Is Your Company Using a Viral Development Innovation Strategy? Either You Are…or You R-Naught. @
Is Your Company Using a Viral Development Strategy? Either You Are…or You R-Naught.
What a Virus Can Teach Businesses About Innovation Strategy
As I write this I am sitting in my apartment wearing three sweatshirts, sipping some hot concoction that is…
I’m not good at very many things. I’m 5’ 8’’ (on a good day) so I’ve never been good at basketball. I was captain of my high-school lacrosse team…wait…the JV lacrosse team. I was pretty good during my time in politics for…damn… John McCain’s 2008 campaign. I can’t network. I hate small talk and tend to bore girls at the bar within about 35 seconds. I blame my shortcomings on the smart, tall, good-looking, athletic successful people who hogged all the talent when the” Man Upstairs” was allocating all the positive attributes. However, there is one thing I’m pretty good at: Picking losers.
That’s right, losers. Now don’t say it: “Takes one to know one.” No. What I am talking about is picking loser companies. And I don’t mean the Sears, the Best Buys and the Zyngas that everyone knows are dying a slow death. I mean the companies that everyone thinks are doing great but in reality are grossly over-priced.
So why is it so easy to confidently pick losers? Because all you have to do is pick a loser is spot a bad deal that doesn’t make sense, and that’s easy. Just look at all the parties or “stakeholders” involved; if everyone is better off after the deal than before, you have a good deal. However, if just one of the parties involved is worse off than before the deal, that kind of deal (and the company pitching it) is not long for this world.
So who is the latest loser? LivingSocial. With Recent slashes to their workforce and deal offerings far removed from anything social, it is evident they are going down the tubes. I would like to talk about the reasons I see for their decline.
I called this a crash-and-burn company about a year ago when they raised a round of funding that valued them at around $9 billion. I recognize that this article might be seen as Monday Morning Quarterbacking, now that their demise is evident and obvious. But I figure I can at least give my rationale for their inevitable, let’s call it “correction” about which I have been spouting off to deaf (or at least bored and annoyed) ears for the better part of this year.
I will focus on LivingSocial, but it all pretty much applies to its evil twin, GroupOn, as neither company has done anything to differentiate itself from the other—save for GroupOn going public first, lifting the veil on the overhyped and unsustainable group-deal business model.
The Issue: Who is the customer?
Here is the problem with both LivingSocial and GroupOn: They don’t know who their customer is (or at least whoever is basically lighting money on fire giving them a $9 billion valuation doesn’t know who the customer is). Because if they did, they would realize they don’t have very many of them, they are burning through them fast and the “party” is ending at 11.
So you might be saying, “What do you mean?! They have over 70 million users!” (As reported by spokesman Andrew Weinstein recently in the LA Times.)
Here’s the problem: The 70 million “users” (the people like you and me buying the coupons) are not the ones really keeping the lights on at the plush LivingSocial offices. The users are, in fact, the suppliers—or more precisely—the products themselves. LivingSocial gets paid to provide traffic to the real customers: the small businesses that run deals with it in the first place.
Though the question, “Who is our customer?” may seem a rudimentary one at best—or at worst, one asked only in classrooms filled with ideological MBA academics—I believe it is one worth exploring.
Let’s define a customer as someone with a need willing to pay to have someone meet that need and a supplier as one who provides the materials or services to satisfy that need.
To illustrate, let’s pretend we run a lemonade stand. We find ourselves on a hot day and recognize a group of people with a serious need: an ice cold, delicious beverage. There are many things that can satisfy that need: soda, water or maybe a Budweiser (‘Merica). However, what would really hit the spot is an ice-cold lemonade. Recognizing this need, we go to the local supermarket and pick up a few bottles of lemonade (we’re real lazy), pay the clerk a few dollars, set up our stand, and start raking in the bucks. So who is our customer and who is our supplier?
In this case it seems pretty clear who our customer is and who our supplier is. Our customer is the guy giving us money to satisfy his need (thirst). Our supplier is the person who makes available resources we need to satisfy that need (lemonade).
How LivingSocial Works: Burgess’ Buns
So let’s take a minute and think about how the LivingSocial business model works. I will use a gourmet burger joint, Burgess’ Buns (unfortunately for all of you ladies, it’s just a hamburger place) as an example.
Burgess’ Buns just opened and has a few customers, but what it really needs to get the word out that they have the best buns around is some feet through their doors to experience the burger-ecstasy that is Burgess’ Buns.
