The Academic and The Professional

Business strategies are just like opinions, and opinions are just like you know what. Everybody has one. If you Google around, or read this blog, you will find a lot of conflicting advice that people give to companies. As with any advice, some of it is good, some bad, and some downright comical. You can categorize this advice into two umbrella categories: Academia and Experience.

Academia

Business strategies from the world of academia are distinctly different from strategies given by an experienced professional (I use the term experienced professional because it fits rather nicely, but you can substitute it for any word that implies real world knowledge). Academic strategies are often from PhD's and business school professors who attempt to explain the world with models. These models are imprecise, but they are general templates of how a business should operate to be successful. Probably the best known model is Michael Porter's Five Forces Analysis, which seeks to develop a framework to understand how intense competition in some industries is. This is a gross simplification of the Porter's model, but I bet if you asked him to pitch it to you in an elevator, that's precisely what he would say. The problem with this model, and any model really, is that it encourages you to fit a business into it even when it doesn't fit.

To illustrate the weaknesses of models, let us take Twitter and try to explain it through the Five Forces Model.

The Threat from New Entrants

This one is relatively simple to explain. It is easy to create a new social media startup, because the barriers to entry are so low. That said, this threat is mitigated somewhat by the difficulty of starting a successful startup that effectively competes with Twitter. Many other factors are present for this threat, such as economies of scale, customer loyalty, government policy, and a slew of others.

Threat of Substitute Services

This force is also simple to explain, and the model accurately reflects the realities of Twitter's business. How easy is it to create a substitute for Twitter? Well, creating the substitute is relatively simple. All you need to make is a service that lets you share 140 characters with the world. Many mimicking services have launched in the past few years, but literally all have failed. The switching costs to a new service are fairly low for Twitter users, since it's free and few people care about their past tweets being transferred to a new service.

Bargaining Power of Customers

This is where the model starts to break down quite a bit. Who are Twitter's customers? Are they the users of the service, or the customers the people who purchase ads on Twitter? The answer isn't clear and can be argued both ways. Incorrect use of the model can get a business in a lot of trouble, which you can say is the failing of the business and not the model. While this is probably true, business models are not like scientific models. People are must more open to accepting a business model such as Porter's Analysis when compared to a scientific model that sets forth a hypothesis. This results in business models that are often treated as gospel.

Bargaining Power of Suppliers

Traditionally, suppliers provided raw materials or some other basic ingredient/service to your company. You can see why Porter factored this into the model, since a powerful supplier could seriously undermine your business. But in the age of the internet, suppliers aren’t nearly as important to web companies like Twitter. This isn’t to say that Twitter doesn’t rely on any suppliers, because they probably rely on dozens of companies. It’s just that this factor is of such minuscule importance that it’s a nuisance to even include when evaluating most web companies.

Intensity of Competitive Rivalry

The problem with this factor is that it’s so comprehensive that a whole model can be built just to understand it. Surely Facebook is a rival of Twitter, since both are popular social networks. But than what about Path, Pinterest, LinkedIn, Yelp, Foursquare, Snapchat, and Tumblr? Isn’t the ultimate competition for the users time? If so, these companies (and many more) would be a competitor to Twitter. It’s worth noting that some are closer competitors (Facebook) and some farther (Foursquare), but my point remains: this factor is totally open-ended.

The goal of this exercise wasn’t to display my Porter Analysis prowess, but to walk you through its strengths and weaknesses. The greater goal, however, was to exemplify how models are used in the world of academia. Porter’s analysis is just one of many academic models, which are all somewhat similar to each other. That is, the world of academia attempts to create models that are comprehensive and general. They seek to explain whole market segments and industries, by citing common trends within these areas.

In a way, these models are naive. Human nature is such that it wants explanations for things, even when the explanation isn’t totally correct. While Porter’s model is extraordinarily helpful in understanding the rivalry within an industry, it suffers from being overly academic. His Five Forces fits for the industries he studied, but as we have seen, they don’t entirely fit Twitter. To try and wedge a web company like Twitter into his model would be to grind coffee with a knife. It might seem like I’m picking on Porter, but almost all of the academic models I have studied suffer from the same broad-stroke failings. The tech community has fully embraced Clayton Christensen’s disruptive innovation, but it is also too comprehensive for its own good. Academia follows the same thinking pattern that it teaches to its students. It would be silly to teach business school students specific strategies applicable in particular industries for distinct companies, so instead, professors focus on high-level theory. Unfortunately, the very same theory they teach becomes the strategic model they attempt to apply to a real-world company, and it simply won’t fit.

