Business Strategy, Internet Industry, Product Management

Thoughts on Innovation At Established Companies

I spent two plus year working in an innovation group at my prior job and in earlier roles I’ve lead many new product efforts. These experiences have taught me about why many corporate innovation efforts fail. I’m not going to name the places where I’ve worked in this piece. While every organization has its specific challenges, this piece focuses on what I see as common challenges to that any organization pursing innovation.

There’s been much written on why companies miss disruptive shifts in their markets. Clayton Christensen’s The Innovators Dilemma is the seminal work in the genre. As much as I think The Innovators Dilemma is mandatory reading and its recommendations are strong, there are a series of more practical issues which that work and others in the genre do not address.

Venture Capital Exists For a Reason

Many new innovative products are financed through venture capital funding new companies. Venture capital is well structured for financing new innovations and established corporations are not.

One of the primary reasons is the power law nature of returns for new innovations.  Power law distributions have much fatter tails than the “normal” distribution. The main implication of the power law is home runs generate more return than the rest of the fund. Venture funds take a portfolio approach. If they invest in 50 companies, then the odds the home run are greater. To increase the size of their portfolio, venture investors almost always co-invest with other funds, broadening their portfolio.

Except for the largest corporations, it’s not possible to establish a broad enough innovation portfolio to have a decent chance of a home run as it takes too much money. Looking at venture funded companies, in general, it takes at least $50M in funding to get them to cash flow positive. For the home runs, levels of investment are often much much higher to fuel the growth necessary to capture the opportunity.

An established company running an innovation effort typically either does not have the level of funds available or is unwilling to spend it. As a venture funded startup goes through its Series A, B, C, etc financing rounds, its financial statements are showing a sea of red ink. Venture investors expect this. For a public company, this level of spending means lower earnings per share which for most companies is not tolerable.

The other alternative is boot-strapping, using a small amount funds up front and using profits to grow the business. We love a great bootstrap story but there really are not that many of them that generate large scale returns. Boot-strapped businesses, because they are capital constrained, tend to grow slower. With in an established company, the slower growth of a boot-strapping will often result in executives thinking it’s too small a business to be worthwhile.

Long Time Scales

The other area where established companies struggle with innovation efforts is the time frame of returns. Venture investors assume, on that average, returns are years away which is why their investment funds have 10 year lifetimes. Venture investors will set aside money for follow-on investment rounds knowing that it takes years and follow-on investment to build a strong business.

Most established companies lack this level of patience and typically expect to see large returns much quicker which typically is not possible. Even an exponential growth rate doesn’t yield big numbers early on. The returns of the new business always seem puny and irrelevant when compared to the firm’s existing businesses.

Risk Aversion

Startups by their very nature move fast and are willing to take risks. If a startup can not show progress and achieve milestones, it will be unable to raise the next round of funding. The greatest risk is not being able to raise the next round.

By contrast, established corporations, particularly publicly traded ones, are risk minimization machines. There are many high paid professionals whose job it is to reduce risk regardless if it reduces speed. Considering there’s more to lose, this is a rational mindset. But for innovation efforts, it can become a serious obstacle.

This obstacle rears its head when there’s risk of lawsuits or regulatory concerns. A start-up will see a 25% risk of a lawsuit or regulatory action as preferable to the 100% certainty of ceasing to exist if it doesn’t make progress. Extreme examples are Uber or Airbnb. It’s inconceivable to me that any established company could have built those businesses because of the risks involved. YouTube is another example. The risk of being sued for copyright infringement is too large for an established company to take on a nascent product.

Option To Give Up

One of greatest impediments to innovation efforts at established companies is that it’s too easy to give up. Being a risk minimization machine, an established organization will at some level see giving up as a good thing when obstacles and risks arise. Those employees working on the innovation efforts will be moved to some other project. The senior executives are spared the discomfort of having to explain a reduction in profitability or a new lawsuit on an earnings call. For the startup, giving up means shutting down or at least a pivot, both of which are painful.

The Technology Myth

At the core of innovation efforts is the belief that new technology is what will drive future business success. The problem with this belief is not that it values technology, but rather that it discounts all the other pieces that go into building a successful business. The ignoring all the activities a business must get right is a primary factor in dramatically underestimating just how much funding it takes to turn one of these ideas into a real business. The technology is the cheap part. Turning an early stage product into a real business which includes productizing it, marketing it, selling it which all gets expensive.

