily Update – it’s one of my most frequent topics. This is my attempt to tie everything together that I have written there ↩

    2. Originally, this bullet stated “Drivers will increasingly be occupied serving Uber customers and be unavailable to serve Lyft customers (i.e. less supply).” However, this was incorrect because drivers utilized on any service are unavailable to every service, incurring no advantage ↩

    3. Lots of people have suggested to me that Uber will be doomed as soon as someone creates an app that serves as a front-end to all of the services allowing you to book the one with the lowest price and/or fastest availability; however, such an app would realistically need the cooperation of the largest player (which would not be forthcoming, and there is no public API) plus need to gain meaningful traction in a given market while competition still exists. It’s not happening ↩

    4. To Damodaran’s immense credit, he was very gracious in his response to Gurley’s post (which, to be clear, was respectful of Daodaran as well)  ↩

    5. The broader effects of Uber on adjacent industries will have to wait for another post ↩

    6. That said, no reporting has suggested a threat to Lacy or her family as many seem to believe; that came from Lacy herself ↩

    7. I am not making any allegations, and it should be noted that Pando Daily shares investors with both Uber and Lyft ↩

    8. First off, Michael’s comments, whether in jest or not, were incredibly stupid. Secondly, Kalanick’s tweetstorm was a terrible idea. You can’t admit that Michael’s “remarks showed a lack of leadership, a lack of humanity, and a departure from our values and ideals” and not fire him. Either stand your ground and insist Michael was misrepresented or let him go ↩

  • Differentiation and Value Capture in the Internet Age

    It’s hard to have a conversation with anyone in tech without the word “scale” entering the conversation; “Internet scale” is a particularly popular variation of the term. Scale is a concept that is at the root of most venture investing: because software has zero marginal cost – one copy costs just as much as 100, or one million – there are massive profits to be gained from reaching huge numbers of customers on a uniform product or service.

    The idea of scale, though, isn’t something unique to the 21st century; in fact, it was the key driver of the 20th, and it all started with Henry Ford and the assembly line.1

    Henry Ford didn’t invent the car; before the Model T there were all kinds of automakers producing cars that were mostly custom-built and only available to the very wealthy. However, they were notoriously unreliable and very difficult to repair. Ford changed all that by building one model in one color with interchangeable parts at scale: this allowed Ford to charge a shockingly low price of $825 upon the Model T’s introduction in 1909 ($21,650 in today’s dollars). What was even more impressive was that, over the following years, Ford continued to decrease the price: a Model T in 1925 cost a mere $260 ($3,500 today). This had a massive impact on the adoption of the automobile, and the entire world began to adapt, paving roads, building gas stations, establishing diners and garages, etc.

    Over time, though, the Model T was very much a victim of its own success: by massively expanding the market for cars and triggering the development of car-friendly infrastructure, Ford created openings for other car manufacturers that previously didn’t exist. A company like General Motors didn’t need to compete with Ford by building a Model T clone; instead they could develop multiple brands at different price points to capture particular segments of the market. The market was so big that scale could be brought to bear in a much more finely-grained way.

    Today, few if any of us drive the exact same car with the exact same color with the exact same interchangeable parts. In the United States you can buy the Nissan Versa for $12,800 or a Lamborghini Veneno Roadster for $4.5 million. Admittedly, the latter isn’t produced at scale (there will be only 9 built in 2014), but the Mercedes-Benz CL-Class is, and it costs over $100,000. A huge percentage of people have a car that fits their preferences and lifestyle, and while they all do the same thing in a technical sense, you can pay for exactly the type of experience that you prefer.

    A few weeks ago I wrote about the smiling curve and how value would increasingly flow from publishers to aggregators operating at scale:

    The Smiling Curve for publishing
    The Smiling Curve for publishing

    However, I didn’t spend much time on the left side of this graph, beyond noting that readers will often be loyal to a specific writer, or to a focused publication. That writer or publication has one unique superpower: they are the only one of their kind. To use the strategic term, they are differentiated, and differentiated people – or products – can charge far more than their marginal cost. And no one is more differentiated than Taylor Swift.

    A few weeks ago, in a widely discussed move, Taylor Swift pulled her music off of Spotify, and then proceeded to become the first artist in history to sell more than 1 million records in a week three albums in a row.2 In an interview with Yahoo Music, Swift argued that Spotify devalued music:

    Music is changing so quickly, and the landscape of the music industry itself is changing so quickly, that everything new, like Spotify, all feels to me a bit like a grand experiment. And I’m not willing to contribute my life’s work to an experiment that I don’t feel fairly compensates the writers, producers, artists, and creators of this music. And I just don’t agree with perpetuating the perception that music has no value and should be free.

    The thing is, though, given that music has a marginal cost of zero – to create one more copy doesn’t cost a cent – its natural price is, well $0. Free by a different name. And, when you look at the industry from this perspective, Spotify is the positive force for music that its CEO, Daniel Ek, believes it is:

    Our whole reason for existence is to help fans find music and help artists connect with fans through a platform that protects them from piracy and pays them for their amazing work. Quincy Jones posted on Facebook that “Spotify is not the enemy; piracy is the enemy”. You know why? Two numbers: Zero and Two Billion. Piracy doesn’t pay artists a penny – nothing, zilch, zero. Spotify has paid more than two billion dollars to labels, publishers and collecting societies for distribution to songwriters and recording artists.

    It’s a compelling argument, and Ek is justified in making it. In fact, I’d go so far as to say he is completely correct when it comes to any random song. But here’s the thing: Swift is completely correct too, especially when it comes to her music in particular. Swift herself explained why earlier this year in an op-ed in the Wall Street Journal:

    In mentioning album sales, I’d like to point out that people are still buying albums, but now they’re buying just a few of them. They are buying only the ones that hit them like an arrow through the heart or have made them feel strong or allowed them to feel like they really aren’t alone in feeling so alone…There are always going to be those artists who break through on an emotional level and end up in people’s lives forever. The way I see it, fans view music the way they view their relationships. Some music is just for fun, a passing fling (the ones they dance to at clubs and parties for a month while the song is a huge radio hit, that they will soon forget they ever danced to). Some songs and albums represent seasons of our lives, like relationships that we hold dear in our memories but had their time and place in the past.

    However, some artists will be like finding “the one.” We will cherish every album they put out until they retire and we will play their music for our children and grandchildren. As an artist, this is the dream bond we hope to establish with our fans. I think the future still holds the possibility for this kind of bond, the one my father has with the Beach Boys and the one my mother has with Carly Simon.

    By all accounts, Swift is describing the relationship she herself has with her fans. Her deeply personal and well-written songs speak to adolescent girls in particular in a way few artists ever have; for her (many) fans, Swift is “the one.” She is, to put it in economic terms, highly differentiated.

    That’s why I loved her decision to pull out of Spotify.3 Taylor Swift is not some sort of Luddite futilely standing against the forces of modernity; rather, she is a highly differentiated content creator capturing the immense value she is creating instead of ceding it to an aggregator that treats every piece of content the same.

    There are other examples of content creators realizing and capturing their value. When it comes to publications, the Wall Street Journal has long led the way in putting much of its content behind a paywall, betting that its focus on finance and business would make its content worth paying for. Other examples are the Financial Times and more recently, the New York Times. To be fair, the results have been mixed, in part because all of the paywalls have varying degrees of leakiness. This, though, gets at one of the most important tradeoffs any content creator has to make: when it comes to capturing the value created through differentiation, reach and profit are inversely correlated.

    In fact, this is the exact dynamic that explains how Apple captures such a huge percentage of the profit in the markets they compete in, even as they have a relatively small market share. iPhones, Macs, etc. are differentiated by Apple’s software and ecosystem, and the company charges accordingly. Those higher prices, though, preclude Apple from ever being the majority player.4

    There are examples in software too. Developers have decried the App Store “race to the bottom”, when in reality the market is behaving exactly as you would expect: software, like music, has zero marginal cost, which means that absent differentiation the fair price of an app is $0. Omni Group, though, sells iOS apps for a whole lot more: OmniFocus for iPhone, for example, is $19.99; the iPad version is $29.99, and, according to founder and CEO Ken Case, Omni is more than satisfied with the company’s foray onto iOS.

    The math is obvious: one customer buying both versions of OmniFocus is worth 50 customers buying one copy at $0.99, and worth an order of magnitude more customers were the app free with ads. Moreover, fewer customers mean lower support costs on one hand, and more ardent evangelists on the other. Customers who are willing to pay for a superior product are valuable in all sorts of ways, and Omni is spot-on in pricing their highly-differentiated apps in such a way that they capture a good part of the value they create.

    It’s easy to wonder why more developers don’t take the same route as Omni – or singers like Swift, or publications like the Wall Street Journal – but the truth is creating differentiation is hard. Case told me:

    Not every app becomes profitable just because it’s priced reasonably with respect to its value. With OmniGraphSketcher, for example, we didn’t find as large a market as we were hoping to, and though its simplicity was great, as a simple app it didn’t offer enough value to justify raising its price to sustain development in its small market. So we stopped selling it (and released it to the public for free as open source, where it also hasn’t found much traction). The lesson I’ve drawn is that it’s important for us to build higher-value apps

    It’s a tough standard, to be sure, but as a consumer, it’s actually pretty great news. Only the best will succeed.

