Over the holiday I became aware of a new tech blog that aims to have deep insights into the next generation of technology, which they call The Hypernet.

Why should you care?

Well, it is established by some of the industries more successful investors – Mike Maples and Roger McNamee.

My favorite post was this one (image above) in which they talked about their 10 hypothesis for technology investing.

It maps to a lot of my own views so I was interested to learn more. If you click through to Roger & Mike’s blog you’ll see that this blog post then links to a detailed presentation on the topic.

The ones I focus on the most are 2-7 and 10.

Hope you enjoy it. And I hope they keep up their early momentum.

There are certain topics that even some of the best journalists can’t fully grok. One of them is profitability.

I find it amusing when a journalist writes an article about a prominent startup (either privately held or preparing for an IPO) and decries that, “They’re not even profitable!”

I mention journalists here because they perpetuate the myth that focusing on profits is ALWAYS the right answer and then I hear many entrepreneurs (and certainly many “normals”) repeating the same mantra.

There is a healthy tension between profits & growth. To grow faster businesses need resources in today’s financial period to fund growth that may not come for 6 months to a year. The most obvious way to explain this is with sales people.

If you hire 6 sales reps in January at $120,000 / year salary then you’ve taken on an extra $60,000 per month in costs yet these sales people might not close new business for 4-6 months. So your Q1 results will be $180,000 less profitable than if you hadn’t hired them.

I know this seems obvious but I promise you that even smart people forget this when talking about profitability.

Hiring more people isn’t always the right answer. You have to understand whether they’re likely to yield revenue growth in the near term OR whether you have access to cheap enough capital to fund your losses until your investments pay off.

Exec Summary:

Most companies (98+%) in the world (even tech startups) should be very profit focused.

Being profitable allows you degrees of freedom you don’t have when you rely upon other people’s money.

• You may have leverage when you DO need to fund raise. (There are many investors who are not looking to build enormous businesses who value the fact that you can run a business profitably)
• It allows you many more exit opportunities. While Google and Facebook will buy “acquihires” (at least as of Dec 2011), many acquirers hate the idea of buying companies that aren’t profitable. When they look at buying your company they often think in terms of “how long will it take until I earn back the profits to pay for my acquisition price?” If you’re not profitable you’re purely a cost center to them.
• Being profitable certainly makes your company more sustainable in difficult times.

The characteristics of somebody who should NOT focus on profitability include those who:

• Have or perceive that they have the opportunity to build an immensely scalable businesses. Internet scale.
• Have easy access to capital by investors who are committed to building businesses at Interent scale

As I like to say,

“If you’re really on to an enormous idea then other people in the market are going to spot that and want to compete with you.

If you have a market lead then raising capital and making investments now will help you as others enter the market.

If you don’t, somebody else WILL!”

The Details

I have had this discussion with many a first-time entrepreneur. They have have raised $2-3 million, built a product that has some amount of market traction and got to annualized revenues of around $1 million.

At this level, as a founder you feel SO CLOSE to profitability that many say, “I’m going to keep my costs really low this year to try and hit profitability. I don’t want to be beholden to investors.”

My response is often, “That’s fine. What’s your objective? Are you looking to potentially sell the company in the next year or two? Do you plan to run this as a smaller business but maintain healthy profits? Do you imagine eventually raising VC and trying to build a faster growing company?”

Because of the circles I run in I tend to meet many people who eventually do want to build large companies and therefore do want to eventually raise VC and “go big.” But they want to do it with leverage.

I often point out that investors at this stage care way more about growth than profits so be careful not to shoot yourself in the foot. I certainly understand the desire to be in control, which is what you are when you earn a profit. Just be careful that it doesn’t come at the expense of investments in growth.

The likely response of a VC to your company that raised $3 million and now is profitably doing $1.5 million in revenue three years later is, “So effing what?” Harsh, but reality.

If you had huge customer growth but just didn’t focus on revenue that’s a different story. If you spent the 3 years perfecting some hugely differentiated technology IP that may also be different. But if you simply went more slowly to show you could earn a profit you may need to look for alternative funding sources to fuel your future growth.

Understanding Profits

No discussion about profitability can sensibly happen without covering the basics first so please forgive the 101 nature of these charts.

Simplifying:

Revenue -
Cost of Goods Sold (COGS) =
Gross Profit (also called Gross Margin or sometimes “Net Revenue”)

- Operating Costs
= Profit

When I look at an income statement (also called a profit & loss statement) I start by focusing on the revenue line.  One thing that should matter to all people trying to understand the performance of a company is whether they have revenue growth.

I always remind this to journalists who ask me about public stocks. If you had two companies each with $100 million in “earnings” (profits) they might have vastly different prospects for the future. One company might be growing its revenue at 50% per year and the other might be growing at 5% per year.

And assuming they both had the same net profit margins (profit / revenue) then the former company would be much better off at the end of the year.

So while the simplest way that people often evaluate stocks is by P/E ratios (price-to-earnings), one also needs to look at other metrics such as the PEG (price-to-earnings-growth). [of course there are MUCH more sophisticated financial tools than either of these, but PEG is a short-hand many people use]

Investors value growth.

The value of a company is the expected value of all future cashflows discounted back to today’s dollar (because as you know a dollar next year is worth less than a dollar today) and a company that is growing more quickly is more likely to yield better overall profits in the future.

So for a start when you want to evaluate companies you want to evaluate “growth.” Looking at earnings alone across two companies won’t tell you the picture of the different prospects.

And when you’re looking at even earlier-stage companies (as VCs do) you might be even more focused on customer growth than revenue growth.

The Nature of your Revenue Matters

When I do evaluate companies that already have revenue, I actually want to understand the revenue line in more detail. What makes up revenue? Is it one product line or multiple? Do 20% of the customers make 80% of the revenue or do the top 3 customers represent 80% of the revenue.

This is called “revenue concentration” and the more concentrated your revenue the higher the risk that your revenue could decline in the future.

I also try to understand things like how you’re pricing your product, how your competitors price and what your pricing expectations will be in the future. Fast early growth in a market is often eroded when competition gets fierce and prices are forced down due to competition.

Revenue is Not Revenue is Not Revenue
But it’s not as simple as just looking at revenue in dollar terms. For example, look at the following graph. You’ll notice that although both companies have the same revenue every year, Company 1 has MUCH higher gross margins than Company 2 because the cost of sales (COGS) is much lower.

“COGS” represents the amount that each sale costs you. For example, if you sell your product through a third-party reseller who charges 30% of any sale then your COGS will be 30% of revenue (assuming no other costs of sales).

The example chart is not actually atypical. The first company represents a normal software company that sells its products directly (either via sales staff or directly off of the internet). Many software companies have 85-90% gross margins, which is why it has historically been a very attractive industry.