What Works Better

Given all these challenges, established firms are most likely to be successful with innovations that are connected or adjacent to their existing businesses. The first reason is there’s leverage from the existing business which both plays to the firm’s existing strengths and lowers some of the costs. In adjacent business, many of the assets of the company are valuable such as the brand, the sales and support operations and the channels to market.

The second reason is that executive leadership will be able to recognize the value being created. The most innovation famous story, one which has reached the level of myth in the technology world, is Xerox Parc which in the late 1970’s invented the future of computing but failed to see the value and commercialize it. Malcolm Gladwell has a great essay on Xerox Parc titled the Creation Myth.  Gladwell tells us there’s one innovation from Parc where Xerox recognized the value:

Meanwhile, the thing that they invented that was similar to their own business—a really big machine that spit paper —they made a lot of money on it.” And so they did. Gary Starkweather’s laser printer made billions for Xerox. It paid for every other single project at Xerox PARC, many times over.

This outcome is partially because Xerox could readily understand the value of laser printing because it was similar to their core copier business and partially because printers was a smaller leap to turn into a real business since many of the activities needed to be the copier business are also useful for the printer business.

The underlying goal of most innovations efforts to create a continuous pipeline of profitable new businesses. Note that a pipeline of profitable business is not what the professional venture investors try to achieve.  Rather they focus on the power law and look for the home runs. Pure innovation is not repeatable or predictable.  For better or worse, established firms want a repeatable process for new sources of profits.

The repeatable process for new sources of profits is a system for successfully moving into adjacencies. Cisco does this via acquiring smaller companies and then leveraging its salesforce, customer relationships and brand to increase the value of the acquired product. Acquisition is not an easy model as most acquisitions fail but Cisco has built strengths in acquiring and integrating so it can achieve a high success rate.

Amazon is another great example. Amazon started in books and has systematically expanded to new categories to the point where it covers a huge portion of the retail landscape. These category expansions leverage all the strengths that Amazon has built including its world class supply chain, fulfillment capabilities and strong brand. One of Amazon’s biggest flops was outside its core competencies, the Fire Phone. Amazon has also been successful at consumer electronics, most notably Alexa.

If you read this far, what I want to leave you with is that innovating is an unpredictable endeavor where failure is much more common than success. Established firms are on the whole not suited to this pursuit in areas disconnected to their core business. Even if an innovation effort discovers a great new technology, the constraints that established firms have mean they are unlikely to successfully commercialize it. Instead, established firms should build a system to move into adjacencies where they are most likely to be successful and can leverage their existing strengths and capabilities.

Internet Industry, Product Management

The Problem With Uber’s Surge Pricing

Uber’s surge pricing causes a ton consternation among for its customers and while surge pricing is a theoretically correct economic response to a shortage, in practice it makes for service that doesn’t meet the all the needs that Uber is trying to fulfill. The idea behind surge is pricing is sound on paper: when there’s more demand than supply, the price should rise so that market clears. The alternative is a shortage which would mean long waits for an Uber, similar to how its difficult to get a taxi in a period of high demand. The problem with surge pricing is that it forces the customer to be in a spot market for transportation. A spot market is where a transaction is made for immediate fulfillment or in simpler terms, an Uber ride can only be bought when you need it and the price fluctuates so there’s no way of knowing in advance (say a day or even an hour before) how much you’ll pay.

Consumers do not like spot markets in general and most of the time, their transportation needs are predictable rather than of the moment. The number of commodities that the average consumer buys at spot prices is quite small. Ones that come to mind are gasoline and food products like milk, fruits, vegetables, and meat. The amount of complaining when gas prices rise is a good indicator of how much people dislike spot markets. There’s less complaining about food because there are many of substitutes. If the price of beef is high, one can always buy chicken or pork instead.

When it comes to transport, people avoid spot markets. When was the last time you walked into the airport and bought a ticket for plane departing in an hour? The problem with walking into the airport and buying a ticket is that the price could be very high. If there are few seats left, a flight that is usually $400 could be $1000. Since most of us rarely need to fly on short notice, we avoid the spot market and make a reservation in advance. If fares are high the weekend we want to fly to Vegas, maybe we go the next weekend or decide to take a road trip instead.