    It’s easy to think that the Internet Age is well-established, but the truth is we’re only getting started. Remember, it took nearly two decades for the Model T to develop the car ecosystem to the point where new opportunities emerged to offer differentiated vehicles at much higher prices and much greater per-unit profit (Mercedes-Benz, for example, wasn’t founded until 1926, right about the time that the Model T reached its lowest price). I strongly believe that we are at a similar turning point when it comes to Internet-enabled businesses.

    The thing about Internet scale is it doesn’t just have to mean you strive to serve the most possible people at the lowest possible price; individuals and focused publications or companies can go the other way and charge relatively high prices but with far better products or services than were possible previously. It’s working for Apple, it’s working for Taylor Swift, it’s working for Omni Software, and I can’t wait to see the sort of companies and products it will work for in the future.5

    1. I previously used Henry Ford and the Model T as an analogy here; I hope you’ll excuse the recycling as 1) I didn’t have any readers then and 2) The focus and takeaway here is totally different ↩

    2. I discussed Swift vs Spotify at length in this Daily Update (members-only)  ↩

    3. According to the New Yorker, Swift would have stayed had Spotify been willing to limit her songs to the paid tier ↩

    4. Which, contra conventional wisdom, is ok, because absolute numbers matter more than percentages  ↩

    5. I’m burying this in a footnote because I’m sheepish, but I’m hopeful that it’s working for me as well ↩

  • An Update on the Stratechery Membership Program

    Last spring I wrote a series about the future of journalism:

    • Part 1: FiveThirtyEight and the End of Average – link
    • Part 2: The Stages of Newspapers’ Decline – link
    • Part 3: Newspapers Are Dead; Long Live Journalism – link

    In the third installment I wrote:

    More and more journalism will be small endeavors, often with only a single writer. The writer will have a narrow focus and be an expert in the field they cover. Distribution will be free (a website), and most marketing will be done through social channels. The main cost will be the writer’s salary.

    Monetization will come from dedicated readers around the world through a freemium model; primary content will be free, with increased access to further discussions, additional writing, data, the author, etc. available for-pay.

    A few weeks later I launched Stratechery 2.0, my perhaps quixotic attempt to put my quite literal money where my mouth was.

    That was a little over six months ago, and since that time I’ve gotten questions about how things are going. I tend to be private about such things, so I haven’t replied, and truthfully, I feel a bit sheepish right now. But I think if any number is worth celebrating it is the number 1,000. I passed that number of active subscribers earlier this month.

    Back in 2008 Kevin Kelly wrote:

    A creator, such as an artist, musician, photographer, craftsperson, performer, animator, designer, videomaker, or author – in other words, anyone producing works of art – needs to acquire only 1,000 True Fans to make a living.

    Making a living is about right. I’m not getting rich by any means, but I’m doing ok financially by doing what I love professionally, and that’s pretty awesome. So that’s my answer to all those asking: I’m doing great.

    More broadly, while nothing is assured, it looks like I might have been on to something when it comes to the viability of writing on the web. There is a lot of doom and gloom among journalists especially about how the Internet has profoundly disrupted publications built on an analog business model, but I think to focus on what has been lost is to overlook what has been gained. There is a flora of new journalism that is only possible because of the web, and I truly believe we are only getting started.

    Most importantly, for anyone reading this who believes they truly have something unique to say, please go for it. It is possible to make it on your own, and the world needs your voice.

    The foundation of Stratechery remains free posts on the main blog, and five Daily Updates a week with 12~15 pieces of analysis about topical tech news. You can sign up here.

    I did want to share a few important updates about the membership program:

    • I have consolidated the membership program down to one level: $10 a month or $100 a year. Now all members not only get the Daily Update every weekday, but also access to the (very active) Stratechery Forum
    • Speaking of the Stratechery Forum, it has been relaunched as a Stratechery-hosted (responsive) message board for all members, with hundreds of posts in less than two weeks. Relatedly, I am ending on-post comments
    • I have ended the sponsored post program. While I am a believer in native advertising, I wanted to focus my incentives behind the membership program both in regards to post frequency as well as customer service. My thanks to the sponsors who supported Stratechery over the last six months

    Now, more than ever, this site and the members who subscribe to the Daily Update are my livelihood (although I do offer strategic consulting). I truly feel blessed and would like to sincerely thank every member who has signed up to date, and anyone who signs up in the future.

    As always, I aim to make it worth your while.

  • Two Microsofts

    My well-chronicled frustration with Microsoft’s corporate strategy comes down to one point: I don’t think any company should have both horizontal (i.e. services) and vertical (i.e. devices) businesses. It creates conflicting incentives: a horizontal business should be great on every platform, while a vertical business should be differentiated.

    Thus, I was quite pleased when Satya Nadella’s first major move as CEO was the announcement of Office for iPad with an Office 365 subscription: finally the company was prioritizing services over its devices. True, convincing consumers to pay for software doesn’t seem to be a viable business model for 2014, but I was eager – and hopeful, for the sake of developers everywhere – for Microsoft to give it a shot.1

    I suspect it was my enthusiasm for this new model that led to my shock at the news that the Microsoft Office iPad apps would no longer need an Office 365 subscription to unlock most of their functionality: what good is a services business that isn’t actually trying to make money? Over the last few days, though, a different model for Microsoft has emerged, and it’s one I’m pretty excited about; the company just hasn’t gone far enough.

    Two Microsofts

    So strongly do I believe in the importance of incentives – and the problems of bad ones – that this summer I called for Microsoft to split itself in two to ensure that the Services side of the company could grow unfettered. Much to my surprise, though, last week’s announcement reveals that a fundamental cleavage has in fact occurred: today’s Microsoft is, more than ever, two different companies. The line of demarcation, though, is not services and devices, but rather enterprise and consumer.

    First, though, a quick aside: Microsoft will continue to make money from traditional Windows and Office licensing for both enterprise and consumer for a good long time; that money, though, is a result of previous strategic decisions. For the rest of this article I am focused solely on growth opportunities – the areas where today’s strategic decisions impact tomorrow’s top and bottom lines.

    And, in that light, by making Office for iOS and Android (mostly) free, Microsoft is effectively giving up on for-pay consumer services. Sure, the company will continue to offer Office 365 for both Mac and PC, but the potential growth has always been on mobile.

    That decision, though, brings some welcome rationality to Microsoft, at least if you look at the consumer and enterprise sides of the business in isolation:

    Microsoft's business makes much more sense if you think of there being two completely separate entities.
    Microsoft’s business makes much more sense if you think of there being two completely separate entities.

    On the consumer side, Microsoft hopes to make money from devices and advertising: they sell Surfaces, Lumias, and Xboxes with differentiated OS’s, hardware, and services, and they have ad-supported services like Bing and Outlook. The enterprise side is the exact opposite: here the focus is 100% on services, especially Azure and Office 365 (to use the Office iPad apps for business still requires a subscription).

    This actually makes all kinds of sense: enterprise and consumer markets not only require different business models, but by extension require very different companies with different priorities, different sales cycles, different marketing, so on and so forth. Everything that makes Office 365 a great idea for the enterprise didn’t necessarily make it the best idea for consumers, just as the model for selling Xbox’s hardly translates to big business. From this perspective, I love the idea of Office on iOS and Android being free for consumers: get people into the Microsoft ecosystem even as you keep them in the Office orbit.

    Microsoft Should Go All the Way

    When I think about Microsoft as two separate businesses, my primary concern with last week’s announcement is that Microsoft didn’t go far enough: specifically, the Office apps aren’t totally free. From the announcement on the Microsoft blog:

    Of course Office 365 subscribers will continue to benefit from the full Office experience across devices with advanced editing and collaboration capabilities, unlimited OneDrive storage, Dropbox integration and a number of other benefits.

    This leaves this decision neither here nor there, and reeks of short-sightedness: by releasing most of the functionality of Office for free, Microsoft is giving up on the iPad as a growth driver for Office 365, but it seems like they can’t quite wean themselves of incremental income from Office diehards. The problem, though, is that not only could this limitation manifest itself as incremental annoyance, it also limits the defensive utility of this move (members-only). If the worry is people getting in the habit of not using Office at all, why tempt them?

    The more interesting question is how long this cleavage will be sustainable. Enterprise Microsoft is doing exceptionally well: its Windows, Office and on-premise Server businesses are throwing off cash, while Office 365 and Azure grow like gangbusters. The consumer side of things is the opposite: Lumia and Surface continue to bleed cash2, the Xbox One is struggling, and while Bing is improving, it’s still not a moneymaker.

    None of this should be a surprise: Microsoft has always been an enterprise company that primarily succeeded in the consumer space by dint of its Windows monopoly. There’s no reason for them to be any more successful with consumers than they are today, and one wonders whether Nadella has made the same determination. Regardless, the clarity in business models is good news.