Company 2 might represent an “ad mediation company” where the company gets paid by ad networks for running ads on publisher websites and the company in turn must pay the publisher 85% of the revenue it collects. This is not atypical for “middle men” who often take 15-30% of the value of the sale

This could also be a travel website who gets paid a bounty for selling airline travel.

Companies like to have high numbers in their revenue column but this can be quite misleading. After all, if you sell $500 million of United Airline tickets that isn’t really YOUR revenue. Your revenue is the $75 million you got paid in booking fees.

It could be an eCommerce website or “flash sale” where they are booking revenue from customers but then having to pay out a high percentage of the sale to the clothing manufacturer. Many eCommerce companies are in fact, middle men. Gross margins can range from 15-40%.

I know you’re shaking your head and thinking, “duh” but I promise you that even some of the most sophisticated people I know get off track on this issue of “gross revenue” versus “net revenue.” I saw this first hand with the growth of the “flash sale” category.

People kept saying,

“Company X is already doing $100 million in revenue! Wow! Amazing growth!”

Um, no,

“Company X is doing $100 million in gross revenue but is only at 12% margins which means the majority of the value is in the goods.

Many of these companies weren’t even taking physical possession of the goods in the early days. So they are really doing $12 million in “revenue.”

That in and of itself is an achievement. But it’s very different than $100 million in two years.”

Shouldn’t All Companies Want to Be Profitable?

Not necessarily.

Let’s consider the following two software companies, both of which have 66% gross margins.

Both companies look the exact same after one year. They both raised angel / seed money of $1.5 million to fund operations in their first year of operations. Both companies lost $1 million in their first year.

Gross margins at 66% is fine (they’re selling through a reseller who takes a 33% margin) but their sales aren’t yet large enough to cover the costs of their IT development team + management + marketing + office costs, etc. In many Internet startups 80% of the operating costs will be people.

So which company is better run?

The answer is that you have no way of knowing. A naive journalist might lament the fact that Company A is “not profitable” or is being a typical Internet startup and not worried about costs. After all, they doubled their operating costs when they weren’t even profitable.

What did they actually do? They raised $5 million in venture capital to fund growth. They used the money to hire a bigger tech team so they could roll out their second product line. They hired a marketing team to promote their products more broadly.

They hired a biz dev team to work on deals where their product could be embedded in other people’s products as a way to increase customer demand. They got a bigger office space so their employees would feel comfortable and they could improve employee retention.

If there was strong market demand for their product then this investment might pay off handsomely.

Let’s look at years 3-5 of the two companies.

Even though Company B initially looked prudent, it turns out that the investment that Company A made in people led to a higher annual growth rate. At the end of year 5 Company A has earned $14 million in cumulative profits (gains – investment years) while Company B has made $5 million.

Company A is now doing $47 million in annual revenue which Company B is doing $12 so years 6-10 appear rosier for Company A as well.

I know which company I’d rather have invested in. Growth matters.

But let’s consider an even more aggressive scenario. Let’s call it the “super high growth” Internet company. You know, the kind that unknowing commentators would be quick to lambast as being wasteful because they’re not profitable.

The company would have had to raise at least $35 million in venture capital to have funded operations like this. More likely they raised $50 million or more. Note that they likely raised this in 2-3 tranches, not all up front or all at once.

Crazy? Stupid? Should they have slowed down operating costs in order to “make a profit.”

Again, it depends. If the growth is as spectacular as it is here and IF they have access to cheap capital then they’d be crazy not to have raised the VC and instead stayed unprofitable.

This is the trade-off between profits & growth. You can drive profits up by not investing today’s dollars in tomorrow’s growth.

The next time a journalist wants to slam Amazon for not being more profitable I wish they’d understand this. Amazon is continuing to grow at such a rapid pace that of course it should take some of today’s profits and reinvest them in growth.

If there is a company that can’t grow fast enough then they should do other things with their profits, like return it to shareholders.

A Final Note on Profitability vs. Being Cashflow Positive

More 101, but experience tells me this is worthwhile to many. Many investors care much more about cashflows than income statements.

It’s worth noting just for those that aren’t familiar with the difference between an Income Statement and a Cashflow statement that being “profitable” is not the same as being “cashflow positive.”

You can be profitable while losing money.

Huh? I thought profitable meant you were making money?

Income statements are designed according to accounting standards that are designed to “match revenues & costs in the period for which they should be attributed.”

Quick examples:

1. An ad network (the middleman) might sell $500,000 in ads. It might agree to pay the publisher who runs those ads in 14 days. The advertiser who bought the ads might pay the ad network in 60 days.

So for this money I might show that I’m profitable on my income statement but I might actually have paid out $500,000 that I didn’t receive yet (negative cashflow)

2. I might have sold a $1.2 million contract over two years. I therefore might be “booking” $50,000 per month in revenue on my income statement. But the customer may be paying me quarterly in arrears (at the end of the quarter). So for the first two months of every quarter I’m showing revenue on my income statement that I don’t yet have in cashflow.

3. The same is true obviously on the cost side. I might have bought $450,000 in equipment that I amortize over the three years that I expect this equipment to be useful. So every year I show costs of $150,000 but I really spent the money up front.

A year ago I invested, along with Dana Settle at Greycroft Partners, in a startup company called Maker Studios.

What excited me was that they had an immensely talented team that understood how to produce & distribute low-cost videos, initially via YouTube. It was founded by Danny Zappin, Lisa Donovan & Ben Donovan (along with several creative talent like Shaycarl, KassemG and others).

They know this model of YouTube production & distribution better than anybody else that I’ve met in my 5 years in Los Angeles.

And anybody who follows this blog knows that I believe television disruption has already begun and it is more likely to resemble Internet content than streaming long-form content to our living rooms.

As I talked about this model with several friends in Silicon Valley I always heard the same refrain, “we don’t invest in content business – they are ‘hits driven’.”

I had to laugh a bit at at the irony of this. For one, the consumer-driven startup world has become immensely hits driven. You need star power of entrepreneurs surrounded by star power angels & VCs who in turn get tons of press from adoring journalists who are insiders amongst this crowd of tech cognoscenti.

And this is at the same time that content has become more predictable. Sure, you need to start with talent. But when you produce on Internet you can test your content in the same way that Silicon Valley firms test early versions of their software.

You can get feedback from your audience and adjust based on their feedback. You can get subscribers who receive every version of your content that you release. You can monetize via Google Ad Sales before you have enough revenue to build your own sales team.

Sound familiar?

Maker Studios is the ultimate “lean startup.”