Experience

The second general category of business advice comes from the experienced professional. This is a person who has worked in an industry, or has specifically followed an industry, for years. Examples that come to mind are consultants, analysts, and C-suite executives who have held important roles within a company. These people usually take a different stance on business strategy - one that is much more nuanced and specific. Consequently, the experienced manager will give advice that is highly specific to one company, and this advice is usually never applicable to other companies. An experienced professional who works for Twitter might argue that keeping their API closed to third parties, effectively limiting the amount of complement products, to Twitter is a good idea. This would obviously be bad advice if applied to another company such as Dropbox, since they want to have their cloud storage available everywhere. The experienced manager does not build models, and instead circumvents them in order to get right to the problem. Business is a touchy-feely and free-flowing animal, while academia models are more rigid.

The experienced professional has his own failings too. Experience is usually narrow and applies to niches. Experience in one company might not apply to the next company the manager joins. It can lead to the overconfidence bias, which may actually hurt performance.

The Academic Professional

After everything I have written above, you could ask why doesn't the experienced professional just read some academia books to embrace the best of both worlds? And you would be right, since that is exactly what any business minded person should do. Both categories of business strategy have failings and biases, which can be circumvented by not fully buying into one way of thinking. Academics shouldn't be so confident about their models, because nothing in business is so black and white. A model that works during this decade might not work the next decade, and you often see businesses have trouble letting go of their old strategies that are no longer applicable. Similarly, the experienced professional should educate himself in the general trends some industries follow, but at the same time he must realize these models are just oversimplifications. Being able to maneuver and shape a model to the realities of the real-world is key to applying it right.

Tensions in Social Media Valuations

Startups are extremely popular today, since the Internet and the post-PC era have allowed small companies to reach an audience of billions. Everybody carries a smartphone with them, which gives the potential access to your new idea to users. Assuming your startup idea is good, you can really hit it big. We have seen this happen to Facebook, Twitter, and Snapchat, who grew (and continue to grow) users at levels retail businesses would kill for. By the way, these services are free.

After reaching such a large audience, these social media companies require money to pay for the cost of doing business, which they first get from investors in angel rounds. The investors, in return, expect to be paid back more than their initial investment. Thus, a social media company (and all companies that require investment, really) must somehow start producing revenues and hopefully profits to pay their investors back. Since their service is free, online advertising has been the only way to generate these revenues. The way online advertising works is the more users see or click the ad, the higher revenues a social media company will get. Key performance indicators (KPI’s) such as monthly active users (MAU’s) are used to calculate a valuation on many such advertising companies.

As I’ve written in the past, these new valuation techniques are extremely young, and their results are to be taken with a grain of salt. My favorite view on this issue is from Aswath Damodaran, a finance professor at NYU Stern. His take says there are currently two major ways to valuate social media companies. The first is from the traditional investor, who looks at revenues, profits, and investments. The newer valuation technique looks at user growth and other user-focused metrics like MAU’s. He argues that as a company matures, it must transition from telling stories to showing meaningful results. These results are mainly focused on the fundamentals of business, like revenues and profits.

As a social media company grows, the way it is valuated shifts from the younger model, to the older, traditional model. Most of the successful social media companies are still too young to fully appreciate this valuation shift. In fact, most investors will probably shift their techniques unknowingly. They will notice how social media companies are maturing, and begin applying the traditional models. Stories will no longer be enough to take investor’s money, and results will have to be shown.

How is Spotify Growing so Rapidly?

As I'm working on a deeper financial analysis of Spotify, I started pondering how Spotify plans to grow and differentiate itself from the other music streaming services. Based on their latest actions, it appears they are partnering with complementors (which are services that increase the value of Spotify), developing good cross-platform apps, and aggressively pricing and marketing their service.

Partnering with Complementors

There is very little platform lock-in with music streaming services. Anyone can sign up for Beats Music, use it for a few months, and then switch to Spotify. While the playlists you make on one service don't transfer to the one you switch to, it's not an issue for most users. People just want to stream particular artists and songs on demand, which all of the streaming services easily provide. Spotify is well aware of this issue, so its been smart to partner with complementors like Facebook and Uber (in addition to many more). For example, the partnership with Facebook allows you to log into your Spotify account and easily find what all of your Facebook friends are listening to. With this feature, you're able to find curated music choices from the people who matter the most in your life.

In addition to Facebook, Spotify also partnered with Uber last week, further increasing their supply of complementors. This latest partnership allows you to play all of your songs while in an Uber car. The goal here is to further increase the value-add of Spotify, as compared to their competitors.

Spotify also makes available a third-party API that allows application developers to tap into the Spotify music collection. Apps like Djay use this API to add extra features on top of the already existing Spotify service. The effect is to further lock-in users, by providing them with more value. This, of course, comes at a lower cost to Spotify, since they don't have to develop these third-party applications - they only have to build the API.

Cross-Platform Apps

This strategy needs very little explanation. Spotify wants to reach as many users as possible, so it builds applications on as many platforms as it can. It has apps on all of the major platforms (iOS, Android, Windows Phone, Mac OS X, Windows), including the web. If somebody wants to try it, Spotify made sure its service will be available anywhere.

