The commons leads to overuse and destruction; the anticommons leads to underuse and waste. In the cultural sphere, ever tighter restrictions on copyright and fair use limit artists’ abilities to sample and build on older works of art. In biotechnology, the explosion of patenting over the past twenty-five years—particularly efforts to patent things like gene fragments—may be retarding drug development, by making it hard to create a new drug without licensing myriad previous patents. Even divided land ownership can have unforeseen consequences. Wind power, for instance, could reliably supply up to twenty per cent of America’s energy needs—but only if new transmission lines were built, allowing the efficient movement of power from the places where it’s generated to the places where it’s consumed. Don’t count on that happening anytime soon. Most of the land that the grid would pass through is owned by individuals, and nobody wants power lines running through his back yard.

From The Permission Problem, James Surowiecki, The New Yorker Magazine.  A very worthwhile read.

Allocation investing has a number of perverse effects on financial markets. For example, in the 80s and 90s venture capital was deemed to be a successful, independent asset class. As a result, many funds decided to allocate some portion of their capital to VC. These pools of capital were so large that they caused the VC industry to grow orders of magnitude larger – many say larger than it should be. In turn, this led to many bad venture investments that drove down returns in the industry (these problems were further exacerbated by the fee structure of VC that encouraged funds to get large and rapidly “put money to work”).

Another perverse effect caused by allocation investing happens in public stock markets when investors decide to allocate a portion of their funds to specific sectors. I recently heard some money managers saying they wanted to allocate portions of their funds to “social media”. Combining this “allocated” demand with a constrained supply (due to the small float of many of these IPOs) can lead to prices that are disconnected from fundamental values. In this scenario, supply will try to match demand, which means mediocre social media companies will go public and non-social media companies will reposition themselves as social media companies or acquire social media companies. They will be chasing the “social premium.”

We saw this happen in the 90s with the rush of companies to reposition themselves as internet companies. In that case, many non-professional investors ended up owning shares in crappy companies when the music stopped. The primary difference now is that the flagship companies like LinkedIn and Facebook have excellent fundamentals. Hopefully this time the market will be discerning and value investing will win out over allocation investing.

Platforms succeed when they are 1) financially sustainable, and 2) have a sufficient number of developers that are financially sustainable. Fostering a successful developer community means convincing developers (and, possibly, investors in developers) that the platform is a worthwhile investment of time and money.

Developers who create applications for platforms take on all the usual risks related to launching a new product, but in addition take on platform-specific risks, namely:

1. Platform decline: the platform will decline or go away entirely.
2. Subsumption risk: the platform will subsume the functionality of the developer’s application.

The most successful platforms try to mitigate these risks for developers (not just the appearance of these risks). One way to mitigate platform decline risk is to launch the platform after the platform’s core product is already successful, as Facebook did with its app platform and Apple did with its iOS platform. Platforms that are not yet launched or established can use other methods to reassure developers; for example, when Microsoft launched the first Xbox they very publicly announced they would invest $1B in the platform.

To mitigate subsumption risk, the platform should give developers predictability around the platform’s feature roadmap. Platforms can do this explicitly by divulging their product roadmap but more often do it implicitly by demonstrating predictable patterns of feature development. Developers and investors are willing to invest in the iOS platform because – although Apple will take 30% of the revenue – it is highly unlikely that Apple will, say, create games to compete with Angry Birds or news to compete with The New York Times. Similarly, Facebook has thus far stuck to “utility” features and not competed with game makers, dating apps, etc.

Platforms that are controlled by for-profit businesses that don’t yet have established business models have special challenges. These companies are usually in highly experimental modes and therefore probably themselves don’t know their future core features. The best they can do to mitigate developers’ risks are 1) provide as much guidance as possible on future features, and 2) when developer subsumption is necessary, do so in a way that keeps the developer ecosystem financially healthy – for example, by acquiring the subsumed products.

The least risky platforms to develop on are successful open platforms like the web, email, and Linux. These platforms tend to change slowly and have very public development roadmaps. In the rare case where a technology is subsumed by an open platform, it is usually apparent far in advance. For example, Adobe Flash might be subsumed by the canvas element in HTML5, but Adobe had years to see HTML5 approaching and adjust its strategy accordingly. The predictability of open platforms is the main reason that vast amounts of wealth have been created on top of them and investment around them continues unabated.

By “incumbents” I mean the big companies that are loosely competitive to your startup.

- The first thing to do is try to understand the incumbent’s strategy.  For example, see my analysis of Google’s strategy.

- Being on an incumbent’s strategic roadmap is a double-edged sword.  On the one hand, they might copy what you build or acquire a competitor.  On the other hand, if you build a valuable asset you could sell your company the acquirer at a “strategic premium.”

- Incumbents that don’t yet have a successful business model (e.g. Twitter) might think they have a strategy, but expect it to change as they figure out their business model.  An incumbent without a successful business model is like a drunk person firing an Uzi around the room.

- Understand the incumbent’s acquisition philosophy. More mature companies like Cisco barely try to do R&D and are happy to acquire startups at high prices.  Incumbents that are immature like Facebook only do “talent acquisitions” which are generally bad outcomes for VC-backed startups (but good for bootstrapped or lightly funded startups). Google is semi-mature, and does a combination of talent and strategic acquisitions.

- Understand the incumbent’s partnership philosophy.  Yahoo and Microsoft are currently very open to partnerships with startups.  Google and Facebook like to either acquire or build internally. If you don’t intend to sell your company, don’t talk seriously about partnerships to incumbents that don’t seriously consider them.

- Every incumbent has M&A people who spend a lot of their time collecting market intelligence. Just because they call you and hint at acquisition doesn’t mean they want to buy you – they are likely just fishing for info. If they really want to buy you, they will aggressively pursue you and make an offer.  As VCs like to say, startups are bought, not sold.

- Try to focus on features/technologies that the incumbents aren’t good at.  Facebook is good at social and social-related (hard-core) technology.  Thus far they’ve kept their features at the “utility level” an haven’t built non-utility features (e.g. games, virtual goods, game mechanics).  Google thus far has been weak at social and Apple has been weak at web services.

- Try to focus on business arrangements that the incumbents aren’t good at.  Facebook and Google only do outbound deals with large companies.  With small companies (e.g. local venues, small publishers) they try to generate business via inbound/self service. Building business relationships that the incumbents don’t have can be a very valuable asset.

- Be careful building on platforms where the incumbent has demonstrated an inconsistent attitude toward developers. Apple rejects apps somewhat arbitrarily and takes a healthy share of revenues, but is generally consistent with app developers.  You can pretty safely predict what they will will allow to flourish. Twitter has been wildly inconsistent and shouldn’t be trusted as a platform.  Facebook has been mostly consistent although recently changed the rules on companies like Zynga with their new payment platform (that said, they generally seem to understand the importance of partners thriving and seem to encourage it).

- Take advantage of incumbents’ entrenched marketing positioning.  The masses think of Twitter as a place to share trivial things like what you had for lunch (even if most power users don’t use it this way) and Facebook as a place to talk to friends.  They are probably stuck with this positioning.  Normals generally think of each website as having one primary use case so if you can carve out a new use case you can distinguish yourself.

- Consider the judo strategy.  When pushed, don’t push back.  When Facebook adds features like check-ins, groups, or likes, consider interoperating with those features and building layers on top of them.

The next step in this evolution is to create web services that are both federated (APIs) and extensible (Apps).

In my ideal world, the social graph would not be controlled by a private company. That said, Facebook, to its credit, has aggressively promoted a fairly open API through Facebook Connect. Facebook has also been a leader in promoting Apps. For Facebook, creating extensible, federated services would mean providing a framework for Facebook Connect Apps – apps that extend Facebook functionality but reside on non-Facebook.com websites.

Consider the following scenario.  Imagine that in the future a geolocation data/algorithm provider like SimpleGeo takes Facebook Places check-in data and, using algorithms and non-Facebook data, produces new data sets, for example: map directions, venue recommendations, and location-based coupons. The combination of Facebook’s data (social graph and check-ins) and SimpleGeo data/algorithms would create much more advanced feature possibilities than either service acting alone.

With today’s APIs, if, say, Gowalla wanted to integrate Facebook plus SimpleGeo into their app*, they would basically have 3 choices:

1) Embed Facebook widgets in Gowalla.  These are simple iframes (effectively separate little websites) that don’t interact with SimpleGeo.  Gowalla would just have to sit and wait and hope that Facebook decided to bake in SimpleGeo-like functionality.

2) Pre-import SimpleGeo data. This significantly limits the size and dynamism of the SimpleGeo data sets and doesn’t incorporate SimpleGeo algorithms, thus severely limiting functionality.

3) Host an instance of SimpleGeo’s servers internally.  This requires heavy technical integration, undermining the main benefit of APIs.

In a world of extensible APIs (or “API Apps”), Gowalla could instead send Facebook data back to SimpleGeo.  The data flow would look something like this:

(Note how there are three parties involved – @peretti calls this a “data threesome”). This configuration is much simpler to integrate – and potentially much more powerful and dynamic – than the other configurations listed above.  You could implement this today, but it would create user experience challenges.  For example, Gowalla would be sending Facebook data to a 3rd party (step 3), which might (depending on the data sent) require explicit user opt-in. Things become more onerous if SimpleGeo wanted to share its own user data with Gowalla. That would require an additional oAuth to SimpleGeo (authorizing step 4).

Allowing websites to be federated and extensible will open up a whole new wave of innovation.  Ideally some spec like oAuth could include the multiple authorizations in a single authorization screen.  Facebook could also do this by allowing 3rd parties to be part of the Facebook Connect authorization process.  Inasmuch as Facebook’s seems to be trying to embed their social graph as deeply as possible into the core experiences of other websites, allowing extensible APIs would seem to be a smart move.

* I have no connection to any of these companies (Facebook, Gowalla, SimpleGeo) and have no knowledge of their product plans beyond their public websites.  I am imagining functionality that Gowalla and SimpleGeo might include someday but for all I know they have no interest in these features – I just picked them somewhat arbitrarily as examples.

A graph consists of a set of nodes connected by edges. The original internet graph is the web itself, where webpages are nodes and links are edges. In social graphs, the nodes are people and the edges friendship. Edges are what mathematicians call relations. Two important properties that relations can either have or not have are symmetry (if A ~ B then B ~ A) and transitivity (if A ~ B and B ~ C then A ~ C).

