7 Powers

by Hamilton Helmer

  So a month later he launched BranchOut, a professional networking Facebook app. Marini went at this hard and by September had pulled together a $6M Series A round led by Accel Partners, Floodgate and Norwest Venture Partners with some notable tech firm execs joining the round as well.

  Recruiters want to make the best use of their time, so they go to the source with the largest number of listed professionals, while at the same time professionals want to list their names on the site with the most recruiters visiting. Such one-hand-shakes-the-other self-reinforcing upward spirals are known as Network Economies22: the value of the service to each customer is enhanced as new customers join the “network.” In such a situation, having the most customers is everything, and Marini knew exactly how this game was played: rapidly scale or die.

  Catch-up is usually impossible if there are Network Economies and LinkedIn already had 70M members. But Marini was betting that the game was not yet over. His idea was to build on Facebook’s base, which was almost 10x that of LinkedIn, enabling this with tools so that a user could seamlessly download all their information from LinkedIn. Marini positioned a Facebook tie-in as a key to better value:

  “Facebook has a strength of connection that LinkedIn doesn’t have. LinkedIn is someone you met at a conference. Facebook is your true support network.”

  Marini’s tactics seemed to get a lot of traction: users ballooned in Q1 2011 from 10,000 to 500,000. Armed with this hyper-scaling, Marini raised an $18M Series B round in May of 2011.

  It did not stop there. The company received numerous awards including selection amongst the FASTech50 for 2011. Monthly active users accelerated and investors poured in more money, bringing total investment to $49 million. LinkedIn’s wildly successful IPO on May 19, 2011, with the share price doubling in a day, seemed further confirmation that the space was hot.

  Users continued to grow rapidly, peaking around 14 million in the spring of 2012. But then, as the graph below details, the party ended and the numbers fell off a cliff. TechCrunch explained the collapse this way:

  Few of BranchOut’s users were truly engaged, and the recruitment search tool it planned to make money with never got serious traction. When Facebook banned the spammy wall post method, BranchOut’s churn quickly outpaced its growth and the company deflated. The train tracks were stripped out from under it.

  In September of 2014 Hearst acquired the assets and team of BranchOut, ending the company.

  Figure 2.1: BranchOut Monthly Active Users (millions, January 1, 2012–June 23, 2012)23

  The success of all three parties on this dance card, BranchOut, Facebook and LinkedIn, was predicated on users’ value of the service depending on the presence of others, the central feature of Network Economies. Their founders were fully aware of this business characteristic and aggressively and competently pushed tactics fully consistent with this understanding. Facebook and LinkedIn could co-exist because their respective networks were walled off from one another: users wanted to keep their personal lives (Facebook) separate from their work lives (LinkedIn). BranchOut hoped to build a bridge between the two, but it just didn’t fly. Users wanted this wall maintained, a lesson Facebook themselves learned in their failed rollout of Facebook at Work.

  Network Economies can result in high Power intensity and some great businesses are built on them: IBM mainframes, operating systems for Microsoft, Steinway Pianos and Exchange Traded Funds.

  The Benefit and the Barrier

  Network Economies occur when the value of a product to a customer is increased by the use of the product by others. Returning to our Benefit/Barrier characterization of Power:

  Benefit. A company in a leadership position with Network Economies can charge higher prices than its competitors, because of the higher value as a result of more users. For example, the value of LinkedIn’s HR Solutions Suite comes from the numbers of LinkedIn users, so LinkedIn can charge more than a competiting product with fewer participants.

  Barrier. The barrier for Network Economies is the unattractive cost/benefit of gaining share, and this can be extremely high. In particular the value deficit of a follower can be so large that the price discount needed to offset this is unthinkable. For example, “What would BranchOut have had to offer users for them to use BranchOut rather than LinkedIn?” I think most observers would agree that every user would have required a non-trivial payment, so the total spend for BranchOut would have been colossal.

  Industries exhibiting Network Economies often exhibit these attributes:

  Winner take all. Businesses with strong Network Economies are frequently characterized by a tipping point: once a single firm achieves a certain degree of leadership, then the other firms just throw in the towel. Game over—the P&L of a challenge would just be too ugly. For example, even a company as competent and with as deep pockets as Google could not unseat Facebook with Google+.

  Boundedness. As powerful as this Barrier is, it is bounded by the character of the network, something well-demonstrated by the continued success of both Facebook and LinkedIn. Facebook has powerful Network Economies itself but these have to do with personal not professional interactions. The boundaries of the network effects determine the boundaries of the business.

  Decisive early product. Due to tipping point dynamics, early relative scaling is critical in developing Power. Who scales the fastest is often determined by who gets the product most right early on. Facebook’s trumping of MySpace is a good example.

  This Benefit/Barrier combination allows me to place Network Economies on the 7 Powers Chart.

  Figure 2.2: Network Economies in the 7 Powers

  Network Economies definition:

  A business in which the value realized by a customer increases as the installed base increases.