Burgess’ Buns has a few options here: send out mailers, get an ad in the local paper or have a guy streak across Nationals Park wearing nothing but a Burgess’ Buns t-shirt. These could all be effective, but they are also expensive and may not produce the conversion rates they need to make the marketing spend (or a night in jail donning a Burgess’ Buns t-shirt) worth the expense.
Enter LivingSocial. They will design an advertisement and send it to thousands of people in Burgess’ Buns’ area and they won’t have to pay them a dime. Sounds good, right? Sort of…The typical deal structure with LivingSocial is that your deal must be at least a 50% discount below the original price of the merchant’s offering. Then they split the revenue 50/50 with the merchant. So that means the merchant is getting a measly 25% of the original price.
So if a meal at Burgess’ Buns is priced at $10, they are required to offer a deal for the meal for at most $5. Of that LivingSocial will take half, leaving Burgess’ Buns with…carry the one…$2.50. That is not a lot of revenue. Even if it does cover the cost of the hamburger, buns and condiments, it surely won’t cover the other expenses, such as the cooks, clerks and wear-and-tear on the equipment that still needs to be paid for to fulfill the orders.
Now I’m not saying that LivingSocial doesn’t add value or is ripping off business owners. The losses sustained by Burgess’ Buns can (and should) be considered a cost of advertising, the same as putting an ad in the paper, except that Burgess’ Buns doesn’t pay a dime unless people are buying the deal.
Who is the customer and who is the supplier?
Let’s go back to our lemonade stand. The customer was the guy with the need (thirst) who gave us money in exchange for a product (lemonade). The supplier was the guy who gave us a product (lemonade) in exchange for something he wanted (money). The grocery store doesn’t care if someone uses their product to sell to people on the street or a party that evening. They have a fixed amount of lemonade for a given price.
What LivingSocial delivers is foot traffic. It has successfully identified the need of small businesses to generate people actually entering a store. That is what LivingSocial can do that Google or facebook cannot with all of its banner ads. LivingSocial can deliver people’s most precious resource: time. It does so by tapping into a market of thousands of individuals who are willing to exchange their product (time) in exchange for something they value (instead of money, it’s 50-75% off a delicious burger).
Just as the store clerk doesn’t care who buys his lemonade (as long as the price is right), so too are LivingSocial subscribers, indiscriminant of with what business they will spend their time (as long as the deal is right). Granted, LivingSocial subscribers are spending money but, assuming the steep discounts are discounted from the true market price, the real challenge is not to convince someone to purchase a delicious hamburger for 75% off, but rather making them aware of it in the first place.
Think about it…If I had a giant email list of people to whom I was offering 50-75% off deals, I could provide buyers all day. The real challenge would be to convince businesses to pay me in the form of cheap deals plus half the revenue from those deals in return for foot traffic.
Don’t believe me? Test it. Right now, Google the name of your home town, plus the words “group deal”. First, notice how many companies pop up. Then notice the types of companies. I bet you a massage for 50% off retail value that (1) there are a ton of companies with group deal offers and (2) they are mostly offered by organizations, such as local newspapers, that have an organically large exposure to people.
So we have established that, just as the grocery store clerk and his bottles of lemonade aren’t going anywhere so long as people are paying for their product, so too will people be willing to offer their time and money so long as there are great deals to be had.
But if LivingSocial is providing value to its small-business customers then why are they facing such dire straits and an inevitable correction to their valuation? I see three reasons:
Problem One: A bad product
The first problem is the nature of the customers that are attracted to coupons. If you were running Burgess’ Buns, what sort of customer would you want? The guy who sees an ad for your delicious burger, recognizes its full, decadent value and happily gives you money in exchange for that medium-rare slice of heaven you call a hamburger? Or do you want the guy who trolls group deal sites in search of the cheapest burger he can get his indiscriminant, barbarous, three-dollar-loving hands on? The point is that every business has an ideal customer whom the business must relentlessly target, and that ideal customer will find you if you are good at what you do without demanding a 50% cut in the price.
Best Buy learned this lesson a few years ago when it rolled out a large coupon campaign. If getting customers in the door was their metric for success then they were wildly successful. But their goal was not to get customers in the door or raise awareness that Best Buy existed—people already knew that. What Best Buy needed was profit—or achieving a return on the investment they made through the discounts they offered their customers with coupons.