Facebook’s social graph is symmetric (if I am friends with you then you are friends with me) but not transitive (I can be friends with you without being friends with your friend).  You could say friendship is probabilistically transitive in the sense that I am more likely to like someone who is a friend’s friend then I am a user chosen at random. This is basis of Facebook’s friend recommendations.

Twitter’s graph is probably best thought of as an interest graph. One of Twitter’s central innovations was to discard symmetry: you can follow someone without them following you. This allowed Twitter to evolve into an extremely useful publishing platform, replacing RSS for many people. The Twitter graph isn’t transitive but one of its most powerful uses is retweeting, which gives the Twitter graph what might be called curated transitivity.

Graphs can be implicitly or explicitly created by users. Facebook and Twitter’s graphs were explicitly created by users (although Twitter’s Suggested User List made much of the graph de facto implicit). Google Buzz attempted to create a social graph implicitly from users’ emailing patterns, which didn’t seem to work very well.

Over the next few years we’ll see the rising importance of other types of graphs. Some examples:

Taste: At Hunch we’ve created what we call the taste graph. We created this implicitly from questions answered by users and other data sources. Our thesis is that for many activities – for example deciding what movie to see or blouse to buy – it’s more useful to have the neighbors on your graph be people with similar tastes versus people who are your friends.

Financial Trust: Social payment startups like Square and Venmo are creating financial graphs – the nodes are people and institutions and the relations are financial trust. These graphs are useful for preventing fraud, streamlining transactions, and lowering the barrier to accepting non-cash payments.

Endorsement: An endorsement graph is one in which people endorse institutions, products, services or other people for a particular skill or activity. LinkedIn created a successful professional graph and a less successful endorsement graph. Facebook seems to be trying to layer an endorsement graph on its social graph with its Like feature. A general endorsement graph could be useful for purchasing decisions and hence highly monetizable.

Local: Location-based startups like Foursquare let users create social graphs (which might evolve into better social graphs than what Facebook has since users seem to be more selective friending people in local apps). But probably more interesting are the people and venue graphs created by the check-in patterns. These local graphs could be useful for, among other things, recommendations, coupons, and advertising.

Besides creating graphs, Facebook and Twitter (via Facebook Connect and OAuth) created identity systems that are extremely useful for the creation of 3rd party graphs. I expect we’ll look back on the next few years as the golden age of graph innovation.

Ask anyone who ran or invested in a mobile app startup pre-iPhone (I invested in one myself). Since the carriers had all the power, getting any distribution (which usually meant getting on the handset “deck”) meant doing a business development deal with the carriers. Business development in this case meant finding the right people at those companies, sending them iPods, taking them to baseball games, and basically figuring out ways to convince them to work with you instead of the 5,000 other people sending them iPods and baseball tickets.  The basis of competition was salesmanship and capital, not innovation or quality.

The carriers had so much power because consumers made their purchasing decisions by choosing a carrier first and a handset second. Post-iPhone, tens of millions of people started choosing handsets over carriers. People like me suffer through AT&T’s poor service and aggressive pricing because I love the iPhone so much.

I’ve talked to a number of mobile app startups lately who say their former contacts at the carriers are shell shocked: no one is knocking on their doors anymore. I guess they have to buy their own iPods and baseball tickets now.

Yes, Apple has rejected some apps for seemingly arbtrary or selfish reasons and imposed aggressive controls on developers. But the iPhone also paved the way for Android and a new wave of handset development. The people griping about Apple’s “closed system” are generally people who are new to the industry and didn’t realize how bad it was before.

When legendary VC John Doerr quit Amazon’s board a few months ago, savvy industry observers like TechCrunch speculated that Google might begin directly competing with Amazon:

[Google] competes with Amazon in a number of areas, particularly web services and big data. And down the road, Google may compete directly in other ways as well. Froogle was a flop, but don’t think Google doesn’t want a bigger chunk of ecommerce revenue from people who begin their product searches on their search engine.*

In fact, Google and Amazon’s are already direct competitors in their core businesses. Like Amazon, Google makes the vast majority of its revenue from users who are looking to make an online purchase. Other query types – searches related to news, blog posts, funny videos, etc. – are mostly a loss leaders for Google.

The key risk for Google is that they are heavily dependent on online purchasing being a two-stage process:  the user does a search on Google, and then clicks on an ad to buy something on another site. As long as the e-commerce world is sufficiently fragmented, users will prefer an intermediary like Google to help them find the right product or merchant. But as Amazon increasingly dominates the e-commerce market, this fragmentation could go away along with users’ need for an intermediary.**

Moreover, Google’s algorithmic results for product searches are generally poor. (Try using Google to decide what dishwasher to buy). These poor results might actually lead to short term revenue increases since the sponsored links are superior to the unsponsored ones.  But long term if Google continues producing poor product search results and Amazon continues consolidating the e-commerce market, Google’s core business is at serious risk.

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* Froogle (and Google Products) have been unsuccessful most likely because Google has had no incentive to make them better: they make plenty of money on these queries already on a CPC basis, and would likely make less if they moved to a CPA model.

** Most Amazon Prime customers probably already do skip Google and go directly to Amazon.  I know I do.

When users are actively looking to purchase something, they typically go to search engines or e-commerce sites. Through advertising or direct sales, these sites harvest intent. Google and Amazon are the biggest financial beneficiaries of intent harvesting.

When the user is not actively looking to buy something, the goal of an online ad is to generate intent. The intent generation market is still fairly fragmented and will grow rapidly over the next few years as brand advertising increasingly moves online. P&G – which alone spends almost $4B/year on brand advertising – needs to convince the next generation of consumers that Crest is better than Colgate. This is why Google paid such a premium for Doubleclick, Yahoo for Right Media, and Microsoft for aQuantive (MS’s biggest acquisition ever).

In 2003, Google introduced AdSense, a program to syndicate their intent harvesting text ads beyond Google’s main property Google.com.  The playbook they followed was: use their popular website to build a critical mass of advertisers; then use that critical mass to run an off-property network that offers the highest payouts to publishers. AdSense became so dominant that competitors like Yahoo quit the syndicated ad business altogether. Today, Google has such a powerful position that they don’t disclose percentage revenue splits to publishers and extract the vast majority of the profits.

It is widely believed that Facebook will soon follow the AdSense playbook by introducing an off-property ad network. They’ll try to use their strong base of advertisers to dominate intent generating ads the way AdSense dominated intent harvesting ads.

But to win the intent generation ad battle, data is as important as a critical mass of advertisers. For intent harvesting, users simply type what they are looking for into a search box. For intent generating ads, you need to use data to make inferences about what might influence the user.

This is what the introduction of the Facebook Like button is all about.  Intent generating ads – which mostly means displays ads – have notoriously low click through rates (well below 1%). Attempts to improve these numbers through demographics have basically failed. Many startups are having success using social data to target ads today. But the holy grail for targeting intent generating ads is taste data – which basically means what the user likes. Knowing, for example, that a user liked Avatar is an incredibly useful datapoint for targeting an Avatar 2 ad.

Publishers who adopt Facebook’s Like feature may get more traffic and perhaps a better user experience as a result.  But they should hope the intent generation ad market doesn’t end up like the intent harvesting ad market – with one dominant player commanding the lion’s share of the profits.

* Most text ads are about intent harvesting and most display ads are about intent generation, but they are not coreferential distinctions. For example, with techniques like “search retargeting” (you do a Google search for washing machines and the later on another site see a display ad for washing machines), sometimes intent harvesting is delivered through display ads.

It is in Facebook’s economic interest to extract most of Zynga’s profits, leaving them just enough to keep investing in games and advertising. Last year’s reduced notification change seemed like one move in this direction as it forced game makers to buy more ads instead of getting traffic organically. This probably hurt Zynga’s profitability but also helped them fend off less well-capitalized rivals. Facebook could also hold up Zynga by entering the games business itself, but this seemed unlikely since thus far Facebook has kept its features limited to things that are “utility like.”

The way Facebook now seems to be holding up Zynga – requiring Zynga to use their payments system –  is particularly clever.  First, payments are still very much a “utility like” feature, and arguably one that benefits the platform, so it doesn’t come across as flagrant hold up. It is also clever because – assuming Facebook has insight into Zynga’s profitability – Facebook can charge whatever percentage gets them an optimal share of Zynga’s profits.

The risk for Zynga is obvious — if they don’t diversify their traffic sources very soon, they are left with a choice between losing profits and losing their entire business.  But there is a risk for Facebook as well. If buyers of traffic (e.g. app makers) fear future hold up, they are less likely to make investments in the platform. The biggest mistake platforms make isn’t charging fees (Facebook) or competing with complements (Twitter), it’s being inconsistent.  Apple also charges 30% fees but they’ve been mostly consistent about it. App makers feel comfortable investing in the Apple platform and even having most of their business depend on them in a way they don’t on Facebook or Twitter.

(Eisenmann acknlowledges the iPhone isn’t fully open to the end user – in the US you need to use AT&T, etc.  I would argue the iPhone is semi-open to the app developer and mobile app development was effectively closed prior to the iPhone. But the main point here is that platforms can be open & closed in many different ways, at different levels, etc.)

The next important distinction is whose interest you are considering when asking what and when to open or close things.  I think there are at least 3 interesting perspectives:

The company: Lots of people have written about this topic (Clay Christensen, Joel Spolsky, more Eisenmann here).   In a nutshell, there are times when a company, acting solely in its self-interest, should close things and other times they should open things.  As a rule of thumb, a company should close their core assets and open/commoditize complementary assets. Google’s search engine is their core asset and therefore Google should want to keep it closed, whereas the operating system is a complement that they should commoditize (my full analysis of what Google should want to own vs commoditize is here). Facebook’s social graph is their core asset so it’s optimal to close it and not interoperate with other graphs, whereas marking up web pages to be more social-network friendly (open graph protocol) is complementary hence optimal for FB to open.  (With respect to social graphs interoperating (e.g. Open Social), it’s generally in the interest of smaller graphs to interoperate and larger ones not to – the same is true of IM networks).  Note that I think there is absolutely nothing wrong with Google and Facebook or any other company keeping closed or trying to open things according to their own best interests.