With Uber, we have none of these options since we don’t know what the price is going to be till right when we need the service. Say I bought an airline ticket for 4 weeks from now. I know 4 weeks in advance that I need transportation to the airport on a particular day and time, but if I want to take Uber, I have no idea what that will cost. If I open the Uber app and see it’s 3x surge pricing, I likely don’t have enough time left to take the bus instead. The same problem exists if I need to be a work at 9am tomorrow and my plan is to take is to take Uber. For much of most peoples transit needs, they know in advance when they will need transportation. That foreknowledge should be useful in making sure that supply and demand are balanced but with Uber, it’s not used at all.

With Uber, the riders are only one-half of the equation. If surge pricing worked as intended, drivers would see the high prices, start driving and increase the supply. For the supply to meaningfully increase, the number of drivers has to be elastic meaning that high prices need to actually significantly increase the supply. Uber drivers have a similar problem to riders in that they don’t know what the rates will be in advance. If an Uber driver is sitting at home in their underwear and watching re-runs on TV then 3x surge pricing might motivate them to put on some pants, get in the car and starting driving. However, if they made other plans or just decided to sleep in, then 3x surge has no effect on their willingness to provide rides. If they had known that it was going to be 3x surge pricing maybe they would not have agreed to go to brunch or stayed out late the night before but with Uber’s current system it’s all guess work. An experienced driver might know when surge pricing is likely and plan accordingly but if it’s unpredictable (either in time or amount), then potential increase in supply is limited to drivers who happen be sitting around doing nothing.

I don’t have access to data on how surge pricing affects supply. Uber certainly has this data but even under heavy criticism, they’ve never (to my knowledge) made any specific claims about how effective surge pricing is at increasing the number of drivers. Even without the data one could presume that if surge pricing was effective at bringing in drivers that surges above 1.5x would be rare as most people would not pass up the chance to earn 50% more than usual. In some geographies, 2x and greater surges are a common event.

New Year’s Eve is surge pricing at its most extreme. On NYE 2013, some riders were paying $500 for rides. Every business that is part of people’s New Year’s Eve festivities, especially bars and restaurants, raises prices on New Year’s Eve which makes sense because demand is so high and supply is fixed so it certainly makes sense that an Uber ride will cost more. Personally, I’m not a huge fan of New Year’s Eve and there’s an amount of income that would at least get me to consider driving for Uber on NYE. However, with the current surge pricing system, I don’t know what I’d make. While some revelers wouldn’t want to pre-plan what time they go home, I suspect many would prefer to book their ride in advance especially if it gave them certainty on the cost. I’m not going to give up my NYE’s because the earning potential might be good but is unknown and I suspect there are many people like me. Predictability would increase supply and make consumer better off.

Allowing reservations and still keeping an element of dynamic pricing so that supply and demand balance isn’t an easy problem. However if ride-sharing services are going to fulfill their vision of enabling people to not own cars, Uber or its competitors will need to create a method where prices are known in advance for transport needs known in advance. While surge pricing might be economically efficient in a purely economic view, that’s too narrow a way to look at the problem. From a product point view, there are customer needs not being met. If Uber can’t figure out how to tell people what it will cost them to get from point A to point B a week now, somebody will come into the market and meet that need.

Business Strategy, Internet Industry

Strategy Lessons from Cloud Price Cuts

Google cut prices dramatically last week on it’s Infrastructure as a Service (IaaS) offering, Google Cloud Platform.   Amazon followed suit on Amazon Web Services the next day and cut prices to match Google’s price cut.  What business strategy lessons can we learn from these prices cuts and what can we predict about the future prices?

Commodity Products Compete On Price

Even though it takes both access to a large amount of capital and a high level of technical capabilities to run a large scale cloud provider, the cloud computing services especially compute and storage are a commodity as one providers offering is equivalent to another’s in the purchasers mind.  There’s little difference in a virtual machine from Amazon, Google or Microsoft Azure.

As cloud resources are undifferentiated products, it’s not surprising that Google is choosing to compete on price.  As a smaller player (in terms of cloud market share) hoping to take share from Amazon, Google needs to compete on price.  Other attributes such as reliability surely matter but there’s not enough difference for Google to effectively compete on those.