What they found was that a lot of customers were coming through the door and buying up big screen TVs at a steep discount but those customers were not coming back to buy that new laptop for the regular price.
If LivingSocial cannot provide subscribers that will continue to patronize the businesses after the deal, never realizing the customer value needed to justify businesses running deals, they will continue to find themselves as they do now…with no customers.
Problem Two: The LivingSocial Paradox
One way LivingSocial can fix its problem is make their deals work for their customers. But they have to face their second problem: what I call the LivingSocial Paradox™ (don’t look it up, I just made that up tonight…actually go ahead and look up paradox.) Here is some background:
When Burgess’ Buns runs a deal, they collect the entire portion of their cut of the revenue, whether the coupon is cashed in or not. So for example, they sell 100 coupons for $5 they get $250. Let’s also assume that a Burgess’ Buns burger costs $2.50 each and let’s ignore the overhead expenses. So if 100% of the coupons are cashed in, they just break even. But if only 50% are cashed in then they make $125…$250 revenue - $125 costs = $125 profit…not bad. Unfortunately the actual percent of coupons that are typically redeemed is about 80%.
So the LivingSocial Paradox™ is that on repeat deals, it is in Burgess’ Buns’ interest to maximize the number of coupons it sells but minimize the number of coupons cashed in; but for LivingSocial to be able to continue to “supply” it’s real customers (the business owners) with people purchasing their deals, they have to keep their 70 million users happy. Their users won’t be happy if they keep buying coupons they never use and will soon stop buying. However, if LivingSocial’s users happily cash in most of their coupons, the business owners lose their buns (sorry, had to do it) on every deal and will likely not run additional, unprofitable deals.
Problem Three: They are out of customers
So I lied, the LivingSocial Paradox™ is not really a paradox because there is a way to keep both the business owners and the users happy: don’t make every deal unprofitable for the business owner. Sure, that means less margin for LivingSocial, but at least it is a model that is sustainable for all parties involved.
Oops, I forgot about one party…the investors.
A poorly structured group-deal company is not quite a paradox. But, a poorly structure group-deal company with a valuation of $9 billion, investors expecting to make a return on their investment and a dwindling customer base is a paradox, which ties together all the problems with a company like LivingSocial.
Here are some numbers. According to an employee 30% of all LivingSocial’s customers run one deal and never run another again, which makes sense. Why continue to sell your product for half the price and take home only a quarter of the revenue but carry the full cost?
Given the types of businesses LivingSocial deals with, there are about 2 million businesses in the US that would be reasonable users of group-deals—not 70 million. So if they lose 1 out of every 3 customers every round of deals; assuming businesses are not going to repeatedly spend 75% of every dollar on marketing (group deals); and GroupOn competing on pace with serving over 70,000 vendors a quarter, the group-deal market will be bone dry in 5 to 10 years.
I began by saying that they don’t know that their real customer is the business owner, not the coupon buyer or user (who is essentially getting paid to use the coupons) and don’t—or at least didn’t—realize how few of them are out there. LivingSocial is not publicly traded—they missed that bus in the wake of the poor GroupOn performance, hoping to wait it out and get a better valuation later—so you cannot verify their performance. So let’s look at what we can verify to see if we can put a final nail in the $9 billion coffin. Here are a couple of revealing indications of a shrinking market, demonstrated by LivingSocial:
Unfortunately for them, and their employees, many of whom I’m sure had stock options, they did not recognize the rapidly eroding customer market and failed to adjust. Fortunately for the idiot at the bar telling me about the “hot LivingSocial IPO” he probably didn’t lose his shirt on that IPO.
To be clear, I am not saying that group deal companies like LivingSocial and GroupOn will go out of business or that they do not provide any value (not like the zero-revenue, black holes of the dot com bubble). They—or someone—will continue to get people through the doors of startup companies or highly seasonally cyclical businesses with excess inventory or beds to fill. LivingSocial provides value, just not $9 billion worth.
I will close with a story. I used to work in a boat yard doing yacht restorations. Our competitor next door was known to operate his business with this little gem you would expect from titan of business he was: “F@!k ‘em once, and if they come back, F#@k ‘em again.” He went bankrupt three times.
Whenever you are looking at whether or not a company will be successful, look no further than the players in the deal. If every single person involved in a deal is not better off after the deal, you better not count on that person returning to the table for long.