And then you can build email lists and market video content to your fans in the same way Gilt Groupe markets its clothes to its end consumers, making it an insanely scalable business.

In the era of the Internet video is not a one-way medium. Content producers can have direct relationships with end viewers that serve as feedback loops & direct marketing vehicles.

And nobody knows how to do this better on the Internet than Maker Studios. They are now the largest independent network who produce in-house videos and distribute them.

Maker Studios is dedicated to working with “talent” in the same way that Silicon Valley is dedicated to working with engineers. Our talent includes writers, directors, actors, singers, post-production professionals, costume designers, lighting professionals, sound mixers, show runners and so on.

This kind of business will not easily be replicated in Silicon Valley precisely because the skills are different.

We are now attracting serious management talent, having recently brought in the venerable Courtney Holt as the COO. And I’m excited to say that we’ve poached a major technologist from Silicon Valley who will move down to Los Angeles join as CTO in January. More on this soon.

But I really couldn’t do an overview of Maker Studios justice. I’ll leave that to Carson Daly who interviews Danny, Lise & Ben for Last Call in this great piece that describes what they do and why I’m privileged to watch them continue to build out their vision.

And if you happen to be “talent” (including tech engineers!) make sure to reach out to team Maker. There isn’t a more talent-friendly Internet video network out there.

I’m often asked by people what investment areas interest me.

It’s true that I have a functional focus on three areas: Performance-based marketing, digital television and mobile computing. I try to invest in things that I know and that I believe I might have better knowledge and relationships than the masses of VCs.

I have other areas of interest & competence such as cloud computing and document management given my background.

It’s also true that I’m mostly founder driven, where the founding team & my personal relationship with them leads to a strong mutual working relationship. If that bond isn’t there or if it feels like I’m in a bidding process for the highest price, I might as well be Wells Fargo.

But one theme in pervasive in all my thinking about investing in Internet-based companies: Deflationary economics.

And it’s something I think you ought to consider when building your Internet businesses.

Here’s what I mean

When you think about the great achievement of the Internet in aiding content, commerce & communication they include:

• Large scales of connected people & information never seen before in humanity
• Unprecedented transparency of information
• Open standards that make it easier to plug into other products & services, creating a global bazaar
• Socially connected individuals and platforms that enable faster roll-outs of successful products
• Payment ready consumers (Amazon, iTunes, PayPal) and businesses (Google AdWords, Square)

So which types of businesses become super successful given this environment?

Ones that offer amazing value (low relative margins) at high volumes that makes it nearly impossible for high-cost incumbents to compete. That’s what I mean by deflationary economics.

It is a classic case of the Innovator’s Dilemma in practice.  If you’re a startup and you haven’t read my summary of Clay Christensen’s seminal work please do.

It’s the single most influential piece of work in determining my investment philosophy and how I think about markets.  In a recent panel discussion I participated in with Fred Wilson he said the same.

Why Deflationary Business Win

In the simplest form, new startups have a product that is INFERIOR to that offered by the competition but at a dramatically lower price with the seller opting for a very thin margin on their product.

Initially their only customers are people who can get by on the reduced functionality or perhaps don’t have the money to spend on the expensive product.

Often it turns out that the market is greatly expanded by having a lower price point new entrant. And over time the new entrant attracts enough business that, as depicted in the graph above, the quality of the product slowly increases over time.

The new entrant keeps margins low but suddenly has a lot of profits due to large volumes of business.

How does the incumbent respond? Not by dropping price & quality – they don’t have an advantage there. Instead they spend more money trying to innovate on product quality and call attention to the weaknesses of the new entrants product quality.

Often major customers defect en masse to the new entrant as they realize that the huge price premium is not justified by the product differentials.

That is what Clay Christenson defined in his book as “The Innovator’s Dilemma.”

And this approach to looking at startup industries is what I call “deflationary economics.”

How it May Apply to Your Business?

When I’m asked about all of the mistakes I made at my first startup (I made them all) I often tell people that the single biggest mistake that I made was charging too much for my products.

We knew how to sell – we had clients paying $1 million / year. We knew there was value in what we provided. In order to grow we hired successful and expensive sales people who in turn were able to (and incentivized to) sell projects at higher margins and close big deals.

This was a mistake.

We grew really fast for a few years. But eventually low-cost new entrants came into the market offering most of our features at 10% the costs. We still won large customers but over time it became harder to compete.

Had I taken the lower-margin approach I really think I’d be sitting atop a $1 billion+ company today.

So when you start your company think carefully about whom your target customer is. If you’re trying to be a value-based product or trying to scale to a large market size you may want to think about deflationary economics.

• Does your product dramatically reduce costs in an industry with large incumbents and fat margins?
• Can you provide a narrowly focused product to a niche of that market who will be attracted to dramatically lower costs?
• As your business grows can you find ways to continually lower your costs by whatever means?

I would also think about how you use scale to your advantage to keep margins low.

• Are you offering a product where the supply costs will continue to drop precipitously? (think Amazon’s Storage costs)
• Are there alternative ways to monetize your product where incumbent are not? (think virtual goods of Zynga, ad supported models, freemium models)
• Are there ways to offer super low margins on your product knowing that you will overlay other product offers to the same customers later that will improve your margins?

Most of the Internet’s Greatest Successes Have Been Deflationary

Craigslist – Think about what Craigslist achieved. It’s remarkable. They took an industry that had charged people large sums of money (the classified industry) and made it almost entirely free. How do existing incumbents compete with that?

Craigslist is kind of an anomaly in that it’s founder seems to run it in a non-traditional style and with some objectives other than the pure profit motive. But by providing free listings he build critical mass (volume) so charging small amounts for certain types of listing (i.e. recruiting) he could build a very profitable business.

Craigslist is everybody’s favorite business to say, “I’m going to disrupt them” but somehow nobody has really been able to. Given their terrible UI I’m sure it will eventually happen. But beating free is hard, as is creating a two-sided market (chicken & egg problem).

Amazon – Amazon is the ultimate deflationary business. Everybody knows the story well. They launched as an online book seller.

They had huge scale advantages because they could offer a much wider book selection since they didn’t need to be limited to the physical floor space of a physical retailer.

They had huge cost advantages because they didn’t need to pay for retail space or all of the retail workers. They even

had a government break because they didn’t need to charge taxes and thus consumers got an even better price.

But Amazon didn’t try to build a hugely profitable business. Does that sound dumb? I always see naïve journalists comment negatively on businesses that are “not profitable.” Sometimes it’s good to not focus on profitability & sometimes it’s bad.

There is a tension between profitability & growth. The more you want the latter the more investments you make in people and infrastructure now to pay for faster growth that expense of short-term profitability.