As is frequently the case when when one player cuts prices, the other players respond with their own price reductions.  Amazon responded by cutting prices to match Google for on-demand instances.  Interestingly, there’s a significant difference in pricing structure for heavy usage.  Google gives automatic discounts at 70% and 100% usage in a billing cycle.  Amazon is cheaper when using reserved instances but they require up front payment and thus the buyer loses the option to terminate or reduce usage with out penalty.  The reserved instance approach helps Amazon when comes to capacity planning but is less buyer friendly.

The other piece to note is that Amazon cut prices only on services where Google competes with them.   Amazon left prices alone on services that do not have a Google equivalent such as Dynamo DB or the RedShift data warehousing service.  Services where the competitors do not have competitive offering are differentiated and not a commodity.

What to Expect For Future Prices

For both compute and storage, we can expect costs to fall due to Moore’s law for processing and that hard drives get denser over time.  Even if data center costs stay flat, providers being able to get more yield for a given amount of rack space and power means costs will continue to fall.  The other question is will competition force lower margins over time?  If so, prices could fall faster than costs as competition drives margins and thus prices provider lower.

As providers show no signs of being able to differentiate offerings in cloud storage and compute, I expect prices to continue to fall.  With prices likely to fall, Amazon three year reserved instances become on a gamble since as realized price for Google’s offering may fall over enough over the next 3 years where it’s a better deal to use Google’s pay as you go price especially considering the flexibility to change or reduce consumption as needs change.

Internet Industry, Mobile

Think Through Your Competitor’s Response Before Acting

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Google Maps Image

Whenever one is evaluating an action to improve or maintain their business’ competitive situation, thinking through the competitor’s likely response is a critical element.  I frequently see companies taking actions and not thinking about competitors response.  A classic move to increase competitiveness is to cut prices.  It’s a huge mistake however to evaluate your offering with lowered prices against your competitors offering with their existing prices.  There will be a new equilibrium once competitors respond to your action.  There maybe several rounds as some initially follow suit, and some wait and see and take action later.  But assuming there will be no response and predicting the outcome using that assumption is foolhardy.

A recent example is Google Maps on iOS.  According to many published reports, Google refused to offer Apple turn-by-turn directions in the Google powered iOS mapping application that was bundled with iOS 5 and before.  Google’s refusal was so they could keep turn-by-turn directions as an Android only feature.  In hindsight, this plan was a strategic blunder as Google  lost a 23 million iOS users as a result. Even in foresight, this was predictably a blunder since it failed to consider Apple’s likely response.  Was it really even possible that Apple would just accept this deficiency in their most profitable product line, the iPhone?  It wasn’t necessarily predictable that Apple would create their own mapping app as there were many companies they could have chosen another partner instead.  But what was predictable was that Apple was going to quit using Google as their mapping provider costing Google many million map users.  Even though Apple’s switch to providing mapping was rocky to a say the least, Google still suffered. And, Google’s response to Apple moving to their own mapping system? To introduce that same turn-by-turn direction feature they originally refused to provide on iOS.  Google had no choice but do so once Apple introduced their feature as losing the entire iOS user base greatly decreases the value of their local content.

It’s entirely possible there were other factors that lead to Apple’s decisions to no longer rely on Google maps which make it difficult to judge how big a blunder this was on Google’s part.  Apple may just not have been comfortable relying on a competitor.  But what is clear is that Google was never going to succeed in gaining any competitive advantage over Apple in the smartphone war by withholding any mapping features as Apple had alternatives for getting these features. The moral of the story is think through the likely response from your competitors when taking any action to boost your competitiveness.  If someone else is proposing a plan, ask them what the competitor’s likely response will be.  If you get a blank look, you know that they haven’t thought it through and their touted benefits are likely fantasy.

Internet Industry

Does Apple’s secrecy help overcome the Innovator’s Dilemma?

Tonight I saw Adam Lashinksky speak about his book Inside Apple: How America’s Most Admired–and Secretive–Company Really Works.  As he was describing how Apple would erect walls inside its offices to keep projects secret , I realized this extreme level of secrecy solves a core part of the The Innovator’s Dilemma.  It becomes impossible  for one part of the company to impede the disruptive innovations of another when the first part has no idea what the second part is doing.  Other pieces of what Lashinksky described about how Apple operate,s including having being functionally organized rather than having multiple business units, helps keep Apple innovating rather than getting mired in protecting its current businesses.  But I’m wondering if the secrecy that was designed to keep information from getting outside the company also prevents Apple from getting it in own way.