    1. And, on the flip side, I was less pleased to see Microsoft pushing ahead with its device strategy just a few months later ↩

    2. I detailed how badly the tech press blew the reporting on last quarter’s Surface numbers here (members-only)  ↩

  • How Apple Creates Leverage, and the Future of Apple Pay

    Tim Cook said something very revealing on last quarter’s earnings call:

    Last month we introduced two new categories; the first is Apple Pay, an entirely new way to pay for things in stores and in apps…The second new category is Apple Watch, our most personal device ever and one that has already captured the world’s imagination.

    Did you catch that? Cook put Apple Pay on the same level as Apple Watch. It is no hobby.

    Something that has characterized most of Apple’s recent successes is the degree to which they have depended on partnerships with normally intractable industries.1 The two most obvious examples are iPod/iTunes and the music industry, and most obviously, the iPhone and the phone carriers. This perhaps seems counterintuitive: Apple is famous for being difficult to deal with, working diligently to ensure it always has the upper hand, even as it holds its partners to impossible standards.

    This reading of Apple’s partnership abilities, though, mistakenly rests on the assumption that business deals grow out of personal affinity. The truth is that while personal likability may help on the margins, the controlling force in Apple’s negotiations is cold hard business logic. Thus, in order to understand why Apple has been so successful in previous partnerships – and, looking forward, to better estimate the chances of Apple Pay becoming widespread – it is essential to understand how the company acquires and uses leverage.

    The most important term in the study of negotiation is BATNA: Best Alternative to a Negotiated Agreement. Your BATNA defines the point at which you are willing to walk away from a deal. In order to “win” a negotiation, you want to make your BATNA as high as possible, so it’s easy for you to walk away, even as you work to make your counterparty’s BATNA as low as possible, so that they will concede more than they would like. Leverage is the means by which you change your counterparty’s BATNA.

    When the iTunes Store née iTunes Music Store launched in early 2003,2 Apple was a very different company than they are today. The iPod had been on the market for a year-and-a-half, but it only worked with a Mac, which was still stuck at well under 5% of the market. This, though, worked to Apple’s advantage in their negotiations with the music labels: not only did Apple not have much to lose, but the labels didn’t really see Apple as being a major player. The labels were far more concerned about the widespread sharing of music online; suing Napster to oblivion simply made music sharing more distributed and harder to control, which, of course, benefited Apple: their customers had alternate means with which to fill their iPods. So when Apple showed up with an offering to build a music store for their small audience, well, why not?

    Just a few months later, Apple expanded iTunes to Windows, and what could the labels say? Despite the fact it only existed on the Mac, the iTunes Music Store was already the number one music download service in the world. It turned out Apple had another ace in the hole: a customer base that, while small, had an outsized willingness and ability to spend. After all, they had already dropped at least $1,500 on a Mac and iPod (and likely a lot more), what was an extra $0.99? At a more basic level, said customers were loyal to Apple not because it made sense from a feature or price perspective, but simply because they loved and valued the experience of using Apple products. That, ultimately, was the key to Apple’s favorable position: they had the best customers because they had the best user experience; if the labels wanted access to them, they had to agree to Apple’s terms.

    Over time the labels’ addiction to iTunes revenues only deepened, and by 2008 iTunes was their biggest source of revenue. Music executives would rant and rave about Apple’s power, and try to increase their own leverage by, for example, allowing DRM-free songs on Amazon but not Apple, but it didn’t matter because Apple had the best experience, and thus the best customers.

    Apple’s negotiations with the music labels was just a warmup for the phone carriers. While Apple in 2006 (in the runup to the iPhone) was in a much stronger position than 2003, they were still much smaller ($60.6 billion market cap) than AT&T ($102.3 billion) or Verizon ($93.8 billion) on an individual basis, much less the carrier industry as a whole. More importantly, carriers weren’t facing a collective existential threat like piracy, which significantly increased their BATNA relative to the music labels.

    The music labels, though, benefitted from a relatively low elasticity of substitution: if I wanted one particular band that wasn’t on the iTunes Music Store, I wouldn’t be easily satisfied by the fact another band happened to be available. The carriers, on the other hand, largely offered the same service: voice, SMS, and data, all of which was interoperable. This increased elasticity of substitution gave Apple an opportunity to pursue a divide-and-conquer strategy: they just needed one carrier.

    Apple reportedly started iPhone negotiations with Verizon, but it turned out that Verizon was already kicking AT&T’s (then Cingular’s) butt through aggressive investment and technology choices, resulting in increasing subscriber numbers largely at AT&T’s expense. Verizon saw no need to change their strategy, which included strong branding and total control over the experience on phones on their network. AT&T, meanwhile, was on the opposite side of the coin: they were losing, and that in turn had a significant effect on their BATNA – they were a lot more willing to compromise when it came to branding and the user experience, and so the iPhone launched on AT&T to Apple’s specifications.

    That is when Apple’s user experience advantage and corresponding customer loyalty took over: for the first time ever customers were willing to endure the hassle and expense of changing phone carriers just so they could have access to a specific device. Over the next several years Verizon began to bleed customers to AT&T even though their service levels were not only better, but actually widening the gap thanks to the iPhone’s impact on AT&T. Four years after launch the iPhone did finally arrive on Verizon with the same lack of carrier branding and control over the user experience; in other words, Verizon eventually accepted the exact same deal they rejected in 2006 because the loyalty of Apple customers gave them no choice.3

    Apple followed the same playbook in country after country: insistence on total control (and over time, significant marketing investments and a guaranteed number of units sold) with a willingness to launch on second or third-place carriers if necessary. Probably the starkest example of the success of this strategy was in Japan. Softbank was in a distant third place in the Japanese market when they began selling the iPhone in 2008; finally after four years second-place KDDI added the iPhone, but only after Softbank had increased its subscriber base from 19 million to 30 million. NTT DoCoMo, long the dominant carrier and a pioneer in carrier-branded services finally caved last year after seeing its share of the market slide from 52% in 2008 to 46%. Apple had all the leverage, because they had customers who cared more about the iPhone than they did their carrier.

    Apple is certainly not shy about proclaiming their fealty towards building great products. And I believe Tim Cook, Jony Ive, and the rest of Apple’s leadership when they say their focus on the experience of using an Apple device comes from their desire to build something they themselves would want to use. But I also believe the strategic implications of this focus are serially undervalued.

    Last year I wrote a piece called What Clayton Christensen Got Wrong that explored the idea that the user experience was the sort of attribute that could never be overshot; as long as Apple provided a superior experience, they would always win the high-end subset of the consumer market that is willing to pay for nice things.

    However, this telling of the story of iTunes and the iPhone suggests that this focus on the user experience not only defends against disruption, but it also provides an offensive advantage as well: namely, Apple increases its user experience advantage through the leverage it gains from consumers loyal to the company. In the case of iTunes, Apple was able to create the most seamless music acquisition process possible: the labels had no choice but to go along. Similarly, when it comes to smartphones, Apple devices from day one have not been cluttered with carrier branding or apps or control over updates. If carriers didn’t like Apple’s insistence on creating the best possible user experience, well, consumers who valued said experience were more than happy to take their business elsewhere. In effect, Apple builds incredible user experiences, which gains them loyal customers who collectively have massive market power, which Apple can then effectively wield to get its way – a way that involves maximizing the user experience. It’s a virtuous circle:

    Apple's focus on creating a great user experience builds consumer loyalty. Consumers then put market pressure on Apple's potential partners, which result in concessions to Apple, further enhancing the user experience
    Apple’s focus on creating a great user experience builds consumer loyalty. Consumers then put market pressure on Apple’s potential partners, which result in concessions to Apple, further enhancing the user experience

    Understanding this circle and how it interacts with the relevant actors is the key to evaluating the prospects of Apple Pay.

    When it comes to Apple Pay adoption, there are five collective players that matter: Apple, Apple customers, credit card networks (Visa, Mastercard and American Express4), banks, and merchants.

    • Apple has, as is their wont, spent a significant amount of time on the Apple Pay experience. Over the last several years they have built the various pieces of Apple Pay, including Touch ID, their own chips (which include the secure enclave), an experimental NFC antenna design, as well as the software to make it work, with the bonus of 800 million credit cards stored in iTunes ready to be potentially added

    • Apple customers continue to have higher amount of income as well as a demonstrated willingness to spend. Apple customers are also very willing to use new technology offered by Apple, including Apple Pay

    • Credit card networks are the closest parallel to the music labels in that their overriding concern is the existential threat posed by potential networks or payment options that cut them out of the loop entirely. No one particularly likes them or the fees they charge. Thus, when Apple declared its willingness to build Apple Pay on top of credit cards, they jumped at the opportunity to take part

    • Banks are the carriers in this story. In the long run Apple Pay completely obscures their role in a customer’s payment activity, and the inevitable end for any invisible service is competition on price. However, banks have two problems when it comes to Apple Pay:

      • Banks are involved with every single Apple Pay transaction, which means if your bank does not support Apple Pay, it simply won’t work
      • Banks are easily substitutable. Sure, switching banks can be a bit of a pain, and you might have been with the same one forever, but if Apple customers were willing to switch carriers to get the iPhone, surely many would be willing to switch banks to be able to use Apple Pay

      Moreover, the banks benefit from Apple Pay’s increased security and correspondingly lower fraud rates – just as, I might add, carriers benefitted from iPhone customer’s higher average revenue per user (ARPU). Sure, it’s just as bad being a dumb bank as it is a dumb pipe, but better a dumb bank that makes money instead of one that customers simply leave

    • Merchants are much more difficult, and there is no real corresponding analogy in Apple’s previous dealings. Apple has much less leverage for a few reasons:

      • Merchants have a lower elasticity of substitution: on the low end, day-to-day purchases aren’t worth the hassle of a longer trip simply to use Apple Pay, and on the high end, retailers are highly differentiated by the products they offer
      • Merchants see much less direct benefit from Apple Pay. True, it’s likely that over time total transactions from Apple Pay-using customers will increase due to the decrease in friction relative to credit cards, but in the short term merchants are paying the exact same fees regardless of how a payment is made5
      • On the flip side, the anonymized nature of an Apple Pay transaction deprives merchant of valuable customer data that can be used to better target marketing campaigns and/or be sold for a profit

    This explains the situation that Apple’s payment initiative is in today: Apple Pay as an experience works incredibly well, Apple’s customers are eager to use it, the credit card networks fully support it, banks are falling over themselves to not only sign up but to pay Apple 0.15% of every transaction for the privilege, but retailers, particularly big chains that pay the most in credit card fees and reap the most benefits from data collection, are much more hesitant.6

    So now what?

