A common piece of advice that I offer entrepreneurs is to find distribution opportunities where there is much greater supply of accessing your customer versus the demand.  Time and time again, you see businesses that take advantage of a temporal period of such distribution dynamics and build their companies to scale giving them a long term competitive advantage.  Here are some examples:

1. Zynga – there was once a time when Facebook allowed you to build apps on Facebook and basically massively spam your friends who in turn would spam their friends.  They basically built their business on the largest free and legal spam platforms.  Zynga’s massive success was born from taking advantage of that opportunity and growing Farmville to over 80 million Monthly Active Users.  Eventually, Facebook changed their rules of how you can message users and that SPAM opportunity  quickly went away.  However, with that initial large user base, Zynga has been able to replenish their stable of games and maintain their customer reach.  At the same time, other game publishers are locked out from building their own large customer base.  The Facebook spam window closing has created a massive barrier for other social game providers to penetrate the market!

2. LegalZoom – I had the pleasure of meeting with Brian Lee this past summer.  Brian is a very successful serial entrepreneur who founded LegalZoom and most recently founded ShoeDazzle.  Brian told me a story of when LegalZoom first started that they were one of the first to try PPC advertising on Search Engines.  At that time, GoTo.com was the only player in the space and they were able to buy clicks at $.01.  To give you perspective, I am sure the terms they were bidding on are now fetching PPCs that are well north of $1.00.   GoTo.com was hosting a user group meeting of some of their most active customers.  Brian was sitting next to someone who asked him how many different keywords he was buying.  Brian thinking that he was a pro at SEM (Search Engine Marketing) answered that they were buying dozens.  He then asked back how many that person was buying and he answered “Ten Thousand”.  Brian was shocked.  He asked that person to show him what they were doing.  Luckily, they were not in a competitive businesses so the person showed him.  Brian went home that night and started expanding his keyword campaigns.  LegalZoom invested heavily in SEM including building their own bidding and optimization technology.  LegalZoom became the leading player in online legal documents by taking advantage of incredibly cheap SEM allowing it build to a level of scale that other players are able to match.

The marketing opportunities usually don’t last long because eventually demand catches up with supply.  However those that take advantage of these opportunities usually build their businesses to a level of scale where they now have more resources to invest in the product and service making them superior to their competitors.  With an existing large installed base of customers and strong brand recognition and less friendly distribution opportunities for their competitors, they then are in dominant market positions.  So as you think of your business, keep abreast of what is happening with the new marketing channels.  Look for areas where there has been a ton of growth in supply because it usually means demand hasn’t caught up.

The reason why the margins of Groupon have held up is because of scale.  When I refer to scale, I mean the size of both their audience (consumers) and merchant network.  Groupon has over 25 million email subscribers giving them the power of being one of the few “rainmakers”.  For businesses that have the capacity and desire to add a lot of new customer, if you are featured on Groupon, they usually deliver enough new customers to completely fill that need.  At this time, very few daily deals site can do that. I would argue that LivingSocial may be the only competitor in the same ball park.  So when people think that Groupon has a lot of competition, in reality, they don’t.  They are working primarily with businesses that want a lot of new customers and the capacity to handle the “firehose” – being featured and getting a ton of new customers.  They are not interested in working with the business that wants a handful of new customers such as the popular restaurant that has a little excess capacity on a Monday night at 5pm.  They want to work with the large new restaurant that needs a lot of new customers right away so their business can quickly have a loyal regular customer base.  If you want the trickle of new customers, you can go to their competitors or just use Groupon Stores.  Groupon Stores doesn’t even to plan to make money from a revenue share just on breakage of non-redeemed vouchers.  The market for the trickle of customers is competitive and will have low margins.  The market for the firehose will not have low margins because it won’t be nearly as competitive.

Will Groupon be the only player with scale?  No, there are plenty of companies with very large audiences and customer bases that will tap into this model.  However, there are not going to be thousands.  There is just not enough consumer attention to have that many at scale.  People will go to a small handful of very large general market plays – like having a few major prime time major tv networks.  And then there will be a good number of middle tier players that are focused on a certain vertical or niche – like having a bunch of pretty popular cable networks.  And then there will be a ton of very small scale players – like having tons of people handing out paper fliers.  So the small handful of very big players and the good number of middle tier players will be a more competitive market than what we have now but there are millions of merchants to choose from on who to partner with to be their “firehose”.  The most coveted merchants will see more generous revenue shares.  However, there are plenty of good merchants to choose from for these larger scale players to choose from who will play ball at these higher revenue shares.  So if you want to pick the winners in this market – pick those who can get to scale as the very big players or the middle tier players.