The industry: When I say “what is good for the industry” I mean what ultimately creates the most aggregate industry-wide shareholder value.  I assume (hope?) this also yields the maximum innovation.  As an active tech entrepreneur and investor I think my personal interests and the tech industry’s interests are mostly aligned (hence you could argue I’m talking my book).  Unfortunately it’s much easier to study open vs. closed strategies at the level of the firm than at the level of an industry, because there are far more “split test” cases to study.  What would the world be like if email (SMTP) were controlled by a single company?  I would tend to think a far less innovative and wealthy one. There are a number of multibillion dollar industries built on email: email clients, webmail systems, email marketing, anti-spam, etc.  The downside of openness is that it’s very hard to upgrade SMTP since you need to get so many parties to agree and coordinate.  So, for example, it has taken forever to add basic anti-spam authentication features to SMTP.  Twitter on the other hand can unilaterally add useful new things like their recent annotations feature.

Here’s what Professor Eisenmann said when I asked him to summarize the state of economic thinking on the topic:

With respect to your question about the impact of open vs closed on the economy, the hard-core economists cited in my book chapter have a lot to say, but it all boils down to “it depends.” Closed platform provides more incentive for innovation because platform owner can collect and redistribute more rent and can ensure that there’s a manageable level of competition in any given application category. Open platform harnesses strong network effects, attracting more application developers, and  thus stimulates lots of competition. There’s some interesting recent work that suggests that markets may evolve in directions that favor the presence of one strong closed player plus one strong open player (consider: Windows + Linux; iPhone + Android). In this scenario, society/economy gets best of both approaches.

Society:  I tend to think what is good for the tech industry is generally good for society.  But others certainly have different views.  Advocates of openness are often accused of being socialist hippies.  Maybe some are.  I am not.  I care about the tech industry.  I think it’s reasonable to question whether moves by large industry players are good or bad for the industry.  Unfortunately most of the debate I’ve seen so far seems driven by ideology and name calling.

Twitter’s moves this week were particular interesting.  A lot of third-party developers were unhappy. I think this is mainly a result of Twitter having sent mixed signals over the past few years. Twitter’s move into complementary areas was entirely predictable – it happens with every platform provider. The real problem is that somehow Twitter had convinced the world they were going to “let a thousand flowers bloom” – as if they were a non-profit out to save the world, or that they would invent some fantastic new business model that didn’t encroach on third-party developers. This week Twitter finally started acting like what it is: a well-financed company run by smart capitalists.

This mixed signaling has been exacerbated by the fact that Twitter has yet to figure out a business model (they sold data to Microsoft & Google but this is likely just one-time R&D purchases). Maybe Twitter thinks they know what their business model is and maybe they’ll even announce it soon. But whatever they think or announce will only truly be their business model when and if it delivers on their multi-billion dollar aspirations. It will likely be at least a year or two before that happens.

Normally, when third parties try to predict whether their products will be subsumed by a platform, the question boils down to whether their products will be strategic to the platform. When the platform has an established business model, this analysis is fairly straightforward (for example, here is my strategic analysis of Google’s platform).  If you make games for the iPhone, you are pretty certain Apple will take their 30% cut and leave you alone. Similarly, if you are a content website relying on SEO and Google Adsense you can be pretty confident Google will leave you alone. Until Twitter has a successful business model, they can’t have a consistent strategy and third parties should expect erratic behavior and even complete and sudden shifts in strategy.

So what might Twitter’s business model eventually be?  I expect that Twitter search will monetize poorly because most searches on Twitter don’t have purchasing intent.  Twitter’s move into mobile clients and hints about a more engaging website suggest they may be trying to mimic Facebook’s display ad model. (Facebook’s ad growth is being driven largely by companies like Zynga who are in turn monetizing users with social games and virtual goods.  Hence it’s no surprise that a Twitter investor is suggesting that developers create social games instead of “filling holes” with URL shorteners etc.) Facebook’s model depends on owning “eyeballs,” which is entirely contradictory to the pure API model Twitter has promoted thus far.  So if Twitter continues in this direction expect a lot of angst among third-party developers.

Hopefully Twitter “fills holes” through acquisitions instead of internal development. Twitter was a hugely clever invention and has grown its user base at a staggering rate, but on the product development front has been underwhelming.  Buying Tweetie seemed to be a tacit acknowledgement of this weakness and an attempt to rectify it. Acquisitions also have the benefit of sending a positive signal to developers since least some of them are embraced and not just replaced.

What’s Facebook doing during all of this?  Last year, Facebook seemed to be frantically copying Twitter – defaulting a lot of information to public, creating a canonical namespace, etc. Now that Twitter seems to be mimicing Facebook, Facebook’s best move is probably just to sit back and watch the Twitter ecosystem fight amongst itself.  As Facebooker Ivan Kirigin tweeted yesterday: “I suppose when your competition is making huge mistakes, you should just stfu.”

Disclosure: As with everything I write, I have a ton of conflicts of interest, some of which are listed here.

The paradox, it seems is this: in a pay-per-click driven world, site visitors who want to stay on your site — due to it having the once-much-lauded quality of “stickiness” — are worth much less than those who want to flee your site because it’s clearly not valuable, and hence will click through to somewhere else.

Facebook recently became the most visited site on the web. Yet their revenues are rumored to around $1B – about 1/30 of what Google’s revenues will be this year. Google has the perfect revenue-generating combination:  people come to the site often, leave quickly, and often have purchasing intent. Facebook has tons of visitors but they generally come to socialize, not to buy things, and they rarely click on ads that take them to other sites. Facebook is like a Starbucks where everyone hangs out for hours but almost never buys anything.

The revenue gap between sites like Facebook and Google should narrow over time.  Cost-per-click search ads are extremely good at harvesting intent, but bad at generating intent.  The vast majority of money spent on intent-generating advertising — brand advertising — still happens offline. Eventually this money will have to go where people spend time, which is increasingly online, at sites like Facebook. Somehow Coke, Tide, Nike, Budweiser etc. will have to convince the next generation to buy their mostly commodity products. Expect the online Starbucks of the future to have a lot more – and more effective – ads.

The reality is that news is a lousy business. Period. Even Google doesn’t make money on it. For example, here are Google’s search results for the phrase “afghanistan war”:

Notice there aren’t any ads on the page. This is because ads for “afghanistan war” generate such low revenues per query that Google doesn’t think it’s worth hurting the user experience with a cluttered page. Google can afford to do this on news queries (along with many other categories of queries) because their real business is selling ads on queries where the user likely has purchasing intent. Big money-making categories include travel, consumer electronics and malpractice lawyers. News queries are loss leaders.

It’s an historical accident that hard news categories like international and investigative reporting were part of profitable businesses. The internet upended this model by 1) providing a new delivery method for classified ads (mainly Craigslist), 2) increasing the supply of newspapers from 1-2 per location to thousands per location, thereby driving the willingness-to-pay for news dramatically down, and 3) unbundling news categories, making cross subsidization increasingly hard.

The internet exposed hard news for what it is: a lousy standalone business. Google arguably contributed to this in many indirect ways, including by helping users find substitute news sources. But the idea that Google takes profits directly from newspapers is simply misinformed.

But there is an additional problem:  even among sites that monetize via sponsored links there is a large overallocation of advertising spending on links that are near the “end of the purchasing process” (or “end of the funnel”). For example, an average camera buyer takes 30 days and clicks on approximately 3 sponsored links from the beginning of researching cameras to actually purchasing one.   Yet in most cases only the last click gets credit, by which I mean:  1) if it’s an affiliate (CPA) deal, it is literally usually the case that only the last affiliate (the site that drops the last cookie) gets paid, 2) if it’s a CPC or CPM deal, most advertisers don’t properly track the users across multiple site visits so simply attribute conversion to the most recent click, causing them to over-allocate to end-of-funnel links 3) if it’s a non-sponsored link (like Google natural search links) the advertiser might over-credit SEO when in fact the natural search click was just the final navigational step in a long process that involved sponsored links along the way.

What this means is there are two huge misallocations of advertising dollars online: the first from intent generators to intent harvesters; the second from intent harvesters that are at the beginning or middle of the purchasing process to those at the end of the purchasing process.  This is not just a problem for internet advertisers and businesses – it affects all internet users.  Where advertising dollars flow, money gets invested. It is well known that content sites are suffering, many are even on their way to dying. Additionally, product/service sites that started off focusing on research are forced to move more and more toward end-of-funnel activities.  Take a look at how sites like TripAdvisor and CNET have devoted increasing real estate to the final purchasing click instead of research.  For the most part, you don’t get paid for the actual research since it’s too high in the funnel.

As with all large problems, this misallocation of advertising dollars also presents a number of opportunities.  One opportunity is for advertisers to correctly attribute their spending by tracking users through the entire purchasing process (in the case of cameras, the full 30 days and multiple sponsored clicks).  Very likely, these sites are currently overpaying end-of-funnel sites (e.g. coupon sites) and underpaying top-of-funnel sites (e.g. research sites). There is also an opportunity for companies that provide technology to help track this better. Finally, if over time advertising dollars do indeed shift to being correctly allocated, this will allow research sites to be pure research sites, content sites to be pure content sites, etc instead of everyone trying to clutter their sites with repetitive, “last click” functionality.

For example, Fred Wilson says about VC:

You cannot invest $25bn per year and generate the kinds of returns investors seek from the asset class. If $100bn per year in exits is a steady state number, then we need to work back from that and determine how much the asset class can manage…. I think “back to the future” is the answer to most of the venture capital asset class problems. Less capital in the asset class, smaller fund sizes, smaller partnerships, smaller deals, and smaller exits

Similarly, Bill Gurley writes:

There are many reasons to believe that a reduction in the size of the VC industry will be healthy for the industry overall and should lead to above average returns in the future.

All of these analyses start with the assumption that aggregate venture-backed exits (acquisition and IPOs) will remain roughly constant. I don’t see why we need to accept that assumption. The aggregate value of venture-backed startups, like all valuations, is a function of profits generated (or predicted to be generated). In technology, profits are driven by innovation. I don’t see any reason we should assume venture-backed innovation can’t be dramatically increased.

