by Tom Taulli
Payments Business
The Payments system allows Facebook partners to charge for their apps. It involves the secure processing of credit cards, PayPal transactions, gift cards, and other payment methods. Facebook gets a juicy 30% fee for all transactions.
In July 2011, Facebook began requiring that all social game operators use the Payments system, which resulted in a spike in revenues. The move was controversial with developers, but they understood the value of the platform.
Zynga accounts for much of the Payments revenues so far. But over time, this should change. Keep in mind that Facebook will likely get into other lucrative areas, such as allowing people to use their smartphones as wallets.
The temptation for entrepreneurs is to build their own payments system because doing so means more control over the process and improved customization of the user experience. But this approach is most likely to be a bad move. Payment systems are extremely expensive to create, requiring complex algorithms and security protocols. For most startups, the best approach is to outsource the function to a standout company like PayPal.
Revenue Drivers
Back in early 2003, Mark Pincus started one of the first social networks, tribe.net. It got lots of traffic but was extremely difficult to monetize because it catered mostly to people with alternative lifestyles. Pincus experimented with different approaches, such as charging premium subscriptions, but nothing worked. He eventually sold the company to Cisco.
When it came to Pincus’s next venture, Zynga, he wanted to prove out the business model as soon as possible. He wondered if people would pay for digital items to advance to higher levels in a game. After a few tests, it was clear that some users definitely would do so, and this testing gave Pincus enough confidence to pursue his innovative business model.
But to make it a success, he needed to understand the main drivers. These became his laser focus.
With more experimentation and testing, Pincus realized that there were some key factors. Perhaps the most important was daily active users (DAUs). Growth in this metric had the highest correlation to revenue generation (this has also been the case with Facebook). Pincus focused heavily on finding ways to boost DAUs, such as aggressive advertising. He once said in a media interview that when he sees a person, he thinks of them as a DAU!
Pincus’ two-step process—to test the business model and find the drivers—is critical for any entrepreneur. Using a random approach is destined for failure, as seen with tribe.net.
Business Model Innovation
From time to time, a company creates a game-changing business model. This was certainly the case with Google AdWords.
But it took several iterations to get it right. Google AdWords started as a simple way to buy text-based ads related to search results. They were separated from other search results and clearly described as advertisements. This allowed for a more authentic user experience.
AdWords did generate lots of revenues and was profitable, but the system was no different from any other Internet company. Simply put, advertisers would bid on common search phrases and the highest bids would get the best rankings. Then, a couple of years later, Google added a crucial twist: the auctions didn’t just rank ads on the amount of the bid but also factored in relevancy. The more clicks an ad got, the higher it was ranked. It was a huge breakthrough and resulted in explosive growth for Google: the ads were much more meaningful for users, which meant advertisers got high-quality leads.
But the company didn’t stop there. Google broadened the business model by also introducing AdSense, which allowed third-party web sites to host AdWords and get a piece of the revenue. It helped propel the business to amazing heights. Competitors like Yahoo! and AOL could not catch up.
Facebook is trying to invent innovative business models as well—but it knows that doing so is extremely tough. To help, the company has engaged in a great deal of experimentation. For example, in New Zealand it’s testing a new program called Highlight, which charges users to make posts to all their friends. It’s still in the early stages but will certainly gauge a user’s loyalty.
Business-model innovation may also come from acquisitions. Consider Facebook’s purchased of Karma in May 2012. The company is an early player in the gift-giving mobile app business. The idea is that Facebook can leverage its social graph to make it easier to recommend gifts to friends, which may result in a massive market for social commerce.
As is the nature of experimentation, many things fail, and Facebook’s experiments are no exception. Its Beacon advertising system, which was launched in 2007, was a total failure because people didn’t want their friends to see their online purchases. There was also a failed attempt to replicate a Groupon-type business.
Nevertheless, it’s worth the effort to be creative with your business model—and it should be an ongoing process. It can easily take a couple of years to refine the model.
But this is not to say that your business must innovate a business model. Many businesses do just fine using traditional approaches. The rest of the chapter looks at the primary ones.
Marketplace
This can be an extremely powerful business model. An example is eBay: it started as a way to sell Pez dispensers, but the platform proved versatile enough to sell virtually anything.
Even during the crazy dot-com era, eBay was one of the few companies that generated strong revenues and profits. The company didn’t need any outside cash but raised venture capital anyway so as to attract a top-notch executive like Meg Whitman.
Why are marketplaces great businesses? A key reason is that they allow members to generate extra income. With eBay, there are people who make thousands of dollars per month; some have made it their full-time business.
Over the past decade, other marketplaces have emerged. One of the most notable is Airbnb. At first, the company began as a way to rent someone’s couch to crash on! But the founders realized the business had much more potential: why not let people rent their apartments or homes to vacationers? It was a brilliant epiphany, and Airbnb turned into an instant hit, with huge revenues. The estimate is that the company will exceed $500 million in 2012.
