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My Congressional Testimony on Internet Music Licensing

I was invited to testify in front of the IP/Competition/Internet Subcommittee of the House Judiciary Committee on the state of internet music licensing. I presented the following testimony today:

Testimony of David B. Pakman
Partner
Venrock

U.S. House of Representatives Committee on the Judiciary
Subcommittee on Intellectual Property, Competition and the Internet
Hearing on “Music Licensing Part One: Legislation in the 112th Congress”

November 28, 2012

Chairman Goodlatte, Congressman Watt, and Members of the Subcommittee:

Thank you for inviting me to testify today regarding the state of internet music radio licensing. I am a venture capitalist with the firm Venrock. We invest in early stage internet, healthcare and energy companies and work to build them into successful, stand-alone, high-growth businesses. We look to invest in outstanding entrepreneurs intending to bring exciting new products to very large and vibrant markets. Our firm has invested more than $2.6 billion in more than 450 companies over the past 40 years. These investments include Apple, Athenahealth, Check Point Software, Intel and DoubleClick.

Although I was previously a multi-time entrepreneur in the digital music business, we are not currently investors in any digital music or internet radio companies.

As venture capitalists, we evaluate new companies largely based on three criteria: the abilities of the team, the size and conditions of the market the company aims to enter, and the quality of the product. Although we have met many great entrepreneurs with great product ideas, we have resisted investing in digital music largely for one reason — the complications and conditions of the state of music licensing. The digital music business is one of the most perilous of all internet businesses. We are skeptical, under the current licensing regime, that profitable stand-alone digital music companies can be built. In fact, hundreds of millions of dollars of venture capital have been lost in failed attempts to launch sustainable companies in this market. While our industry is used to failure, the failure rate of digital music companies is among the highest of any industry we have evaluated. This is solely due to the over-burdensome royalty requirements imposed upon digital music licensees by record companies under both voluntary and compulsory rate structures. The compulsory royalty rates imposed upon internet radio companies render them non-investible businesses from the perspective of many VCs.

The internet has delivered unprecedented innovation to the music community and allowed more and more artists to be heard unfiltered by the incumbent major record labels and terrestrial radio stations. I believe more people listen to a more diverse set of music today than ever before in our time. However the companies trying to deliver these innovative services are unsustainable under the current rates and frequently shut down once their investors grow tired of subsidizing these high rates and elusive profits fail to arrive at any scale. Pandora is a company that has done an amazing job of trying to make their business work at the incredibly high rates under which it currently operates — but their quarterly earnings reports make abundantly clear why they are virtually alone in this category. Regretfully, I cannot point to a single stand-alone business that operates profitably in internet radio. In fact, in all of digital music, only very large companies who subsidize their music efforts with profits from elsewhere in their business currently survive as distributors or retailers of music.

There was a time when the record companies were part of conglomerate media companies which also distributed and licensed the music they controlled. These joint “owners” and “users” of music appreciated the need for healthy economics on both sides of a license. Once the internet emerged, new distributors or “users” of music grew outside of major label ownership. Perhaps in response to their failure to prosper as internet distributors of music, the major labels took a short-term approach and refused to license their music on terms that would allow the “music users” to enjoy healthy businesses. To this day, more than 15 years since I first entered the digital music business, I remain baffled by this practice. In my opinion, it is in the long-term best interest of music rights holders to encourage a healthy, profitable digital music business that attracts investment capital, encourages innovation, and indeed celebrates the successes of the licensees of its music. A healthy future for the recorded music business demands an ecosystem of hundreds or even thousands of successful music licensees, prospering by delivering innovative music services to the global internet. Yet the actions of the RIAA seem counter to this very goal. They have appeared on the opposite side of every issue facing digital music innovators, opposed to sensible licensing rates meant to achieve a healthy market. Regretfully, and perhaps most upsetting to all of us, the artists are the ones who suffer most. They depend on the actions of their labels to encourage a healthy market to grow and have little influence on the decisions of the RIAA.

I am a believer in the value of open and unfettered markets and generally prefer market-based solutions. Unfortunately, the music industry is controlled by a mere three major labels, two of them controlling about two-thirds of all record sales. That amount of concentrated monopoly power has prevented a free market from operating and letting a healthy group of music licensees thrive. That said, I do believe there has been great value in compulsory licensing regimes such as the one governing internet radio. This structure has allowed internet radio companies to license the catalogs of all record labels and tens of thousands of independent artists, not just the dominant majors, bringing unprecedented exposure and revenue to the vibrant long tail of indie music — often where music innovation itself gestates.