It doesn’t work for every business. But if you are growing uber fast, building for scale and have access to capital to fund your growth then it’s always the smart play.

So instead of maximizing price they kept cutting costs.  Innovator’s Dilemma. How do physical retailers compete with that? Especially when Amazon will offer free shipping for its best customers.

And Amazon wasn’t content with just being books, they wanted to be THE Internet retailer. Walmart in the cloud. This generation’s Sears Catalog. So they kept cutting costs of everything they offered.

And then they decided they wanted to be the Internet retailer of computing services so they created Amazon Web Services

(AWS). And they made it so cheap that everybody gravitated towards them. They had a scale advantage and were driving deflationary economics (in other words, massively driving down the costs of goods & services).

I was at Salesforce.com when Amazon was super aggressive on that storage pricing. I met with our network experts to figure out whether we could launch a competing service. The assessment of our best experts was that we couldn’t. Their view was that Amazon was taking a loss on providing Internet storage.

I have not inside data on that but I’ll be they were right. I’ll bet that Amazon’s view was to start with a loss leader because they knew that storage costs could come down and that they could add more service on top of their storage product and ultimately provide a profitable bundle of IT services to their customers.

In other words, storage might have been a “loss leader.” In any event, they had such scale advantages in providing this Internet infrastructure that to this day nobody in the industry has come close to matching them.

In my estimation this is one of the biggest strategic mistakes Google has made in not competing more aggressively with AWS. The Cloud is the future at Amazon has an enormous lead. As far as I know, the revenue in AWS is not publicly broken out but the last rumor I heard was that it had crossed $1 billion per year.

Google – They have led the deflationary pressure on advertising, bringing whole industries into chaos. This has particularly hurt the print media businesses that can no longer charge enough to pay for editorial, printing & distribution.

They are bringing deflationary economics to word processing, spreadsheets and office automation. They are bringing deflationary economics to local advertising.

I guess I would describe Google as the ultimate scale & deflationary business.

Skype – As with many deflationary businesses, Skype started by giving away its product for free. Free phone calls anywhere in the world is as deflationary as it gets.

Telecommunication companies are still charging people for phone calls when the costs to them of providing the calls is infinitesimally small. Data transfer is what costs telecom companies money these days.

Ultimately when Skype had 10’s of millions of users it rolled out products that made money. They started with “Skype Out” which was placing a call from a Skype line to somebody on a normal telephone. They charge for this call, but they charge at rates that are an order of magnitude cheaper than a telco.

Expect this industry to be whiplashed by deflationary economics in the next 5-10 years. It’s no wonder they’re pushing so hard to be become our Internet supplier and our TV suppliers. Unfortunately for them neither of these businesses will escape the deflationary maelstrom either.

TextPlus – Speaking of telecom disruption, a new breed of mobile telco is emerging that are riding the deflationary wave. It’s the reason I invested in TextPlus. At 25 million downloads & 10 million monthly active users we’re achieving a scale that makes it a very attractive opportunity.

We started offering free text messaging at a time when most telcos are still charging $240 / year for unlimited-texting plans. In many parts of America that’s a lot of money for families to be absorbing for something that costs the telcos almost zero. That’s one reason a free texting app has been so popular.

But beyond that TextPlus now offers free phone calls to other TextPlus users and out-of-app calls are a fraction of the normal costs by mobile providers.

Expect a deflationary revolution in the global telecom market – at a minimum for voice services. And with 6 billion global handsets you can imagine what an immense market this will be.

LinkedIn – Lots of people talk about LinkedIn as a social network. What interests me is the deflationary impact that LinkedIn and other recruiting websites have had on the recruiting market.

Think of the principles I described about Internet economics of Craigslist: huge scale, many parts of the service are free and monetize the narrow features where businesses are willing to pay – and at hugely deflationary prices to their normal recruiting fees.

Zynga – Deflationary. In the offline world people were buying consoles and then paying for game titles separately – many in the $29-49 price range per game. Along comes an immensely scaled business that offers games for free.

I know, it isn’t offering the same quality of games so I’m not arguing that the entire game console business goes away over night. But it is hard to argue longer-term against the deflationary pressures that Zynga brings.

Maker Studios – Network television costs $50,000 – 100,000 per minute to produce. Reality shows can be cheaper, with the lowest-end costing $6,000 – 8,000 per minute.

Maker Studios is an Internet producer of content relying on deflationary economics. It produces shows for $500 – 1,000 per minute. It’s no surprise that it has now become one of the most viewed networks of video programming in the world, achieving 500 million video views per month having only raised $3 million in venture capital.

Maker Studios produces shows like =3 by Ray William Johnson (NSFW), one of the most subscribed to shows on YouTube. Many episodes are garnering 8-12 million views while its network competitor (and equally brilliant show) Tosh.O is getting 3 million views.

Other shows like Epic Rap Battles of History (my personal favorite – if you get addicted we’ve produced about 15 or so now. The best ones have been watched more than 35 million times) and Animonsters are delivering huge audiences and significant revenues.

I know that the networks, studios & cable companies don’t yet see this business as a threat. My experience in looking at deflationary businesses says that they should pay attention to it. Deflationary economics tend to eat at the core of traditional offline businesses.

Of course I could go on and on including businesses like AirBnB, DropBox, Box.net, Yammer and so on. All deflationary. But by now you more than got the point.

So What Do I Look for In My Investments?

Exactly what I’ve outlined.

• Teams that care about keeping costs low.
• Teams that want to drive waste out of the system.
• Teams that have a “lean” mentality.
• Teams that are comfortable with transparency of pricing & costs and don’t mind competing in that environment.
• Teams who aspire to build really big businesses and believe in deflationary economics.

Fred Wilson recently posted a great video on his blog with the CEO of Forrester Research, George Colony. The money slide is the graphic below.

The chart shows three scarce resources and their improvements over time. The top line is available storage (S), the middle line represents processing power (following Moore’s law) or (P) and the bottom line is the Network (N).

In it he asserts that the web is dying and in its ashes will see the rise of the “App Internet.” The App Internet is different than the HTML Internet (aka The Web, WWW and in the mobile arena “The Mobile Internet” or short-hand HTML5) because the “presentation layer” and “client side” functionality are defined by applications that run on your mobile device and connect into the open Internet back-end to exchange information with other web services.

He’s right about this. But only temporarily in my view. And while the App Internet is currently more powerful than the Mobile Internet it has fundamental flaws. It isn’t open in either its standards or in the way that applications are marketed and distributed. I will cover this in my post.

Colony’s presentation is intriguing (and worth a watch if you have a few minutes) because I love to see when informed people make arguments that are different than you ordinarily hear (and different from my own views). In the end, my bet is that George’s bets will largely prove wrong. This blog post lays out my case. If anybody from Forrester reads this I hope they won’t see it as an attack on George’s presentation, which I found enlightening, well argued and interesting. My views are just a data point in the debate.