I described this to a good friend and mentor – Bill Lohse.  Bill has had a very accomplished career including being President of Ziff Davis Publishing and he told me that what I longed for again is when a company is a family or a tribe versus an organization.  When a company is less than 20 people it really is like a “Family”.  Everyone is incredibly close.  It doesn’t mean that you all get along at all times but there is a level of connection and loyalty that is so powerful.  Everyone knows what is going on, there are no secrets.  Not because there are formal communication plans, it is because that you are all working so closely together that this complete openness is just organic.  When a company is between 20 and 50 people, it is like a “Tribe”.  The connection is still really powerful and there is this great underlying feeling of support from one another.  Greater than 50 people and especially over 100 people is when the company becomes an “Organization”.  There are HR policies, formality, hierarchy, roles and structure.  I enjoyed the challenge of growing an organization but I longed for the days of the family and tribe.  To this day, I think about those family and tribe members.  My family, there were obviously the co-founders: Pete, Mike, Cal and Grace.  Then there were those people that joined and help grow our family and tribe,: Betty, Omar, Candace, Ian, Stephanie, Alexis, Bea, Rashmi, Gary, Dan, Zakia, Edmund, Maheen, Mallie, George, Arul and Kingsley to name a few.  Those were amazing times and we all keep in touch one way or another.  Watching our careers evolve, attending each others weddings, celebrating the birth of our children.  I feel that the impression that was made on us from those days will last forever and be something that we all cherish.  I know I do at least.  This may be the biggest reason why I wanted to get back into start ups.  Having a chance to work with a group of people as a family and tribe is truly an awesome experience.  It may not be for everyone but I know it’s for me.

There will soon be hundreds if not thousands of Group Buying sites

There are now over 80 group buying sites in the U.S. alone.   I predict there will soon be thousands.  Let’s talk about the barriers of entry.  A service like Groupon which has scale in audience can go to merchants and ask for exclusives by guaranteeing high minimums and they will get them.  However, their value proposition is about being selective and curating deals that they think are the most relevant.  So in a city like NY where they feature 2 deals per day, they can only lock up about 800 merchants per year.  NY has nearly 2 million small businesses and I suspect a good percent would be a good fit for a group buying service.  Unlike flash sales sites like Gilt which have more scarcity in brands that they can work with, group buying sites have a much longer way to go before they actually really start stepping on each others toes.

So selling to merchants is not much of a barrier, how about the technology platform?  Well, that is even more commoditized.  These platforms have proven to be pretty simple thus far and are quickly becoming a non issue.  New companies such as Group Commerce, Offer Foundry and AdBlade are already offering white label solutions to partners and only asking for a revenue share.  I am sure there will be more solutions in the market with even lower costs.  Some of these platform plays are also building out their own salesforce to bring in merchant deals.  That way they package both commodities – merchant sales and the platform.  The partner just needs to bring the audience.  So with merchant sales and the platform not being much of a competitive barrier, what is the competitive advantage?

Race to the Inbox and staying there

At the end of the day, the only main competitive barrier is distribution in the Inbox.  Email is proving to be the most effective way of delivering these deals.  From a user’s perspective, signing up for more than 2 to 3 of these services is just too overwhelming.  So the main goal for all of these players is to get users to subscribe to your email and to have them keep it there.  Who will win in this race to the inbox?  Well, those that can acquire email subscribers the fastest by either raising the capital to aggressively acquire users or who have existing audiences that they can get to sign up.  But once you have them, you need to keep them.  If you lack relevancy, the switching costs are so low that you will easily see them move elsewhere.  Relevancy will be based on how well you match up the deals to the taste and preferences of the user.  These services will offer greater filtering technology to show you relevant deals.  I think this will be led by aggregator services like Yipit, who ask users for interest preferences such as sporting events, restaurants or spas and comb through the 80+ sites to show you the most relevant deals.  The other route to go is for these services to be much more verticalized by demographics or psychographics.  An example of this is Gilt City which caters to more luxury offers.  So instead of offering the pizza place that Groupon features, Gilt City will feature the Michelin star restaurant.

So get ready for a new gold rush!  There will be an unbelievable amount of competitors in the space.  For consumers, great news as you will benefit from so many great offers.  As for the competitve players, it’s all about execution……..good luck!

The Gold Rush is Over!