For example, innovation has varied widely across times and places – the most innovative region in the world for the last 50 years being Silicon Valley. What if, say, Steve Jobs hadn’t grown up in Silicon Valley? What if he had gone to work for another company? Does anyone really think Apple – and all the innovation and wealth it created – would exist if Jobs hadn’t happened to grow up in a culture that was so startup friendly? Jobs is obviously a remarkable person, but there are probably 100 Steve Jobs born every year. The vast majority just never have a chance or give a thought to starting a revolutionary new company.

Some people blame our education system, or assume that there is some fixed number of entrepreneurs born every year. I think the problem is cultural. As much as we like to think of our culture as being entrepreneurial, the reality is 99% of our top talent doesn’t seriously contemplate starting companies. Colleges crank out tons of extremely smart and well-educated kids every year. The vast majority go into “administrative” careers that don’t really produce anything – law, banking and consulting. Most of the rest join big companies. As I’ve argued many times before, big companies (with a few notable exceptions) aren’t nearly as successful as startups at creating new products.  The bigger the company, the more likely it suffers from agency issues, strategy taxes, and myopia. But most of all: nothing is more motivating and inspiring than the sense of ownership and self-direction only a startup can provide.

Whenever I see a brilliant kid decide to join Goldman Sachs, McKinsey, or Google, I think to myself: a startup just died, and as a result our world is a little less wealthy, innovative, and interesting.

I am by no means an expert in enterprise sales. Personally, I vastly prefer marketing (one-to-many) versus sales (one-to-one), hence only start companies making consumer or small business products (advertising based or sub-$5000 price tags). But I have been involved in a few enterprise companies over the years. Here’s the main thing I’ve observed. Almost every enterprise startup I’ve seen has a product that would solve a problem their prospective customers have. But that isn’t the key question. The key question is whether it solves a problem that is one of the prospective customer’s top immediate priorities. Getting an enterprise to cough up $100K+ requires the “buy in” of many people, most of whom would prefer to maintain the status quo. Only if your product is a top priority can you get powerful “champions” to cut through the red tape.

My rule of thumb is that every enterprise (or large business unit within an enterprise) will, at best, buy 1-3 new enterprise products per year.  You can have the greatest hardware/software in the world, but if you aren’t one of their top three priorities, you won’t be able to profitably sell to them.

One final note: enterprise-focused VC’s sometimes refer to products priced between (roughly) $5k and $100K as falling in the “valley of death.” Above $100K, you might be able to make a profit given the cost of sales. Below $5k you might be able to market your product, hence have a very low cost of sales. In between, you need to do sales but it’s hard to do it profitably. Your best bet is a “channel” strategy; however, for innovative new products that is often a lot like trying to push a string.

Howard is also the founder of Stocktwits. Stocktwits is potentially genuinely disruptive in that it dis-intermediates Wall Street. It is one of those things that some people think is a toy now but could end up being the next big thing.

Anyways, here’s the interview:

The Wire is a Greek tragedy in which the postmodern institutions are the Olympian forces. It’s the police department, or the drug economy, or the political structures, or the school administration, or the macroeconomics forces that are throwing the lightning bolts and hitting people in the ass for no reason. In much of television, and in a good deal of our stage drama, individuals are often portrayed as rising above institutions to achieve catharsis. In this drama, the institutions always prove larger, and those characters with hubris enough to challenge the postmodern construct of American empire are invariably mocked, marginalized, or crushed. Greek tragedy for the new millennium, so to speak.

What’s amazing about the show is you see in a very realistic and compelling way how, say, 1) the well intentioned mayor needs to get the crime numbers down to get his school reform passed so 2) he pressures the (well-intentioned) police chief to do so, 3) who in turn cuts off a (well-intentioned) investigation that wasn’t going to yield short term metrics, 4) which emboldens the gang leader being investigated, 5) who recruits a sympathetic high school student into a life of crime. And so on.

This blog is mostly about startups so let me tell a true Wire-like startup story. There is a large, publicly-traded company we’ll call BigCo. BigCo has a new CEO who is under heavy scrutiny and expected to get the stock price up over the next few fiscal quarters. Wall Street analysts who follow BigCo value the stock at a multiple of earnings, which are driven by Operating Expenses (“OpEx”), which are ongoing expenses versus “one time” expenses like acquisitions (called “CapEx”). (If you read analyst reports, you’ll see that stocks are generally considered, correctly or not, to have key financial drivers. The stock price is often those drivers times a “multiple” which in turn is often determined by the company’s expected growth rate). The “smart money” like hedge funds may or may not believe these analysts’ models, but they know other people believe them so place their bets according to how they think these numbers will move (see Keynes on the stock market as a “beauty contest”). (Financial academics who believe in “efficient markets” would say none of this is possible but anyone who’s actually participated in these markets knows the academics are living in fantasy land.)

All this means the CEO is fixated on growing BigCo’s revenues while keeping operating expenses down. A great way to do this is through acquisitons, which analysts consider one-time expenses (CapEx). Let’s say BigCo is currently growing at 20%, but their multiple suggests they need to grow at 30%. So the M&A team goes out and looks for companies they can acquire growing at, say, 50%, to get the average up. BigCo spends lavishly to buy these companies since the costs can be considered CapEx. They even have elaborate dinners and incur other large expenses that can be counted as part of the acquisition. Once the deal is closed they immediately start planning how to cut operating expenses from the newly acquired company. They decide the best way is to move the engineering offshore. This rips the heart out of the engineering-driven culture and as a result morale drops, product quality falls, and key people quit. But the short term revenues are up and operating expenses down, so BigCo’s CEO keeps her job and makes a lot of money off her stock options.

The winners here are the people who understand the system and play it cynically (hedge funds, BigCo’s CEO & board, perhaps the acquired company’s founders & investors). The losers are everyone else – the company’s customers, the employees who lose their jobs, and the stock market investors who don’t understand the game is rigged.

With respect to requiring apps to be approved, consider the current state of the iPhone platform. There are over 100,000 apps and thus far not a single virus, worm, spyware app etc. (I don’t count utterly farfetched theoretical scenarios). As a would-be iPhone developer, I can report firsthand that the Apple approval process is a nightmare and should be overhauled. But what’s the alternative? Before the iPhone, getting your app on a phone meant doing complicated and expensive business development deals with wireless carriers. At the other end of the spectrum: If the iPhone OS were completely open, would we really have better apps?  What apps are we missing today besides viruses?

With respect to the strategic issue of tightly integrating the iPhone/iPad software and hardware, a strong case can be made that Apple’s “closed” strategy is smart. Clay Christensen has given us the only serious theory I know of to predict when it’s optimal for a company to adopt an open versus closed strategy for (among other things) operating systems. The basic idea is that every new tech product starts out undershooting customer needs and then – because technology gets better faster than customers needs go up - eventually “overshoots” them. (PC’s have overshot today – most people don’t care if the processors get faster or Windows adds new features). Once a product overshoots, the basis of competition shifts from things like features and performance to things like price.

The key difference today between desktop computers and mobile devices is that mobile devices still have a long way to go before customers don’t want more speed, more features, better battery life, smaller size, etc. Just look at all the complaints yesterday about the iPad - that it lacks multitasking, a camera, is too heavy, has poor battery life, etc. This despite the fact that Apple is now even building their own semiconductors (!) to squeeze every last bit of performance out of the iPad. Until mobile devices compete mainly on price (probably a decade from now), tight vertical integration will produce the best device and is likely the best strategy.

*It’s worth noting that Steve Jobs wasn’t the one who screwed up Apple. Jobs co-founded Apple in 1976. He was pushed out in in May 1985 when the company was valued at about $2.2B. He returned in 1996 when Apple was worth $3B. Today it is worth $187B.

The first thing to try to figure out is whether what you are building will eventually be on the incumbent’s product roadmap. The best way to do predict this is to figure out whether what you are doing is strategic for the company. (I try to outline what I think is strategic for Google here). Note that asking people who work at the incumbents isn’t very useful – even they don’t know what will be important to them in, say, two years.

If what you are doing is strategic for the incumbents, be prepared for them to enter the market at some point. This could be good for you if you build a great product, recruit a great team, and are happy with a “product sale” or “trade sale” – usually sub $50M. If you are going for this size outcome, you should plan your financing strategy appropriately. Trade sales are generally great for bootstrapped or seed-funded companies but bad if you have raised lots of VC money.

If your product is strategic for the incumbent and you’re shooting for a bigger outcome, you probably need to either 1) be far enough ahead of the curve that by the time the big guys get there you’re already entrenched, or 2) be doing something the big guys aren’t good at. Google has been good at a surprising number of things. One important area they haven’t been good at (yet) is software with a social component (Google Video vs YouTube, Orkut vs Facebook, Knol vs Wikipedia, etc).

The final question to ask is whether your product is disruptive or sustaining (in the Christensen sense).  If it’s disruptive, you most likely will go unnoticed by the incumbents for a long time (because it will look like a toy to them). If the your technology is sustaining and you get noticed early you probably want to try to sell (and if you can’t, pivot). My last company, SiteAdvisor, was very much a sustaining technology, and the big guys literally told us if we didn’t sell they’d build it. In that case, the gig is up and you gotta sell.

Mobile ads will be displayed to users either in a web browser or in a mobile application. Thanks to the iPhone and now Android, web browsing on mobile devices is becoming just like web browsing on the desktop. Sites are often running the same HTML – and the same ads – whether the browser is on the desktop or mobile web. Thus, if an ad network supplies ads to the nytimes desktop version, they’ll also supply ads to the nytimes mobile version. The battle for web publishers on mobile browser-based ads would seem to be the same battle already happening on the desktop web.  This battle is dominated by Google, Yahoo, Microsoft etc. and I can’t imagine Apple is trying to seriously enter the battle at this late stage.

Thus, Apple’s interest in Quattro must be about ads in mobile applications. Apple is currently in a very strong position with respect to app developers, given their tight control over the dominant app platform. How could Google supplant them there? For one thing, Android and other platforms could gain significant market share. But Google could threaten Apple even on ads in iPhone apps. Unless Apple forced developers to use their ad network, iPhone app developers would select the ad network that provided the highest payouts, which – as with all ad networks – would depend heavily on which had the most advertisers.

So the Quattro purchase seems to be mostly about Apple getting a base of mobile advertisers (not publishers) that will allow them to offer competitive payouts on mobile app ads (not mobile browser-based ads).