In the end, Seth Godin’s comments on Fred’s blog post said it best:

“His black swan is showing.

The problem with just about every prediction made by industry firms like Forrester (all the way back to 1985 when these firms said that the Commodore 64 was going to change the world–until the VCR interrupted to become the next big thing) is that they are based on sophisticated analysis of what’s in the rear-view mirror. 

A tough way to drive.

The trends are legit, but we have no idea what unexpected breakthrough in human interaction is going to change everything.”

In other words, nobody can really assert authoritatively what the future of tech or the Internet will hold. I have some educated guesses.

George’s Arguments

1. The web is dying and will be replaced by “the App Internet.” He says that since storage & processing are growing at a much more rapid rate than the network we’ll be at a point where not having apps on devices will greatly under utilize the power of the devices in our hands. In other words, our mobile devices are all powerful and the network that they connect into sucks.

2. Social networking is peaking. He cites that we have reaching a saturation of social networking in which nearly everybody is already using social networks (85+% in most developed countries and in urban environments in the developing world) and the amount of time dedicated to social activities already exceeds many other important tasks such as exercise and is even approaching the same amount of time we dedicate to child care. He argues for a world he calls POSO (post social) in which we will only use social applications which drastically cut down our time involvement and/or increase our productivity.

3. Social media will be pervasive in the enterprise and is primarily driving by customer interactions. He shows data that the overwhelming majority of major enterprise in the US is currently adopting or looking to adopt social networking technology. When asked what their objectives are they cite some form of “improving customer communications” by a long margin.

A (Very) Brief (and Selective) History in Computing
To understand my perspective you have to rewind to the late 80′s / early 90′s in business computing. As a software developer I wrote code on what was called a “dumb terminal” because it literally had no processing capability. It is the opposite of the world that Colony describes. The local computer had no processing capability, the network did its job and the central computer was the master.

We wrote programs that existed solely on a centralized computer (a mainframe), all of our data was stored centrally and all processing was centralized. When we wanted to compile our programs (turning human programming language into an executable file that the computer can read) we had to submit them to the mainframe and wait for them to be processed in sequence along with everybody else’s code.

In busy times compiling a program could take more than an hour, so we obviously didn’t submit often and if our program had errors and was unable to compile it was devastating. Things got so bad on one project that we ended up doing split shifts with teams of people programming from 8pm-6am and the next team arriving at 8am.

Throughout the 90′s the PC became much more popular in corporate environments, so companies began to replace dumb terminals with PCs. We ran software on the PCs called “terminal emulation” that allowed us to act like a dumb terminal to interact with mainframes and to act like a PC (with word processing, spreadsheets, etc. the rest of the time.

In this era the computing model known as “client / server computing” was popularized. What this model said was that since we now had really powerful processing on our desktops we should split the computing responsibilities between the PC (the client) and the mainframe (the server). Initially the computer did basic functions like “screen validation” (making sure that you didn’t enter non-sensical data into fields, for example) and could take over functions like compiling your software code so you could check for errors before submitting it to the mainframe.

Over time the PCs began to do more and more. They took over the “presentation layer” of computing. As a society we got used to the windows metaphor of computing. So suddenly we had “drop down” boxes that gave us multiple choice selection of data, we had dialog boxes that would prompt us with “Are you sure you want to proceed? Y/N.” This initially took on what was called “thin clients” because the server did most of the work.

The more the processors on our PC improved, the more we expected our PCs to do and everybody gushed about this new era where we had much better user interfaces and we had way more individual device power. Centralized computing was giving way to smart, distributed devices.

Sound familiar?

It was wonderful. For 5 minutes. Then the unintended consequences started cropping up.

• How much data was acceptable to sit on local devices? Few had considered what happened in a world in which the data was distributed. Suddenly you had security risks, confidentiality problems, privacy concerns (think about your medical records being distributed), etc.
• What happened when you submitted a processing request to a central server (think, I’d like to transfer money from my bank to yours) but the transaction didn’t complete? You could be in a situation where your local computer had assumed the money was transferred and it wasn’t. We had to develop whole frameworks of “middleware” to deal with this problem. We had to come up with “two phase commits” and “rollbacks” and other data tricks to keep our devices in sync.
• We started to realize that that most expensive part of computing was actually manpower. Manpower to develop all of these applications, manpower to maintain them, and manpower to deal with all of these devices, which added great complexity to our IT environments. For example, on any software upgrade for a typical client/server enterprise package it would take up to 50% of the overall development budgets to deal with testing the software in heterogenous environments.

So having powerful devices with decentralized computing is not always a panacea.

Enter the World Wide Web (WWW).

As George appropriately describes in his video, the Internet and the Web are two different, but related things. The Internet represents what you might think of as “plumbing.” It defines how data gets moved around on networks, how files get located, how files get transfered between devices, how packets of data get sent via routers, etc. The WWW is the presentation layer. It’s central standard was HTML (hyper text markup language) that described how we would show data on computer screens.

When web browsers (the programs that can read and interpret HTML) were popularized they were “dumb.” It was literally like returning to the old days of computing. On the Web almost all of the processing was centralized and your browser was your input / output device. As an example of how dumb they were (for those that don’t remember) whenever you changed one field in a browser-designed program the entire screen had to refresh. It was a terrible user experience.

But for software developers like my company the web was a blessing. We were able to crank out software code at a much greater pace than was ever possible for. We designed our code and tested it in a Firefox browser and once we had working code we then had to figure out how to make the clunky Internet Explorer work. But the heterogenous environment was practically eliminated. We didn’t have to worry about which computer you were on. we didn’t have to support 3 database types, worry about network configurations, etc.

We flirted for a brief period with building some client-side applications (mostly for offline use) but abandoned those efforts when we realized how much overhead it took to maintain – especially as we release new versions of our code and had to always keep the local, offline software in sync with our releases.

We adopted an ethos that all of our development would be web only and that eventually browsers would become more powerful and make the user experience much better. And that’s what happened. A series of standards emerged known as “AJAX” (asynchronous javascript and xml) that gave the web-based designer much more control over the browser. Suddenly you could update small portions of the browser without refreshing the whole screen.

AJAX was one of the major drivers of the “dot com renaissance” that became known as Web 2.0. As people realized streamlining client-side development really matters to cost-effectively build software, new tool sets emerged to streamline the process. Libraries like jQuery have emerged that lower the effort to build front-end code.

