Ah-ha 2.0

So now to Part 2 on my thoughts on impulse discount ecommerce.  A new category has emerged this past year – Local Group Savings.  The two most popular sites are Groupon and LivingSocial Deals.  If you haven’t checked them out, here is how it works.  You sign up to receive a daily email for one heavily discounted deal in your local area.  It is basically a coupon offer of 50% to 80% off but you actually have to buy the coupon making it more of a voucher.  So you might buy a $100 spa package voucher for $50.   However, this deal is not active until a certain number of people actually buy it.  This encourages you to share with these deals with your friends via email, Facebook, Twitter, word of mouth, etc.

Groupon and LivingSocial take about 25% to 50% of the sales receipts as their commission.  Yes!  50%!  So as a local business, if you offer a 50% discount, you may only be getting 25% of the original pre-marked down sale price.  Crazy right?  Well not so fast.  Local merchants have been very happy with the results.  Here is their value proposition of why you should accept it:

1. Chance for upsells while customers are in the store. A business that offers a voucher of $100 for $50 also gets the benefit of upselling the customer for over $100 while they are at the store.  Anything over the $100 completely goes to them also improving the margins of the voucher.
2. New Customer Acquisition.  Since these vouchers are bought from impulse buyers and are sometimes even limited to new customers (such as dentist patients), these customer tend to be first time customers.  A lot of these businesses are looking for new ways to acquire customers and will take any loss in margin as a cost for acquiring a new customer which they hope will eventually pay for itself in repeat business.
3. Shot of Cash. These businesses often get paid net of commission within 10 business days of the sale.  This is a nice injection of cash for businesses that deal with month by month cash flow issues.  Certain business have seen a remarkable surge.  Take for example, this story about a sky diving school which signed up 1,600 customers in one day.  They normally only do 6,000 for the whole year!

So, it sounds all great.  What are some predictions?  Well, the main problem I have with this business is the lack of competitive barriers.  Starting up these businesses requires very little capital .  The most intensive part is the business development with the local merchants.  However, what happens when all local merchants understands how these things work and know the benefits then there will less of a sales barrier and you can probably get them to sign up via telesales reps or some self serve interface.  Then all of the players will start reducing their commissions to close deals putting margin pressure on the business.  I can even see a player going in and offering 0% commissions in order to build an advertising supported model around this.  So my prediction will be that this market will expand rapidly but may end up actually shrinking later down the line (the money that the group discount providers make) due to low barriers of entry.

Any other predictions?  Please add your thoughts in the comment section below!

2009 was the year of emergence for impulse discount ecommerce.  First of all, what is impulse discount ecommerce?  It is when a consumer buys a good or service without originally seeking it and that good or service is heavily discounted (usually more than 50%).  Three categories have emerged (1) Online Private Sale Companies (2) Local Group Savings and (3) Pay to Bid Auctions.  Each of really interesting business models and value propositions.  I will share some of my insights of these 3 categories into three different post.  Here is part 1:

Online Private Sale Companies

You probably have already heard of them: Gilt, RueLala, Ideeli and Hautelook.  These companies are trying to replicate the sample sale by putting up excess inventory of luxury good or services online.   Why have luxury brands used these sites?  Well, selling excess inventory via outlets or discount store such as TJ Max and Filene’s Basement is usually brand suicide  It sends a message to your consumer that they shouldn’t buy at regular prices because the stuff is on sale at these stores and regulary available.  These sites protect that by offering these sales for a limited time.  In fact, if you have shopped on Gilt.com you realize that a sale may be sold out in just a few minutes.  If there is scarcity in the discount experience then it protects the core retail business.