The reason big new things sneak by incumbents is that the next big thing always starts out being dismissed as a “toy.”  This is one of the main insights of Clay Christensen’s “disruptive technology” theory. This theory starts with the observation that technologies tend to get better at a faster rate than users’ needs increase. From this simple insight follows all kinds of interesting conclusions about how markets and products change over time.

Disruptive technologies are dismissed as toys because when they are first launched they “undershoot” user needs. The first telephone could only carry voices a mile or two. The leading telco of the time, Western Union, passed on acquiring the phone because they didn’t see how it could possibly be useful to businesses and railroads – their primary customers. What they failed to anticipate was how rapidly telephone technology and infrastructure would improve (technology adoption is usually non-linear due to so-called complementary network effects). The same was true of how mainframe companies viewed the PC (microcomputer), and how modern telecom companies viewed Skype. (Christensen has many more examples in his books).

This does not mean every product that looks like a toy will turn out to be the next big thing. To distinguish toys that are disruptive from toys that will remain just toys, you need to look at products as processes. Obviously, products get better inasmuch as the designer adds features, but this is a relatively weak force. Much more powerful are external forces: microchips getting cheaper, bandwidth becoming ubiquitous, mobile devices getting smarter, etc. For a product to be disruptive it needs to be designed to ride these changes up the utility curve.

Social software is an interesting special case where the strongest forces of improvement are users’ actions. As Clay Shirky explains in his latest book, Wikipedia is literally a process – every day it is edited by spammers, vandals, wackos etc., yet every day the good guys make it better at a faster rate. If you had gone back to 2001 and analyzed Wikipedia as a static product it would have looked very much like a toy. The reason Wikipedia works so brilliantly are subtle design features that sculpt the torrent of user edits such that they yield a net improvement over time. Since users’ needs for encyclopedic information remains relatively steady, as long as Wikipedia got steadily better, it would eventually meet and surpass user needs.

A product doesn’t have to be disruptive to be valuable. There are plenty of products that are useful from day one and continue being useful long term. These are what Christensen calls sustaining technologies. When startups build useful sustaining technologies, they are often quickly acquired or copied by incumbents. If your timing and execution is right, you can create a very successful business on the back of a sustaining technology.

But startups with sustaining technologies are very unlikely to be the new ones we see on top lists in 2020. Those will be disruptive technologies – the ones that sneak by because people dismiss them as toys.

Google makes 99% of their revenue selling text ads for things like airplane tickets, dvd players, and malpractice lawyers. A project is strategic for Google if it affects what sits between the person clicking on an ad and the company paying for the ad. Here is my rough breakdown of the “layers in the stack” between humans and the money:

Human - device – OS – browser – bandwidth –  websites - ads – ad tech – relationship to advertiser – $$$

At each layer, Google either wants to dominate it or commoditize it. (For more on the strategic move known as commoditizing the complement, see here, here and here). Here’s my a brief analysis of the more interesting layers:

Device: Desktop hardware already commoditized. Mobile hardware is not, hence Google Phone (Nexus One).

OS: Not commoditized, and dominated by archenemy (Microsoft)!!   Hence Android/Google Chrome OS is very strategic. Google also needs to remove main reasons people choose Windows. Main reasons (rational ones – ignoring sociological reasons, organizational momentum etc) are Office (hence Google Apps), Outlook (hence Gmail etc), gaming (look for Google to support cross-OS gaming frameworks), and the long tail of Windows-only apps (these are moving to the web anyways but Google is trying to accelerate the trend with programming tools).

Browser: Not commoditized, and dominated by arch enemy! Hence Chrome is strategic, as is alliance with Mozilla, as are strong cross-browser standards that maintain low switching costs.

Bandwidth:  Dominated by wireless carriers, cable operators and telcos. Very hard for Google to dominate without massive infrastructure investment, hence Google is currently trying to commoditize/weaken via 1) more competition (WiMAX via Clearwire, free public Wi-Fi) 2) regulation (net neutrality).

Websites/search (“ad inventory”): Search is obviously dominated by Google. Google’s syndicated ads (AdSense) are dominant because Google has the highest payouts since they have the most advertisers bidding. This in turn is due largely to their hugely valuable anchor property, Google.com. Acquired Youtube to be their anchor property for video/display ads, and DoubleClick to increase their publisher display footprint. On the emerging but fast growing mobile side, presumably they bought AdMob for their publisher relationships (versus advertiser relationships where Google is already dominant). The key risks on this layer are 1) people skip the ads altogether and go straight to, say, Amazon to buy things, 2) someone like Facebook or MS uses anchor property to aggressively compete in syndicated display market.

Relationships to advertisers:  Google is dominant in non-local direct-response ads, both SMB self serve and big company serviced accounts.  They are much weaker in display. Local advertisers (which historically is half of the total ad market) is still a very underdeveloped channel – hence (I presume) the interest in acquiring Yelp.

This doesn’t mean Google will always act strategically. Obviously the company is run by humans who are fallible, emotional, subject to whims, etc. But smart business should be practiced like smart chess: you should make moves that assume your opponents will respond by optimizing their interests.

The assertion seems to be that there is something special about the mobile internet that compels people to pay for things they wouldn’t pay for on the desktop internet.  It is this same thinking that has newspapers and magazines hoping the Kindle or a tablet device might be their savior.

It is certainly true that today people are paying for things on iPhones and Kindles that they aren’t paying for on the desktop internet. Personally, I’ve bought a bunch of iPhone games that I would have expected to get for free online. I also paid for the New York Times and some magazines on my Kindle that I never paid for on my desktop.

But longer term, the question is whether this is because of something fundamentally – and sustainably – different about mobile versus desktop or whether it is just good old fashioned supply and demand.

I think we are in the AOL “walled garden” days of the mobile internet. Demand is far outpacing supply, so consumers are paying for digital goods. I don’t pay for news or simple games on the desktop internet because there are so many substitutes that my willingness to pay is driven down to zero.

What are the arguments that the mobile internet is sustainably different than the desktop internet? One of the main ones I’ve heard is habit: digital goods providers made a mistake in the 90′s by giving stuff away for free. Now people are habituated to free stuff on the desktop internet. Mobile is a chance to start over.

I think this habit argument is greatly overplayed. The same argument has been made for years by the music industry: “kids today think music should be free” and so on. Back in the 90s, I bought CDs, not because I was habituated to paying for music, but because there was no other reasonably convenient way to get it. If tomorrow you waved a magic wand and CD’s were once again the only way kids could buy the Jonas Brothers and Taylor Swift, they’d pay for them. It’s the fact that there are convenient and free substitutes that’s killing the music industry, not consumers’ habits.

As the supply of mobile digital goods grows — the same way it did on the desktop internet — consumers’ willingness-to-pay will drop and either advertising will emerge as the key driver of mobile economic growth or the mobile economy will disappoint. I was going to buy a Chess app for my iPhone this morning but when I searched and found dozens of free ones I downloaded one of those.  At some point there will be lots of Tweetie, Red Laser, and Flight Control substitutes and they too will be free.

Let’s assume that, over time, ad spending on a medium becomes roughly proportional to the time consumers spend using that medium. I doubt there are any technologists reading this blog who doubt that in five years most people in industrialized countries will spend 50% or more of their “media time” on the web.  This means there are hundreds of billions of ad revenues waiting to move to the web.

Advertising is usually divided into two categories: direct-response and brand advertising. Direct-response advertising tries to get users to take immediate action. Brand advertising tries to build up positive associations over time in people’s minds. In the past decade, we saw a massive shift of direct response advertising to the web. The main beneficiary of this shift has been Google. We saw far less of a shift of brand advertising to the web.

It is therefore very likely that most of this new ad spending will be brand advertising.  This is why Google, Yahoo and Microsoft are all so intensely focused on display advertising. It is why they paid huge premiums to acquire Doubleclick, Right Media, and Avenue A.

Right now there are lots of inhibitors to brand advertising dollars flowing onto the web. Among them 1) most of the brand dollars are controlled by ad agencies, who seem far more comfortable with traditional media channels, 2) it is hard to know where your online advertising is appearing and whether it is effective, 3) banner ads seem extremely ineffective and are often poorly targeted, 4) big brand advertisers seem scared of user-generated content, today’s major source of ad inventory growth.

But economic logic suggests these problems will be figured out, because advertisers have no choice but to go where the consumers are.

Google talks a lot about openness and their commitment to open source software. What they are really doing is practicing a classic business strategy known as “commoditizing the complement“*.

Google makes 99% of their revenue by selling text ads for things like plane tickets, dvd players and malpractice lawyers. Many of these ads are syndicated to non-Google properties. But the anchor that gives Google their best “inventory” is the main search engine at Google.com.  And the secret sauce behind Google.com is the algorithm for ranking search results. If Google is really committed to openness, it is this algorithm that they need to open source.

The alleged argument against doing so is that search spammers would be able to learn from the algorithm to improve their spamming methods. This form of argument is an old argument in the security community known as “security through obscurity.” Security through obscurity is a technique generally associated with companies like Microsoft and is generally opposed as ineffective and risky by security experts. When you open source something you give the bad guys more info, but you also enlist an army of good guys to help you fight them.

Until Google open sources what really matters – their search ranking algorithm – you should dismiss all their other open-source talk as empty posturing. And millions of websites will have to continue blindly relying on a small group of anonymous engineers in charge of the secret algorithm that determines their fate.

* You can understand a large portion of technology business strategy by understanding strategies around complements. One major point: companies generally try to reduce the price of their products complements (Joel Spolsky has an excellent discussion of the topic here). If you think of the consumer as having a willingness to pay a fixed N for product A plus complementary product B, then each side is fighting for a bigger piece of the pie. This is why, for example, cable companies and content companies are constantly battling. It is also why Google wants open source operating systems to win, and for broadband to be cheap and ubiquitous. [link to full post]

Paul started by querying Google with the phrase dishwasher reviews:

Pretty much every link on this page has an interesting story to tell about the state of the web.  I’ll just focus here on the top organic (non-sponsored) result:

http://www.consumersearch.com/dishwasher-reviews

clicking through this link takes you here:

Consumersearch is owned by About.com, which in turn is owned by the New York Times.