Web & Social Change the Landscape of the Web

Prior to the popularization of smart phones and Facebook we were in a pretty good place on the Web. The one big concern many people had was how to constrain the total dominance of Google. Every startup (every company, really) was beholden to the traffic god that was Google search. One change in Google’s algorithm and whole businesses could be wiped out as chronicled in this excellent book by John Battelle called The Search.

The growth of social networking (er, the growth of Facebook) along with the growth of the iPhone have changed the landscape dramatically.

In this chart from Silicon Alley Insider you can see the first major trend to affect the open Web – the growth of Facebook. And Facebook’s popularity has only increased in the past year.

Why does the rise of Facebook affect the web? Because it isn’t a part of the open WWW. Facebook exists behind a walled garden. You need to log in to use it. Content or software developers who want to build products that work in Facebook have got to develop inside of Facebook’s framework rather than working on open, Internet standards.

Brands, celebrities and even individuals like you who produce information inside this walled garden are subject to the rules & conditions set upon you by a private company – Facebook. This isn’t a case against Facebook, it’s just a statement of fact.

As more people consume Facebook pages, less people are consuming open Web pages.

I wrote about this previously here and spoke about it on YouTube with Howard Lindzon here & here. (if you’re not that familiar with the topic it’s worth a 20-minute watch)

Is the App Emerging as the Winner?
The App Internet had a clear advantage in the past few years. Why? Because the mobile devices had a series of new features for which mobile browsers were not optimized. Examples include the camera, GPS, the accelerometer and the small screen sizes.

And importantly when developing games that require high-end graphics to handle game play you need to make use of the iPhone’s PowerVR GPU (graphics processing unit).

So Apps were inherently more powerful than browser-based applications.

It also had two other huge advantages.

1. Apple had a mechanism for charging users for apps and because most people already had an iTunes account it was simply 1-click to purchase an item. This meant that small teams could create games and make real revenue whereas on the Web this was much harder because you either had to build (or license) your own billing infrastructure, convince consumers to get out their credit cards (which they don’t like to do) or you had to sell enough advertising to make it worth offering your product.

2. Apple had a store. For early game developers this made it easier for your application to be found on the limited “shelves” in the iPhone App Store. Now that there are MANY more apps out there – this isn’t such an easy game. But in the early days the App Store was very appealing to new entrants.

Round 1 clearly goes to the App Internet.

Will the App Metaphor Hold for Mobile?
This is where my disagreement with many starts. I think the allure of Round 1 has convinced people that in mobile, apps are better. I’m not so sure.

1. Workarounds are developed. The surest sign of a market inefficiency is when solutions emerge to help developers get around the bottlenecks of platform development. This is what is happening in mobile. Developers are now able to build apps in native languages such as Javascript or HTML5 that can run in multiple platforms.

There are companies that develop “wrappers” that in essence handle all of the functionality needed to control each individual device that “abstracts” the programmer from having to build in device specific code. Some of the companies that do this include PhoneGap, Appcelerator, Strobe and RhoMobile.

2. Browsers will catch up. Just as in the first round of the web when everybody complained that web browsers weren’t powerful enough to build applications on, many of us believed that open systems would win. Eventually standards will emerge that will make it easier to build natively into browsers. Effectively either the wrapper developers become browsers or the browsers build wrappers or the two groups merge.

Also note that AJAX finally took off when Google open-sourced a bunch of its internally built AJAX frameworks. I wouldn’t be surprised if big innovations from Facebook and others in the mobile web eventually see there way into open-source mobile initiatives.

3. The costs of multi-platform development are too expensive. The costs for developers to build for multiple platforms is too great, the gatekeepers are too powerful and the outcomes ultimately limit innovation as happens in any system when a few players are a choke hold on distribution.

If you want to do a deeper dive on why I believe this is bad overall for the system despite the short-term allure of iPhone’s beautiful products please see my post “App is Crap, why Apple is bad for your health.” And before Fanboys slam me, please note that I own 3 Mac laptops, 2 iPads, 5 iPod devices & Apple TV. I love the products. That doesn’t mean I think it’s great for our future as an industry to have a close distribution system.

4. Distribution becomes a stranglehold. Fred Wilson talks about this in his “mobile gatekeepers” post. The early allure of empty shelves in the App Store is making way to the over-crowded shelve (currently tallied at more than 500,000 SKUs). This leads to all sorts of games by developers to get into the rankings, most of which favor companies with more cash.

Also, whenever we see distribution strangleholds we tend to see slower innovation and more resistance by the distributor to change. Think about the following examples:

• mobile phone companies who controlled our crappy phones prior to the iPhone breaking that hegemony
• cable & satellite companies who have controlled our paid TV through set-top boxes that make it impossible for innovation on the TV set
• radio stations that controlled the music we listened to until music could achieve wider distribution on the Internet

Choke points are never good for innovation.

5. Data, data, data. Just as when we first went from mainframe computing to client-server computing we forgot that data leakage and data management across multiple devices is a big issue. The App Internet creates the potential for many more data issues. That doesn’t mean they can’t be solved, but it’s not as easy as saying, “powerful apps on our mobile devices is the best answer.” More power, more distribution = more data problems.

6. TCO. There is an acronym we use in computing called TCO or Total Cost of Ownership. It is often used in ROI calculation on projects to estimate a build vs. buy decision. Often people who build apps internally at their company calculate only the costs of the initial build rather than the total costs of maintenance of the project. Maintenance often greatly exceeds the development costs when you consider both human costs of maintenance plus the loss of productivity of not having an app that innovates as fast as the market solutions do.

I think there’s a TCO argument to be made against the proliferation of the App Internet. The more companies build their own apps, the more maintenance work they’ll need to do, the more employees they’ll need to maintain their apps and the further the innovation drain. I know this is a harder concept to quantify and intellectualize but I’ve seen it first hand in 20 years of working with large corporation on “legacy” IT projects. The App Internet opens the door to many more legacy apps.

This argument never features into any young developers mind because it takes years to see the decaying effect of legacy infrastructure in corporations (plus, many app developers prefer the sexy world of consumer apps).

To be clear … I think that the App Internet won’t disappear overnight. I also think certain apps will always be more effective built natively. But the same is true of today’s non-mobile computing. Still, most apps need not exist. Long live the Mobile Web.

And What about Colony’s Assertions about Social?
I’m going to save that for a future post. Coming soon.

Postscript:

“If I had more time, I would have written a shorter letter.”

Marcus T Cicero

Sorry for the uber long post. Given more time I could make it concise. And I’d have fewer typos. But I valued getting my ideas out there. If you think there are any inaccuracies I’d be glad to meet you in the comments section and I’ll gladly amend any mistakes (rather than differences of opinion)

I recently gave a talk about the Future of Television. I’m still planning to write some in depth pieces on the topic but I thought I’d do the quick version here.

