Stickiness is bad for business

It is common to hear entrepreneurs and investors talk about the high level of engagement (what we used to call “stickiness”) of their website.  They quite rightly believe that it’s better to have a more engaging user experience, as that generally means happy users. Unfortunately, the dominant advertising model on the web – Cost per Click (CPC) – rewards un-sticky websites.  As Randall Lucas said in response to one of my earlier posts:

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.

Are people more willing to pay for digital goods on mobile devices?

Mary Meeker’s presentation this year on internet trends was all about mobile. Inasmuch as data-heavy research report from a major investment bank can be said to have a “climax,” it was probably these slides:Screen shot 2009-12-27 at 11.51.18 AM

Screen shot 2009-12-27 at 11.51.24 AM

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.

What’s the relationship between cost and price?

What’s the relationship between price – the ability to charge for your product – and cost – how much it costs you to produce it?

Price is a function of supply and demand.  Notice the word “cost” doesn’t occur there.  It is true that cost is, over the long term, a lower bound for price – otherwise you’d go out of business.  It is also true that high upfront fixed costs can create barriers to entry and therefore lower supply.

The only case in which price is determined by (variable) costs is in a commoditized market.  A market is commoditized when competing products are effectively interchangeable and therefore customers make decisions based solely on price.  In commoditized markets, price tends to converge toward cost.

In non-commoditized markets, variable costs have no effect on price.  Most information technology companies are not commoditized, therefore variable cost and price are unrelated.  That is why there can exist companies like Google and Microsoft that are so insanely profitable.  If the cost of producing and distributing a copy of Microsoft Office dropped tomorrow, there is no reason to think that would affect their pricing.  The most profitable industry historically has been pharmaceuticals, because they are effectively granted monopolies, via patents, reducing the supply of a given drug to one.

There are two ways people get confused about cost and price – a rudimentary way and a more advanced way.  The rudimentary way is confusing fixed and variable costs.  People who gripe about the price/cost gap of SMS messages seem to not realize the telecom industry is like the movie industry in that they make huge upfront investments but have relatively low marginal costs.   I, for one, have always thought movies are a great deal – they spend $100M making a movie, I pay $12 to see it.  It would be silly to compare how much you pay to see a movie to the variable cost of projecting the movie.

The more advanced way people get confused about cost and price is to think that because costs are dropping, prices will necessarily follow. For example, the cost of distributing newspapers has dropped almost to zero.  This is not the primary cause of the downfall of the newspaper industry.  The downfall of newspapers has been caused by a number of things – losing the classifieds business was huge – but mainly because when newspapers went online and were no longer able to partition the market geographically, supply in each region went up by orders of magnitudes.  Once the majority of newspapers go out of business causing supply to go way down, pricing power should return to the survivors.

The problem with online “local” businesses

One of the most popular areas for startups today is “local.”  I probably see a couple of business plans a week that involve local search, local news, local online advertising, etc.

Here’s the biggest challenge with local.  Let’s say you create a great service that users love and it gets popular.  Yelp has done this. Maybe Foursquare, Loopt etc. will do this.  Now you want to make money. It’s very hard to charge users so you want to charge local businesses instead.

The problem is that, for the most part, these local business either don’t think of the web as an important medium or don’t understand how to use it.  Ask you nearest restaurant owner or dry cleaner about online advertising.  They don’t see it as critical and/or are confused about it.  Even Google has barely monetized local.

People who have been successful monetizing local have done it with outbound call centers.   The problem with that approach is it’s expensive.  Even if you succeed in getting local businesses to pay you, it often costs you more to acquire them than you earn over the lifetime of the relationship.

To add insult to injury, local businesses often have very high churn rates.  I have heard that the average is as high as 40%.  Anyone who has done “lifetime customer value analysis” can tell you how that ruins the economics of recurring revenue businesses.

Hopefully this will change in time as local businesses come to see the web as a critical advertising medium and understand how to make it work for them.  But for now, monetizing local is a really tough slog.

* This is what I hear from industry sources.  If readers have better numbers or sources I’d love to hear them.

What if online business model innovation is slowing down?

There is a widely held assumption that new business models will continue to emerge online – that statements like “how will Twitter ever make money?” will look as silly in 10 years as similar statements made 10 years ago about Google look now.

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.