So how did consumersearch.com get the top organic spot? Most SEO experts I talk to (e.g. SEOMoz‘s Rand Fishkin) think inbound links from a large number of domains still matter far more than other factors. One of the best tools for finding inbound links is Yahoo Site Explorer (which, sadly, is supposed to be killed soon). Using this tool, here’s one of the sites linking to the dishwasher section of Consumersearch:

http://www.whirlpooldishwasher.net/

(Yes, this site’s CSS looks scarily like my own blog – that’s because we both use a generic WordPress template).

This site appears has two goals: 1) fool Google into thinking it’s a blog about dishwashers and 2) link to consumersearch.com.

Who owns this site?  The Whois records are private. (Supposedly the reason Google became a domain registrar a few years ago was to peer behind the domain name privacy veil and weed out sites like this.)

I spent a little time analyzing the “blog” text (it’s actually pretty funny – I encourage you to read it).  It looks like the “blog posts” are fragments from places like Wikipedia run through some obfuscator (perhaps by machine translating from English to another language and back?).  The site was impressively assembled from various sources. For example, the “comments” to the “blog entries” were extracted from Yahoo Answers:

Here is the source of this text on Yahoo Answers:

The key is to have enough dishwaster-related text to look like it’s a blog about dishwashers, while also having enough text diversity to avoid being detected by Google as duplicative or automatically generated content.

So who created this fake blog?  It could have been Consumersearch, or a “black hat” SEO consultant, or someone in an affiliate program that Consumersearch doesn’t even know. I’m not trying to imply that Consumersearch did anything wrong. The problem is systematic. When you have a multibillion dollar economy built around keywords and links, the ultimate “products” optimize for just that:  keywords and links. The incentive to create quality content diminishes.

I don’t use any of Microsoft’s software anymore, but from what I hear they’ve toned down the feature creep a lot in recent versions of Windows and Word.

Google has been adding so many new features to its results page, they are starting to feel like the new Microsoft.  Here’s an approximation of what Google used to look like (I couldn’t find an image of actual Google 1998 SRPs — anyone have one?)

And here is Google today:

Options on the left, ads on top and on the right, news results up top, images, and buttons to vote results up/down and annotate them.  But worst of all are the new scrolling “real time” results.  The static image I’ve embedded doesn’t do justice to how annoying this is. Random, out-of-context, and mostly asinine fragments of conversations scrolling by.  I think it might be Google’s Clippy.

Some people hope the social web — link sharing via Twitter, Facebook etc — will save us.  Fred Wilson argues that “social beats search” because it’s harder to game people’s social graph.  Cody Brown tweeted:

On Twitter you have to ‘game’ people, not algorithms. Look how many followers @demandmedia has. A lot less then you guys: @arrington @jason

These are both sound points. Lost amid this discussion, however, is that the links people tend to share on social networks – news, blog posts, videos – are in categories Google barely makes money on. (The same point also seems lost on Rupert Murdoch and news organizations who accuse Google of profiting off their misery).

Searches related to news, blog posts, funny videos, etc. are mostly a loss leaders for Google. Google’s real business is selling ads for plane tickets, dvd players, and malpractice lawyers. (I realize this might be depressing to some internet idealists, but it’s a reality). Online advertising revenue is directly correlated with finding users who have purchasing intent. Google’s true primary competitive threats are product-related sites, especially Amazon. As it gets harder to find a washing machine on Google, people will skip search and go directly to Amazon and other product-related sites.

This is not to say that the links shared on social networks can’t be extremely valuable.  But most likely they will be valuable as critical inputs to better search-ranking algorithms. Cody’s point that it’s harder to game humans than machines is very true, but remember that Google’s algorithm was always meant to be based on human-created links. As the spammers have become more sophisticated, the good guys have come to need new mechanisms to determine which links are from trustworthy humans. Social networks might be those new mechanisms, but that doesn’t mean they’ll displace search as the primary method for navigating the web.

There are likely multiple reasons for their different outcomes.  Joost had day-to-day management that didn’t have much startup experience.  The P2P technology that required a download made sense for chat but not for video.  The companies were started at different times:  Skype when there was far less investment in – and therefore competition among – consumer internet products.

But the really important difference was that Joost’s product had a critical input that depended on a stubborn, backward-thinking industry – video content owners.  Whereas Skype could brazenly threaten the industry it sought to disrupt, Joost had to get their blessing.  Eventually the content companies licensed some content to Joost, but not nearly enough to make it competitive with cable TV or other new platforms like Hulu and iTunes.

Real life, non-techie users care almost exclusively about “content.”  They want to watch American Idol and listen to Jay-Z. They don’t really care how that content is delivered or what platform it’s on. Which is why Joost failed, and why so many video and music-related startups have struggled. Skype, on the other hand, didn’t have significant dependencies on other companies – its content, like its technology, was truly peer to peer.

The most important question to ask before taking seed money link

The challenge of creating a new category link

Man and superman link

The new economy link

Why content sites are getting ripped off link

Software patents should be abolished link

Climbing the wrong hill link

Google and newspapers: the false choice of opting out link

New York City is poised for a tech revival link

To make smarter systems, it’s all about the data link

The one number you should know about your equity grant link

Why you shouldn’t keep your startup idea secret link

Ideal first round funding terms link

This insight has practical implications when building internet services.  One thing I learned from my Hunch co-founder Tom Pinckney is, if you really care about having a reliable website, always host your servers at two data centers, owned by different companies, on networks owned by different companies, on separate power grids, and so forth.  Our last company, SiteAdvisor, handled billions of requests per hour but never went down when the institutions we depended on went down – which was surprisingly often.  (We did have downtime, but it was due to our own flawed components, assumptions etc.).

The importance of institutional redundancy is profoundly more important when applied to the internet at large. The US government originally designed the internet to be fully decentralized so as to withstand large-scale nuclear attack.  The core services built on top of the internet – the web (HTTP), email (SMTP), subscription messaging (RSS) – were made similarly open and therefore distributible across institutions.  This explains their remarkable system-wide reliability.  It also explains why we should be worried about reliability when core internet services are owned by a single company.

The principle of not depending on single institutions applies beyond technology.  Every institution is opaque to outsiders, with single points of failure, human and otherwise.  For example, one of the primary lessons of the recent financial crisis is that the most important form of diversification is across institutions, not, as the experts have told us for decades, across asset classes.  The Madoff fraud was one extreme, but there were plenty of cases of lesser fraud and countless cases of poor financial management, most of which would have been almost impossible to anticipate by outsiders.

Some people are saying a great Droid would mean more competition amongst handsets.  But you can’t really choose a handset – you choose a handset-carrier pair.  The real innovation inhibitor in the cellular world has been the power of the carriers to dictate what devices you can use and what apps go on those devices.  Just ask an entrepreneur who tried to create handsets or cellular apps.  They are completely beholden to the whims of the carriers.

Apple has gotten very close to breaking the carrier stranglehold – just look at how many people put up with AT&T’s atrocious network to have one.  Had Verizon capitulated and accepted Apple’s presumably stringent terms in order to carry the iPhone, we might have finally started to see a true decoupling of handsets from carriers.

Finally, don’t think just because the Droid runs Android it’s going to be truly open.  Verizon knows a truly open OS – one that allows you to run Google Voice, Skype, 3rd party SMS apps – would make their network a dumb pipe.  They’ve shown in the past they won’t let that happen.

In every case you can find the one sentence or paragraph that describes their unique business model advantage.  It could be their unique distribution system or the retailing model.  It’s the factor that accounts for their success. It turns out the factor that explains their success at the beginning is what accounts for their failure later.

As a former philosophy student, I was reminded of Aristotle’s concept of “hamartia,” sometimes known as a “fatal flaw”:

In Aristotle’s understanding, all tragic heroes have a “hamartia,” but this is not inherent in their characters, for then the audience would lose respect for them and be unable to pity them; likewise, if the hero’s failing were entirely accidental and involuntary, the audience would not fear for the hero. Instead, the character’s flaw must result from something that is also a central part of their virtue, which goes somewhat awry, usually due to a lack of knowledge.

It’s an interesting exercise to apply this principle to technology companies:

1) Google’s strength is its uber-engineering mindset.  This seems to increasingly be a liability as the web becomes ever more social.

2) Yahoo’s strength was its breadth.  Now they call it the “peanut butter” problem.

3) AOL’s strength was being a closed garden.  As users became internet savvy, they were no longer afraid of venturing outside of it.

4) Apple’s strength lies in its genius, authoritarian leader.  Apple’s decline will begin when he leaves (sadly).

5) Facebook’s strength is authenticity and privacy – your friends are (mostly) your real friends, and only they see your activity.  Facebook has been trying to respond to Twitter’s rise with “open” features like the public micro-messaging.   It remains to be seen whether they can successfully go against their own core strengths.  I’m skeptical, but give them credit for trying.

6) Twitter’s strength is its simplicity and openness.  Will its openness be its downfall?  For example, will Twitter end up fighting its apps?  Or will it be its simplicity?

This principle also implies how to use incumbents’ strengths against them (sometimes called the “Judo Strategy”).  In the chess game of competitive strategy, you can usually bet that incumbents won’t make moves that undermine their core strengths – until it’s too late.

The alternative view argues that history is largely determined by a complex series of societal, political, institutional, technological and other forces.  This view argues that great people are more a product of their time than the times are a product of them.

You can apply these theories to companies, in particular to the founders of technology companies who keep their companies great long after their “natural” life cycle.  Most successful companies start with one great product and ride its growth but fail to pull off a second act.

The companies that defy this natural cycle are invariable run by “supermen” (or women).  Akio Morita founded Sony in 1946 and was a very active CEO until 1994.   At the time he left, Sony had a $40B market cap.  Today it is valued at $28B.  Akio had an incredible run of hit products: the first transistor radio, the first transistor television, the Walkman, the first video cassette recorder, and the compact disc. Akio ran Sony based on his intuitions.  For example, he ignored focus groups that hated the Walkman, saying:

“We don’t ask consumers what they want. They don’t know. Instead we apply our brain power to what they need, and will want, and make sure we’re there, ready”

Steve Jobs co-founded Apple in 1976.  He was pushed out in in May 1985 when the company was valued at about $2.2B.  He returned in 1996 when Apple was worth $3B.  Today it is worth $169B.  Jobs famously micromanages every product detail and like Akio makes decisions based on intuitions.