Next Week: When you find yourself in a hole, quit digging…when you find yourself in a hole filled with cement, find a way out. How LivingSocial can stop the bleeding.
2:38 AM 2013 Predictions
Below is an article I wrote a couple years ago after winning the 2010 Trans-Atlantic Sailing Race
This past winter I completed the 25th Annual Atlantic Rally for Cruisers (ARC) – a transatlantic race that started on November 21, 2010 in the harbor at Las Palmas in the Canary Islands off the coast of Spain. Sailing through the Canaries, we headed for a December destination in St. Lucia’s Rodney Bay in the Caribbean, 2,700 nautical miles away. Among the 233 boats in the race, I competed on Europa Horizons 01 (called EH01), a UK-flagged 47’ Beneteau First. In a race marked by unusually strong headwinds and high seas – and improbable aberrations in established trade winds – after 20 days, 20 hours and 32 minutes EHO1 finished first in the Class A racing division and first overall.
I love competition of any kind, and I have always been interested in what leads to winning. Prior to the race, I had just completed my MBA in Entrepreneurship from the Acton School of Business in Austin, Texas where I learned, through rigorous analysis of 350+ business cases, what makes organizations and their leaders successful in the business world. Since winning the race, I have consulted with dozens of businesses through my membership in SCORE—where I provide pro-bono consulting services to small businesses in my community—and through my consulting firm, The NorthStar Group where I help small and midsized businesses with social media, marketing and business improvement. In my day-to-day work, I began to reflect on the 21 days I spent on the Atlantic. It came to me after a few days on the water that the same principles that drive success and effectiveness in business were also reflected in the winning behavior of the crew of EH01.
Importance of Mission and Priorities
Countless books on management and stories of the most successful companies of our time stress the importance of a clear and compelling mission to align the members of an organization. As a member of the crew of EH01 I saw this concept in action.
The night before the race, our captain Andy Middleton, a Brit, sat the crew down and in his thick Essex accent said, “Look, there is no reason why we can’t win this bloody race. If we are going to win we are going to have to be giving it 100% all the time. The key to winning will be consistently high boat speed with no mistakes or missteps.” So our mission and priorities were clear:
At that point we all knew that this was not going to be a leisurely cruise across the ocean…and we were all on board.
The importance of mission was amplified just over a week into the race. In the beginning of the race we were well back in the pack. The leader – rather than taking the traditional route of “going south until the butter melts,” catching the trade winds and then heading west – turned west immediately out of the Canary Islands, taking the rhumb line to St. Lucia. But eight days into the race, after forging ahead of the rest of the pack, the prevailing winds forced the leaders to make a sharp turn to the south. By that time, we were in 3rd place and realized we had a real shot at winning. Reinforced by the validation of our early decision to turn west, we all rallied around our mission to WIN.
By this time into the race, our crew had become self-governing, “Catch the vision or catch the bus” – and in the middle of the Atlantic there was no bus. We were constantly asking ourselves what we could do to make the boat go faster. If the man at the helm was a few degrees off the intended course he would get a gentle reminder from the crew. If the crew did not hear the Lewmar winches cranking, constantly trimming the spinnaker, the trimmers were called on it. We didn’t need a leader to govern us; we were governed by our mission.
Priorities were also clear. Get there—Are we taking care of our equipment? Get there fast—Are we taking the best route and trimming the boat to go as fast as possible? Get there safe—Is everyone drinking water? Is everyone wearing life-jackets and strapped to the boat? These three priorities, all essential to our mission of winning, were always front of mind.
In business, you must first identify what winning means—at what it is you will be the best in the world (and define your world, i.e. your industry, your product, your discipline, etc.) Then figure out how you will get there, operating from a set of aspirational, performance, and ethical priorities.
If you don’t get there you can’t win. We knew our destination and we knew that we had to take care of the boat, checking daily for chafe and at one point dropping the sails altogether for three hours to attend to a deteriorated mast collar.
In business, you also have to identify what might prevent your business from “getting there,” – the blockers that could keep your business from reaching its destination or spoilers that can sink your business before it can become great – and do your best to make sure they don’t materialize.
Get There Fast
For us to accomplish our mission we had to keep a consistently high boat speed. We were constantly trimming and changing sails to make the boat go as fast as we could – all the time, 24/7 for 20 days straight.