Once a marketplace hits critical mass, it’s tough to dislodge. After more than 16 years, eBay is still the biggest player in online auctions. And it looks like this will remain the case for many years to come.
But there is something that can derail a marketplace: loss of trust. If users feel they may get ripped off, it can be a disaster. In the early days of eBay, the company had to deal with members who sold items and didn’t deliver them. As a result, the company took a variety of actions to reduce this activity. A key was implementing user ratings, which allowed for peer pressure.
Airbnb has had to deal with similar problems with user trust. In a couple of high-profile cases, members’ homes were trashed and valuable property was stolen. Airbnb took actions to deal with the issues, such as offering video verification systems and a personal property guarantee (up to $1 million). There is also a 24-hour customer-support line.
Entrepreneurs looking to create a marketplace need a lot of realism. It’s a proverbial chicken-and-egg dilemma: to get buyers, you need people to sell stuff; but to get sellers, you need buyers. The key for a successful marketplace is to continually find the right balance, which takes a tremendous amount of effort and good timing.
Freemium
A freemium means you have a fully functional free version of your product as well as a premium version. Because of this, it’s easier to get new users. Who doesn’t want to get a free product—especially one that provides a lot of value?
But the business model can be tricky. You need to have a low cost structure so you can make money from upgrades, which are based on a small number of users. The typical conversion rate is 1% to 5%. In other words, you need a large user base—say, over several million—for the freemium model to work. This has been the case with companies like LinkedIn, Evernote, Pandora, and Dropbox.
Once you have paid users, you need to make sure you provide strong ongoing support and innovation. If you don’t, you will likely suffer from attrition, which can kill the freemium model.
In Silicon Valley, this business model is red hot, but many entrepreneurs set themselves up for failure. Many types of businesses don’t have huge numbers of users, which means the freemium model probably won’t reach critical mass.
Selling Data
Data can be extremely valuable and can be the basis of a compelling business model. It’s been around for decades: companies like Dun & Bradstreet, Equifax, and Experian have made billions from the market. They have created extensive databases of customer information obtained from warranty cards, credit applications, magazine subscriptions, online forms, and so on.
But when it comes to using data from social applications, the level of skepticism is much higher. Perhaps it’s because the medium is new or the information is deeply personal.
Whatever the reason, there has been considerable pushback about using the data-selling model when it comes to social apps. This is not to imply that there is no business opportunity. But it needs to be done with a lot of thought and clear-cut disclosure to users. Still, given the potential of online data, it could be the launch pad of a hugely successful business model over the next decade.
Commissions
Commissions have become a major source of revenues for Internet companies. This is especially the case for online travel companies, such as Expedia, Kayak, Priceline.com, and Hipmunk.
Commission revenues have two forms: merchant revenue, when the company charges the customer’s credit card directly; and agency revenues, when the customer is referred to a third party and a commission is remitted. Which is better? Probably the merchant revenue approach, even though it’s more expensive to implement. You have more control over the customer experience and should also be able to collect more information. In the end, it should result in higher revenues because a company has an easier time remarketing to its customer base.
Flawed Business Models
A company may show growth—such as in users—but not have a viable business model. An example is ICQ, which was one of the early players in instant messaging during the late 1990s. It quickly gained millions of users but was unable to generate much revenue. ICQ was essentially a feature, not a company.
When this is the case—and it’s common—the best strategy is to sell out. Over the long haul, it will probably be quixotic to find a business model that works. In the case of ICQ, the company accepted a buyout from AOL. The huge Internet powerhouse liked the company because it gave users another reason to come back, which increased the opportunity to boost ad revenues.
On the other hand, a company’s business model may generate lots of revenue but still have inherent danger. A typical scenario is when a company relies on major suppliers. This has been the case with Netflix. To build its highly popular video-streaming service, the company must invest huge sums in gaining access to premium content. The problem is that it has little negotiating leverage because it competes against mega-companies like Amazon.com and Comcast, which can pay even higher prices for content. Those competitors have the luxury of making up for the revenue shortfall by relying on their other businesses.
To avoid these kinds of business-model problems, you need to think about potential vulnerabilities. Is your product mostly a nice feature, or is it a stand-alone product? Might a larger competitor outbid you for content or distribution? Going through numerous scenarios is a very helpful activity and can help to avert disasters.
Finding the Ideal Business Model
When you’re brainstorming and iterating your business model, there are some key things to keep in mind. Bill Gurley (a venture capitalist at Benchmark Capital, which has funded companies like Twitter, eBay and Instagram) wrote a blog about this topic and set forth some helpful factors.1 Here’s what he looks for:
Sustainable competitive advantage: You need a way to deal with rivals for the long haul. It could be a great brand, network effects, or a strong infrastructure. Some companies have all three, such as Microsoft, Facebook, and Apple.