Since this is about how video will consume the Internet over the next 5 years, what better way to exemplify this than with a 10-minute video? Here’s a link to watch it or click the image above (Sorry for speaking so quickly. I was given the impossible task of covering this in just 10 minutes.) The the text summary is below.

1. The promise has been made for too long, People are cynical – We’ve been promising digital, interactive video since the Time Warner trials in Orlando Florida in the early 90′s. So the industry has heard this claim for long enough that nobody really believes it will happen.

2. The right factors are finally in place - I believe that for any innovation to take place you need a variety of factors to be present. For example, YouTube took off rapidly because they timed some changes of Flash perfectly that allowed you to be able to watch video on the Internet with limited hassle. The key factors that had to come together are depicted in the graphic below

3. YouTube is the new Comcast - Many people perceive YouTube as “dogs on skateboards” and don’t realize that it is now professionally produced content that is driving billions of video views each month.

The first two companies to realize this en mass were Machinima & Maker Studios (where I am an investor. If you press on the link to the company you’ll see a very cool, short video that describes the company). If you add Vevo & MovieClips these companies are doing well in excess 3 billion video views / month. They are becoming very large businesses in a rapid period of time. Note that the logo of YouTube used to say, “Broadcast Yourself.” It no longer does.

YouTube is the new Comcast. It is the new distributor of video. Yes, it’s lower quality than network, primetime television. But many network shows cost up to $100,000 PER MINUTE to produce. Maker Studios costs about $500 per minute. Guess who has a huge advantage in the future of the medium.

4. The distributed ad platform enabled this industry to evolve – What people often don’t realize is that until we had a “distributed ad market” it was very hard to build a low-cost video business. But with YouTube / Google now selling both pre-roll (the 15 second spot before a video) and translucent overlay ads), video producers can now make profits on producing ads – provided that they can produce them at a low enough cost.

This is a point that is lost on many in the industry who complain about the “low CPMs on YouTube.” They don’t realize that “low” is relative. If you don’t have the huge costs of production & distribution you can build a meaningful business on “low.” And keep in mind that YouTube sells your inventory for you. This allows startups to reach a certain scale before hiring a direct salesforce.

5. Internet TV is following the CLASSIC case of the “Innovator’s Dilemma” – the most fundamental driver of the Internet destruction of industries that we’ve witnessed over the past 15 years. If you want a quick description of the Innovator’s Dilemma and why it chews up existing industries see this short post.

6. Cable & Satellite packages will become music albums – In fact, I believe we’re finally on the verge of seeing some of the signs of television following the music industry. My analogy is that “cable & satellite bundles are the album. and given choice consumers prefer either singles or to make their own bundles.” Watch the video if you want to understand this analogy more deeply.

The TV industry in the US is worth $350 billion in its own right. 91% of all US households pay for television bundles. This is overpriced and consumers are paying for content they don’t watch. In a world of controlled distribution the powers that control the distribution can force that on consumers. The Internet changes all of that. The industry feels slightly complacent due to the “cry wolf” problems of saying it’s right around the corner for nearly 20 years.

It’s not “right around the corner” but the sea change has already begun.

7. Mass adoption of Internet video has already taken place – 86% of all Internet consumers in the US now watch online videos. That means your mom is now watching online videos. Yup. In fact, 108 million people will watch 1.3 billion videos. TODAY. (according to Comscore). In August of this year 185 million people watched 42 billion videos for 17 hours. That’s 228 videos PER PERSON.

8. TV is the medium people prefer (whether we like it or not) – Much as intelligent people don’t want to believe it, Americans watch on average of 5.3 hours of TV PER DAY and read less than 1 hour. They are online for 3 hours / day. So I would argue that the future of the Internet will be video. And lots of it. In fact, 12-17 year olds already spend 33% of their online time watching videos.

9. Video is different than text. It requires unique, creative skills – And who’s going to produce all of this content? It’s not as easy as text. It takes screen writers, sound people, lighting, editing, costumes, direction, post-production and acting. I think that creative talent is going to play a major role in the next wave of the Internet. And I find that exciting.

10. This revolution is starting in Los Angeles. This is the first time LA has had our own locally produced, massive tech opportunity that is unique to our city – the majority of these people live and work in Los Angeles. Where I call home. And where GRP Partners, the VC firm in which I’m a partner, is based. We’ve seen other centers of excellence in the Internet era here (lead generation, price comparisons, affiliate networking, ad technology) but nothing of this scale. And it’s exciting.

If you want the PowerPoint version in stead of the TV version of my presentation I can still do that, too. I’m Old Skool. Deck is below. You can download it, too.

Future of TV

The tech market is filled with many stories of early-stage funding. It’s even more exciting when you can report an exit of a company that is a major win. That’s why I’m proud to announce today that HealthDataInsights (founded by Victor Chaltiel), where GRP Partners was a 30% owner, has been acquired for $400 million. It maps to several themes about “solving bigger problems,” “taking more meaningful ownership positions” and “women in entrepreneurship.”

Let me explain all three.

1. Solving bigger problems
HealthDataInsights (HDI) is a company that helps to recover money for the government or private insurers who have been incorrectly billed or fraudulently charged. This is important because at the US federal level Medicare is billed about $500 billion (yes, that’s half a trillion!) / year and it estimates that up to 9% of its billings are over-billed or fraud. That’s $45 billion just in federal billings. HDI also focused on state Medicaid programs as well as private insurers.

Just how effective has HDI been at recoveries? At the federal level HDI is responsible for auditing 22% of the US territory yet has been responsible for 41% of all US refunds or a whopping $658 million between the original pilot program and the current program.

So when I talk about solving big problems – 2/3rd of a billion dollars to taxpayers is high on my list. The longer-term potential of this is enormous, which is why the company was acquired by HMS Holdings. They are excellent at what they do.

The science of finding recoveries is based on computer-based algorithms that flag high-potential errors and trained technicians that then review these claims. My partner & mentor Yves Sisteron (You can get to know Yves in this YouTube video) has been active at HDI for years (as has our CFO, Dana Kibler).

2. Taking more meaningingful ownership positions
Every investor has different strategies for driving returns to its shareholders. At GRP Partners our focus has always been on having a small number of investments in the industries we know well. Our investments focus heavily on the financial services industry, digital media, mobile applications & infrastructure, SaaS / Cloud and retail innovation. These are industries in which our partners have focused for the past 15-20 years.

And we’re not restricted to territories. HDI is based in Las Vegas. Our other big wins came from Chicago (Ulta & Envestnet), Baltimore (BillMeLater), New York (DealerTrack) & LA (TrueCar). We have two big winners in France, one in the UK and a couple in San Francisco.