  Network Economies: Industry Economics and Competitive Position

  Power insures the ability to earn outsized returns well into the future, driving up value. This is captured by the Benefit/Barrier requirement. As before in Chapter 1, I will use Surplus Leader Margin to calibrate the intensity of Power: “What governs the leader’s profitability when prices are such that the challenger makes no profit at all?”

  In the case of Network Economies, I assume all costs are variable (c), so the challenger’s profit is zero when the price equals these variable costs. The value the leader offers is greater than this by the differential network benefits it offers, and I assume they can bump up price to account for this.

  Surplus Leader Margin24 = 1 – 1/[1+δ(SN – WN)]

  Where

  δ ≡ the benefit which accrues to each existing network member when one more member joins the network divided by the variable cost per unit of production

  SN ≡ the installed base of the leader

  WN ≡ the installed base of the follower

  δ is a measure of the intensity of Network Economies: how important the network effect is relative to industry costs. This formula is of course stylized. In a real world situation like that faced by BranchOut, LinkedIn and Facebook, the value of the benefit of others on the network is more complex. For example, it would not be expected to be strictly linear: if you are a US college student on Facebook, another user in Ulan Bator is likely to be of far less value to you than the presence of one of your classmates.

  It was the hope of Marini and his investors that the δ of BranchOut would be driven by the absolute installed base leadership of Facebook rather than keyed to the more narrowly defined “professional” space installed base of BranchOut. It turned out that there was very little spillover. This meant that LinkedIn had an insurmountable advantage in this space.

  [SN – WN] is the leader’s absolute advantage in installed base. As you would expect, as this approaches zero, the Surplus Leader Margin also approaches zero, even if the industry has strong Network Economies. This equation also makes evident the tipping point outcome of Network Economies. As the installed base difference gets large, the pricing such that the follower has zero profits results in
very large leader margins (100% at the limit). This means a leader can price at very attractive margins while still pricing well below the breakeven point for the follower. The result is that a follower would have to price at a significant loss to offer equivalent value. As pointed out earlier, in BranchOut’s case it would not surprise me if users would have had to be paid (a negative price) to switch from LinkedIn.

  So once again I have parsed the intensity of a Power type into separate components: one reflecting industry economics (δ, the degree to which network economies exist in a particular business) and the other competitive position ( [SN – WN] ) within that structure. As noted in the last chapter, these need to be understood independently.

  Figure 2.3: Power Intensity Determinants

  Appendix 2.1: Derivation of Surplus Leader Margin for Network Economies

  To calibrate the intensity of Power, I ask the question “What governs profitability of the company with Power (S) when prices are such that the company with no Power (W) makes no profit at all?”

  The total network size (#users) ≡ N = SN + WN

  Where S is the strong company and W the weak company

  Suppose for simplicity the network effects are homogeneous; then S is able to charge a price premium:

  SP – WP = δ [SN – WN] where δ ≡ the marginal benefit to all users from one joiner

  There are no scale economies so

  Profit in a time period ≡ π = [P – c] Q

  with

  P ≡ price

  c ≡ variable cost per unit

  Q ≡ units produced per time period

  As an indication of leverage, assess:

  What governs S’s margins if P is set Э Wπ = 0?

  Some comments on Network Economies:

  There can be positive network effects but no potential for Power. The network effect δ needs to be large enough relative to the potential installed base and the cost structure for there even to be one profitable player as this fulfills the Benefit condition. If homogeneous network effects are the only value source, then if N δ < c, a firm cannot reach profitability.

  This is the problem I see often in Silicon Valley. If one supposes Network Economies then the strategy imperative is to scale much faster than anyone else—if another firm gets to the tipping point before you, then the game is over.

  However, ex ante it is often very difficult to have much assurance in sizing potential N and δ. So you are left with a situation that sometimes requires significant up front capital but an uncertain ability to monetize. This for example has plagued Twitter. Usually management gets the blame but we are back to Buffett’s observation: “When a manager with a reputation for brilliance tackles a business with a reputation for bad economics, the reputation of the business remains intact.”25

  Network effects can be very complex. As indicated earlier, however, there are many excellent treatments so I have been brief. A common twist I have not covered are indirect network effects (also called demand side network effects). If a business has important complements and these complements are somehow exclusive to each offering, then a leader will attract more and/or better complements.

  As a result the entire value proposition to a customer is improved (increasing SLM for example).

  An example of this would be smartphone apps. Another smartphone OS would be hard to offer at this point because it would start out with a dearth of apps. This would make it very unattractive. Developers of apps would of course not be incented to spend their scarce resources since the market would be small.

  Note that in this case the contribution of additional complements is not linear.