The problem is simply that the rates available to internet radio companies under this compulsory license are too high. They frighten off investment capital, prevent great entrepreneurs from innovating, and kill off exciting attempts to bring great new music services to consumers. American entrepreneurship and innovation require vibrant markets unburdened by artificially high rate structures. I am hopeful you will see through the rhetoric often employed in this debate and make sensible policy based on sound economics. I would like nothing more than to invest in the many entrepreneurs we have met who have great ideas about the future of music. With a sensible rate structure in place, our focus on this market could return.

Please note: the views expressed herein are my own and are not necessarily those held by Venrock or other individual partners at the firm.

Dollar-Shave-Club

Dollar Shave Club − The Power of Asymmetric Marketing

Today we announced our investment in Dollar Shave Club, a consumer subscription service focused on men’s grooming. I am honored to be joining the board of the company Michael Dubin has so successfully introduced to the world.

eCommerce companies can be challenging for venture investors. They tend to require lots of capital and usually have low multiples. There are a few cases where outliers can emerge. In subscription commerce, a few rules have to be met for large companies to be created. First, the market must be enormously large. Subscription, by its very nature, usually appeals to a subset of any market it aims to serve. Consumers must intend to make a long-term commitment to a brand in order to subscribe and must not tire of of the service. My experience running eMusic taught me the key metrics to look for in subscription models in order for large companies to be built. Churn rates must be very low. If your average customer leaves after, say, nine months, a large company cannot be built. Your average customer must stay in the service for many years. Think cable, satellite radio, and Netflix. These companies have average monthly churn rates of less than 3%. In the razor market, brand loyalty is measured on the order of twenty-five years. You generally can acquire a customer for a lifetime. And that is exactly what Dollar Shave Club aims to do.

Even more exciting, however, is how Michael sets out to build the brand. He believes that brands are now publishers and must market themselves largely through content. His overwhelmingly successful launch video, viewed more than seven million times, instantly went viral and jointly conveyed the brand personality and the benefits of the service deftly. In this age where social media dominates our collective conversations, we believe very large brands can be built without the widespread use of paid traditional media. It will take several years for the incumbent CPG companies to master these new marketing arts. In the meantime, companies like DSC emerge and get very large despite the massive spend of the traditional guys. We refer to this as asymmetric marketing — no matter how much money spent by the incumbent, the new brand can still become very large for tiny fractions of that spend.

Michael and his fine team have exciting plans. They look to build an enormously successful men’s lifestyle brand. I hope you’ll give Dollar Shave Club a try. I loved the product so much, I invested in the company. ;-)

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Who Holds the Power in Media − Content or Distribution?

On Friday night, Chris Dixon (@cdixon), Jonathan Glick (@jonathanglick), Peter Kafka (@pkafka), Todd Sawicki (@sawickipedia) and I had a conversation on Twitter about media concentration and where the power lies these days. It was inspired by an Erin Griffith (@eringriffith) post called “Spotify’s Best Chance at Beating the Digital Streaming “Suicide Pact” Is With Ads.” Chris assigned me the homework of blogging about it, so here goes.

Typically, as a distributor gains scale with lots of customers, we expect market power to accrue to them and provide them negotiating power over rights and rates of content from the content owners. As we will see below, this is true in some forms of media, but not in others. What types of media are more prone to distributor power? Jonathan offers us a framework:

  • Content tends to be more fungible and less likely to benefit from concentration when it takes less time/cost to create a hit, the value of a hit is in decline, many substitutional offerings exist, aggregators have existing strong market power, and/or a strong motivation exists for self-publishing.
  • Content tends to be less fungible and offers concentrators great benefit when it takes significant time/cost to create a hit, the value of a hit is increasing or sustained, there are few substitutions available (by regulation, uniqueness or otherwise), aggregators have low value, and/or content creators have strong and sustaining brands.
  • A shift seems to occur allowing distributors to amass power when a disruption materializes in the format/form of the media object itself (usually the new object has higher volume, velocity, virality). Some recent examples, perhaps, are YouTube clips, Tweets and Kindle singles.
  • Any media that’s worth owning is worth concentrating and there will always be capital available to do so. Only limit is regulators, until a format disruption occurs.

Let’s examine the state of many top media categories.