    It turns out that Apple has acquired a few more pieces of leverage through this process:

    • In the U.S.,7 October 2015 brings the liability shift in which the less secure party in a transaction (i.e. a magnetic swipe card used at a payment terminal that accepts chip-enabled cards, or swipe-only terminal accepting a chip-enabled card) assumes liability for that transaction. This should spur the purchase of new credit card terminals at the vast majority of merchants; most of those new terminals will likely have NFC

    • By adopting industry-standard NFC, Apple has ensured that Apple Pay will “just work” at any NFC-enabled payment terminal that is not explicitly configured to not accept Apple Pay. This means that by the end of next year it’s likely that Apple Pay will work in a large part of the “long tail” of retail

    • For retailers that are still holding out, Apple has two new bargaining chips:

      • The 0.15% that Apple is receiving from the banks for each Apple Pay transaction could be funneled back to the retailers, resulting in an immediate impact on the bottom line. Keep in mind retail is a very low margin business; turning down any reduction in credit card fees will be difficult to do
      • Apple Pay could incorporate retailer loyalty programs, helping close the loop when it comes to data collection. This could work similarly to the offering Apple has for Newsstand publishers: customers opt in to sharing data, an offer that most will likely accept in exchange for the various discounts that typically accompany such programs. In fact, it seems that such an offering is already in the works

    In short, Apple could very well soon have an offer that might be too good for the vast majority of retailers to refuse: get the lift that comes with seamless transactions, plus a reduction in credit card fees, along with the seamless inclusion of pre-existing loyalty programs. Oh-and-by-the-way, if a particular retailer or three still wishes to hold out, then Apple’s loyal customers will sooner rather than later have a huge number of alternatives willing to take their business.

    Presuming this works out as well for Apple as I expect it to, there are two key lessons to be drawn. First, all of Apple’s leverage ultimately – either directly or indirectly – stems from consumer loyalty, which itself is based on Apple’s focus on the user experience. Second, the reason why Tim Cook so confidently called out Apple Pay as a new category is that he knew it was an area where Apple could bring that leverage to bear, just as they did in music and telephony. This is in marked contrast to the Apple TV, which is still a hobby: TV remains a much stronger business that is far more resistant to disruption than most people in tech appreciate, and until Apple has a means of obtaining leverage it will only ever remain so.

    1. Benedict Evans touched on this theme last week ↩

    2. Yes, I just called April early ↩

    3. Apple did originally sign a five-year exclusive agreement with AT&T, but that deal was negotiated several times and Apple likely could have moved to Verizon sooner had the carrier been willing to make the necessary concessions ↩

    4. American Express is also effectively a bank ↩

    5. This analysis applies to off-line retailers; I expect Apple Pay to immediately get significant penetration in apps for online purchases simply because the lift resulting from fewer customers falling off at the payment form will be significant ↩

    6. I covered MCX and CurrentC in-depth in this daily update (members-only)  ↩

    7. Apple Pay is only available in the U.S. currently, so that is the center of this analysis ↩

  • Publishers and the Smiling Curve

    One would not normally draw a connection from a company like Largan Precision (TPE:3008), a small Taiwanese component supplier, to the publishing industry. But it was a very insightful observation from another Taiwanese company’s CEO – Acer founder Stan Shih – about what he called the “Smiling Curve” that created the analogy in my mind. From Wikipedia:

    A smiling curve is an illustration of value-adding potentials of different components of the value chain in an IT-related manufacturing industry…According to Shih’s observation, in the personal computer industry, both ends of the value chain command higher values added to the product than the middle part of the value chain. If this phenomenon is presented in a graph with a Y-axis for value-added and an X-axis for value chain (stage of production), the resulting curve appears like a “smile”.

    Created by Rico Shen for Wikipedia
    Created by Rico Shen for Wikipedia

    What makes this observation particularly ironic is that Acer is the epitomical company at the bottom of the curve. They put PCs together, but it was the critical component makers like Intel and Windows that captured most of the value on the left, and systems integrators and value-added resellers like IBM or Accenture that captured the rest of the value on the right. Acer and its merry band of 8 OEMs1 competed themselves to single digit margins and ultimately stagnant growth; there simply isn’t any money in the undifferentiated middle.

    Fortunately for Acer, their smartphone efforts have largely failed, so they are being spared the same cycle in mobile: Nokia is gone, Sony is bleeding money, and even mighty Samsung is getting hammered (and is in fact retreating to their component business (members-only)). We all know about how Apple and Google are benefitting, as well as other services like Facebook or WeChat, but life is also good on the left side of the curve, and that is where Largan Precision comes in.

    While the iPhone got less attention than usual at its launch event (due to the Apple Watch), by far the greatest amount of time was spent on its camera. And for good reason: review after review has lauded the iPhone 6 camera as possibly the best phone camera ever. It turns out, though, that there are only a couple of companies in the world that are capable of producing such a camera, and Largan Precision is one of them.2 That is why they provide the camera for the iPhone 6 (as they have for several models now) and that is why their stock performance looks like this:

    Largan Precision Co. all-time stock performance
    Largan Precision Co. all-time stock performance

    True, their $9.6 billion market cap barely registers when compared to Apple’s $623.6 billion number,3 but when you consider that Largan Precision is a relatively tiny company that’s pretty darn impressive, and I can assure you the founders are living much more comfortably than all but the most senior Apple managers. Moreover, it’s not that far off from Foxconn, who actually builds the iPhone; their market cap is only 5x greater than the maker of a single component.

    There simply isn’t that much money in the middle.

    I was reminded of the smiling curve while reading this excellent piece by David Carr in the New York Times about Facebook and publishers:

    For traditional publishers, the home page may soon become akin to the print edition — nice to have, but not the primary attraction. In the last few months, more than half the visitors to The New York Times have come via mobile — the figure increases with each passing month — and that percentage is higher for many other publishers.

    Enter Facebook’s popular mobile app, which has captured greater amounts of time and, more remarkably, managed to fit a business model onto the small screen by providing extremely relevant advertising…the company has become the No. 1 source of traffic for many digital publishers. Yes, search from Google still creates inbound interest, and Twitter can spark attention, especially among media types, but when it comes to sheer tonnage of eyeballs, nothing rivals Facebook.

    “The traffic they send is astounding and it’s been great that they have made an effort to reach out and boost quality content,” said one digital publishing executive, who declined to be identified so as not to ruffle the feathers of the golden goose. “But all any of us are talking about is when the other shoe might drop.”

    Here’s the thing: the shoe has in many respects already dropped. When people follow a link on Facebook (or Google or Twitter or even in an email), the page view that results is not generated because the viewer has any particular affinity for the publication that is hosting the link, and it is uncertain at best whether or not their affinity will increase once they’ve read the article. If anything, the reader is likely to ascribe any positive feelings to the author, perhaps taking a peek at their archives or Twitter feed.

    Over time, as this cycle repeats itself and as people grow increasingly accustomed to getting most of their “news” from Facebook (or Google or Twitter), value moves to the ends, just like it did in the IT manufacturing industry or smartphone industry:

    On the right you have the content aggregators, names everyone is familiar with: Google ($369.7 billion), Facebook ($209.0 billion), Twitter ($26.4 billion), Pinterest (private). They are worth by far the most of anyone in this discussion.

    Traditional publishers, meanwhile, are stuck in the middle. The New York Times, the most august publisher of all, is worth a mere $2.03 billion.4 Gannett Company, the largest publisher in the United States, is worth $7.14 billion, but the vast majority of that value lies in their broadcast and digital advertising holdings; most of the newspapers are worthless. I recounted the problem for newspapers in Economic Power in the Age of Abundance:

    One of the great paradoxes for newspapers today is that their financial prospects are inversely correlated to their addressable market. Even as advertising revenues have fallen off a cliff – adjusted for inflation, ad revenues are at the same level as the 1950s – newspapers are able to reach audiences not just in their hometowns but literally all over the world.