However, the past year was an incredible time for these sites.  When the economy fell off a cliff, these brands had inventory stocked for a good economy.  This gave private sale companies plenty of inventory from them to choose from and sell.  However, what do you do now that these brands have adjusted their production quantities for a tough economy?  If you can’t offer enough inventory, you create a bad user experience because there will be a lack of merchandise and consumers will stop coming back if they can’t find anything they like or they never have a real chance of buying it because there is never enough of it.  Well, one thing they are doing is going to the designers and actually not selling excess inventory.  They are actually buying wholesale just like other retailers and ordering merchandise for production.  How do they avoid conflict with the retail channel?  Well, they order changes to the collection and create a different sku just for them that way they won’t have the same items as a retail channel thus avoiding the conflict.  Will this work?  Well luxury brands have been doing this for a while via retail channels such as H&M, Target and Gap.  Luxury brands such as Stella McCartney and Jimmy Choo have created lines to be placed in H&M with much success.  In fact some of these brands are basically treating their regularly prices luxury lines as loss leaders to create their brand as high end and then creating lines or goods at lower price points whether it be the H&M collection, the $200 sunglasses or the $50 bottle of perfume as the way they make money.  Therefore, be prepared to see these online private sale companies evolve just to be another mass retail channel and there really won’t be anything “private” about them.

So the social games market has been exploding in growth.  Companies like Zynga, Playfish and Playdom are virtually minting money as they distribute their games via Facebook and other social networking sites.  It is funny as I speak to people about this business, they say to me “I don’t get it”.  And to be honest, that is the beauty of the model.  With about only 8% of users actually paying and really 2% driving 80% of the revenues, it is only a small amount of people that really “get it”.  If you actually dig in and understand why people pay for some of these games, it gets really interesting.  First of all, the motivations of why people play social games are:

1. Challenge of the game.  It is a game and people enjoy the challenge of winning or doing better.

2. Escapism.  I was speaking with a friend of mine of why she plays Farmville and she said she plays it because she like to take a quick break from other thing in her life. Games have often been a  a form of “escapism” and it is true for Social Games

3. Competing and Collaborating among friends.  These games are both competitive in which you want to do better than your friends.  However, a lot people especially women love to collaborate with their friends in order to get better at the game together.

So all of this is interesting but what actually makes people pay?

Well one reason why people pay is because of their impatience. The most successful games in generating revenues from microtransactions are about selling you virtual goods in order for you to achieve higher levels without having to wait.  This is actually a big difference from games designed for hard core gamers like those that play MMOGs like World of Warcraft.  Those games sell virtual goods in order to save you time.  Most of these gamers spend countless hours “grinding” it out in order to achieve higher levels.  However, social games have been designed to be used primarily by people that may go in it every day and spend a short amount of time (like 10 minutes) when they visit.  This is why it has become much more for the masses as it actually doesn’t consume that much of your day.  However, to progress in the game you have to wait.  Take Farmville for an example.  I asked a friend if she thought about actually spending money to buy “coins” and she said she almost did.  Here is what she said

“I was real close to buying coins.  I basically spent all the currency I earned to expand my farm.  I accidentally let some my raspberries wilt and had to wait 4 days for my next harvest.  I thought about buying at that point.  I didn’t and it took me almost two weeks to earn enough currency to afford to harvest a full crop.”

So for a lot of these games, people are ultimately paying because of their impatience.  A lot of these games are not about grinding it out but more about waiting it out.  The game sets you up to have aspirations to progress at higher levels and gives you a chance to get their more quickly by buying virtual goods to get you there.  Still sound weird to you?  Well, we have been accustomed to buying things because of our impatience like express delivery when you shop online.  And that is what driving the growth in the virtual goods market – building games that sell to our needs whether it be impatience, power or fame.

So I just read an ebook titled “Early Exits” by Basil Peters. The book argues that VCs are spurring on companies to go for the “home runs” when it may not be in best interest of the entrepreneurs or angel investors . The book argues that companies should be wary of taking VC money as their business models are reliant to go for huge return exits versus going for “singles” or “doubles”. These singles and doubles can offer very rewarding returns for their shareholders payed out much earlier and with greater probability.

To illustrate the point about the VC business model, he writes the following:

“An Outline of the VC Math

Peter Rip of Leapfrog Ventures describes the math behind VC funds in a fascinating post titled ‘Traditional Venture Capital Sure Seems Broken—It’s About Time.’ This is a high level summary of
how the math works for a VC fund.

In a typical VC portfolio, all the returns are from 20% of the investments. These are the two out of ten investments that are winners. A minimum respectable return for a VC fund is a 20% compound return. For a ten-year VC fund, the fund needs to pay investors 6x their investment to generate a 20% compound return. So those two winners each have to make a 30x return on average to provide investors with the 20% compound return—and that’s just to generate a minimum respectable return.