Music

One assumption many people have made about Spotify is that, while their current economics as provided to them by label licensing rates are essentially unsustainable, once they reach scale, they will have leverage over record labels and will be able to reduce their on-demand royalty rates. The reason this won’t happen is because of extreme continued concentration of supply. In 1999, when Napster was the harbinger of the demise of the recorded music business, there were six major labels who controlled about seventy-five per cent of the commercial recorded music market. With the EU’s recent approval of UMG’s purchase of EMI, there are now only three major labels. They control about seventy per cent of the world’s music catalogs. Indies have made a good run, and have grown in importance, but the world’s superstars are, for the most part, on major labels. And you just can’t operate a digital music retailer at scale without hit music content. I tried, when I ran eMusic for five years. We were the largest online retailer of indie music, but only reached about a half a million subs at our peak and came to believe that we could never be significantly larger than that without major label content.

So, suppose Spotify reaches 50M listeners and 10M paid subs? Or even 50M paid subs? Will they be able to demand better rates? No. Because they don’t have a service without the full catalogs from those three majors. If even one of them pulled their catalog, at least twenty per cent of all Spotify’s content would disappear. All the playlists on the service would break. And a third of the hits would be gone. Paying consumers would never stand for it and the service would crumble. The labels know this. They know they have fully concentrated power. In fact, I would bet that if Spotify ever reaches that scale, the majors will demand even higher rates, and they may be able to get them. Highly concentrated popular content allows owners to extract unprofitable rights deals. Even though Spotify is building listener scale, the absolute dollars they pay to labels still small, given that streaming rates are very low per play.

Does this mean Spotify has no future? That’s a different discussion, and my view is they do, if they diversify into other content types. But the music business for them will be, at best, a twenty per cent gross margin business (it was two per cent last year), and that is tough. (Remember, even Apple, the world’s largest music retailer did not have leverage to hold rates steady and gave in to rate increases imposed by the majors.)

So, in music, the power is in the hands of the content owners, not the distributors. Will this change? Will there be fragmentation among ownership? I hope so, and it is conceivable, but the amount of time it will take for a highly fragmented market to occur could be 10 – 50 years. At this rate, we will likely have two major labels within the next three years.

TV

I blogged about Hunter Walk’s view that TV content sits in three main buckets, No Substitute, Nice to see, and Filler. If you want to be an MVPD, you must have the No Substitute and the Nice to see content. Sure, you could try to operate a service without the Filler, but that is not how programming is sold. It’s sold by the channel, and each channel has its mix of each of the three tiers above. (Actually, it is sold as a package of channels, to be more precise. If you want MTV, you must also take Logo, etc.) Whenever an MVPD gets in a rate dispute with a programmer and the channels get pulled, the customers go crazy, put huge pressure on the MVPD, and start switching services. The MVPD generally gets beat. This is why Comcast bought NBC…to finally have some hedge protection against the power continuing to concentrate in the hands of the programmers. So, in traditionally delivered TV, the power is in the hands of programmers. I am told the NFL Sunday Ticket deal leaves DirecTV with essentially no margin in ways similar to online music rights deals.

How might this change? Well, one scenario is that the rise of IP-delivered TV programming (Netflix, Amazon, Apple TV, YouTube, etc.) breaks the channel model back into shows, since that is all we care about as consumers. In that case, the supply is quite fragmented. You can operate an IP-delivered video service without all the content (in fact, all of them do today, since none of them offer a package as complete as an MVPD). The challenge here is that the programmers are pricing their hit content in such a way as to make it economically challenging for you to assemble all of your shows on-demand, and/or they are withholding key programming from IP delivery unless you authenticate as a paying MVPD subscriber. Note that YouTube is attacking this market differently, and is going after the time we spend watching Filler programming. I think they will succeed.

News

In this category, supply is highly diversified. Content is highly substitutional. While important brands exist here, and we show a preference for many of them, the power exists in the hands of the distributor. Audience size brings increased revenue (whether ad-supported or consumer paid). This content category is highly fungible. A storm-is-a-brewing because of social media, however. Many prominent writers (and ones less so) are building enormous social media brands sometimes bigger and more loyal than the audience size of the news distributors themselves.