    The problem for publishers, though, is that the free distribution provided by the Internet is not an exclusive. It’s available to every other newspaper as well. Moreover, it’s also available to publishers of any type, even bloggers like myself.

    In short, publishers (all of them, not just newspapers) don’t really have an exclusive on anything anymore. They are Acer, offering the same PC as the next guy, and watching as the lion’s share of the value goes to the folks who are actually putting the content in front of readers.

    That Stratechery article, by the way, was about how German publishers were taking Google to court to demand compensation for article snippets that appeared on Google News. Instead Google simply removed the snippets, which resulted in such a drop in traffic that the publishers this week came crawling back asking Google to re-add the snippets, no compensation required. The general takeaway is that Google proved it was adding value to the publishers, but I have a different angle: the publisher’s demonstrated that they provide no value to their writers.

    See, Largan Precision doesn’t really care if their camera phone modules end up in iPhones or Galaxys or Lumias, or if they’re physically integrated by Foxconn or Quanta or Compal. They survive – and survive quite profitably – based solely on their ability to manufacture the best miniature cameras in the world. I remain convinced that the most successful writers and publications will pursue a similar strategy: do what they do best and accrue outsized value relative to publishers that are rapidly shifting from platform to obstacle.

    This trend isn’t limited to publishing, either. Last week HBO announced that it was finally going direct to customers; while I think declarations that this decision will lead to cord-cutting are massively overstated, it is certainly a devaluing of the cable middle person. You can also view AT&T’s decision to lock the Apple SIM to their network in a similar light: they are trying to stave off their inevitable future as a dumb pipe between valuable content and valuable devices. Apple Pay will, in the long run, have a similar effect on banks (which is one reason it’s so fascinating to see banks embrace it while some merchants – who will benefit from more and faster transaction – be opposed).

    All of this is because of the Internet: by removing friction it removes the need for folks in the middle, and the result is that value will flow to the edges. In the case of publishing that is aggregators on one side, and focused, responsive, and differentiated5 writers and publications on the other.

    1. HP, Dell, Acer, Asus, Sony, Toshiba, Lenovo and Samsung are the Big 8 Windows OEMs. Well, were. Sony has left, and Samsung has a foot out the door ↩

    2. For what it’s worth, Largan Precision is yet another company suing Samsung, as well as fellow Apple supplier Genius Electronic Optical Co., for patent infringement ↩

    3. All numbers as of October 28, 2014 ↩

    4. Which, to the Times’ credit, is more than double their nadir in 2012 ↩

    5. My canonical examples: focused – Daring Fireball, responsive – BuzzFeed, differentiated – Vox ↩

  • Peak Google

    Despite the hype about disruption, the truth is most tech giants, particularly platform providers, are not so much displaced as they are eclipsed. IBM, for example, has been successfully selling and servicing mainframes for going on 50 years (although they are now in serious trouble (members-only)). During the PC era, though, they were eclipsed by Microsoft.

    Mainframes didn't stop being a viable business; it was just a much smaller business than PCs
    Mainframes didn’t stop being a viable business; it was just a much smaller business than PCs

    The same happened to Microsoft: Windows still dominates PCs,1 and in all likelihood will for the foreseeable future (although there are certainly cracks in the foundation, a la IBM). The company isn’t going anywhere. PCs, however, have been eclipsed by smartphones, to the benefit of Apple (in terms of revenue and profit) and Google (in terms of market share).

    PCs have in the past few years been eclipsed by smartphones. To see a similar graph with exact data, see this post by Benedict Evans
    PCs have in the past few years been eclipsed by smartphones. To see a similar graph with exact data, see this post by Benedict Evans

    These eclipses are obvious in retrospect, but the truth is few if any could have predicted them before they occurred. PCs were thought to be a tremendous boon for IBM, and they did profit greatly until Compaq copied their BIOS leaving Microsoft all the leverage; similarly, Microsoft looked set to conquer mobile (which was why Google bought Android in the first place) before a resurgent Apple introduced the iPhone. In both cases it turned out that the incumbents’ prior success resulted in misdirected incentives: IBM focused on selling and servicing PCs, instead of building a platform, while Microsoft focused on extending Windows to mobile instead of the user experience. If you’ll forgive a war analogy, both companies won the battle but lost the war.

    And so, if one wishes to predict who might follow in this illustrious but ultimately tarnished path, it might be useful to look for similar characteristics: the company should be dominant in its field, and the company should seem to have an advantage in a far larger adjacent field, but that advantage, on closer inspection, should prove to be just as much a hindrance as a help.

    The clear candidate is Google.

    Google posted its quarterly results last Friday, and they were ok, not great. Earnings and revenue may have missed analysts’ expectations ($6.53 per share and $16.52 billion), but the company was still hugely profitable. More importantly, they still dominate the most effective and lucrative type of Internet advertising: search. In July Dan Frommer at Quartz wrote an article titled Google has run away with the web search market and almost no one is chasing:

    Search represents the largest digital advertising market — almost $50 billion last year globally, according to PwC, compared to just $34 billion for display ads — and is growing roughly 10% a year. But Google so thoroughly dominates the search industry that few are even bothering to challenge it anymore.

    Frommer goes on to list potential challengers to Google’s dominance, but the outcome is clear: Google will continue to dominate, just as IBM has continued to dominate mainframes and Microsoft has continued to dominate the PC. They will be a very profitable company for many years to come. That is why this is not an article about disruption. Rather, the question is if Google might be eclipsed.

    $50 billion for worldwide search advertising (of which Google captures a huge majority) sounds like a lot, but it’s only a small percentage of total ad spend, projected to be $545 billion in 2014. The vast majority of that spend is not about direct response – i.e. ads that spur you to make a purchase on the spot; rather most of the money is spent on brand advertising.

    The idea behind brand advertising is to build “affinity” among potential customers. For example, a company like Unilever will spend a lot of money to promote Axe or Dove, but the intent is not to make you order deodorant via e-commerce. Rather, when you’re rushing through the supermarket and just need to grab something, the idea is that you’ll gravitate to the brand you have developed an affinity for. And once a customer has picked a brand, they’re loyal for years. That adds up to a lot of lifetime value, which is why consumer-packaged goods companies, telecom companies, car companies, etc. are among the biggest brand advertisers (I’ve written about CPG companies and brand advertising previously here).

    To date this type of brand advertising has strongly favored television; targeting is certainly nice, but channels like Lifetime (Dove) or ESPN (Axe) are specific enough, and the actual process of implementing a campaign at scale is far more efficient and cost effective on TV. This is especially true given that the primary digital offering for brand advertisers has been the banner ad, an idea that was bad to begin with and that now is all but invisible, particularly to younger customers that have by far the most value to brand advertisers (more years in the actuary table equals more lifetime value!).

    However, over the last few years a new type of advertising has emerged: native advertising. I’ve already made my defense of native advertising here, but just to be clear, I classify any sort of “in-stream” advertising as native advertising. Thus, for a news site, native advertising is advertising in article format; for Twitter, native advertising is a promoted tweet; for Facebook, native advertising is ads in your news feed; for Pinterest (a future giant) a promoted pin. These sorts of ads are proving to be massively more effective and engaging than banner advertisements – as they should be! In every medium (except, arguably, newspapers, which had geographic monopolies) native advertising is the norm simply because it’s more effective for advertisers and a better experience for users: TV commercials are 30 or 60 second fully produced dramas, magazine ads are highly refined visual experiences, radio ads are jingles, etc. And so it will inevitably go with digital advertising, at least when it comes to brand advertising.

    The problem for Google is that there is no obvious reason why they should win this category. Yes, they’re an ad company, but the key to native advertising on the Internet is the capability of producing immersive content within which to place the ad, such as Facebook’s newsfeed, Twitter’s stream, a Pinterest board, or even your typical news site’s home page. Sites like Buzzfeed have taken this idea to its logical conclusion: their content is basically a marketing tool meant to show advertisers how skilled they are at going viral. Google has nothing in this regard.2 Moreover, all of the things that make Google great at search and search advertising – the algorithm, the auction system, and machine learning – are skills that don’t really translate to the more touchy-feely qualities that make a social service or content site compelling.

    And so we have our parallel to IBM and Microsoft. IBM didn’t capitalize on PCs because their skills lay on the hardware side, not software. Microsoft didn’t capitalize on mobile because they emphasized compatibility, not the user experience. And now Google is dominant when it comes to the algorithm, but lacks the human touch needed for social or viral content. And so, when all of that brand advertising finally begins to move from TV to the Internet – and that migration is a lot closer than it was even a year ago – I suspect that Google is not going to capture nearly as much of it as many observers might expect.

    The result, then, is a chart that looks a lot like the ones I drew for IBM and Microsoft:

    Brand advertising is worth a lot more than search advertising; if it moves to the Internet, .Google's share of digital advertising would be dwarfed
    Brand advertising is worth a lot more than search advertising; if it moves to the Internet, .Google’s share of digital advertising would be dwarfed

    This is the primary basis of my thesis that Google may very well be in a similar situation to early-eighties IBM or early-oughts Microsoft: a hugely profitable company bestride the tech industry that at the moment seems infallible, but that history will show to have peaked in dominance and relevancy.