Predictable revenue: Quarter after quarter, a company needs to increase its revenues. This should be not only because of a growing market but also due to strong pricing. At the same time, existing customers will continue to come back—and usually buy more of the company’s product.
Customer retention: This is a major factor for Facebook. Just imagine the hassle of reconstructing your social graph somewhere else!
Gross margin: This needs to be over 70% or so. As you saw in Chapter 8, a high gross margin means much more latitude to invest in the product and marketing. It’s also important that the gross margin tend to increase as revenues increase. This is a sign of a powerful business model.
Customer fragmentation: A business model has risk if one or more customers represent over 10% of overall revenues. The reason is that they may have leverage in getting better terms. The ideal is to have a large customer base.
Marketing: As much as possible, there should be small outlays for this expense item. Of course, Facebook had the advantage of being a highly viral platform that has been able to attract millions of users at extremely low costs.
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1 Bill Gurley, “All Revenue Is Not Created Equal: The Keys to the 10X Revenue Club,” May 2011, http://abovethecrowd.com/2011/05/24/all-revenue-is-not-created-equal-the-keys-to-the-10x-revenue-club/.
Summary
This chapter has looked at how Facebook has evolved its business model and found highly effective ways to generate profitable revenues. You’ve also seen some other innovative approaches and considered some of the risks. It’s important to remember that you probably won’t figure out the right business model early on; it takes time to experiment. But a product generally has just one optimal business model.
The next chapter covers the often-mysterious topic of being a CEO. And yes, Zuckerberg has some extremely helpful lessons.
Being a Great CEO
Leadership and learning are indispensable to each other.
—John F. Kennedy
Have you heard of Jonathan Abrams? Unless you are tied into Silicon Valley, you probably haven’t. Jonathan created Friendster in 2002; it was one of the first social networks. The site was an immediate hit and should have become the dominant player in the space, not Facebook.
Friendster raised substantial amounts of venture capital from tier-1 players like Kleiner Perkins Caufield & Byers, and Benchmark Capital. The company also received various juicy buyout offers, including one from Google.
Yet a couple of years later, Friendster imploded. There were many reasons—including destructive internal politics and too much focus on getting media attention—but a key problem was that the company had a feeble infrastructure. When millions of users hit the site, it slowed to a crawl. It often took over a minute for a page to appear!
Mark Zuckerberg learned some valuable lessons from Friendster, thanks to the fact that Peter Thiel, Reid Hoffman, and Sean Parker were Friendster investors. But avoiding mistakes was just one part of making Facebook great. Zuckerberg also needed to make strategic decisions about the product, business model, and funding. In other words, he needed to be a great CEO.
This chapter looks at some of the key takeaways from Zuckerberg’s journey. The good news is that you don’t have to be a natural-born leader to be a great CEO. It’s definitely something that can be learned.
“CEO Lessons”
In the early days of Facebook, Zuckerberg was a terrible CEO. He didn’t communicate well, he kept things to himself, and he often riled his employees. He also had a bit of an attitude. One famous example was his business card, which had the following at the top and bolded: “I’m the CEO, Bitch.”
In late 2005, things were getting worse. Zuckerberg was spending most of his time hanging out with media moguls, flying private jets and dining at elite restaurants. These pastimes may have
been a great ego boost, but they were taking a toll on Facebook’s employees. Was the company up for sale? Would the owner be a global media conglomerate? Employees were becoming demoralized, and it was harming the company.
Trying to get things back on track, the company’s in-house recruiter, Robin Reed, confronted Zuckerberg and said, “You’d better take CEO lessons, or this isn’t going to work for you.”
It was a pivotal moment—and a wakeup call. Zuckerberg was mature enough to evaluate the criticism and act on it. It was a valuable lesson and critical for the company’s growth. From that point on, Zuckerberg set out to get CEO lessons from people who included some of the world’s best leaders: Steve Jobs, Marc Andreessen, Jim Breyer, Bill Gates, and even Warren Buffett.
But perhaps the most influential—at least during the critical early years—was Donald Graham, CEO of the Washington Post. The two had an instant rapport. Zuckerberg was impressed with Graham’s long-term strategic ideas about building a company that thrives across generations. To soak up information, Zuckerberg followed him around the offices.
No doubt, being a CEO can be lonely. You can’t say something like, “I have no idea what to do. Any suggestions?” To do that would be a killer. This is why it’s important to find mentors, as Zuckerberg did—especially those who have several rungs more experience than you.
But a CEO also needs to encourage an open environment. Employees should feel free to say negative things. If they don’t, it will be nearly impossible for the CEO to understand the company’s problems, especially as it grows at hyperspeed. The very fact that Reed was able to criticize Zuckerberg was an encouraging sign that Facebook had a culture of openness; and this became an element of his Hacker Way.