Books/eBooks

As Benedict Evans (@benedictevans) points out, there is considerable diversity on the supply side here, with many book publishers and one dominant eBook distributor today in Amazon. In traditional book retailing, there is less of an all-or-nothing phenomenon  It is possible to create retailers without complete book catalogs. Nevertheless, a hit dynamic happens here too, and it’s hard to be a leading seller of books/eBooks if you don’t carry Harry Potter or whatever 4-5 titles dominate the bestseller lists. Today, in eBooks, Amazon has the balance of power and is certainly exercising it on pricing. Publishers hope Apple and B&N pose some competition here.

 

Generally, we expect the distributor to have power when supply is highly fragmented, and most media follow that axiom. While the internet has allowed a massive diversity of publishers and contributors to enter the market, big media ownership of “hit” content has been consolidating to extend their grip on pricing in the short-term. It’s reasonable to expect, however, that more and more “hits” will come from outside the consolidated super-structure. In TV, one could argue that nothing stops Netflix from buying high-end video programming direct from content creators, for example. But in the last few years, the networks (who often own/fund production companies) have worked hard to prevent this from happening and try to extract full value from their content before it gets into Netflix’s hands. In written media, super-blogs employ well-established mainstream writers. And in music, Adele is signed to an indie. But where hit media remains consolidated, media giants will exercise leverage.

 

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Not All Traffic Is Created Equal

To build the online media giants of tomorrow, companies need models where the costs of both content and distribution are near zero. Google, Facebook, Twitter, Instagram, Pinterest and countless others employ this model. These models allow scale to emerge at very low-cost. And in these particular examples, the scale achieved is astronomical — on the order of hundreds of millions or billions of users. In thinking through how to build businesses around this scale, a lens emerges: what kind of traffic produces that scale? In the case of social media companies like Facebook, Twitter, Instagram, Pinterest and Tumblr, the root activity on the site is the sharing of content. But the content shared on those sites differs widely, particularly around which content attracts the most engagement. Broadly, Facebook attracts photo sharing and light-hearted personal content. Twitter responds far better to true news and topical information sharing. Tumblr seems to resonate around entertainment and creative media. And Pinterest lights up around home design, apparel, food and other commercial items. (I am taking some liberties by generalizing, but you get the point.) At the scale of Facebook, you could have your users share almost anything and still be able to build a large business, purely by loading the site up with lots of advertising that is (at very least) rudimentary targeted. At that scale, you can reach billions of dollars in revenue. And I believe, even at their scale, their ad load will need to further increase (along with their targeting abilities) in order to signficantly grow the business. (They also must move advertising off-site, as they are now doing, which I detail in this post.) But if your service attracts particular verticals of content engagement, not all content is created equal, and some is much more valuable than others. I divide traffic/content engagement into three buckets: topical, informational and transactional.

  • Topical content engagement is what is mostly taking place on Facebook, Tumblr and Twitter. It is comprised of posts generally linking to news, information, family, entertainment, photos, etc. The signal in this stream is the lowest of the three in terms of monetizeable traffic.
  • Informational content, often found on sites like SlideShare, Zillow and automotive blogs is the sharing of information that is near the top of the funnel for demand creation. Things like business white-papers or product reviews are perfect examples of informational traffic. This traffic has significantly more value than topical traffic, and excels at attracting endemic advertisers in the key verticals of travel, auto, tech, financial services, real estate and pharma, to name a few. Intent is well understood in this traffic and the signal is strong.
  • Transactional content is traffic that is essentially one click away from a purchase. Obviously, traffic found on ecommerce sites is the prime example of this and search traffic is a close second, but increasingly Pinterest is proving itself to be a massive source of high-converting traffic. Here, intent is clear and the signal is strongest.

I believe, with the Facebook share price correction, we are entering a period where sites based on topical content traffic are going to struggle in generating value for themselves. Much of the valuations around the consumer web are rationalizing, and because of that, investors are once again focused on understanding business models. Social media properties building traffic around informational or transactional content will be significantly more valuable than topical ones in this forthcoming period. This general notion that every social property with scale will be able to create their own custom “social ad” units and monetize themselves consistent with their earlier valuations, I think, is flawed, unless those properties are in the two higher tiers of content.

How to Hackathon

A traditional and effective way to launch software platform companies is to recruit early developers and host hackathons. Singly, the social data platform company did just that on June 3rd in San Francisco. Singly offered a grand prize of $10,000 to whomever created the most creative and interesting app based on the Singly API. The response was fantastic. They had more than 200 developers attend the 48 hour hackathon in person and more than 20 apps submitted at the end of the weekend. Somewhat surprising to many of us, a bunch of teams were working on apps during the weekend but were not physically in attendance. They showed up at the Sunday 5pm deadline with completed apps, working with our dev teams in the IRC chat rooms.