    It’s worth noting that there are other potential parallels as well:

    • Both IBM and Microsoft competed fiercely – and ultimately, illegally – to win the platform that they thought represented both a huge threat and an opportunity. In the case of IBM it was software for the System/360; Microsoft fought for the browser. It wasn’t an application maker that eclipsed IBM though, but rather an OS maker; for Microsoft, their undoing was not a competing browser, but rather mobile. For Google, the parallel is the massive amount of effort they have put behind Android. True, they own massive market share and have ensured that mobile is safe for Google services,3 but might that prove to be a pyrrhic victory not unlike Internet Explorer if most of the digital advertising value increase is in native advertising? (Relevant: Mobile Makes Facebook Just an App; That’s Great News)

    • Relatedly, and as hinted above, both IBM and Microsoft were found to have abused their monopolies in an attempt to dominate application software and browsers respectively; it’s increasingly plausible to argue, as The Information has reported, that Google is doing the same with Android and its increasingly onerous requirements around the inclusion of Google’s services

    • It’s hard to read about Google X – the Google division responsible for Google Glass, self-driving cars, life sciences research, etc. – and not draw a parallel to Microsoft Research. That division has produced some amazing technology that makes for amazing demos and promo videos, but it has ultimately made very little difference to the bottom line (Kinect is arguably an exception, but the damage its forced inclusion did to the Xbox One negates the value it created as a standalone product). Both divisions reek of a company that has too much money and not a clear idea about what will actually drive the market moving forward

    I do write this article with some trepidation; it’s a lot easier to be a cheerleader, and from a business perspective I’m a big fan of Google’s. They have earned every point of share they have in search, and Android was a brilliant strategic gambit to protect the money makers. Moreover, these sorts of predictions are almost always losers: you’re always wrong until the moment when you’re right, with all the attendant loss of credibility that entails.

    Still, I hope the subtle point I’m trying to make is clear: I think Google is quite safe when it comes to search, and that they will be a very profitable company for the foreseeable future. I just suspect we will all think differently about that dominance when it’s a smaller percentage of total digital advertising, just as we thought differently about IBM’s dominance of mainframes in the age of the PC, or Microsoft’s dominance of PCs in the age of the smartphone.


    Update – I wanted to make three clarifications based on feedback:

    • Technically speaking, yes, search ads are native. Native is great! However, they’re not vehicles for brand advertising (in fact, what makes them so powerful is that they are much further down the funnel)
    • To reiterate, by native advertising I mean all forms of advertising that appear in stream. This is much broader than just advertorials
    • I should have made a bigger deal about YouTube. It’s a massive opportunity for Google and will go down (if it has not already) as one of the all-time great acquisitions

    Finally, as I noted at the beginning, this is not about the decline of Google. It’s about there being a much broader opportunity than just search advertising.

    1. For all the (deserved) hype about the Mac’s growth, Microsoft still controls well over 90% of the market ↩

    2. With the notable exception of YouTube, although for many YouTube is less of a destination that you visit directly than it is an endpoint you are directed to; how many “live” in YouTube like they do Facebook? ↩

    3. Outside of China, anyways ↩

  • The Diminished iPad

    Something very strange is happening this week: there is an Apple event, and very few people – including myself – are particularly jazzed up about it. Oh sure, I’ll watch it, and I hope I’m surprised, but there is very little in the rumor mill – a retina iMac, OS X Yosemite, and the iPad Air 2 – that is particularly noteworthy. If anything, it is that lack of noteworthiness that is the most noteworthy thing of all.

    Earlier this week, one of my absolute favorite Twitter followees – SammyWalrusIV – posted a brilliant piece about the iPad:

    The iPad is at a crossroads. Introduced by Steve Jobs four years ago, the iPad has gone on to become a phenomenal success (225 million units sold bringing in $112 billion of revenue and approximately $30 billion of profit), but I suspect Apple management will alter the iPad line-up in response to wearable devices and larger-screen phones and in the process iPad’s ultimate trajectory will be more modest and niche than many expect.

    This is certainly a big comedown from the sky-high expectations that followed the iPad’s explosive growth in 2010 and especially in 2011, when many conjectured that the iPad business would ultimately be bigger than the iPhone. The question, though, is if the decline in the iPad’s fortunes is simply the natural order of things, Apple cannibalizing itself before others have the chance, or a missed opportunity.

    I think that it’s all three.

    The Disappearing Middle

    At the first iPad presentation, Steve Jobs was at pains to explain that the iPad would only work as a product if it found a spot between the iPhone and Mac where it did some number of things much better than either.

    Jobs iPad Placement Slide

    There’s no question, at least in my mind, that the iPad delivered. From day one it was a great reading and video device especially, and games – particularly the complex Euro-style board games that I like – were a revelation. New apps soon arrived, too; I particularly remember how blown away I was by Flipboard. The iPad, though, truly came into its own with the iPad 2; it was significantly lighter, making it a lot easier to hold, and much faster. And by that time the App Store was in full swing, with compelling new apps being released constantly, all on top of an interface that was far more approachable and usable for simple everyday tasks. In addition, the iPad had seemingly impossibly long battery life, making it well worth the carry anytime you were away from the house for an extended period of time.

    Over time, though, that middle has shrunk. Macs have gotten much smaller and, more importantly, achieved much better battery life, removing one of the iPad’s biggest advantages. Suddenly convenience pushed in the direction of carrying only one device. And, while the iPad may have been simple, its limitations meant that if there were only one device, it would usually be the more powerful but complex Mac.1

    Apple’s Self-Cannibalization

    And now the iPhone is making a major play for the original iPad standbys: reading and video. One can absolutely argue that the iPhone Plus is superior to the iPad or iPad mini for reading; it’s lighter, thinner, yet plenty big enough to get lost in a good book or essay (for me, the iPhone 6 is enough; then again, I used to read RSS feeds over WAP). The battery life is just as good, if not better; more importantly, it’s always with you: on the bus, in line, and on the couch. Reaching three feet for an iPad may not seem like much, but the additional friction of physical movement, finding your app, waiting to sync, etc. just doesn’t seem worth it anymore. As Sammy put it:

    Why buy an iPad when you could have an iPhone with a screen that doesn’t seem that much smaller than an iPad mini? Why buy an iPad when you can have a more powerful and just as easily transportable Macbook Air? The space between a phone and PC is smaller now than in 2010 primarily as the phone has become more powerful and larger. Tablets are getting squeezed.

    Obvious though larger iPhones may have seemed to many of us, Apple still deserves praise for pushing ahead with the iPhone Plus in particular. Anyone who thinks this won’t have an impact on iPad sales is surely kidding themselves. And make no mistake: that’s bad for Apple in the short term. Sure, the iPhone Plus has much better margins – both in percentage and absolute terms – than the iPad mini especially, but one iPhone Plus per customer is still much less money for Apple than that same customer buying both an iPhone and an iPad.2 Apple though, just as they did with the iPod and Mac previously, has proved itself willing to cannibalize itself.

    To be sure, Apple is certainly not too worried: the downside of a bigger phone is reduced convenience and portability, opening up room for a device that is even more portable and always with you – the Apple Watch. And, just as the iPhone was much more profitable than the iPod it replaced, the Watch will almost certainly be much more profitable than an iPad.

    The iPad’s Missed Opportunity

    However, I think that Apple has missed a significant opportunity to make the iPad into an essential fourth device (in addition to the iPhone, Mac and eventual Watch). Sammy gets at the problem:

    I can’t remember the last time I downloaded an iPad app. Curious to see how others were doing, I posed a question on Twitter, “How many iPad apps have you downloaded in the past month?” On any given question I get a decent number of responses, but this time I received a very muted reaction with a few “0” responses. Why am I not downloading iPad apps? I consider iPad app innovation to have slowed with iPhone continuing to take a disproportionately high amount of attention in the app ecosystem. Most of my daily mobile usage now occurs on an iPhone.

    This echoes my own personal experience. While I still use Paper on the iPad (primarily for this blog), much of my reading has moved to the iPhone simply because the iPad apps are inferior (TweetBot) or non-existent (Nuzzel).3 More broadly, there simply aren’t that many apps like Paper that make an iPad essential. I personally will always own an iPad simply because Paper on the iPad does something for me that no other Apple device does; this simply isn’t the case for nearly enough people.

    This is Apple’s fault.

    While I wrote a few months ago that too many developers blame Apple for their own business mistakes, the fact remains that Apple has incentivized developers to build shallow apps with customer-unfriendly business models. Specifically, by not enabling trials, which would allow truly superior apps to charge more for paid downloads,4 and most damagingly, not providing built-in paid upgrades, which would incentivize developers to build and iterate complex apps with the confidence they could capture additional revenue from their existing customers over time,5 Apple has made it a fool’s errand to build something like the aforementioned Paper.