This math is simplified but it’s more than accurate enough to illustrate this important point. If you are not familiar with the math behind an investment portfolio, I hope you will spend a few minutes with a spreadsheet so you feel comfortable with these numbers.

Even more interesting is that a traditional venture fund is usually a limited partnership. This means that the fund managers only get to invest the money once. So if they make an investment and exit for a 3-4x return, they give the principal and gains back to their institutional investors. They don’t get a chance to invest it again. From the VC partner’s perspective, this effectively guarantees they have failed.”

This is probably a bit exaggerated. In speaking with some other friends that are either VCs or been VCs there are plenty of situations where they would be very content to take a 3 or 4x return. This is especially true if they are a later stage venture capital firm where that type of return would be considered a home run. However, for early stage VCs, I do believe that their model definitely has them put on rose colored glasses if they see that their portfolio company may be able to achieve that home run. This is because the personal risk/reward scenarios for the stakeholders involved.

Think about it this way, for a basic “single” or “double” exit, you can see entrepreneurs making single digit millions of dollars and angels would make anywhere between 3 to 5x from their original investment. Each of them would probably be pretty happy with that. As for the VCs personally (not the funds investor but them personally), it is a very different story. Let’s say they put $3 million in and could exit with a 3x exit. That would mean that they had a $6 million gain ($9 million for original investment of $3 million). The VC would take 20% of the carry being about $1.2 million ($6 million x 20%). Split that among 5 general partners and that is less than $250k each. After tax, that is really not much at all for them personally. So if they have a chance to go for a home run which they could make millions or tens of million of dollars individually and all they had to risk is something like $125k after tax. I think they are more inclined to “go for it”. This is the danger of taking VC money. The shareholders may not be aligned given the very different economic incentives. So bottomline, if you do take VC money, be ready to realign your personal incentives to more closely match theirs or set your terms so they don’t get to completely control your destiny.

This topic comes up constantly. Facebook has crossed the 300 million active member mark which is staggering but there is still some skepticism that they will flame out like Friendster or MySpace. However, what people don’t realize is how Facebook has differentiated themselves as a social networking site. Facebook has done an incredible job on focusing on real life relationships. Unlike other social networking sites, Facebook adheres to people sharing their real identity and connecting with others only if they are actually friends in real life. This positioning is quite different from sites like MySpace or even sites like the ones we created at Community Connect such as BlackPlanet.com. These sites became dominated by people meeting new people. How do I know this? Easy, look at most of the friends’ lists on these sites. Most people have friends of the opposite sex (for heterosexual members of course) and that is because men don’t go online to make new friends with other dudes. That’s not cool. The problem is that it it opens itself to lower competitive barriers and some might argue to a naturally “trendy” lifecycle. If the core experience is meeting new people, the site is more susceptible to lose to the “cooler” place because switching costs are low and past connections don’t have that much value. Think of it this way, sites like MySpace are like night clubs in that they get popular but eventually lose their buzz as other sites come in and offer a new experience for people to meet new people. The switching costs are not high and therefore allow competitors to gain share quickly. Facebook on the other hand has a major advantage. By focusing on existing relationships and the social graph, they now established real switching costs. Going to a new site and having to re-establish all of those relationships is real work. On sites where my “friends” are more superficial and transient, the switching costs are really low. Someone asked me why BlackPlanet.com didn’t completely flame out and that answer is simple – No one opened up another good black online night club.

Mark Zuckerberg was brilliant to take Facebook and make it more niche than sites like MySpace. Think about it, he wanted to make Facebook bigger than MySpace and the key to that goal was to have Facebook narrow down the focus of what MySpace was doing. MySpace wanted you to do both – meet new people and connect with real life friends. He realized that to truly serve those that wanted to connect with real friends that he had to position his site to ignore those that want to meet new people. He realize that by focusing on that segment, he could actually become bigger than MySpace. It’s an example of how making a product more niche and focused actually make the market larger. Facebook is a much better position by focused on the social graph and I predict will be around for a long time.