As important as it is to attract developers to a platform, demonstrating responsiveness to their needs is key. During the 48 hour hackathon, the Singly team re-deployed the API more than 25 times based on bug fixes and feature requests. This was truly development in real-time.

At the end of the 48 hours, 6 judges (including yours truly) evaluated the apps and picked a bunch of exciting winners. It was amazing to see so many apps born in such a short time. Congrats to Yard Rush and all the winners!

The team has a great blog post up about how they did it and what they learned.

A quick video of the entire experience is above.

The Pressure on TV Networks, Ari Emmanuel and Cable Companies

Lots of recent discussion on TV and Hollywood. Ari Emmanuel accuses Google (again) of aiding and abetting pirates. Henry Blodget writes a nice piece on the changing TV viewing habits of consumers. Dan Frommer says those changing habits won’t really affect the MSOs and Networks anytime soon. And Jeremie Allaire seems to claim that Apple’s next move in TV will be to emulate TiVo’s (largely failed) box/cable-card strategy (but correctly points out the disruptive power of AirPlay). Oh, and Sean Parker launched version one of AirTime.

I wanted to add a few points to the discussion about the pressures on the TV industry. First, some basic observations:

TV programming is not homogenous

The uber-bright Hunter Walk provided me with a fascinating view into his opinion of the real tiers of TV programming. Out of the 4-5 hours of TV the average household watches each day, there are essentially three tiers:

  • Hour 1 (No Substitute) – This is the never-miss-an-episode, live-sports, must-see-TV that exists across many networks. The Sopranos, Mad Men, Yankees/Red Sox, French Open, Homeland, etc. When we watch TV, this is the first hour we watch. We watch this stuff live or DVR it and try never to miss it. We will pay for it any way we can and even endure roadblocks to watch it (like when networks won’t make it available on our preferred viewing device, or expire old episodes, etc.) While the networks believe 80% of their content fits this description, it is probably more like 20% of all shows currently on the air, at most.
  • Hours 2-3 (Nice to see) – This is stuff that we have an allegiance to, but are comfortable missing an episode and won’t really endure friction to see it. Many comedies fit this category, from 30 Rock to The Simpsons, as well as the countless procedural crime dramas like CSI, etc. The networks think all of this content is in the category above, but it really isn’t. And probably another 30% of all shows on the air fit this category.
  • Hours 4-5 (Filler) – This is the low-budget, mostly reality show programming that networks use to fill the time between their one or two hit shows. Think Kate Plus 8 or Let’s Make a Deal re-runs. The only time you watch this stuff is when you are couch-surfing. This is probably 50% of all programming on air.

When Ari insists that Facebook, Google, Twitter and everyone else in tech will have to “pay for Aaron Sorkin”, he is really talking about the “Hour 1″ category of programming. That stuff is really high-value and is not in a lot of danger of being disrupted any time soon (although the rising production costs and off-the-charts no-risk fees paid to talent are surely to be reconsidered in the future.) But as for the other two categories…

Our attention is shifting away from TV

All media operates in an attention economy. They compete for our attention against the backdrop of thousands of choices as to how we spend our time: email, video games, Facebook, Twitter, Flipboard, Instagram, etc. The latest numbers show those choices are finally catching up with TV; we are watching less of it, whether DVR’d or not. We aren’t watching less of that incredible No Substitute programming, but we are watching less of the 80% of the other stuff. And by the way, those big “hit” shows that Ari talks about have relatively small audiences. Only about 3 million people “tune in” for an episode of “Game of Thrones” and over the course of a week about 9 million people have seen it through various means. Same for Mad Men (3 million)Desperate Housewives (9 million) and The Good Wife (9 million). That’s a pretty small audience compared to, say, the 450 million on Facebook every day, the 800 million who watch YouTube videos every month, or the more than 100M people who watched the final episode of M*A*S*H. As TV and other entertainment choices proliferate, “hit” audience sizes have decreased. So, one of the immediate threats to network/cable television is that we are likely to watch less and less of the “Hours 2-5″ programming that fills so much of their programming grids. (The smart production companies know this and are already producing much lower-cost, quality programming for YouTube and other online-only outlets.) And where will that lead us?