So what has happened?  Well Facebook has completely curtailed all of the viral mechanics that made these games successful.  To give you an idea of some of the practices that were stopped, here is an example.  Game developers were building aggressive practices such as showing a friend invite screen to anyone that first joins the game and then defaulting the invite so all of your friends are checked.  So you were defaulted to opt in to invite all your friends on Facebook.  People would mistakenly hit “Continue” not knowing that they just sent an invite to their hundreds of friends and then their friends would go through the same experience as they checked out that game and most likely fall for the same viral trick.  Facebook obviously found this “spammy” which they should and made a rule to all developers that they were no longer allowed to mass invite your friends to a game when you first join or they would be shut down.  This is one of many changes made by Facebook and some people would argue that reason why they are shutting down these viral channels is to force social gaming companies to spend money on advertising via Facebook.  That may definitely be true but I think the bigger motivator was that it just added a lot of “spam like content” on Facebook and users were getting fed up.  When you have a Facebook fan page titled  “I dont care about your farm, or your fish, or your park, or your mafia!!!” and it has over 6 million fans, pretty much proves the point that these virality mechanics were definitely getting spammy.

So where does it leave us.  Well, if you are a game developer without a hit game/app that has achieved scale then you are pretty much toast.  There were 3 legs of the marketing stool to FB apps/games – viral, cross marketing and paid.  If you are not already one of the bigger boys then you are now left with just 1 leg of that stool – paid marketing.  And unless you have figured out how to monetize your app or game so much better than everyone else, it is pretty impossible to make the economics work when your marketing costs are now so high.  For the companies that have already achieved scale, they survive for now by having the 2 legs of the stool they need to explore other avenues of distribution.  And from recent announcements from Zynga such as the distribution deal from Yahoo, it sounds like they are doing just that.

1. The Value Proposition is a Great One

The product that is being sold is offering consumers steep discounts to try the services of local merchants.  These discounts are at least 50% off and are truly deals and as you know people love deals.

Even more importantly, merchants have found these type of promotions extremely successful in attracting a new customer base.  They are bringing in new customers into their stores and are willing to give big discounts to do so in order to have the chance to keep them as loyal long term customers.

These companies are just enabling this Win-Win relationship to happen.  With both parties greatly satisfied, you have a solid foundation for a great business.

2. The Potential Market is Huge!

The real interesting part of this business is that it is about connecting local merchants to local consumers via the Internet but the consumers are ultimately going offline locally to consume the service.  Local businesses continue to struggle with the challenges of online marketing hence the need for businesses such as ReachLocal and Yodle.  And offline retail is ALOT bigger than online retail.  Offline retail is over a $2 trillion market and online retail is approximately $150 billion.  What is interesting about that $2 trillion offline retail market is that by 2011 half of those purchases will be influenced by online research according to Forrester Research.  What businesses like Groupon and LivingSocial are doing is taking a slice of that $1 trillion market by connecting consumers with deals offered by merchants.  A slice of a $1 trillion offline retail market versus a slice of a $150 billion online retail market is a BIG difference.  A 1% slice could mean a $10 billion market!  Is a 1% slice possible?  Getting back to point 1 – people love deals.  So I say yes!

So how much capital should be invested in a market that may reach in the tens of billions of dollars?  I would say a lot more than the $55MM that Groupon or LivingSocial have raised recently.  These companies are far from being overfunded if they are really going after it!

Well, lesson #27 in Lessin’s Lessons is :

“27. There are no new ideas, just recycled ideas whose time has come.”

He talks about how before Facebook there was SixDegrees.com which he was a first round investor in. SixDegrees was launched a few month prior to AsianAvenue.com and I have also got to know the founder and CEO, Andrew Weinreich, over the years. The concept of SixDegrees had so many similarities to Facebook but failed to dominate the digital world as Facebook has because of reasons that were really out of its control. Whether it be the fact that digital cameras were not pervasive (do you think Facebook would be that interesting without photos), the lack of an online ad market to support it or because technology costs were 100x more expensive as they are now. As Bob states in his book “Ultimately, like most great concepts, they ran out of money”. The success of Facebook has less to do with truly innovative ideas but more on taking the lessons learned in the past and taking advantage of market changes that make the business much more viable.