Bill Gates was the co-founder and CEO of Microsoft, building it to an astounding $470B market cap.  Under him, Microsoft had multiple acts, among them:  DOS, Windows, Office, and enterprise server software.  Since Steve Ballmer became CEO, the company’s value has declined to $223B. I’m sure Steve Ballmer is a smart and passionate guy, but he’s no superman.

Some observers like the author Jim Collins think great companies are all about culture, not a singularly great leader.  Collin’s “built to last” case study companies included Circuit City and Fannie Mae, both of which have been catastrophic failures.  His “portfolio” has underperformed to S&P.

It is convenient to think you can take greatness and bottle it up and sell it in a book.   In fact, life is unfair:  there are geniuses and then there are the rest of us.  When great leaders go away, so does the greatness of their companies.

Twitter is the most open application people are currently using. It’s open on the way in and the way out. The variety of applications using the Twitter api are astounding in that they cover many use cases.

Given that, why will Ashton and Oprah someday care?

The problem is Twitter isn’t really open.  For Twitter to be truly open, it would have to be possible to use “Twitter” without an any way involving Twitter the institution. Instead, all data goes through Twitter’s centralized service.   Today’s dominant core internet services – the web (HTTP), email (SMTP), and subscription messaging (RSS) - are open protocols that are distributed across millions of institutions.  If Twitter supplants RSS, it will be the first core internet service that has a single, for-profit gatekeeper.

Why would this matter to Ashton or Oprah?  Imagine if Microsoft Exchange server wasn’t just an instantiation of SMTP but was a centralized service that all email had to pass through.  A single institution is never as reliable as a system distributed across millions of institutions.   Nor is it as secure – for example, a distributed denial-of-service attack can much more easily bring down one service than the entire internet.

But most importantly, having one company control a core internet service hinders competition and therefore innovation.  To continue the Microsoft Exchange analogy – do you think in that world we would have such a diverse email ecosystem if everyone had to go through Microsoft to build stuff?

And this is all true while we are still living in the fantasy land where everything involving Twitter is free.  At some point Twitter will need to make lots of money to justify their valuation.  Then we can really assess the impact of having a single company control a core internet service.

Contrary to all the uninformed handwringing about how Twitter is making people dumb, I find I’m reading more long form blog and newspaper content than ever.   And the stuff I’m reading is more interesting and relevant.  That’s a good thing.

Meanwhile, Google Reader has been desperately adding social features such as sharing starred posts and automatically recommending blogs.  These features are clumsy and won’t save Reader, or RSS, from its inevitable decline.

Although I’m generally happier as a user, I think all of this is bad for the internet.  Twitter isn’t an open protocol.   It’s a private company with a profit motive that has a history of unreliable service. Moreover, URL shorteners – a byproduct of Twitter – are effectively creating a second layer DNS service that is far less secure and reliable.

I know that many people have been calling for an open alternative to Twitter for a long time.  I support them, but I’m afraid it’s too late. The network effects of Twitter’s social graph are just too strong.  Not to mention its brand momentum.  But the biggest reason Twitter has won is that mainstream users don’t care enough about these “principled” objections to switch.  Do you think Ashton or Oprah cares about open protocols?  I doubt it.

But someday they will care – when the internet is less open, less reliable and less secure.

Today’s link economy is built around purchasing intent harvesting.  (Worse still, it’s all based on last click intent harvesting- but that is for another blog post).  Most of this happens on search engines or through affiliate programs.  Almost no one decides which products to buy based on Google searches or affiliate referrers.  They decide based on content sites – Gizmodo, New York Times, Twitter, etc.  Those sites generate intent, which is the most important part of creating purchasing intent, which is directly correlated to high advertising revenues.

But content sites have no way to track their role in generating purchasing intent.  Often intent generation doesn’t involve a single trackable click.  Even if there were some direct way to measure intent generation, doing so would be seen by many today as a blurring of the the advertising/editorial line.  So content sites are left only with impression-based display ads, haggling over CPMs without a meaningful measurement of their impact on generating purchasing intent.

All of this has caused a massive shift in revenues from the top to the bottom of the purchasing funnel – from intent generators to intent harvesters.  Somehow this needs to get fixed.

It all starts when a user sees an ad on Facebook:

After clicking and installing the app, she gets a little farm where she can grow tomatoes and such.

Game seems pretty fun.  But she runs out of seeds, and wants more.  So she goes shopping for virtual goods.

Let’s say our protagonist is too young to have a credit card, so she decides instead to buy coins by signing up for a free offer.

She decides to download a toolbar.  Free greeting cards seem like fun.

The download puts an Ask.com search toolbar in the user’s browser.  Ask.com makes money off search ads.  Ask probably paid $1 to $2 for the install.  Some portion of that goes to Zynga, and then back to Facebook when Zynga advertises.

Farmville apparently does not advertise on Ask.com:

Thereby preventing the entire new internet economy from imploding in an endless cycle of circularity.

There is no question that, if they wanted to, Twitter could make tens of millions of dollars tomorrow, by, say, running ads or by licensing data feeds.   The big question is whether Twitter and other social media sites will figure out how to make Google-scale money and not just Facebook-scale money.  Google and Facebook get (ballpark) the same number of monthly visits to their sites.  Facebook made hundreds of millions of dollars last year and reportedly lost money.   Google made over $22B last year with huge profit margins.

The optimistic view (which I tend to hold myself) says that where people spend time, money will follow.  If people are spending all their time on Facebook and Twitter, the Proctor and Gamble’s of the world will eventually find an effective way to shift the bulk of their ad spending online.   The tacit assumption in this view is that the next 15 years will see as much business model innovation as the last 15 years.

On the other hand, what if we are mostly done creating big new business models for the web? History suggests that business model innovation is rapid right after the advent of a new medium and then slows down considerably.   If indeed it is slowing down, social media could end up like instant messaging – incredibly popular but basically lousy at monetizing.

But how will Google ever make money? There’s the rub. The company’s adamant refusal to use banner or other graphical ads eliminates what is the most lucrative income stream for rival search engines. Although Google does have other revenue sources, such as licensing and text-based advertisements, the privately held company’s business remains limited compared with its competitors’.

We now know what people were missing back then and why Google generates such massive revenues from advertising.  The lesson is that the RPMs* of online ads are directly proportional to the degree** to which the user has purchasing intent.  This is why when you search Google for “cameras” you’ll see ads everywhere (and those advertisers are paying high CPCs), but when you search for “Abraham Lincoln’s birthday” Google doesn’t even bother to show ads at all.

This is also why Nextag will have revenues this year in the ballpark of Facebook’s revenues, even though Nextag gets a fraction of the visits:

When people talk about search being a great business model (for, say, Twitter), they should distinguish between search with puchasing intent, which is an incredible business model, and search without purchasing intent, which is a terrible one.

This may change as brand advertising moves to the web.  But for now web advertising is dominated by “direct response” ads, and those are all about purchasing intent.

* RPMs = revenue per thousand impressions – can we please agree to start saying RPMs instead of CPMs or eCPMs?  :)

** degree being how close the user is to actually purchasing multiplied by the profit margin on what they are purchasing

Now we learn Yahoo is going to spend $100 million on an advertising campaign.  The slogan is “It’s Y!ou” which sounds like one of those meaningless taglines invented by PR firms.  I’m quite sure no one will remember it and their money will be wasted (quick, name the tagline of any big tech company).

By CEO Carol Bartz’s own admission, Yahoo is incredibly well known, especially outside of techie circles:

When you get outside of New York City and Silicon Valley, everybody loves Yahoo…. We do great things for [users] and we’re excited about what we are.

Yes, Yahoo has one of the best brands on the web. Which is precisely why they shouldn’t be spending $100M on branding.  That’s the last thing Yahoo needs.  What they need are new technologies, new revenue streams, and new products that people love.  If they can’t build those things themselves, then they should acquire them.  They’re coasting on inertia right now.  As we saw with AOL and countless other tech companies before them, that inertia will be lost if they fail to innovate.

I think the Yahoo-Bing search deal is a great thing for startups as it potentially makes search competitive again.  But as a longtime Yahoo user it makes me kind of sad.  Between the branding campaign and the search deal, it feels like Yahoo has thrown in the towel.

Perhaps patents are necessary in the pharmaceutical industry.  I know very little about that industry but it would seem that some sort of temporary grants of monopoly are necessary to compel companies to spend billions of dollars of upfront R&D.

What I do know about is the software/internet/hardware industry. And I am absolutely sure that if we got rid of patents tomorrow innovation wouldn’t be reduced at all, and the only losers would be lawyers and patent trolls.

Ask any experienced software/internet/hardware entrepreneur if she wouldn’t have started her company if patent law didn’t exist.  Ask any experienced venture investor if the non-existence of patent law would have changed their views on investments they made.  The answer will invariably be no (unless their company was a patent troll or something related).

Yes, most venture-backed companies file patents (I have filed them myself), but this is because 1) patents can have some defensive value, 2) they can grease the wheels of an acquisition (mostly because big companies want a large patent portfolio for defensive purposes), and 3) occasionally failed startups will get funded by investors whose intention is to go around suing people (hence providing “downside value” for the initial investors).

Articles like this recent one in New York Times promote the urban myth that the main beneficiary of patents are lone inventors whose idea is stolen by the big guys.  I have no special knowledge of the situation referred to, but I find it hard to believe in 1995 the idea of tying GPS to mobile devices wasn’t obvious to anyone in the field.   Almost all software and technology patents that I’ve ever come across are similarly obvious to practitioners at that time.  In theory obviousness is grounds for disallowing patents, but in practice patent examiners grants tons of silly patents.

Take the case of Blackberry and NTP.   NTP is a “patent holding company” – a patent troll – whose sole purpose is to sue people.  Now, I’ve been around long enough to know that the idea of mobile email is as old as email itself.  What RIM did was they actually went and made it a reality.  They figured out how to make a simple device that people loved, how to market it, and how to convince investors to give them money for what probably at the time seemed like an overwhelmingly difficult project.  The founders of RIM are the heroes of the story.   They didn’t need to sue anyone because they built a product and made money by actually selling a product people wanted.

How did having patents help society here?  NTP never tried to build any products.  No one is claiming RIM took the idea from them.  The only beneficiaries here are a company that never built anything and a lot of lawyers.

Software/internet/hardware patents have no benefit to society and should be abolished.