The pressure will first come from the advertisers

If Nielsen didn’t lie and try to convince TV advertisers that the 50% of people with DVRs still watch commercials (hint: that is utterly ridiculous. We don’t watch any commercials anymore unless we watch a live sports event), I believe advertisers would appreciate that we aren’t seeing their commercials anymore. While the PC and mobile web still don’t offer nearly the great story-telling opportunities for advertisers as TV commercials do, it just doesn’t make sense to continue to buy very expensive TV media when no one sees your commercials. Certainly live sports TV CPMs will go up, but the rest has to fall as advertisers figure this out. And reports detailing that we are watching less TV has to start to sink in. Advertisers would love to try to buy only the hit stuff, but networks are good at bundling to force them to buy the filler programming too. But the whole bundle will start to feel more and more pressure.

The dual revenue stream model of the cable networks provides lots of air cover against decreased ad revenue. The affiliate fees they get for carriage will sustain them for a while. Brand advertisers are looking elsewhere to find places to tell their stories and to reach their audience. And online, we can target viewers and assemble audiences with drastically better efficiency (and reliability) than on TV. Online video is becoming so performance-based, that advertisers now can pay only when someone has actually watched the commercial and not pressed the “skip this ad” button. If you really care about making sure someone sees your commercial, online is the only place to show it. And more and more, we just aren’t seeing the ad on TV anymore.

What’s This Mean?

  • Advertisers will begin to spend less on TV and that will be the canary in the coal mine that big changes are afoot
  • We will continue our shift away from viewing traditional TV and towards IP-delivered unbundled shows, some which will have migrated from traditional TV, but many that will be organic and native to internet programming (the made for YouTube stuff is a prime example here.)
  • Ari will continue to demand high prices for the “Hour 1″ shows created by his elite clients, but the audiences for those shows will grow smaller and smaller.
  • As a result, networks will begin to feel the pinch of decreased advertiser spending, and they will try to raise carriage prices to the MSOs more aggressively
  • MSOs will keep trying to push our bundled TV prices up higher as a result of this, pushing more and more of us away and into other IP-delivered options
  • Finally, I believe the as more of us watch IP-delivered programming, the lure of certainty that the audience you really care about is seeing your ads will prove appealing to more and more advertisers, and online video ad revenues will continue a dramatic ascent
  • And so the cycle will go

(Update: this report from Pivotal Research refutes all of Henry’s points…but bases all of its observations on data provided from a single and biased vendor: Nielsen – a panel-based research method that looks at activities of only 25,000 households – and has concluded, for one, that those of us with DVRs still watch ads. Go figure. Oh, they make their money from the TV industry.)

 

 

Why Should eBooks Cost $15?

Last week’s announcement by the Justice Department that they are suing Apple and several of the world’s biggest book publishers for conspiring to keep eBook prices high generated plenty of media coverage. One challenge in wading through this coverage is that most of it tends to be written by…journalists. And some journalists are also authors. And authors seem to have a soft spot for publishers who fight for higher prices. So, we get lots of coverage sympathetic to the plight of the poor book publishers. Amazon is evil, you see.

Absent from most of this coverage are two main questions: a) what is the right price for eBooks and who gets to set it, and b) why are eBooks not interoperable on different devices? These questions, in my mind, are far more interesting than the ongoing struggle of publishers to adapt to Amazon’s dominance in book retailing. In fact, the answers can significantly help legacy publishers stay competitive for the future and avoid extinction.

eBook Pricing

First, a conversation about eBook pricing. Readers of this blog are familiar with my many discussions on digital good pricing and price elasticity. There’s “Weighing In On the Amazon/Macmillan Pricing Debate” where I detail that the market can tell you your optimal (i.e., highest profit producing) price for digital goods. Each incremental digital good has no additional cost. The marginal cost of distributing it is zero. So you really want to maximize total profit by finding the price that produces the most number of copies sold. In these markets, you make a mistake when you set your price by looking at your legacy costs (which were designed for a physical goods market in pre-digital times). Digital markets produce much lower profit per item, since digital markets tend to have lower prices for goods. (See “As Big Media Goes Digital, Markets Shrink“.) In all the discussions about why book publishers demand that eBooks should be $15 and not $10, they say it is because they cannot afford to sell books at $10. That is, they cannot cover their legacy cost models on that number. Right. Which is why you must rebuild your cost structure for a digital goods industry with far lower prices. You start by paying your top execs much less than millions of dollars a year. Then you move your offices out of fancy midtown office buildings. Why should eBooks cost $15? Amazon is far more of an expert on optimal book pricing. They have far more data than publishers, since they experiment with pricing hundreds of thousands of times a day across millions of titles. Amazon can tell you the exact price for a title that will produce the most number of copies sold. Amazon is pretty sure that number is closer to $10 than to $15. Yes, they want to sell more Kindles. And they believe that lower eBook prices mean more eBooks sold which means more demand for Kindle. The negative coverage of Amazon is centered on them selling eBooks below cost in order to reach the $10 price point. But that is a function of publishers setting the cost higher than $10. If the profit-maximizing price for an eBook is $10, then publishers must adapt to set a wholesale price lower than that, even if it means your legacy cost structure doesn’t allow it. And that’s the rub. [By the way, as publishers continue to resist this market force, new “publisher” models are appearing and will replace the traditional functions of publishers with more digital-friendly models.]

