Posted on January 2, 2008
Filed Under Dramanomics |
I’m starting off the new year with a new feature: Dramanomics. Economics is one of my favorite subjects and this year I plan to look more at economic issues. In many cases, I’ll try to relate them to the world of technology startups, as I’m doing with this post.
The possibility of a recession in the United States in 2008 is certainly going to be one of the most prominent headlines in the first part of this new year. Articles about the faltering US economy have been included in recent Drama’s Roundup posts and for good reason: even if the downturn is less dramatic than a recession, as the Economist pointed out in a fantastic article, it’s likely that most Americans are going to feel like they’re in a recession:
The bigger point is that even if the economy technically avoids a recession, it will feel like one to most Americans—because it will be led by consumers. That will be a big change. Consumer spending has not fallen in a single quarter since 1991; it has not fallen on an annual basis since 1980. Consumers barely noticed America’s last recession—when low interest rates and high house prices kept them spending solidly (see chart 5). Just how voters and politicians react to a consumer downturn in an election year is worryingly uncertain.
What’s more, the squeeze on consumers will last longer than many expect because it involves the unwinding of an asset-price bubble and attendant financial excesses. Just as corporate spending stayed weak for years after the 2001 recession, so consumer spending will be crimped for more than a few months.
Slowed consumer spending, whether part of an official recession or not, will impact lots of businesses. And this includes consumer Internet companies.
Recently, my involvement in new consumer Internet venture got me thinking about various consumer Internet business models and how they might fare in a recession (or noticeable downturn). I started asking myself: if consumer spending decreases, would it be better to run a consumer Internet company that derives most of its revenues from advertising (i.e. Facebook) or would it be better to run a company that derives most of its revenues from paid services (i.e. World of Warcraft)?
In a downturn, an ad-driven business would be affected because reduced consumer spending would force the consumer brands that fuel the lucrative online advertising market to cut their advertising budgets (and these budgets are among the first to get cut when times get rough). A paid services business, however, would also be affected because reduced consumer spending would almost certainly result in some customer attrition as consumers tighten the grip on their wallets. On the surface, it might appear that both businesses would face problems of a similar magnitude. However upon further reflection, I actually believe that advertising-dependent companies would, on average, fare far worse.
The reasons are actually quite simple.
Ad-Driven Businesses and Paid Service Businesses are Scaled Differently
One of the appeals of running an ad-driven business is that, when the market is good, revenue potential seems almost unlimited. In many cases, the amount an ad-driven business can earn is potentially much higher than if the business charged consumers directly for its offerings. For instance, it would have been extremely difficult for MySpace and Facebook to earn anywhere near the revenues they’re generating today had they forced their members to pay. After all, it would have been difficult for MySpace and Facebook to attract members in the first place if they had to pay.
The problem, however, for ad-driven businesses is that they scale operations based upon a perceived revenue ceiling (which can be massive) and as we saw in Bubble 1.0, when the economy turns, perceived revenue ceilings fall to the ground while the company is still left with operational expenses that were supposed to be subsidized by advertisers. Paid service businesses, on the other hand, typically scale based upon actual revenues as well as perceived revenue ceilings that are a little more conservative. It’s quite simple: they know that, realistically, only so many paying customers exist. For instance, if you operate an online photo sharing service that charges members $9.95/month, it’s far easier to project future revenues than it is if you operate a free social network that charges its members nothing. While both businesses will be impacted by a downturn, the ad-driven business has likely scaled far faster and far more than the paid service business, leaving it in a much more precarious situation.
Additionally, ad-driven businesses are typically forced to scale infrastructure differently than paid service businesses. For instance, if you run a successful free online video service, you need to scale your infrastructure far more significantly than an online video service that charges members for usage. When a downturn occurs, the free online video service still needs to maintain (and grow) its infrastructure to support a large volume of (non-paying) members but no longer has the same “subsidy” from advertisers and thus could potentially face a scenario where it does not have enough money to survive. The paid online video service, however, in theory never has to subsidize a member that doesn’t generate revenues (assuming the service is entirely paid).
In all areas of scaling, ad-driven businesses will typically scale in a fashion that creates substantial risk during a downturn. The businesses that offer paid services however, will typically have a better-aligned relationship between revenues and expenses and therefore should be less prone to downturns. In theory, they can scale down far more easily to save the company if necessary.
All Consumers Aren’t the Same
When reflecting on recession, I also considered that individuals are affected differently by the economy. For instance, in the Great Depression, not only did some individuals maintain a decent life, some actually thrived. I think this has some application to the ad-driven business versus paid service business discussion.
The major consumer brands that all ad-driven businesses hope to obtain as advertisers typically market to a wide range of consumers and many are dependent on middle-class consumers. Thus, when a recession occurs and the “average” American is feeling the pain, it’s no surprise that these consumer brands hurt too and cut their advertising budgets accordingly. Reduced advertising budgets by the top consumer brands can potentially have a significant impact on lots of businesses.
In a recession, paid service businesses can expect to see attrition, however I would hypothesize that the type of individual purchasing paid services online is more likely to be amongst the group that will get through the downturn in far better shape than others might. Why? When you consider that there are today free versions of most types of online services, a consumer who has made a decision to use one that isn’t free seems, at best, more likely to have more disposable income and, at worst, to have some rationale for why that service is worth paying for. In both cases, it appears reasonable to expect that this type of consumer may be less likely to cancel his or her membership to paid services just because the economy has soured.
While this is simply a hypothesis, I think it’s a decent one and therefore believe that in addition to the fact that paid service businesses have a significant advantage in a downturn because of the way they scale, they might not actually have as much customer attrition as one might initially expect (unless of course the entire economy collapses and the Internet becomes irrelevant to a nation of Tom Joads).
After reflecting on this subject, it is apparent to me that consumer Internet companies should not be so quick to de-emphasize a paid service business model simply because the advertising market has been hot. Ad-driven companies can do extremely well in a hot market, but are vulnerable to potentially fatal downside risk in a cold market. Paid services companies may not be as “sexy” as their ad-driven counterparts, but they have the potential to succeed solidly, if not spectacularly, in both kinds of markets.
At the very least, I believe more consumer Internet companies, especially startups, should hedge their bets and develop some paid services. Mixi, Japan’s popular publicly-traded social network, and LinkedIn, the most popular business social network, are both thriving revenue-wise despite the fact that, in terms of registered users, they’re much less popular than MySpace and Facebook. A big part of the reason is that they generate a notable amount of their revenues from paid services. It is these types of companies that have the best chance at surviving if recession hits and therefore I think any company that doesn’t take this issue seriously while looking at the macroeconomic big picture is risking far more than it probably needs to.
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