    I wrote about Paper specifically in a series last year about Apple’s App Store failures:

    • Papering Over App-Store Problems link
    • Casual Gaming is a Sustainable Business but not a Platform Differentiator link
    • Why Doesn’t Apple Enable Sustainable Businesses on the App Store? link

    In that final piece, I chalked up Apple’s refusal to allow developers to build sustainable businesses to their 1997 paranoia:

    The trouble for Apple – or any platform provider – is apps that cross that line from nice-to-have to completely irreplaceable. It’s at that point a user’s loyalty shifts from platform to app, and there are no greater examples than the aforementioned Photoshop and Microsoft Office [which Jobs had to beg to continue supporting the Mac, most famously at the 1997 Boston Macworld Expo]…

    But there have been downsides to this paranoia. Apple’s inefficient use of its cash is the most famous, but I think developer hostility is an aftereffect as well. I would go so far as to argue that that Boston keynote was at the root of Jobs’ opposition to any 3rd-party apps on the iPhone, much less app store policies that enable sustainable businesses. Never again would Apple be held hostage to an app that was bigger than Apple.

    The problem is that must-have apps are exactly what the iPad needs to become indispensable. And sadly, while Apple seemed to shrug off much of that 1997 paranoia at this year’s WWDC, they didn’t make any real changes to the App Store policies around trials and upgrades that would truly make a difference. Truth be told, though, this year’s WWDC was likely already too late. By then iPad sales had already started to decline on an annual basis, giving developers even less incentive to focus on the iPad.

    The iPad Going Forward

    To be clear, I’m by no means declaring the iPad doomed. It remains far more accessible for many people than a Mac will ever be, and rumors about split-screen apps and larger sizes suggest that Apple sees its role as slowly but surely replacing the Mac over time, particularly for the younger and older generations. It remains a killer device for video, although that’s a job that is fulfilled just as well by cheap Android tablets. There are also niches that are thriving on the iPad, particularly in music, and here the iPad is highly differentiated from Android. In addition, Apple is clearly positioning the iPad as a tool for the enterprise; Tim Cook’s default answer for questions about the iPad has been to point to Apple’s partnership with IBM.

    Still, I can’t help but reminisce about what might have been had Apple harnessed the incredible developer enthusiasm for the iPad in 2010-2012. More than any other iOS device the iPad needed help to make it indispensable to everyone, but Apple famously doesn’t like depending on anyone. And now no one cares.

    1. I’m using Mac as a stand-in for all PCs; the point holds regardless ↩

    2. I keep hearing people say that Apple is actually coming out ahead not only because an iPhone Plus is more expensive than an iPad but also because people will update the iPhone Plus more frequently; that’s true, but ignores the fact that said customers were already buying iPhones regularly. Two devices is worth more than one, no matter which way you cut it ↩

    3. It should be noted that TweetBot’s lack of updates are likely due to Twitter’s token restrictions, while a Nuzzel app is coming. The more important point, though, is about Paper and similar iPad-only apps ↩

    4. There is no way for customers to know with confidence that a paid app is worth the money; trials would separate the wheat from the chaff ↩

    5. It’s not an apples-to-apples comparison, but Aldus PageMaker, the application that made the Macintosh a success, charged around $500 for an upgrade every couple of years ↩

  • PayPal’s Incentive Problem

    Last week eBay announced that PayPal would be spun out into a separate company, fixing two big problems for PayPal:

    • While PayPal grew big by being the payment method of choice for eBay transactions,1 off-eBay transactions have since become the majority of PayPal’s revenue, meaning management’s need to prioritize eBay’s needs was misaligned with PayPal’s growth opportunities
    • PayPal also had an individual-level incentive problem because they didn’t have their own stock. Stock options and/or grants are the incentive tool of choice for everyone from the CEO down to new hires in the tech industry, which meant any new PayPal hire was necessarily hitching their wagon to eBay

    Still, I understood eBay’s previous argument that there were tremendous synergies between the businesses, and there’s no question that the loss of PayPal and the insight gained from being party to every transaction on the eBay marketplace is going to hurt the core business. Moreover, I think it’s highly likely that much of PayPal’s recent (impressive) growth was paid for with cash thrown off by eBay’s marketplace. There is a lot of logic to staying together.

    That’s the thing with most big company endeavors, though: they almost always look good on paper. After all, the big company has all the cash, all the experience, all the developers that they can throw at any problem that arises. And yet, Silicon Valley is in many way premised on the idea that big companies can be beaten by, as the myth has it, a founder in a garage with little more than an idea. On paper it doesn’t make sense, and yet the examples are legion.

    I’m not surprised though. Something I’ve learned over time – and believe today more strongly than I ever have – is that nothing matters more than incentives. It doesn’t matter how much money or experience or developers you have if your incentives are not aligned to solve the right problem. This is the big advantage that startups have vis a vis corporations: a startup starts with the problem and then creates the incentive structure under which their company operates. To put it another way, for a startup the incentives are defined by the problem. Small wonder, then, that startups are so focused on a solution.

    A start-ups incentives are defined by the problem they are seeking to solve
    A start-ups incentives are defined by the problem they are seeking to solve

    A big company, on the other hand, has already solved a different problem – the problem that defined them back when they were as a startup. Now that the big company is facing a new problem, they have the wrong set of incentives – incentives that are defined by the old problem, not the new one.

    When a successful company seeks to address a new problem, they are often handicapped by their old incentive structure, leaving them susceptible to a startup able to fashion problem-specific incentives
    When a successful company seeks to address a new problem, they are often handicapped by their old incentive structure, leaving them susceptible to a startup able to fashion problem-specific incentives

    This means that all of the advantages a big company has – their money, their experience, their developers – are all pointed in the wrong direction, leaving an opening for the new startup who has defined themselves by the new problem.

    Unfortunately for PayPal and their future shareholders, PayPal is the old startup in this example. Their success in solving the “square” (peer-to-peer payments) problem has left them handicapped when it comes to the next “pentagon” opportunity: merchant-based payments, both online and off. eBay may be selling on top.

    The central issue with peer-to-peer payments is that there is no merchant account involved. That means the entire infrastructure that has grown up around payments – particularly around credit cards – is not applicable. This infrastructure included fraud protection, authentication, dispute settling, and fees, lots of fees. PayPal built up something completely different: their primary connection was with your bank account, not your credit card, and instead of charging credit card-type fees, they simply kept your money a few days extras and profited off the float.

    More broadly, the PayPal network – and the advantages that accrue to anyone who owns a network – was based on accounts with usernames and passwords. You couldn’t send money to someone – or more importantly, accept money – unless you had a PayPal account. In fact, many of PayPal’s legendary growth hacks, including literally paying people for signing up their friends, were predicated on increasing the number of user accounts on PayPal and thereby increasing the value of the network.

    The problem for PayPal is that, as noted, peer-to-peer payments is a “square”-shaped problem; all of PayPal’s internal incentives are designed to solve this problem first-and-foremost. That’s why when it comes to a new problem, like easily enabling an individual or small business to be a merchant, PayPal is markedly inferior to what is on offer from startups like Stripe (for e-commerce) and Square (for offline purchases). For example, consider the purchase process on Stratechery:

    • Stripe (my choice):
      • Customer enters credit card right on the site
      • Done!
    • PayPal
      • Customer is kicked out to a PayPal payment page
      • Customer is asked to sign-in to PayPal, create an account, or proceed anonymously
      • Should a customer sign in or create an account, they will be pushed to use a bank account to pay (the credit card option will be available but it’s purposely buried)
      • Customer enters or selects a credit card on file
      • Done!

    The entire PayPal process is much more convoluted for users – I haven’t even gotten to how much more painful PayPal compared to Stripe is for merchants, but take my word that it’s even worse – and the reason has nothing to do with the transaction at hand; rather, pushing users to make accounts and to use their bank were keys to the old PayPal problem of enabling widespread peer-to-peer payments, and PayPal – like nearly all incumbents – can’t help but apply the old solution to the new problem even though it makes the new solution worse than it otherwise can be. And so Stripe is eating their lunch in the “pentagon”-shaped problem that is enabling someone like me to be a merchant.2

    PayPal’s offline challenges are much more basic: while PayPal was the first to allow individuals or small businesses to accept credit cards at all without a merchant account, physical retailers almost certainly already have a merchant account set up. This means that PayPal has to convert merchants from what most feel is a “good-enough” solution to one that, frankly, is only better because PayPal says it is. Sure, merchants like lower fees, but not necessarily the hassle of obtaining and training workers on new point-of-sale systems, and, even if they were to go through the trouble of supporting PayPal, what customer wants to unlock their phone, open an app, and enter a password when they can simply swipe a credit card?3

    And now, into the offline space comes Apple Pay, offering a payment experience that is far more secure and simple than anything that has come before. From an excellent write-up on the The Unofficial Apple Weblog about how Apple Pay security works:

    With Apple Pay, no credit card data — even in encrypted form — is ever stored on the iPhone or on Apple’s servers. Similarly, no credit card data is ever transmitted to or stored on a merchant’s servers…the fundamental aspects of Apple Pay weren’t concocted in Cupertino. Rather, Apple Pay was designed in accordance with an emerging token-based mobile payments standard which aims to increase security and reduce the incidence of fraud. To that end, Apple is getting into the mobile payments space at just the right time.4 So while Apple isn’t necessarily inventing the wheel here, Apple Pay again represents the first real implementation, on a massive scale no less, of the relatively fresh tokenization specification.