Internet Industry

Is streaming video a disruptive technology?

Reaction to Netflix’s decision to spit streaming video and DVD rental into separate business has ranged from awe to bafflement.   Clayton Christen who is the oracle when it comes to disruptive innovation says:

And while it’s always worrisome to disagree with a luminary like Clayton Christen, I’m not buying that streaming video is a disruptive technology for Netflix. The key element of a disruptive technology is that it’s performance is much poorer on some attribute that the incumbents dismiss it. Let’s looks at attributes of streaming vs. DVD:

Attribute Streaming Video DVD Advantage
Time to content 30 seconds minimum 2 days Streaming
Content Consumable in Month More than anyone should watch Limited by DVD mailing time Streaming
Video quality HD – depends on bandwidth Full 1080p with Blu-ray DVD
Equipment Needed Streaming enabled TV or Blu-ray player, Broadband internet DVD or Blu-ray player DVD
Payment model Subscription (or pay per at competitors) Subscription (or pay per at competitors) Draw
Cost $7.99/month $7.99 and up, depending on number of discs, Blu-ray Streaming


Streaming’s instant access alone means most people find it superior. Given the choice of the same content library and same price, most consumers (at least the ones with solid broadband connections) would opt for streaming.

Many would argue the content available on DVD is far greater so that’s a strong advantage for DVD. However, that’s not an advantage of DVD technology itself but rather an artifact of US copyright law. As a matter of technology, DVD and streaming are both capable of delivering the same content. And the limitation on catalog is not an issue for content producers who want to enter the streaming video market.

Incumbents like Amazon and Apple embraced streaming video quite early on. The TV studios have gone so far as to create their own service, Hulu. Television networks like ABC, NBC and HBO, all offer their content via streaming through their websites and iPad apps. Cable companies like Comcast offer extensive video on demand services. I’m hard pressed to think of an incumbent in the entertainment space who did not see streaming video coming and enter the market. Retailers without the resources and technical know-how of Amazon are the only ones I can think of.

Looking at the combination of streaming technology not seriously lacking in any performance attribute and most incumbents in the entertainment space already entering the streaming market, I can only conclude that streaming video is a sustaining technology and not a disruptive one at least when it comes to Netflix’s existing DVD business.  The cable and satellite TV business models of expensive packages of channels will experience declines as streaming grows and the reluctance to give up the large revenue streams that channel packages provide may cause the TV providers to move less aggressively into streaming content which is a disruption story.

Netflix’s decision to break streaming and DVD into separate brands services is a risky gambit due to the impacts I outline in my last post.  The rational for separating the pricing makes plenty of sense as content licensing costs will grow as Netflix expands it’s content library and as Bill Gurley points out, licensing costs may be driven by the number of subscribers.  But given that the disruptive technology story does not fit for streaming vs DVD, it’s hard to see how side-lining the DVD business is good move for Netflix’s customers or investors.

Internet Industry

Netflix’s Huge Gamble

Ever since Netflix announced its new pricing structure, I thought the structure odd as there’s no discount for subscribing both to DVDs and streaming.  The resulting subscriber loss erased 2.8 billion is market value between Wednesday’s market close and Friday’s close after new subscriber projections were announced.  25.6% of Netflix market cap evaporated over two days even as the S&P 500 rose 2.3%.   Today, Netflix announced that it’s renaming and separating the DVD business.    This move is a stunning gamble as it will likely lead to further subscriber erosion and is the underlying reason for the new pricing structure which is leaving money on the table in the short run.

Bundle Pricing

The lack of bundle pricing is costing both revenue and profit today.   A quick thought experiment illustrates how:  First, figure out the highest price you would pay for Netflix’s unlimited streaming service.   This what economists call your reservation price.  It’s the price at which one penny more would cause you not to buy the service.  Next, figure out the highest price you would pay for Netflix’s DVD service. Now assume that you already have Netflix’s streaming service.  Either someone gave it you or you purchased it.  Now what’s the highest price you would pay for DVD service?  For most people, the reservation price for DVDs falls if they already have streaming.  People already have so much demand for entertainment and once they have some options, the value they place on additional options falls.