It has been a while since I posted to this blog.  I have spent the last 3 months out in Asia.  I did a little work but it was definitely mostly pleasure.  Great to get away from things and have time to think, reflect and clear the mind.  So I have been back in New York for about 2 weeks and recently had lunch with a friend who is a CEO of a publicly traded Internet company.  He asked me during that lunch that now having sold and no longer being a part of Community Connect if I had reflected on what I would have done differently.  It is a funny question because I have thought about it but mostly by recounting specific incidences or situations and not pulling it all together to give an overall assessment.  I ended giving an answer but I think it was a lot of rambling and if I could take a mulligan, this is what I would ultimately say would be the 1 biggest thing I would have changed:

I was Too Deep in the Weeds and not Strategic Enough.

To say the very least, I was a very hands on CEO.  I know this was a flaw of mine.  I often deep dived into certain business operations and initiatives.  For a company of about 100 people, I think it is inevitable that you do that once in a while to make sure that the “factory” is running efficiently but I was in it too much.  Trends and dynamics in this industry change so quickly and you need to be on top of it.  I should have been better aware of our competitors, technology trends, VC dynamics, potential suitor situations and shifts in the consumer market.  I didn’t have my head in the sand but I didn’t spend nearly enough time understanding how the dynamics that affect our business was changing.  Someone once told me that “Timing is Everything” and I realize that it’s not about being lucky.  Instead it is about grasping market dynamics  and being able to “time” the best way to react to those changes especially when they hit that watershed moment.  For Community Connect,  I saw the wave of Social Networking 2.0 sites (Friendster, MySpace, Facebook) but didn’t fully grasp how much of a tsunami it was going to be.  The change that happened in the industry was incredible from consumer behavior, advertising demand, traditional media needs and venture capital funding.  Our path is that we should have either made a bigger move earlier or we should have been bought when we were in more of a leadership position.  We took too much of a middle of the road path and that was not the way to react to such a huge shift.  Some people say to me “how can anyone have anticipated that type of transformation?”.  I should have been able to anticipate it.  We were leaders in the market with the most experience in building a successful online community business.  I should have completely predicted how quickly social media was going to take off.  Timing is everything.   These monumental shifts happen.  You just need to be prepared to take advantage of it.  I won’t make that same mistake…..trust me. 

Fred Wilson recently posted on his blog his presentation about Disruptive business models that he gave to Google staffers.  The slide I like the most was the one he talks about Shrinking a Market.  He discusses how the Internet continues to get more and more capital efficient.  The costs for things like software, hardware, bandwidth and storage are 1/10th what they were 10 years ago.  I think that this is an underestimation.  Bandwidth for example, used to cost $1200 per Mbps.   Now you can easily get a rate of less than $30 per Mbps.  Anyway, things are a lot cheaper.  Well, combine this capital efficiency and target a market where you can win not only by providing a more effective service but also by undercutting the price and you may become the market leader by shrinking the market.  Fred Wilson quotes another VC who uses this thesis as part of his investment criteria who said “If you have a business that will shrink an existing market, allowing you take $5 of revenue from a competitor for every $1 you earn, let’s talk!”

The example that Fred Wilson discusses is Craigslist and the classifieds business.  The classifieds business was a multibillion business for newspapers and Craigslist completely dismantled that business with a basic online classifieds system that is almost all free.  They charge a minimum amount for certain categories such as job postings that if you talk to any HR person, they will tell you is the most efficient buy in terms of a cost per applicant.  Craigslist is the dominant player in classifieds and has shrunk the market to probably no more than $100 million.  However, by completely owning the market Craig Newmark is basically running a monopoly because no one can touch him in both price and scale.

Shrinking the market isn’t limited to a Web service business that targets a market dominated by an offline business.   It happens in markets dominated by online businesses as well.  An example of this is what PlentyofFish.com is doing.  I was always puzzled on how much money online personal sites could charge and how it really is a capital efficient business if you didn’t have to pay a lot in marketing costs.  Well, Markus Frind figured that out and applied some basic rules including:

1. Pick a Market where competitors charge money and do it for free!

2. Keep your cost low.  Really Low.

He is disrupting a billion dollar online personals market by attempting to shrink the market.  And he is making some incredible traction. Look how he is quickly catching up with market leader Match with just a small fraction of the resources and advertising budget.

So what does this mean for Internet Entrepreneurs?  Well, in a recession economy, running a capital efficient business in not only a necessity but actually can be the main advantage.  Target markets in which you can shrink the market and be the disruptor.