  C H A P T E R 3

  COUNTER-POSITIONING

  SCYLLA AND CHARYBDIS

  Bogle’s Folly

  This chapter introduces Counter-Positioning, the next Power type. I developed this concept to depict a not well-understood competitive dynamic I often have observed both as a strategy advisor and an equity investor. I must confess it is my favorite form of Power, both because of my authorship and because it is so contrarian. As we will see, it is an avenue for defeating an incumbent who appears unassailable by conventional wisdom metrics of competitive strength.

  The case that I start out with is just such a contest, Vanguard’s assault on the world of active equity management. Everyone now knows Vanguard as the poster child for low-cost passive index funds by which they have become one of the largest asset managers in the world. But their founder, John C. Bogle, faced a very different world at the inception of Vanguard, a world in which active equity management ruled the day. So, to our story.

  On May 1, 1975, John C. Bogle carried the day by persuading the reluctant Wellington Management board to back Vanguard. Vanguard’s charter was radical: the new investment management company would initiate an equity mutual fund that simply tracked the market, dispensing with any pretensions of active management. Not only that, but it would also operate “at cost”—owned by the funds it administered, paying all returns back to shareholders. The following year, the third innovation was put in place: Vanguard became a no-load fund—one with no sales commissions.

  Creating something really new in business is challenging in the best of times. Vanguard was no exception; its gestation period was attenuated and its birth painful. Bogle traces its roots as far back as his Princeton senior thesis, penned twenty-five years before, in 1950. In 1969, when Wells Fargo began pioneering index funds, Bogle took note. He also drew inspiration from foundational academic work, in particular Paul Samuelson’s seminal 1974 piece for The Journal of Portfolio Management, in which the Nobel Laureate in Economics envisioned a fund that would enable investors to simply track the market.

  Bogle attracted prominent underwriters, and the fund launched in August of 1976. You could charitably describe the reception as unenthusiastic: only $11M trickled in from investors. Soon after the launch, Samuelson himself lauded the effort in his column for Newsweek, but with little result: the fund had reached only $17M by mid-1977. Vanguard’s operating model depended on others for distribution, and brokers in particular were put off by a product that was predicated on the notion that they provided no value in helping their clients choose which active funds to select.

  Swimming against the riptide of self-interest in the investment business is not for the faint of heart, but Bogle’s bull terrier grip on his new business model was implacable, and he vigorously enjoined the battle. Of course, Vanguard, by design, possessed a fundamental advantage in the iron law of active management: the average gross return of active funds has to equal the market return, and since their expenses are substantially higher than passive funds, their average net returns will always be less than those of passive funds. Complementing this is the lack of significant serial correlation of returns in active funds’ ability to best the market—this year’s winner has little advantage for next year. Inevitably the outcome of this is that active funds are on average a loser’s game as indicated by the chart below.

  Vanguard’s inauspicious starting capital was followed by modest growth in assets. A merger with Exeter helped, and bit by bit the company achieved respectable scale, as the chart below indicates. Still, more than a decade would pass before Vanguard reached full escape velocity. Once it did take off, however, the upward arc was stunning with assets under management exceeding $3T by the end of 2015.

  Figure 3.1: Share of Actively Managed US Equity Funds that Beat the US Equity Market26

  Figure 3.2: Vanguard Assets Under Management (1975–2015)27:

  Fueling the fire, too, was the advent of exchange-traded funds (ETFs), which more often than not mimicked the low cost and passive approach pioneered by Vanguard. What had started as a trickle now became a torrent: as the chart below indicates, in the 7 years from 2007 to 2013, actively managed mutual funds gave up $600B while ETFs and domestic equity mutual funds gained more than $700B.

  Figure 3.3: Cumulative Investment Flows by Fund Type28

  Counter-Positioning: the Be
nefit and Barrier

  There are few occurences in business as complex as the emergence and eventual success of a new business model. Think of the diverse circumstances attending Vanguard’s rise: huge and successful incumbent active mutual funds, a committed entrepreneur, an advancing intellectual frontier, fast-improving computer technology, entrenched channel disincentives, consumer misinformation, and so on.

  In situations like this, it falls to the strategist to carefully peel back the layers of complexity and eventually seize upon some irreduceable kernel of insight amidst the competitive reality.

  To understand the ascendancy of Vanguard, I must first note these characteristics:

  An upstart who developed a superior, heterodox business model.

  That business model’s ability to successfully challenge well-entrenched and formidable incumbents.

  The steady accumulation of customers, all while the incumbent remains seemingly paralyzed and unable to respond.

  These elements were not unique to Vanguard—they were pieces of an oft-repeated story. Think of Dell vs. Compaq, Nokia vs. Apple, Amazon vs. Borders, In-N-Out vs. McDonalds, Charles Schwab vs. Merrill Lynch, Netflix vs. Blockbuster, etc. But nearly always, these featured the same outcome: the incumbent responds either not at all or too late.

  These victories aren’t born of happenstance, of course; they are strategic, and the upstarts usually succeed in creating a lot of value for themselves, while severely diminishing that of the incumbents.

  Returning to our Benefit/Barrier characterization of Power: