Connected Strategy

by Nicolaj Siggelkow

  As a manager of a business, you often think about your supply chain. You buy components, manufacture your product, and sell it to retailers who sell it to consumers. Unfortunately, there are only so many degrees of freedom in this supply chain—only so many parties you could go to for revenue. Or are there?

  Recent research in strategic management has moved the focus from the supply chain to the ecosystem. The ecosystem is much broader and includes all firms or other organizational and individual entities that have some interest in your product. To figure out which entities are in your ecosystem, ask yourself, “Who else would derive value from our connected toothbrush?” For this product, the list might include entities such as the following:

  Insurance companies paying for dental care

  Dental practices that understand that the new brush means potentially fewer cavities and the need to be on the toothbrush’s list for referrals

  Toothpaste companies

  Parents who are concerned about their children’s brushing habits

  Consumer product companies that would love to learn about the habits of consumers

  Comcast, Verizon, and other carriers that are happy about almost anything that consumes bandwidth

  Many of these companies would benefit if the Smart Connect XL3000 succeeded. In other words, they might be willing to share with us some of the value they get from our existence.

  There have been numerous examples in which firms provided a connected product or service to their customers and made their revenue from other sources besides charging the customer. Examples include the following:

  Many of the peer-to-peer network apps that we discussed in chapter 7 are free to customers. Some companies occupy two positions in the ecosystem: they are the organizer of the peer-to-peer network and the producer of a complementary product that is used in this network (example: Nike running shoes).

  In the world of connected security, insurance companies subsidize the installation of advanced fire alarms. Similarly, car insurance companies offer discounts for drivers who are willing to have their driving monitored.

  In the world of personal fitness, many gyms now get more revenue from insurance companies than directly from the users sweating on their treadmills.

  Principle 4: Get Paid as Value Is Created

  For most products or services, customers derive benefit over time. You buy a car and drive it for years. You buy running shoes and run five hundred miles in them. In the traditional episodic relationship, however, payment typically happens upfront in one chunk. You could send Nike fifty cents every time you go running, but it’s likely neither you nor Nike wants to do that. More specifically, Nike would not trust you enough to give you a pair of shoes upfront without a payment guarantee in place. And you might not like the idea of sending Nike a payment every time you go running unless it was automated.

  In a connected relationship these problems disappear, and the result is a victory over limited trust and frictional inefficiencies in payment. When your shoe talks to your phone and your phone connects to your bank account, you could pay Nike ten cents per mile. This is the pay-as-you-go model.

  The world of hardware and software has seen a big shift from huge upfront transactions to pay-as-you-go models. Many firms no longer buy huge servers anymore, instead paying for “infrastructure as a service” from providers such as IBM or Amazon Web Services, paying on a per-use basis by the hour, week, or month. The key value for customers is a reduction of risk. Customers are never out of capacity, nor do customers have any idle capacity. They also have no upfront equipment or maintenance costs, which may be prohibitive for small companies that need cloud services. Another revenue model option is “platform as a service,” which is priced per application or per gigabyte of memory consumed per hour. Platform-as-a-service providers include Google and Microsoft.

  Similarly, software has moved in many cases from a model of purchasing and installing it on local machines to “software as a service,” where customers pay based on features and use. Firms like Salesforce and Netsuite have adopted this revenue model.

  Related to pay-as-you-go models are “freemium” models, where firms provide a basic model for free and charge for access to premium versions of their product. Dropbox and LinkedIn are examples. The free version attracts customers, while the premium version (“Ran out of storage space? Upgrade!”) is used to drive revenue. Freemium models must find the right balance between giving away enough features for free to attract customers (especially when customer benefits increase with network size, as with LinkedIn) and retaining significant improvements in the premium versions to persuade at least a fraction of the customers to upgrade. Many newspapers and some magazines with an online presence have gone this route as well. A certain number of articles can be read for free each month, then customers must subscribe to access more content.

  What makes many freemium models feasible is the ability to manage micropayments efficiently. With the advent of smartphone apps, in-app purchases have made the micropayment model seamless. Many apps start out as free for users, offering basic services or experiences before prompting the user to unlock premium content by spending a small sum. In China, for instance, Tencent introduced QQ Show, which allowed users to design their own avatar that could be used not only in the instant messenger of the QQ app but also for the group chat, gaming, and dating functions within the app. The customization options included appearance, virtual clothing, jewelry, and cosmetics. These items could also be purchased as a gift for other members. Each item only cost a few RMB (pennies in US currency) but created a significant revenue source for Tencent, given its more than eight hundred million active users on QQ. (For more on Tencent, see the sidebar.)