What if some startup Google sought to achieve the same goal by outsourcing its data management to the telcos, say, by mounting servers in their premises to help deliver Web applications more quickly? This would be a win-win for both parties. Data that travels within a carrier’s system is cheaper to deliver than data that must be handed off between two or more carriers. Would such an arrangement be a violation of net neutrality? Google would likely shriek so.

Huh?   Pretty much every startup I know does host their web apps at telcos.  My company Hunch, for example, hosts at Level 3.  The 20 or so startups I’ve invested in all do as well.  I’ve never heard any net neutrality advocate argue against this practice.  It also sounds like he’s unfamiliar with CDNs like Akamai.  In my experience those only tend to be affordable by large, international companies, so hardly favor startups.

He also seems unaware that there is already metered pricing on the internet today – it’s just paid for on the server side, by Google, Microsoft, my company, etc.

The greatest fear of Microsoft, Amazon, eBay and Yahoo is having to plumb their deep pockets and offer competing payments to broadband carriers to speed their bits to consumers.

I’m happy to show Mr Jenkin’s our Hunch bandwidth bill or he could just go look, for example, at Rackspace’s pricing page.   Apparently he wants websites to pay twice, once to the hosting provider and again to the ISP.  At any rate, I can’t imagine how “the more you pay, the faster your site runs” could possibly favor startups over cash rich incumbents like Google and Microsoft.

On the ISP side, he repeats the common anti-net neutrality assertion that there is genuine competition between ISPs.  Maybe there is where he lives.  Where I live in Brooklyn there is only one viable choice (Time Warner Cable).  Maybe once Verizon FIOS comes to my area this will change but for now I can’t get it.  At my office in Manhattan we couldn’t get T-1 service in our building, the Verizon DSL had atrocious quality of service and we ended up with only one viable choice – Towerstream WiMax beamed from the Empire State Building.

Finally, he argues that Google, Microsoft et al are just looking after their own interests:

But usage-based pricing that would give consumers a reason to think twice before clicking on a Google-sponsored ad? It would be the end of Google’s business model.

I agree this would be the end of Google’s business model.  But it would also be the end of the business models of pretty much every startup that is ad based – the vast majority of consumer internet startups today.

Personally, I tend to think net neutrality legislation is unnecessary as true competition in the ISP space is likely and will prevent any use-based pricing from gaining traction.  I am quite sure, however, that use-based pricing by ISPs would be disastrous for internet innovation, and especially for internet startups.

In fact, especially in the technology sector, some of the most brutal competition has occurred between complements. Products are complements when they are more valuable because of the existence of one another – e.g. hotdogs and hotdog buns, PCs and operating systems.

There is inherent tension between complements.  If a customer is willing to pay $2 for a hotdog plus bun, the hotdog maker wants buns to be cheaper so he can capture more of the $2, or lower the price of the bundle and thereby increase demand.  (For a great primer on competition between complements, I highly recommend this Joel Spolsky post.  I’ve also been writing about complements, here and here).

Microsoft is famous for destroying companies that offer complementary products, either by bundling complementary apps with Windows (Windows Media Player, MSN Messenger, IE) or aggressively competing head-to-head against the most popular ones (Adobe, Intuit).  The surviving 3rd party apps are usually ones that are too small for Microsoft to care about.  The best (selfish) economic situation for a platform like Windows is lots of tiny complements that have little pricing power but that make the platform itself more valuable.

One of Google’s main complements is the web browser and desktop operating systems, which is why they built and open sourced the Chrome browser and OS.  Google’s other big complement is broadband access – hence their excursions into public Wifi and cellular spectrum.

So what does all of this have to do with Twitter?  At some point, significant (non-VC) money will enter the Twitter ecosystem.  I have no idea whether this is will be by charging consumers, charging businesses users, search advertising, sponsored tweets, licensing the twitter data feed, data from URL shorteners, or something else. But history suggests that where there is so much user engagement, dollars follow.

For the sake of argument, let’s suppose Twitter’s eventual dominant business model is putting ads by search results.   Who gets the revenue when a user is searching on a 3rd party Twitter client?   Even if Twitter gets a portion of revenue from ads on 3rd party apps, there will always be an incentive for them to create their own client app, or to “commodotize” the client app by, say, promoting an open source version.

I’m not saying this will happen in the immediate future.  First, Twitter and a lot of app makers* have raised a lot of money, so aren’t under (much) pressure yet to generate revenues.  Secondly, some of the lucky Twitter apps will get acquired by Twitter.  I think this is what many of their investors are hoping for.  But those that aren’t so lucky will eventually find their biggest competitor to be Twitter itself, not the substitute product they see themselves as competing against today.

* when I say Twitter apps, I mean any product, website, or service that eventually makes money and depends on Twitter’s API.

Secondly, I think Google itself has almost nothing to do with the decline of newspapers.  That is due to, among other things, 1) the newspapers losing their classified business to Craigslist and others, 2) the internet making geography irrelevant and hence causing newspaper competition go from 1 or 2 papers per market to thousands.

That said, I am bothered by the arguments I hear in internet circles of the form:

Premise 1:  X can stop working with Y at anytime.  (NYTimes could opt out of Google search results / Google news at any time)

Premise 2:  X would lose out if it did that (NYTimes would lose traffic and revenue if they opted out of Google).

Conclusion:   Hence Y is helping X.  (Google is helping the NYTimes and the NYTimes should stop whining.)

The conclusion doesn’t follow from the premises.  The NYTimes might in fact be better off in a world without Google.  More specifically, they would be better off if the search engine market were genuinely competitive.

The power dynamics between Google and the newspapers has the same dynamics of any buyer-supplier market.

Newspapers, like all websites, are suppliers of content to Google.  In most markets, with genuinely competitive buyers and suppliers, the revenues are shared between buyers and suppliers in proportion to their relative bargaining power.  Their bargaining power depends on how fragmented each side of the market is – how many genuine alternatives each company has.

Normally there is some reasonable level of interdependence between buyers and suppliers, hence the revenue split is positive and non-negligible. Pepsi and Coke are always jostling with their bottlers about the percentage split but in the end each side usually makes a profit.

And in situations where the relative bargaining power is severely imbalanced, there are normally business mechanisms for correcting the imbalance.   For example, before Staples was founded, office supply stores were mostly mom-and-pop shops that were tiny relative to their suppliers, and hence had very little bargaining power.  The central business concept behind creating Staples was to “roll up” these shops and thereby increase their bargaining power with their suppliers.  In doing so, they were able lower their costs and increase their margins even while lowering their prices.   One of the primary reasons companies merge is to increase bargaining power with respect to buyers and suppliers.

As a “buyer” of web content, Google has incredible dominance, so much so that the price they pay for that content is zero.  If the NYTimes decided to opt out of Google tomorrow, Google users would barely notice.  (Perhaps the only content site that would matter and hence in theory could bargain with Google would be Wikipedia – but even Wikipedia only accounts for ~2% of Google click throughs).  On the flip side, the NYTimes would see a massive decrease in traffic and hence ad revenues.  Google has so much power they can split 0% of the revenue for organic traffic (and of course charge for paid links).

Now imagine a world where search engines are truly competitive.  I know it’s hard – but imagine there are say 20 search engines, each with 5% market share.  And suppose they differ primarily according to which content sites they index.  (I am not saying I’d prefer this world – I’d actually hate it – but please bear with me for the sake of argument).   On the content side, suppose there are only a couple of newspapers left – maybe the NYTimes, WSJ, USA Today, and the Financial Times (which, btw, will probably be the case in a few years).  In this situation the newspapers would have enough leverage to get the search engines to pay them for inclusion in their organic listings.  I know that in my own case if two search engines were nearly identical except one included my favorite newspaper and the other didn’t, I’d use the one that did.  I suspect a lot of other people would make the same decision.

There is nothing inherently un-monetizable about newspaper content.  Like all goods and services, if newspaper content has value to people and is scarce (it’s not scarce today but as more newspapers go out of business will become increasingly so), they can eventually generate sustainable revenue (albeit probably operating at a much smaller scale).  The revenue can come either through consumers paying directly or buyers like Google sharing revenues, or some combination thereof.

For the moment, and for the foreseeable future, newspapers (and all content sites) just happen to be in a dreadful bargaining position with respect to Google.

“…Wall Street will remain a big, important part of our economy, just as it was in the ’70s and the ’80s. It just won’t be half of our economy. And that means that more talent, more resources will be going to other sectors of the economy. And I actually think that’s healthy. We don’t want every single college grad with mathematical aptitude to become a derivatives trader. We want some of them to go into engineering, and we want some of them to be going into computer design.”

“That’s why I don’t just want to see more college graduates; I also want to specifically see more math and science graduates, I specifically want to see more folks in engineering. I think part of the postbubble economy that I’m describing is one in which we are restoring a balance between making things and providing services…”

link

But almost every computer security related article I read in it is just dead wrong. As someone who started and succesfully sold a computer security company (SiteAdvisor to McAfee) I feel like this is one area I know something about. (scary thought: does the NYTimes just happen to be wrong about my area of expertise or are they wrong about a lot more and this is the only area where I’m able to detect it?).

Today’s poorly researched and flat-out wrong security article claims Macs Aren’t Safer, Just a Smaller Target. The sole piece of evidence comes from a study by Symantec, a company that sells Mac anti-virus software. When your only source has a significant business interest in “results” of the study, shouldn’t the “newspaper of record” get a second opinion? For example, maybe talk to an operating systems expert, most if not all of whom will tell you Mac’s Unix-based OS is just a vastly better architecture from a security perspective.

Moreover, as comments on the article point out, Mac’s market share is big enough now (~10%) that it certainly seems like a reasonable target. In fact with all the talk of how Mac’s don’t get viruses, if I were a virus writer today looking to make my name, I’d imagine targeting the Mac would be a far more interesting way to go.

I literally can’t remember the last time I met a techie in CA or NYC who used a PC. At this point using a Mac versus PC in the tech world has become an IQ test, not a preference.

But how will Google ever make money? There’s the rub. The company’s adamant refusal to use banner or other graphical ads eliminates what is the most lucrative income stream for rival search engines. Although Google does have other revenue sources, such as licensing and text-based advertisements, the privately held company’s business remains limited compared with its competitors’.

from “Will Google’s Purity Pay Off?” BusinessWeek, Dec 7, 2000