In business getting there fast is analogous to tenaciously seeking a competitive advantage and using it to acquire, serve and retain your customers. What will you do to convince your customers to use your product or service rather than your competitor’s and move you ever closer to your company’s goal?
Get There Safe
Safety is job #1 – in the factory and the field as well as on the sailboat. In sailboat racing and business, you often take risks that may compromise money, time, facilities or equipment. But you never intentionally put people at risk. In fact, the safety of employees and the safety of your crew is job #1.
Based on a thorough analysis we chose a route that would send us into high winds and seas but would get us there faster. During the worst of it we experienced 30+ mph winds and 15 foot seas. Despite making personal safety job #1, I suffered a dislocated shoulder when a wave crashed over the side of the boat, washing me down the deck. It would have been “man overboard” had I not clung to a stanchion. On another occasion, mates were working the bow as it dug deep into crashing waves nearly tossing two crew members overboard – not once but several times.
Was this safe? Most would say no. But the risks we took were calculated risks. The boat and the crew (my shoulder included) paid a price for those risks. We endured five straight days of 20-30 mph winds, high seas and a boat heeled over at 30-40 degrees – leading to a special kind of pain and suffering. The experience of novelty and loss of control was, I imagine, like a rocket-lift-off during an earthquake. Nothing is easy in those conditions: Simple tasks like cooking, using the head, standing, walking or sleeping became difficult and took a major toll on the crew. Taking the far southern, trade-wind route would have been safer and surely more comfortable, but it would have forced us to endure the risk of losing speed and not achieving our goal.
In business as in yacht racing, you must ensure that you “get there”. However, playing it safe—having a me-too product or never risking investment to grow your organization—will never make your company a a high performer.
Barriers and Competition
On our boat, we divided our 10-man crew into two watches of five each. As the race progressed and we moved up through the leader ranks, the two watches developed a healthy competition. After every shift members of the watch stepping down would not be shy about their accomplishments. “We had an average boat speed of 8.5 knots. Beat that.” The two watches pushed themselves not just to demonstrate their own skills but also for the good of the team and our progress toward our mission to win.
This sense of competition can even break through seemingly unbreakable barriers. In our case that barrier was top boat speed. On the downwind legs of the race, each watch would push the boat to its limits trying to get the highest speed. The speeds were 11.5 knots, then 12.5, then 13 and 14 – a result achieved by catching the wind in the massive spinnaker and surfing down the enormous Atlantic swells. Then, in the last week of the race we began another surf in the trough of the wave, slowing the boat to 7 knots. We watched the speed readout as the wave squeezed under our boat from the stern: 7, 8, 9,10 knots—the rudder began a high-pitched hum—11, 12, 13 knots—the hum got louder and we wondered how long we could ride this wave—14, 15 and then it happened: 16.4 knots! A new record for EH01! (We later checked with Beneteau and were told that our speed was also a record for that boat.)
Competition is the fuel of our capitalist system. Just as we made the boat go faster and faster without regard for barriers, businesses today continue to make products and deliver services faster, cheaper, and better. In business you always encounter barriers, but to be successful you must first see them for what they are and then respond to them effectively. As one successful CEO wrote, “The first job of a leader is to describe reality” – including your assets, liabilities, barriers and opportunities. Then you figure out how to use your assets to break through (or avoid) the barriers and achieve your goal. You accomplish this through focus and discipline along with experimentation and innovation, always keeping your eye on your mission and goal.
I have never understood why people say, “If that would work, I’m sure someone would already be doing it.” But if everyone said that, then nothing would ever get done. So whether you are starting a new business or growing your current business, do what a good racing sailor does: Mobilize your assets, dampen or neutralize your liabilities, and then look at barriers as opportunities to beat your competition and become the best.
You Can’t Manage What You Don’t Measure
On EH01 we were constantly tracking data to monitor our performance. We decided that the key metric we needed to optimize to accomplish our mission of winning was average boat speed. We would constantly watch the speed readout and trim the spinnaker to get an extra tenth of a knot out of the boat. All night and all day for 20 days you would hear, “Grind!” and “Hold!” “Ease!” and other commands as the trimmers tweaked the sails.
After each watch we would report the average boat speed to determine how we were doing with what was expected, given the wind speed and sailing angle. We also used software to run scenario after scenario on our computer to find our optimal route to St. Lucia, given constantly changing information about winds, currents and weather patterns.