  One of the biggest sectors for micropayments is video game development. Gamers buy virtual currency with real money and spend it to upgrade their characters, buy special weapons, access hidden levels, and speed progress in the game. While individual purchases can be small (as little as ninety-nine cents), aggregate purchases can be staggering. It has been estimated that the free mobile game Clash of Clans has earned more than $3.5 billion through in-app purchases (of products that practically have zero cost of production).

  Micropayments also allow peer-to-peer networks to create payments across members. Da shang, or virtual tipping, is an increasingly popular form of micropayment for Chinese netizens. For websites or social media platforms that support this function, viewers can choose to virtually tip content creators when they are wowed by the experience. Places that have adopted this format include blogs, video sites, and various social media platforms such as WeChat. The model encourages content creators to put up quality content for free, hoping to recoup the development cost through tips.

  WECHAT: THE OPERATING SYSTEM FOR LIFE IN CHINA

  WeChat, an app owned by the Chinese company Tencent, originally started out as a messaging system. It has evolved into an all-encompassing app that allows its users to have group chats, make calls, post personal news (including text, images, or videos), read news, order food, make doctor appointments, hail cabs, pay merchants, send money to friends, play games, and much more. Functionality is expanded by more than 580,000 mini programs that work similarly to separate apps but are housed within the WeChat app. WeChat now has more than nine hundred million daily active users spending more than an hour on the app on average. What makes Tencent as a company different from Google, Facebook, and other players is that most of its revenue stems from value-added services rather than from advertising. While Google derives more than 90 percent of its revenue from advertising, Tencent derives more than 80 percent of its revenue from micropayments for services such as in-app purchases within online games or fees for using the WeChat pay function.

  Whether it’s a freemium model or a micropayment method, they both capture one idea: get paid at the same time as your product or service creates value for your customers, because at that time, customers are often quite happy to pay.

  Principl
e 5: Reinvest Some of the Created Value into the Long-Term Relationship

  As we have seen, one great benefit of connected strategy is that you engage with your customers in a long-lasting relationship. From an economic perspective, that means the firm does not have to compete for every transaction with each customer. This translates into lower discounts and less spending on customer acquisition costs in sales and marketing. At the same time, value is also generated for the customers who no longer need to engage in costly and inconvenient searches and are provided with highly personalized offerings.

  To create a sustainable advantage, it is important that at least some of the value that is created is reinvested, strengthening the repeat dimension of the connected strategy. Rather than taking the value and simply handing it back to the customer, as is done in traditional loyalty programs, the firm should seek to increase the level of customization it can provide. As we discussed in chapter 5, we can use the value created by connectivity to move further up the hierarchy of needs of our customers and establish our firm as a trusted partner.

  At the level of a trusted partner, we are granted the authority of handling a broader need, be it oral care (the Smart Connect XL3000), education and career management (recall the example of Lynda.com), or wealth management. This responsibility is coupled with ongoing compensation, as illustrated by these examples:

  The original benefit of becoming an Amazon Prime member for a yearly fee was free two-day shipping on many items sold by Amazon. Over time, Amazon has reinvested and increased the benefits to include access to Prime Video (including licensed and original content), Prime Music, Prime Reading, photo storage, and other features. Each of these additional services increased customer value and the information that Amazon received about its customers, allowing it to further personalize its offerings and to increase customer loyalty. In 2018, Amazon Prime exceeded one hundred million members, counting half of all US households among them.

  As a result of repeated interactions, subscription services can curate and contextualize based on the learned customer’s preferences. Birchbox, a monthly beauty products subscription service, invests its created value in data and analytics to analyze what customers value most highly in order to better serve them with future products. This leads to lower churn rates, increasing the lifetime value of a customer and the ability to dedicate additional spending, which creates a positive feedback loop.

  Principle 6: Be Cautious When Replacing Cash Payments with Data Payments from Users

  Several of the most successful connected strategy companies have a seemingly odd revenue model: giving away their product. Google doesn’t charge for searches or Gmail; Facebook and LinkedIn do not charge you to become part of their networks; and TripAdvisor does not charge you to find the most popular attractions in cities around the world. But obviously, nothing is free. Users of these sites do not pay with their money; they pay with their data.

  Somebody searching for the term spine surgery on Google is very likely to have back pain. Spine surgery is a very profitable product line for hospitals and private practices alike, so knowing that Joe Miller in Chicago is looking for spine surgeries is something that health care providers are willing to pay for. How much? With the clearing price for most Google AdWords costing pennies per click, it is notable that those concerning medical needs currently stand at around forty dollars per click.

  As this example shows, one key revenue stream can come from advertisers, who can use the data to create more targeted and more effective advertising campaigns. For instance, navigation apps such as Waze do not make money by charging their users. Instead, they harvest user location data to display the most relevant location-based ads within the app. This determines what shops, restaurants, and other small businesses you see on the map as you drive.