Openness and Interoperability

Now, how do legacy book publishers fight back? Well, to begin, their biggest mistake prior to over-reaching on pricing was to insist retailers DRM their eBook titles. Just like in online music, this insistence on anti-copying protection (albeit with limited usefulness) not only creates inconveniences for consumers, it allows for dominant proprietary ecosystems to form (like Apple did with iPod/iTunes, where tracks bought from iTunes only played on iPods, Kindle books can only be read on Kindles.) Instead, publishers should have demanded the opposite. All eBooks should be sold in open, interoperable formats, so an eBook sold at Amazon could be read on a Nook, etc. This would have separated the reader market from the retail market and lessened Amazon’s eBook dominance. It may be too late for this change to work, but it is worth exploring. Incidentally, I predicted this in 2009 with this piece, “The Book Industry Is In Trouble, But Piracy Is Just A Symptom.”

Here’s the essence of what I see — we have authors and publishers screaming that Amazon wants to sell their books at prices lower than the arbitrary costs the authors and publishers have set. But why must eBook prices be $15? What is so magical about that price? Will it maximize profit? I am skeptical that this price does optimize profit. I see how it attempts to protect a legacy cost structure that is out-of-whack with a digital goods market. Yes, Amazon is a relentless competitor. But they always seem to be on the side of lower prices. And as consumers, we love this about Amazon. But none of the articles I have read seem to mention that the winner in a lower-price eBook market is the person authors are all writing books for in the first place. The reader.

(Incidentally, I am completely unmoved by the argument that if Amazon forces traditional publishers to sell books at lower costs, then the publishers will go away and we won’t have books anymore. Hogwash. The publishers built for a printed books world may go away, but their digital native versions will replace them.)

Continuously Updated Awesomeness − The Spotify Play Button

I was completely psyched by Spotify’s announcement of their new play button to embed legal, licensed music into web pages. The web has needed this for far too long, and this is the missing step to enable Spotify to become the universal music platform on the web, allowing us to share songs with each other with the confidence that they will play. We still have the small problem that not everyone is a Spotify user, but that may take care of itself with this announcement.

I get a lot of requests for music recommendations. I maintain a Spotify playlist called “Continuously Updated Awesomeness” where I add my favorite new finds. I am happily embedding it below! Enjoy, and please subscribe…

Network Effects Are Magical


The following is a guest post by my partner Brian Ascher in our Palo Alto office. He blogs at VC Waves where this originally appeared. This set of thinking drives many of our investment decisions. If you are not one of these models, you should be.

Network Effects are magical.  They are the pixie dust that makes certain Information Technology businesses, especially on the Internet, into juggernauts.  They can be found in both consumer and enterprise companies.  Network Effects are special because they:

  1. Provide  logarithmic growth and value creation potential
  2. Erect barriers to entry to thwart would-be competitors
  3. Can create “Winner Take All” market opportunities

Network Effects are like a flywheel–the faster you spin it the more momentum you generate and enjoy.  But not all markets lend themselves to Network Effects.  They are not the same as Economies of Scale where “bigger is better.”  To be certain, Economies of Scale can give strong competitive advantage and defensibility to the first to get really big (or Minimum Efficient Scale as the economists call it.)  For example, SAP and Oracle benefit from having massive revenue bases which enable them to employ armies of engineers who develop rich feature sets and also to hire huge sales forces.  However large these companies are today, though, their growth rates, especially in their early years, were far more modest compared to those Network Effect companies whose growth resemble a curved ramp off of which they launched into the stratosphere.