In business, data are of vital importance. Once you have defined your mission, it is essential to determine your key financial, economic, market size and other drivers and how they will guide you in managing your company toward accomplishing its mission. On the boat it was easy because we had instruments to tell us that information, but as a manager you should develop your own dashboard to tell you how you are doing; This may include customer satisfaction, profit per square foot of retail space or a host of other measures that give you a window on your performance.
We were able to push ourselves because first, we knew the goal and second, we knew how we were doing. One is of no use without the other.
Bold Decision-Making and Execution
The importance of bold decision-making and execution showed when we decided to turn west. We were faced with a crucial decision: Continue south and hope the trade winds would establish, or turn west and beat into 20-30 mph winds for days. Our skipper was analyzing the two decisions when one evening, the first-mate woke up the skipper and said, “I think we should turn.” The skipper looked around, looked the first mate in the eye and said, “OK.” He then went back to sleep. He trusted his first-mate’s judgment.
We decided to turn west a few hundred miles north of the Cape Verde Islands off the African coast. This was a bold move but not as bold as some. A few boats made the westward turn immediately south of the starting point in the Canary Islands, which brought 30 mph headwinds and high seas almost immediately. These boats were well ahead of us at the point we decided to turn, but then came a lesson in geometry and a lesson in execution.
The geometry lesson: In sailing, the shortest distance between two points is still a straight line; but the fastest route may not be a straight line.
The execution lesson: After we turned west, we soon faced the same weather as the boats to our north who turned west earlier. It was bad but we held our course and executed, doing our best to catch up with the northern boats, almost 200 miles ahead of us. But as we tracked the course of the other boats, our computer monitor told us the lead boat was taking a sharp turn south. Reason: The head winds and seas were too much for the boat and crew; they wanted relief. They continued south, crossing our path well behind us, putting us in 2nd place and eventually in the lead.
Bold decision making and execution go hand-in-hand; one is no good without the other. If you make a bold decision but don’t execute or execute on a weak decision you will be doomed to mediocre performance. In business, establish your company’s goal, analyze how you will get there, get the right people on board, determine how you will measure and evaluate your progress, then execute, keeping an eye on your own performance and that of others in case mid-course corrections are warranted.
In speaking with successful entrepreneurs, I often hear luck sited as a key reason for success. But my experience studying business, running a business, speaking with many successful entrepreneurs and crossing the Atlantic have shown me that, yes, luck is a factor in success, but to paraphrase Thomas Jefferson, “I am a great believer in luck: the harder I work, the luckier I get.”
In over 20 days of racing over 3,500 nautical miles of ocean, we only won by 40 minutes – 40 minutes out of more than 28,000 minutes of racing. We may have experienced luck: The winds could have changed; we could have selected the wrong course; our equipment could have failed. But these things didn’t happen. Instead, our preparation, our good assets (people, equipment, technology, and information),our training, the long watches, the constant trimming, the endurance of everything from hellish weather and equipment failures to dislocated shoulders gave us the opportunity to win. But actually winning? The crucial ingredients were focus, discipline, perseverance and leadership. Those who work hard may not get lucky and may fail; but for those who don’t work hard – and those without focus, discipline and perseverance – no amount of luck will bring success.
The winning crew of Europa Horizons 01 (called EH01), a UK-flagged 47’ Beneteau First, at anchor in Rodney Bay, St. Lucia, after completing the 25th annual ARC race from Spain’s Canary Islands to the Caribbean.
Above is our path in red and the path of our closest competitors in, We Sale for the Whale in blue and Blue Nights in purple. Note our Southern route turning west before the Cape Verde Islands and crossing paths with Blue Nights as they turned south.
The ARC is the world’s largest sailing event. See http://www.worldcruising.com/arc/. ARC 2010 included 233 yachts from 26 nations. EHO1 was one of 19 yachts competing in the IRC Racing Division, run under the auspices of the Royal Ocean Racing Club (RORC). The racing boats were first to start, crossing the line towards the southwest of the Grand Turk Islands lying off the northwest coast of Africa. All 19 boats flew spinnakers for the start. EHO1 (GBR), was the first across the line – followed by Alcor V (ITA), Caro (GER), Marisja (NED), We Sail for the Whale (AUT) and Nibani (ITA).
Here is the first post in my series of 2012 predictions:
With the Facebook IPO fast approaching and a buzz of valuations approaching $100 billion, I have to ask: Does this make any sense?