Compare a business like Gilt.com. People in the U.S. think that this flash shopping site was a great innovative idea. The truth as reported in New York Magazine was how Kevin Ryan, former Doubleclick CEO and head of New York incubator Alley Corp, just mimicked an overseas success story. “Ryan was aware that a French company called Vente Privée was raking in money by selling fashion overstock, and he thought its business model could work just as well in America.” Trying to launch this type of business during good economic times would have been impossible because you could not get luxury brands to “play ball”.  This type of discount play was perceived to be too risky in terms of damaging their brands. However, the recession and how fast it hit us left these luxury brands with tons of excess inventory and in desperate need of cash. The time for Gilt had come and they took advantage of it. It is reported that Gilt.com is expected to generate over $400 million in sales this year. Pretty good for a business that is only about 3 years old!

So the lesson learned for me?  Look for recycled ideas that time has come.  These type of businesses tend to be a lot more capital efficient and therefore much more likely to succeed.

1. Paid Marketing is really Cheap!

So there are 3 paid marketing channels if you want to advertise your social game on Facebook.  The first is on other social games that have a virtual currency system.  These social games allows you to buy virtual goods either through actual payment (credit card, paypal, etc.) or through offers.  Offers consists of getting virtual currency for actions such as signing up for Netflix or a credit card.  It also consists of installing another Facebook application.  You can advertise with companies that power these “offer walls” on a cost per acquisition basis.  A social game without any targeting with a basic sign up would pay about $.25 to $.40 per install.  Warning, these are incentivized offers and the quality of the users may not be that good given that they are not doing it primarily for the interest of your game.  However, if they are already thinking about paying for virtual goods on a social game one could argue that this would actually be a very attractive customer.

Another paid marketing channel are Facebook application ad networks.  These ad networks represent the ad inventory of many app publishers that serve up advertising within their app.  Given the explosive growth in Facebook and app traffic, the supply of inventory is greatly larger than demand so this inventory is very cheap.  This inventory is not incentivized and is served up as standard display ads.  You can also cut CPA deals with these ad networks mitigating your risk.  You should expect to pay about $.70 per install.

The third paid marketing channel is buying Facebook ads themselves.  These are the ones that you see on the right hand column while you are on Facebook.  If you haven’t seen the power of the Facebook ad platform, you are missing out.  You can buy on a CPC basis and the level of targeting is amazing.  Not only can you target by incredibly detailed demos but you can also base your targeting on specific psychographics whether it be interests and even more interesting if that person uses specific apps.  This type of marketing may be the most costly but you can still achieve $1 CPA or less with good execution.

So if the LTV of a user of a social game is only $.40, how do you make the economics work since your CPA costs from paid marketing is between $.25 to $1?  Well, this is when the Facebook Viral Loop kicks in.

2. Facebook Viral Loop Makes the CPA much better!

Successful social games know how to leverage all the viral marketing channels on Facebook by building incentives in the game.  Let’s take a look at how Farmville uses the Facebook viral loops.

- If you add more “neighbors” which consists of inviting your friends, you get to expand your farm.

- As you “level up” in the game they prompt you to post to your Newsfeed for all your friends to see.

- They constantly offer virtual gifts that you can give to your friends in order for them to join.

These are just  a few of the game mechanics to get users to share the game with their friends.  The main benefit here is that this is free marketing that really makes your marketing efforts much more efficient.  How well a game is at this viral marketing is measured and represented as a Viral Coefficient.   By effectively using the Facebook viral loop, an effective social game can reduce their effective CPA cost down to $.10 or less.

So let’s recap on wht the economics looks like:

If Life Time Value of a User > Cost per Acquisition then the game  will be financially successful.

So based on my estimates:

$.40 LTV of a user > $.10 CPA of a user = SOCIAL GAME GOLD RUSH!

As you can see the Social Game Gold Rush has less to do with any real paradigm shifts in game play or design.  Where the paradigm shift has happened is in Facebook being this incredible distribution system that allows the games to be viral.

What does the future entail?  Well, the economics of this distribution will change.  Cost per Acquisition will increase as it gets more competitive.  However, the quality of social games and apps will improve and monetization will become more effective.  This industry will be experience some serious growth over the next few years.

“It’s also important to understand something about ‘social games’: Most of them are not social. They tend to be single or multi-player games that use social networks (mostly Facebook) as an easy way to drive player adoption. What the industry is calling ‘social games’ are more accurately described as ‘viral games’. “

When you dig into the success of these games, you realize why Facebook has been such an incredible opportunity.  Facebook offers incredible distribution for these games, making the formula for success much more viable.  Let’s take a closer look:

If Life Time Value of a User > Cost per Acquisition then the game  will be financially successful.