This substitution effect between Netflix’s two services is easily addressed by bundle pricing.  A discount for subscribing to both services would have meant less canceling subscribers as some customers would have found the bundle to provide enough value even though  buying both separately did not.  The customers who are closest to their reservation prices are likely to the DVD customers who turn over their DVD’s the least often and are thus the most profitable, as costs in the DVD business primarily driven by postage.   Not offering bundle pricing loses customers and reduces both revenue and earnings though higher subscriber loss.

Brand Equity

The Netflix brand has enjoyed a very strong reputation.  The DVD business being renamed means that DVD business will lose the benefits of the brand.  Building a new brand from scratch is a difficult, long-term, and often expensive endeavor.  In the customer’s mind, offering both DVD and streaming both fit within the brand.  Separating the brands,  doesn’t provide any business value today.

An Impaired Product Experience

The integrated streaming and DVD website provided a great experience customers who subscribed to both services.  Ratings a movie improved recommendations for both services.  Searching for a movie shows both the streaming and DVD options.  Separating the two services means users have to rate on two different sites to get recommendations and search for movies they want to see twice.  This is a degraded user experience and one customers have been quick to point out the Netflix blog.

A Huge Gamble

Given all the immediate negatives for the business Netflix has today, the move to separate the streaming and DVD services places a huge bet on it’s streaming service.  And while it’s clear the growth opportunities are in streaming business, what’s not clear is where to capitalize on the streaming opportunity required forgoing a substantial immediate value in the DVD business.

Most great companies can handle multiple related lines of business.  Apple didn’t marginalize the Mac business to capitalize on the iOS opportunity.  Other than the management challenges of managing related lines of business, there’s no external reason that Netflix could not have kept multiple integrated services under one brand.  It will be quite interesting to see how this gamble turns out in the long run.  I suspect the Netflix stock will be in for a rough ride in the short-term.

Internet Industry

A Better Way to Price Hot IPOs

LinkedIn stock’s large price jump following it’s IPO last Thursday has caused many to comment that LinkedIn was “ripped off” by its underwriters by pricing the offering too low.  LinkedIn used the standard offering process where the its underwriters, Morgan Stanley and Bank of America, offer the stock to their clients and set the offering price.  Most of the commentary has missed the underlying economic fault in the traditional offering process which is having individuals price anything especially when they have competing incentives is asking for a poor outcome.  The underwriters benefit by giving their best clients a big instant return on a hot IPO as they extract part of that gain through high fees on those clients.  Pricing too high will lead to a failed offering which the underwriters will be blamed for.

There’s a better way as Google demonstrated  in its 2004 IPO.  A modified Dutch auction will set a market price for the IPO and maximize the value the company and the shareholders participating in the offering receive.  For those not familiar  with the procedure, a modified Dutch auction is pretty simple.  Everyone interested in buying shares makes a bid saying they will buy X shares at a price of Y.  The auction prices at highest price, called the clearing price, that will sell all the shares on offer with everyone biding the clearing price or higher getting their bid filled.   The US Treasury uses the process to sell Treasury Bills and Bonds so it’s empirically proven in addition to being a theoretically sound.

To compare the two alternatives I normalized the offering prices of LinkedIn and Google to 100 and looked at the relative returns over the first 3 trading days.  Google returned 18% over its offering price versus 109% on the first day for LinkedIn.  Much more money could have ended up in LinkedIn coffers if they had priced as close to the market price as Google did.

There are too few examples of high demand IPOs being Dutch auctioned to do a statistically significant comparison.  However, the available evidence suggests it’s a much better pricing mechanism and economic theory is solidly behind that conclusion.  I doubt Dutch auctions will become anymore common though.  For non-hot IPOs, it’s not clear would be enough bidders.  The underwriters will be opposed since it both marginalizes their role in the process and reduces the amount of value they can capture for their clients and ultimately themselves.  Underwriters can not be eliminated from process since the securities laws require them.  Corporate executives aren’t likely to clamor for it either.  While a Dutch auction will benefit their shareholders, doing something unconventional always carries more risk of negative personal repercussions if it goes wrong.  It’s lot easier to blame the underwriters for a unsuccessful IPO if their advice for  traditional offering is followed rather than actively discarded.