  Another key revenue stream can come from referral fees. For instance, Mint offers the convenience of managing all of a customer’s personal finances in one place. While it is free to use, Mint generates revenue based on referrals made to consumer product companies or financial institutions that sell financial products or credit cards. It also derives revenues from the aggregation and distribution of user data. Although unique identifiers are removed to preserve individual confidentiality, the pool of real-time financial data has tremendous value in assessing consumer trends.

  The almost irresistible psychological attraction of free products, coupled with the opacity of what data is collected and how it is used, often obscured in long terms-and-conditions statements—“click here to accept”—has led to a veritable gold rush of firms trying to collect as much data as possible through whatever means available. Firms often collect data with the sole purpose of reselling the information. It seems like the Wild West out there. To us, this development does not appear sustainable in the long run … and we would be very glad if that turned out to be the case. It is not hard to imagine that rising societal concerns over privacy, coupled with technological solutions that provide customers with much more control over their own data, will create a higher burden of proof for the feasibility of revenue models that are solely based on paying with data. We can imagine that in the future, privacy settings will be moderated and negotiated by customer-owned software that sits between the customer and the various data-gathering apps, rather than being hidden within the various apps. At that point, customers will have the ability to release their personal data slice by slice if they see true value in doing so. Until this technological solution is available, we can only caution firms that want to use the reselling of data as their main revenue stream. To create a truly sustainable revenue model will require firms to navigate a minefield that is constantly shifting.

  First, as we have discussed before, the goal of a connected relationship is to become a trusted partner to the user, requiring a much higher degree of trust than necessary in a traditional episodic interaction between customer and firm. For this, we propose, a firm needs to help customers understand the price they pay, even if this is not a monetary price but rather only in the form of data. Paying through data can yield value to both parties, but it has to be transparent to the customers what happens with the data they provide.

  Second, several technology experts recently have proposed to replace the pay-with-data revenue model with a pay-for-data model. The argument is that customers should not only be rewarded for their user-generated content, such as teaching Google how to recognize the human voice and collecting traffic data in the connected car by getting a free product or service, they should receive a cash compensation on top of this. Though the price of data ultimately should be shaped by market forces, the almost unlimited appetite for data of artificial intelligence–based businesses makes the idea of paying customers for their data at least an interesting twist to the revenue model. For instance, it has been estimated that Facebook’s Instagram is worth some $100 billion and that its users have uploaded twenty billion photos. The following calculation is not meant to be scientific, but the numbers tell a story: a $100 billion valuation for twenty billion user-generated pictures—that equates to $5 per picture. Shouldn’t those who took these pictures get a part of the pie? True, Instagram has done much more than just accumulate photos. Nevertheless, more and more technology experts have raised the question of to what extent users should be compensated for the data they provide.

  Third, when customers pay with their wallet, jurisdictional questions—for example, tax implications of such transactions—are fairly clear. When customers pay with data, this becomes much more complex. Suddenly, questions such as where the data is processed and where it is stored matter a lot, as reflected by the 2018 implementation of the European Union’s General Data Protection Regulation, which applies to all companies processing the personal data of customers residing in the European Union, regardless of the company’s location.

  As you are creating your connected strategy—whether selling data becomes part of your revenue model or data collection is used purely to extend your own relat
ionship with your customers—you need to deal with these issues actively. Given how quickly this field is changing, you have to keep abreast of rapidly changing regulations and update your answers frequently.

  Six Principles for Designing Revenue Models in a Connected Strategy

  We opened this chapter by asking you about the right price for a connected product. Our discussion in the remainder of this chapter emphasized that creating a good revenue model is more than what is suggested by the word pricing. Instead, designing a revenue model is based on identifying the various players in the ecosystem, understanding their (typically conflicting) objectives, and leveraging technology, all with the objective of maximizing value.

  Value is maximized when the corrosive forces of limited information, limited trust, and transactional friction are overcome, which plays to the strengths of a connected relationship. In this chapter, we have articulated a set of principles that will help guide you in the design of your own revenue model:

  Think value creation first.

  Make pricing contingent on performance.

  Remember the ecosystem is broader than the supply chain.

  Get paid as value is created.

  Reinvest some of the created value into the long-term relationship.

  Be cautious when replacing cash payments with data payments from users.

  How can these principles be implemented? The workshop that follows the next chapter will provide you with exercises to help you use these principles to create the revenue model that’s right for your business.

  9

  Technology Infrastructure for Connected Strategies

  Advances in technology are critical to connected delivery models. How should we think about the enormous opportunities technology presents? Do you need to be a technology expert to create a connected strategy? This chapter aims to guide you through that maze. Rather than offering a comprehensive catalog of technologies that inevitably will date quickly, we provide a framework for thinking about connected technologies so that you can design and implement your connected strategy. We discuss specific technologies to illustrate general principles and illuminate what we hope is a more timeless perspective.