    This is the tough part about being a tech company: PayPal spent years perfecting the perfect solution to that square-shaped hole that addressed thorny problems like identity, security, and fraud, and they were successful because we had nothing better. But time and technology move on, things like tokenization and NFC and Touch ID are invented, and new market opportunities predicated on the ease and ubiquity of credit cards but without the hassle and insecurity come along. And over there on the sideline is PayPal fixing a problem in a much smaller and ultimately less attractive market.

    The analogy I would draw to PayPal today is Microsoft and mobile. I wrote in Microsoft’s Mobile Muddle:

    Saying “Microsoft missed mobile” is a bit unfair; Windows Mobile came out way back in 2000, and the whole reason Google bought Android was the fear that Microsoft would dominate mobile the way they dominated the PC era. It turned out, though, that mobile devices, with their focus on touch, simplified interfaces, and ARM foundation, were nothing like PCs. Everyone had to start from scratch, and if starting from scratch, by definition Microsoft didn’t have any sort of built-in advantage. They were simply out-executed.

    It’s actually more nefarious than that; it’s not only that Microsoft didn’t have any advantage in mobile relative to Apple or Google or anyone else, it’s that their previous success in a closely connected but ultimately different field put them at a significant disadvantage. Microsoft was (and in my opinion, continues to be) heavily incentivized to approach the world with a PC mindset, but that’s the exact mindset they needed to let go of to build an effective mobile platform.

    So it is with PayPal. Moving money between people who lack merchant accounts is an interesting problem that PayPal has mostly solved, but it turns out that this is a different problem than merchant account payment problems. Worse, it’s PayPal’s old solution – user accounts – that made them the least likely to come up with the new solution based on anonymous tokens, something that would have been true whether PayPal were a part of eBay or not.5

    In the long run PayPal will have a nice business with peer-to-peer transactions and, at least for the short term, moving money internationally (although this is clearly Bitcoin’s most obvious killer use case). However, the massive growth that awaits companies playing in the merchant space, including Apple, will always be just out of reach of a company willingly – and understandably – tying its own hands behind its back.6

    1. I was on eBay from the beginning, which meant I was very familiar with getting money orders and sending them through the mail with faith the seller would come through. PayPal was a game-changer, their desperate efforts to diversify away from eBay notwithstanding ↩

    2. Thus the acquisition of Braintree ↩

    3. This is why PayPal was so slow to challenge Square; the sort of merchant who uses Square has no time for PayPal-style payments. They want to just deal with credit cards, which made the entire market less of a priority for PayPal ↩

    4. Merchants also have an October 2015 deadline to update their terminals to support chip-and-pin; since new terminal will certainly include NFC, nearly all merchants will support NFC by next year ↩

    5. I am aware that Apple Pay – and Stripe for that matter – are largely U.S. only affairs. I expect this situation will be fleeting, but even so, the U.S. is by far the largest payment opportunity in the world ↩

    6. Yes, I have basically described disruption ↩

  • Ello and Consumer-Friendly Business Models

    Vox introduced Ello this way:

    A brand-new social networking startup — Ello — has gone viral. At one point on Thursday, the site was acquiring 31,000 new users an hour — many of whom flocked to there because of a disagreement with Facebook over its policy requiring real names, which some say is unfair to LGBTQ and transgender users.

    Ello might be the new Facebook or the new Twitter or the new social media flop. It’s too early to tell.

    Actually, no, it’s not too early. Ello will fail, deservedly so. It has a consumer hostile business model.

    Discussion of how a company makes money – its business model – is often completely divorced from discussion about the product at hand, but I think that’s a mistake; business models fundamentally impact product, if not now, then assuredly in the future. To their credit, Ello is quite up-front about the fact that many of their decisions are driven by business models, specifically, their opposition to ads. From their WTF document:

    Many other social networks (like Twitter, Facebook, Tumblr, Google+, Instagram, etc. etc.) started out ad-free, then suddenly switched gears. They modified their privacy policies, started selling information about their users to data brokers, and bombarded us with ads. Many users of those networks feel betrayed.

    Ello’s entire structure is based around a no-ad and no data-mining policy. Quite frankly, were we to break this commitment, we would lose most of the Ello community. Including ourselves, because we dislike ads more than almost anyone else out there. Which is why we built Ello in the first place.

    OK, so how exactly will Ello make money?

    Very soon we will begin offering special features to our users. If we create a special feature that you like, you can choose to pay a very small amount of money to add it to your Ello account forever. We believe that everyone is unique and that we all want and need different things from a social network. So, we are going to offer all sorts of ways for users to customize their Ello experience.

    I have no idea what these features might be – a mobile app and an API would be good places to start – but the gist is clear: to get the optimal Ello experience you had better pay up, but only once, and you’ll have it forever.

    This is a terrible idea.

    Here’s how this policy will play out in practice:

    • The initial experience of using Ello will be a poor one because you won’t have access to all of the features
    • A poor initial experience will lead to high rates of abandonment among the few friends you manage to convince to try the service
    • You will complain to Ello and they will have exactly zero incentive to make things better

    It’s this final point that is critical for me whenever I evaluate a new product or service: does the product’s business model incentivise the developer to be responsive to my needs as a user?

    The way this drives my decision-making in hardware is the easiest to understand:

    • Businesses predicated on selling high margin products are highly incentivized to differentiate their products to attract my purchase, and also highly incentivized to ensure quality to guarantee that I stay loyal
    • Businesses predicated on achieving the lowest prices are highly incentivized to drive down costs, and are much more likely to sacrifice quality

    Thus, I almost always buy high margin products, especially for products I use regularly. The incentives are better for me as a customer, according to the criteria that I consider important.

    Things are a little more complex when it comes to software, but the same guiding principle is still in place: I like companies that are incentivized to make and keep me happy:

    • My favorite business model is a subscription: I pay every month for a piece of software or a service, which means the software or service provider is always under pressure to earn my money

    • Advertising is actually not far off from a subscription-style service: while in a very narrow view the adage “you’re the product that’s being bought and sold” is certainly true, the reality is that the Google and Facebooks of the world are arguably even more incentivized to make sure the user experience is great. After all, the value they offer has to be sufficient to overcome the negative effects of advertising (and in some case, particularly Google search, there are times when advertising is actually additive to the user experience)

    • Up-front payments can go either way:

      • I’m a fan of up-front payments if the developer has plans to release new versions of the software that require me to pay to upgrade. This sort of business is similar to high-margin hardware: not only must this developer offer something very compelling to earn my up-front payment, they must also deliver something of quality to ensure I’m willing to pay for versions two, three, and four
      • On the other hand, if the developer will never charge for upgrades, then I think this business model isn’t consumer friendly at all. A developer of such an app is incentivized to garner as many up-front payments as possible with no regard for existing customers
    • “Unlock”-type schemes are the worse. These can be products where you need to pay for features or assistance to accomplish some given task (free-to-play definitely falls in this category). Developers who use these schemes are incentivized to make the experience of their product frustrating so that I might be willing to pay to avoid the frustration. But, once I pay, there is no incentive to keep me happy

    That said, my business model preference is impacted by the type of product that is being offered. For example, while I particularly like subscriptions for productivity-focused products that I use on a regular basis, games are more singular experiences that I take in at a particular moment in time; in that case I like paid downloads that let me experience the game on my own schedule. When it comes to social networks, on the other hand, advertising is clearly the best option: after all, a social network is only as good as the number of friends that are on it, and the best way to get my friends on board is to offer a kick-ass product for free. In other words, the exact opposite of the feature-limited product that Ello is proposing.

    Make no mistake: I am very much aware that Facebook is tracking everything I do – and that it’s getting worse. As I wrote on Monday in my Daily Update (members-only), the killer feature of the just-relaunched Atlas is not buying ads outside of Facebook. Rather:

    What Facebook is proposing with Atlas is that advertisers can connect the dots between online advertising – on Facebook or off – to actual purchases made by customers no matter where those purchases are made. This means that ads served through Atlas will, in the long run, be much more effective for marketers, even as Facebook improves their targeting which will allow them to command ever higher rates across all of their ad offerings.

    Not only is that a marketer’s dream, it’s also profoundly creepy.

    Here’s the thing though: the reason Facebook can pull that off is because companies like Datalogix, Epsilon, Acxiom, and Bluekai – all Facebook partners since 2013 – have been tracking what I do and buy for years. Privacy died a long time ago; pretending like Facebook killed it is naive (just ask Richard Stallman). If you truly care about privacy then don’t use the Internet, credit cards, a mobile phone, the list goes on-and-on.

    If, on the other hand, you care about making a successful social network that users will find useful over the long run, then actually build something that is as good as you can possibly make it and incentivize yourself to earn and keep as many users as possible.

    As for Ello, well, co-founder Paul Budnitz told Mashable:

    “The advertisers are the customer and the user is the product that’s being bought and sold,” he told Mashable. “We don’t see ourselves competing with [Facebook], because what we’re doing feels so different.”

    I completely agree; it feels like a political statement not a product that I – and more importantly, none of my friends – would want to use, and I’m pretty certain that Mark Zuckerberg doesn’t see them as competition either.