Aggressive Pricing and Marketing

The price for music streaming services is an established $9.99 per month on all the major services. Spotify also offers family and student plans, however. The family plan is $10/month for the first family member, and is discounted to $5/month for additional members. This isn't a novel feature, but not all of the music services offer a family discount. Again, Spotify wants to appeal to as many users as possible.

There is also a student plan that goes for 50% off, or $4.99/month. The aim here is presumably to indoctrinate students, who will eventually graduate and switch to the full price plan. Students are also much more likely to download their music illegally, and having them pay discounted rates is much better than having them pay nothing. Lastly, Spotify must know how vital word of mouth is for younger audiences, which essentially provides free marketing.

It's no wonder why Spotify has been growing faster than their competition - they've been engaging in beneficial partnerships, providing access to all the major platforms, and pricing themselves aggressively. This doesn't mean that they will succeed in the long term, though, it just means they're currently doing well. Perhaps Taylor Swift was foolish to pull her music off Spotify after all?

New Valuation Techniques

I must admit, in the past I was highly skeptical of staggering acquisitions like WhatsApp, which sold for $19 billion. I did not believe that a company such as WhatsApp, with almost no revenues and an unclear business model, would be able to monetize and provide that amount of value in a million years. To be perfectly honest, I still am a bit skeptical, but I am now more willing to accept these insanely pricey acquisitions. My thinking on this topic has changed fairly recently, as I've been trying to think outside of my traditional business education, and understand this new wave of valuations. 

I'm not the only one who is trying to understand valuations in high growth industries. Here is what Jeff Liu and Jim Reinhart write in a report for EY: 

Clearly, traditional valuation metrics based on multiples of current earnings or revenues don’t accurately reflect the future expectations that the valuations imply in recent large transformative transactions. Consider the $19 billion price tag placed on WhatsApp, which reportedly generated only about $20 million in 2013 revenue — a multiple of 950x revenue! In fact, applying traditional valuation approaches may cause companies to overlook acquisitions that can transform their business by propelling growth in new markets or industries.

This whole time, I was looking at these acquisitions through my traditional accounting and finance education, which preaches metrics like book value, net income, and simple year over year growth. While these are still solid metrics to gauge most businesses by, they begin to break down for unprofitable companies that are experiencing rapid growth, which defines most social media startups. The truth is, there is no fundamental metric that can precisely predict the future growth, profitability, and success of companies in this industry. Social media, startups, the other companies that we associate with Silicon Valley all fall into an extremely young industry that has not been studied in enough detail yet. Everything in this business is an estimate, at best. And while new metrics to value these companies have emerged, they are not battle-tested enough to spend billions of dollars based on their results. I bet a large part of the WhatsApp purchase was Zuckerberg's gut. 

iTunes or Beats?

It's been roughly half a year since Apple purchased Beats, and apart from a few updates to the Beats app, not much has been done that is visible from the outside. To be fair, integrating a huge team into an even larger company with a unique way doing things isn't easy. Apple had to let go 200 of the 700 person team, likely because teams at Apple tend to be small. 

Recently, however, it's been reported that the Beats brand will be subsumed into the iTunes brand, presumably as the iTunes music streaming service. If Apple goes this route, I think they will be forfeiting a lot of goodwill from the Beats brand. 

iTunes is a dinosaur, and it is seen as such by many music listeners. At University, I know very few people who still use iTunes, instead opting for streaming services like Spotify, Pandora, and Rdio. iTunes has an ancient business model, requiring you to buy and own songs and albums individually. People have long been transitioning away from owning music to leasing it, and iTunes is associated with the old world. Rebranding the new Beats music streaming service as iTunes streaming, or something similar, will diminish the goodwill the Beats purchase brought. It must be difficult for Apple to let go of the product that started the whole music revolution, but every product has a definite life span and should at times be euthanized. 

When the Beats purchase was announced, I was looking forward to it being the new iTunes. I still think this would be the best strategy for Apple. Rebrand iTunes as Beats, and make the new service primarily a music streaming service, while also offering music purchases for those who want it. Although Beats headphones are looked down upon within the tech community, most consumers love them because they look great and are represented by Dr. Dre (who is not an actual doctor). Similarly, the music streaming service should be pitched as the cool streaming service - one that has ties to the music industry. Apple has many contacts in the music business, and striking deals with musicians and labels to promote their music on Beats would be a winning strategy. Of course, the music industry doesn't want to bow to Apple as it did with iTunes, but Apple has the leverage to negotiate favorable contracts (Apple had 800 million accounts registered in April, most of which have credit cards attached).

Apple probably did this cost benefit analysis, and it still decided to go with iTunes as the brand for all of its music products. They decided to keep the iTunes name because it's such an established brand, which everybody has heard of. But this is precisely why iTunes should be rebranded to Beats. People know about iTunes, but it's no longer the cool new product from Apple. The brand can stick around for another few years, but this is a long term play, and Beats is a name that can possess the cool factor for the next decade.