Internet Industry

Thoughts on Facebook’s rumored entry to email

email icon

Image courtesy of husin.sani

I’m a bit surprised that Facebook is (rumored to be) entering the email market.   Partially my surprise is that consumer email feels like a mature market and I expect Facebook to be concentrating on areas where more innovation and value creation is possible.   The rest of my surprise is why Facebook book wants to enter a space that’s not a great business for any of the incumbents.  EMail is essential to Yahoo and AOL for the recirculation opportunities it provides to better monetizing channels but in and of itself, email does not move the needle for anyone today.

Here’s my take on the pros and cons for Facebook entering the email market:

The Downside

1) Free consumer email is a tough business

Being an email provider is expensive because you have store to an ever growing amount of old emails essentially forever even though they are rarely, if ever, viewed.   Being rarely viewed means it’s impossible to monetize those petabytes of messages eating up storage space in the data center.   In the old days before GMail changed consumer expectations forever, storage space for free accounts was sharply limited and additional space meant highly profitable premium revenue.

Compounding the problem, email page views monetize poorly compared to other types of content.  Partially this is because the incumbent providers (Yahoo, AOL, Windows Live) with exception of GMail do not target using email content.  My suspicion is even targeting off of email content does not help that much anyway.  Advertising is valuable either when the purchase intent is high (where search is king) or there’s value in brand affiliation (full page New York Times ad).   Email has neither of these characteristics and is likely getting worse on purchase intent.  No one emails anymore to ask which camera, laptop, cell phone they should buy since it’s easier and hipper to ask in a Facebook status.

2) EMail does not fit well into the walled garden model of Facebook

Facebook messaging today is an unpolluted stream where messages are almost certain to have been sent by person.  There’s no outside spam.  EMail is the exact opposite both due to its history and the expectations around it.    EMail started off with no way to verify sender identity and thus invites spam and scams.  There have been some technical fixes (DKIM, SPF) but at the end of the day you really do not know who is sent a message.   It’s also expected to be ubiquitous and completely interoperable thus removing the option of excluding bad actors from the system.

In contrast, Facebook can kick anyone out of their network.  The Stuff White People Like article on Facebook is humor but its underlying point resonates with me.  The nice, safe neighborhood feel of Facebook is a key part of its success.  Most people over 30 were never going take to the generally messiness of My Space.  Opening up your Facebook account to email, is almost like inviting the world to come by and litter on your front lawn.  And there’s no way to “de-friend” someone sending you email.  None of this is to say email is not an essential method of communication in the modern world.  I just don’t see adding email fits with the positioning that’s made Facebook so successful.

The Upside

Facebook does have several things going for it in the email market:

1) Capability to run large scale operations at low cost

Facebook has the operational know how to run a email operation at lower cost than most of the incumbents other Google.  A cost advantage is always a huge competitive advantage in a low margin market.  It’s harder to leverage though in email since pricing to the consumer is already zero.   The price of an email account is really the amount of ads and Google has been able to effectively exploit their low costs through less intrusive advertising.

2) Good targeting data

Facebook already knows so much about their users they do not need to use email for targeting.  How valuable this makes email to them is a function of how much excess ad inventory they already have.  If Facebook ad inventory is already selling out at least for certain segments, adding email will be valuable simply by boosting ad inventory.  If they are already swimming in inventory which is going for fire sale prices, there’s not a lot of money to be made.

3) Keep younger users away from Google and Yahoo

Although the kids of today do not have much use email, they will get older and need to start interacting with the grown-up world which still largely runs on email.  At that point, they will need an email address.  Providing them though Facebook keeps those users from deepening or even creating their relationship with Google or Yahoo which may benefit Facebook in the long run.   However, that benefit is mitigated by the Google and Yahoo’s failure to be at all competitive in the social space.

4) Social Graph

Facebook’s biggest advantage in any area they enter into is their owership of all that social graph information.  Maybe they have found a clever way to leverage it with email.  I’m a bit skeptical because of the inherent identity problems with email.

I’m curious to see what Facebook has come up or if the rumors are even in the right ballpark.  However, I doubt I’ll be creating myself a Facebook email address.  GMail serves my needs really well today.