This is the basic formula for the financial success of any social game.  The interesting part about it is when you realize why distribution on Facebook has made the economics so much more favorable.  Let’s break down the components.  The first is Life Time Value of a User (LTV).  This is driven by 2 key factors.  The first is retention of the users.  In order to make money, you need to get that user coming back and coming back often.  A successful social game on Facebook is able to get over 15% of their Monthly Active Users coming back each day.  An extremely successful game gets that stat above 30%.  Facebook is so successful at driving high retention because it already gets their users coming back.  With over 27 billion minutes spent and nearly 45 billion page views per month, Facebook has quickly become for most people, their home on the Web.  You add the fact that as a social game application developer you can integrate your game into the Facebook core UI with communication points such as News Feeds, notifications and wall posts, you have this incredible opportunity to increase your retention rates by folds versus what they would be as a standalone web site.  Of course, you need a game that is also compelling to play.  However as important as good game play, your social game needs to be well integrated into Facebook’s communication system.

Lifetime value of a user also depends on your ability to monetize game players.  A good social game will convert about 1 to 2% of its Monthly Active Users to paid users who spend on average about $20 per month.  It doesn’t sounds like a high conversion rate and it isn’t.  However with such large scale from the massive distribution on Facebook, it can add up pretty quickly.  I think one way that this may improve is when Facebook rolls out its own payment platform to streamline purchases as how Apple has done with apps on the Iphone.

I have estimated that the LTV of a fairly successful social game is somewhere around $.40 to $.50.  That type of LTV is actually pretty hard to make work if you were a standalone web site because of the Cost per Acquisition of that user is usually significantly higher than the LTV.  However in the case of Facebook distribution, the LTV is actually much higher than the incredibly low CPAs that can be found on Facebook.  To be discussed in the next post.

It’s not just about how much you are willing to pay but how much you are willing to lose.

Traditional auctions like Ebay pushes purchasers on how much they are willing to pay but adding the element of how much you are willing to lose adds another economic value to the process.  By adding that additional element, these sites are able to capture an economic value that is often greater than the retail price.  How often do sites like Ebay capture value that is above retail?  Not often at all.  On sites like BigDeal, it happens all the time.  Here is a quick sample of the last 10 transactions (as of Dec. 16 at 6:30pm EDT) on BigDeal and the economics of those transactions:

When you use BigDeal, you first see what the winning bid was and you say to yourself “Wow!  What a deal!”.  You think BigDeal is getting the short end of the stick. Well, guess again!  If you consider the cost of the tokens which are $.75 each which only allows you to bid up an incremental $.15; for every dollar that the bid price goes up, it costs the bidders $5.00 collectively!  At the end of the day, the winning bidder is probably getting a very good deal but the losers of the auction are actually losing money.  BigDeal captures the value of what the winning bidder is willing to pay but also what the losing bidders are willing to spend to try to get a great deal.  That economic value is substantially greater than the actual retail price of the goods.  Based on the last 10 transactions, BigDeal was able to capture 172% of the retail value of those goods from the combination of the winning bid price and cost of the tokens.  Imagine if Ebay saw those economics! The trick to making this system work is to make it fairly difficult for the bidders to actually calculate how much they are risking per each session.  On BigDeal, you are buying weird lots like 30 tokens for $22.50 and each bid increments by only $.15.  They are trying to make it difficult for you to really know how much you are risking during your bidding process.  At the end of the day, about 83% of the value is captured from the tokens.  Bidders know they are risking money for each bid but most of the time they don’t really know how much they are spending to bid.  Bidders are also factoring that they can get the value of the tokens back in the form of gift card credits which also reduces the cost of the token/bid to them.  The economics then mulptiply because BigDeal captures the risk value across multiple bidders.   So for an $100 item, if 10 bidders are willing to risk $20 to get it at half price, you will get a lot more value from the bidders that lose than the actual person that wins.  The whole dynamic is brilliant!

These Pay for Bidding auction sites do an exceptional job of making the system very game like with the goal of the game being who can get the great deal.  With the example from BigDeal, the last 10 deals were sold at a range from 25% off to 90% off; there is an excitement of getting the great deal for users.  The sites allow you to track past winning bids for an item, what the track record is of the bidders involved and other information to allow users to develop strategies.  Combining the great deal with a game like environment brings a greater entertainment value to this impulse buying experience.  This is definitely not for everyone but for the risk taker/gambler that also like great deals – it is perfect!

Impulse Discount Ecommerce is starting to evolve to take many different forms.  It is exciting to see what they come up with next!