I am the humble owner of The NorthStar Group, a small consulting firm helping business owners in the DC area to start and grow their business. I am not an expert…It’s just that things don’t seem to add up for me…
Sure, Facebook and social media have changed the world and how we interact with one another. Facebook provides customers with tremendous value, but providing value does not necessarily mean one will derive an adequate return on one’s investment given the investment’s risk and time horizon.
At a potential valuation of $100 billion and estimated earnings of under $1 billion, Facebook will have a price to earning ratio (P/E ratio) of over 100X. That means it will either have to see huge growth over the next few years or will have to be very safe with little growth for the next 80-100 years.
I don’t think investors want to wait 100 years to get their money back so let’s see what kind of growth we would need to get our money back in a reasonable time, say, 10 years with a reasonable rate of return of, say, 10%.
The Situation: Currently Facebook has around 800 million members, which produced expected net earnings of about $1 billion. That is $1.25 of earnings for every member.
Facebook makes money off online advertising. To make money off advertising requires traffic. There are a few variables that go into Facebook making money off ads:
Option #1. The only way to increase the click-through-rate (CTR) is to make better-looking, more engaging ads, which I assume advertisers are already optimizing.The quality of ads is largely out of Facebook’s control so let’s hold the CTR constant.
Option #2. What about increasing per-user page views and user activity? Well, people might become more active as Facebook expands its platform and features but the evidence shows otherwise. Even though Facebook is continually adding new features:
“…activities…seem to be falling out of favor [including] messaging to friends (down 14.8% in the U.S. and 7.4% worldwide), joining a group (12.8%, 6.5%), searching for new contacts (12.7%, 4.5%), installing an app (10.4%, 3.1%) and instant messaging (7.5%, 1.5%). Those activities are not only falling faster in the U.S. than elsewhere, but are declining even more among under-30 college-educated users in the U.S.”-Mashable.com
Further, Facebook relies on people continually posting updates and pictures to add value. Unlike Google, which provides real, standalone products such as Gmail and the Android OS, Facebook offers no value without user activity, which—by most measurements—is declining.
OK, so any hope of drastically increasing individual user activity is probably out.
Option #3. So what about increasing the total number of users? That sounds like a plan. So, how much would Facebook have to grow each year to reach our goal of a 10% return over 10 years? Well, holding earnings per customer constant at $1.25/customer, my calculations (NPV, 5X terminal value at year 11) show that Facebook would have to grow its users by over…
50% per year for the next 10 years!
“Sure, that’s high…But Facebook is the biggest and the best; and social media is growing way faster than that. Of course they can grow 50% Y/Y in perpetuity.” One eager day-trader or Morgan Stanley banker might confidently pronounce.
Yes, social media and Facebook have seen massive historic growth rates; but here’s the problem:
At 50% compounded growth, Facebook runs out of people—as in world population—in just seven years…and that’s assuming 100% world-market penetration. Yes. Every man, woman and child in the world…All “Facebooking.”
So, it seems that even in the best-case scenario Facebook is in trouble. But what if we are already seeing the dreaded “growth plateau” in a far-from-saturated market?
*Cue ominous music*
Global Web Index’s report, predicts the number of Facebook users in the U.S. will rise 13.4% this year, after 38.6% growth in 2010 and a 90.3% rise in 2009.
Currently, around 50% of the U.S. is on Facebook and already they are seeing a plateau in new-user growth, so, any hope for world domination looks pretty grim.
Therefore, the only path I see for Facebook to reach a $100 billion dollar valuation with their current business model is to increase the world population fast enough sustain its necessary growth…that’s a lot of babies.
So, for the sake of Mark Zuckerburg and the eager day-traders drooling over the highly-anticipated Facebook IPO this week…go forth…and procreate.
Let me know what you think on Twitter @BenNorthStar.
Check back for the rest of 2012 predictions.
Side note: Although the calculations make the $100 billion Facebook valuation seem impossible, there are changes to the business model I see that could justify it. For example: If they adopt the eBay model and allow vendors to sell directly off their Fan page it could increase sales conversions, diminish the role of individual websites and generate huge returns to Facebook…but I don’t hear people talking about any business model changes in their $100 billion valuations.
Disclaimer: Another potential life-saver could be that as revenues grow, their margins will also increase given the highly-scalable nature of their business; however, even if they are generating moderately better margins than Google, they would still have to accomplish a nearly impossible growth trajectory.