Business Unusual

Scale may no longer be the best way to achieve growth

The Internet 3.0 was founded on the principles of scale and network effects. If you don’t know what that is, you may find this useful. If you do know you may find this even more helpful.

All companies exist to generate a return on investment. The return is often to shareholders, it may be the founders, the community it serves or even society in general. Whichever group, the expectation remains the same, create more value than required to generate it.

When times are tough, it is acceptable to create enough value to not fail in the hope that the environment will change and things will improve.

At a biological level it makes sense. Plants grow, reproduce and expand to make the most of the available resources. As competition increases only the fittest survive to make the most of the resources and to ensure the cycle continues.

Agriculture, mining and manufacturing all conform to the principle that the inputs should never exceed the output to sustain yourself.

The same should apply to digital products... unless it doesn’t. Digital companies have had a different approach to scale. There are two terms you will hear about digital businesses that are key. Network effects and marginal costs. They are fundamental and transformative to scale, but the effect is not infinite. Are we approaching the limits of scale for scale’s sake as digital companies burn through investor funds with only the hope to one day turn a profit?

Enough jargon, time to explain each of the concepts.

Marginal Costs

The cost to build a car prototype is very high, the first models to roll off the production line are almost as expensive, but with each additional unit, the total cost of the production begins to reduce. Sell enough units and the cost to build each subsequent unit falls to basically the cost of the raw materials and labour.

Now consider the cost to write a song. The effort and time and recording costs are significant. Once the song is released digitally the cost to reproduce it and distribute it is almost zero.

As more products and services are created and distributed using digital means, the marginal cost of production shrinks allowing for the service or product to be sold to a massive audience at a minimal marginal cost.

Network Effects

Consider the person with the first mobile phone. They could receive a call from anyone with a phone, but they could still only call someone on their landline.

Having a mobile phone if you needed to call someone was not a significant advantage. Once five people had phones you could connect in ten ways, and when there were ten people, you could connect not in 20 but 45 ways. As each additional person joined the number of connections did not increase by one, but by a multiple.

If 1000 people have a mobile phone, they can make almost half a million connections!

Facebook has 2 billion users, so the number of potential connections is an eye-watering 2 quintillion. That is two and 18 zeroes. If you were to wait for 2 quintillion seconds, you would be waiting for 63 billion years. The universe is not even 14 billion years old yet.

Perhaps an earlier example might make more sense. During the First Industrial Revolution, the rail network was the social network. Initially, railways connected two towns. This was not that helpful if you were travelling somewhere else. But as railways began to connect towns with more towns, all the small private networks could allow a traveller to get further than just the next town.

It was not easy. Not only did you need to buy multiple tickets, you had to work with many timetables, and if your train travelled east or west, you also had to deal with time zone changes.

In the US most of the rail network was build privately funded via bonds and investments on Wall Street.

The initial costs of building the rail networks saw many companies run out of money dooming their investors to complete loss. While the network effects were real, the demand and revenue were not enough to keep the trains running.

This was further compounded by economic conditions that saw a major crash in the 1870s ending the mad rush for scale at any cost. Instead, new operators with deep pockets and an eye for a good deal bought up struggling and bankrupt rail companies, with little of the debt they inherited a network and trains which they could run at a lower cost and with better deals for passengers and those looking to move cargo.

The consolidation was so successful that they soon became an effective monopoly earning huge profits and the scrutiny of regulators. One rail mogul set the wheels in motion for another boom in the late 1990s. Stanford University was founded by Leland Stanford in Palo Alto, in the area known as Silicon Valley. When two students working on a project to better index the world wide web, founding Google, a new rush for building networks to generate profits began. The investments in infrastructure lead to a bust in 2000, the fallout allowed for consolidation of the network infrastructure opening the way for a boom in low-cost access and enormous opportunities for new web service companies like Facebook and YouTube to grow into the world dominators they are today.

MoviePass

If this is all true, then the founding of MoviePass in 2011 suggested a brilliant disruptor to the movie business. You paid a subscription and, in return, you could buy discounted movie tickets. The discount was not provided by the cinema but by Movie Pass and the trade-off was that when enough people used the service, the user behaviour could be mined and sold. The founders were correct in that the company was bought by an analytics firm in August 2017. They reduced prices and subscriptions skyrocketed. By June this year 3 million people were using the service and burning through millions of dollars in movies. Last month they hit the first big block. An emergency loan was needed to cover a shortfall. It has resulted in a 99% drop in the share price and a concern that despite being the claimed fastest growing subscription service in history, the ability to scale does not guarantee the ability to survive.

Time will tell, but with much of the digital economy now with well-established and for the most part profitable incumbents, the start-ups that are able to displace them are about as likely as a railway start-up may take over the rail network.

2018 may be the year the digital gold rush shifted to early maturity and that unicorns once again became fantastic mythical beasts.

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