There are four main types of Network Effects:

  1. Classic Networks, in which the value of a product or service increases exponentially with the number of others using it.  Communications networks like telephones, fax, Instant Messaging, texting, email, and Skype are all examples.  Metcalfe’s Law captured this as a simple equation where the Value of a network = N², where N is the number of nodes.  Typically, each node in a classic network is similar to each other and possesses both send and receive capabilities.  This will become clear juxtaposed against the other network effects below where there are different types of nodes.  Other examples of classic Networks are social networks (eg Facebook) and payments (eg PayPal).
  2. Marketplaces, where aggregations of buyers and sellers attract each other.  Lots of sellers means variety, competition, and price pressure, which all serve to attract more customers.  And because the customers flock, more sellers are enticed to participate in the marketplace.  eBay, stock exchanges, and advertising networks are all examples.  One nuance of marketplaces, however, is they differ in terms of the scale required for acceptable liquidity.  For example, ad networks can achieve sufficient reach and liquidity at relatively low levels which is why you see thousands of online ad networks, where they each exhibit network effects but not in a winner take all fashion.  Stock exchanges and payment networks require far greater scale for network effects to operate, which is why you see much greater concentration in these industries.
  3. Big Data Learning Loops:  “Big Data” is all the rage in techland, but just having gobs of data is not necessarily a Network Effect, nor any sort of competitive advantage per se.  What you really need is unique data and algorithms that process that data into insights which then lead to decisions and actions.  A flywheel effect comes when you get a critical mass of data that you mine for insights; pump that value back in to your product or service; which attracts more users which get you more data.  And so on.   Venrock portfolio company Inrix is a good example, where they mine GPS data points to derive automotive traffic flow data.  The more commercial fleets, mobile app users, and car companies they can get data from, the better their traffic analysis becomes, which gets them more users and hence more data.  They turn data into an accuracy advantage that earns them the right to get even more data.
  4. Platforms – are a very special and powerful form of network effects.  In Information Technology, a true “platform” is where other developers build technology and businesses on top of your technology and business because you offer them one or more of the following:
  • Lots of users/customers, and you represent a distribution opportunity for them
  • Compelling development tools, technology, and (sometimes) advantageous pricing
  • Monetization opportunities

Example include Operating Systems like Microsoft Windows, Apple App Store, and Amazon Web Services.

Each of these four types of network effects can be extremely powerful on their own.  Yet, even more power is derived when a business can harness multiple types of network effects in synergistic ways.  Google, Apple and Facebook do this for sure, but a less well known example is Venrock portfolio company AppNexus that operates a real-time online advertising exchange and technology platform.  The exchange aggregates advertisers, agencies, publishers and ad networks for marketplace liquidity, but also offers a hosting and technology platform for other AdTech companies and ad networks to augment their own businesses.  And the vast troves of data AppNexus processes every millisecond flows back into the system as optimized and targeted ad serving.

Network Effects are what you want fueling your business.  Sometimes you just need to get clever about discovering and harnessing them.

How to Negotiate Valuation With a VC

This post originally appear on NASDAQ on Tumblr.

So, you have received a term sheet from a VC to fund your financing round. But you aren’t comfortable with the valuation. So, how do you negotiate? Here are a few pointers:

1) The first is to understand the VC firm’s philosophy on price and term sheets. Some VCs are flexible on price but will introduce other terms to essentially manipulate the effective price (such as participating preferred, the size of the option pool, anti-dilution provisions, etc.)Other VCs, such as Venrock, prefer to deliver vanilla term sheets but have a clear agreement on price. In other words, because valuation is only one term in a term sheet, you first need to be clear what you are negotiating. Ask the VC what their views on price are.

2) The most effective way to negotiate price (and other terms in a term sheet) is to have a competing offer. Receiving multiple term sheets gives you a clearer signal on the market’s view of what your company is worth. You can most quickly move price by telling a VC, “I want to work with you and your firm, but our term sheet from this other firm is offering us a price of x.” The more term sheets you have, the more pressure you are able to place on all interested VCs.

3) Some caution is prudent here. In my view, it should never be your goal to maximize price. Picking the right partner and the right firm who truly understand your company and mission and have lots of experience building successful companies like yours is far more important than squeezing every last penny out of the market. Also, be careful what you wish for. The higher the price, the bigger expectation you are setting for your exit. Be reasonable about what you are most likely to accomplish and pick a partner worthy enough to join you on your entrepreneurial journey.

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