When we invest we tend to be very active in our companies and we look to invest enough capital to have meaningful ownership stakes. In the case of HDI, for example, we owned 30% of the company, which therefore returns a sizable portion of that fund (the company was profitable enough that it had already dividended out a 2x return on capital invested prior to the exit).

Having had several big exits like this under our belt (the largest being Ulta) is what drives the Prequin returns for our last GRP fund to be ranked at the top performing fund in the US for its vintage year. (note: some people note that Prequin is only one of several industry databases ranking companies. Whatever the outcome, our fund will be ranked in the top 5 funds or top 1% no matter how it’s sliced).

9 companies out of 33 drove our largest returns. Where we find companies that perform well, we always look to invest more capital over time, not reduce our stake. We believe in the model of investing in a few companies and spending much time with them over the years.

3. Women Entrepreneurs
I thought it was worth noting since “women in tech” is a much debated topic, that our two biggest returns of our last fund – Ulta & HDI – were run by women. Andrea Benko, the founder & CEO of HDI, is simply one of the most talented CEOs we have worked with in our portfolio and that included 15 companies that have exited north of $1 billion. Lyn Kirby ran Ulta Cosmetics from its early days through its successful IPO.

I don’t think that makes us unique or says that we did anything proactive to encourage this. I don’t want to give us any unique credit. Still, for all the discussion about there not being more female entrepreneurs it’s quite an achievement and testament to Andrea & Lyn that they were the most successful in our peer group and both built extraordinary companies.

I will be giving a speech today on The Future of Television at the PaidContent conference in LA. I will write way more details about this in the coming months but I thought I’d give you a sneak peak at my presentation for today.

Future of TV

Feel free to leave comments and we can have a discussion about the topic in the Disqus comments section

*** (if there are typos in the presentation don’t bust my chops. I tend not to care about that sorta thing. I value getting my ideas out for debate – not whether I had time for spell check)

Early today I gave a keynote at the VCJ Venture Alpha conference here in San Francisco. I was asked to speak about the topic of “what is going on in the venture capital world and what is the next big thing after social networking?”

Future of VC Internet –

Tough topic, but what the heck?

Next week I promised to follow up on PE Hub, one of the main journals VCs read about our industry, with a detail description of some specifics that are happening. Watch out for that – I will have a lot more details.

I’ve listed some great VCs in the presentation. I’ve left off many great ones. It isn’t intentional. You can’t cover everybody in a prezzo. Please don’t read anything into that. Some of the big ones I left off was Tim Connors of PivotNorth and Aydin Senkut of Felicis Ventures.

And all feedback welcome! See you in the comments.

By now you probably know that Netflix is splitting its business into two parts: its digital streaming business (retains the name Netflix) and its DVD mailing business, which was its original business (to be called Qwikster).

If you haven’t read Reed’s explanation of this split make sure you read it (of course, after you’re done with this post ) —> here. It’s simply brilliant.

1. He acknowledged mistakes in his past communications and apologized
2. He offers a transparent explanation of his business and;
3. [most importantly] – It’s a great strategic decision.

With nearly 25 million customers using Netflix it’s clear that everyone will have an opinion on this. And many short-termists will think it’s a bad idea. Indeed, my Twitter stream tells me so. I find much of the criticism so far fairly reactionary. I would like to take the opposite side of that debate.

If you haven’t read my post on the Future of Television and the Digital Living Room you might enjoy that as a primer. In it I talked about how I believe that Netflix has a very strong lead in the battle for the “head end” of the digital living room. Right now they’re the leading platform for streaming movies. Hulu is the leading player for streaming television.

Frankly, I’m surprised Netflix doesn’t buy Hulu. In my opinion it’s the most natural fit and it would give Netflix a very strong presence in Los Angeles and in TV (obviously subject to getting the right rights from the studios).

So why on Earth should Netflix split into two businesses?

1. Innovator’s Dilemma – In his seminal book, “The Innovator’s Dilemma,” Clay Christensen talks about why industry leaders almost always fail to act when “disruptive change” enters their business. He defines this as new products that are dramatically cheaper, lower quality, lower margin but larger markets. Incumbents can’t react.

If you haven’t read his book please do yourself a favor and buy it. It’s the most profound book I’ve read on thinking about how the Internet is changing business. Period. But for now feel free to read my short summary of the key principles.

The reason that incumbents can’t react is that their revenue and defensibility are continued by serving the high-end of the market for which it would take too much time & money for any competitors to effectively challenge. In Netflix’s case this is their DVD distribution business. It’s hard to imagine somebody else being able to effectively compete with that.

But the real threat comes from the change in technologies that rule the old business obsolete. Streaming. It’s clear that in the future movies & TV will be delivered to our homes from the cloud. Indeed for many this is already the case.

To win the future he needs to attack his core assets by building new ones. Very few companies ever do this. It would be like if Microsoft undermined its Office franchise by aggressively pursuing a Google-Docs-like strategy. Yeah, I know they did, but too little, too late, too lame.

2. Focus – By having two separate businesses, each with its own CEO and own teams, they can focus on their two very different businesses and develop the right strategies for each. The Qwikster team can’t make any excuses for not hitting their numbers and can’t argue that their resources are being funneled onto streaming projects.

The execs of Qwickster have got to continue to sell the merits of that DVD business – the most notable of assets is the much deeper library than the streaming business.

Equally, the streaming business has got to accelerate content acquisition, focus on customer retention, improve streaming technologies to make it better for users / worse for competitors, and they’ve got to continually improve the UI.

3. DVDs won’t die quickly – As Mark Twain would say, “The reports of my death are greatly exaggerated.” We all predict that technology change will cause obsolescence of previous technologies much more quickly than they actually do.

MapQuest was (and is) a much shittier product than Google Maps yet people used it for years. It defied logic. People still pay for AOL dial up years after they no longer need to. And many people actually still use Evite. Crappy. Old. Evite.

Many people are happy to receive their regular DVD mailers and for these people (still 14 million subscribers!) this service will continue.

4. Charge the right prices for the right services – But as fewer people take the DVD service over time, there will be less revenue to cover the relatively high fixed cost structure of the mailer (Qwikster). So it wouldn’t be a surprise to see price increases in Qwikster in the future. No time soon. But eventually. It seems logical.

And what about streaming? This business will adapt, too. Who says that “all you can eat” pricing is the right one for a streaming service? Maybe it is, maybe it isn’t. In the DVD world they could always limit you because you could only have a certain number of videos outstanding and any time. With streaming, this is harder to enforce.

Plus, content rights are harder to secure for streaming. If you haven’t followed this check out what’s happened with Netflix’s biggest content partner who has withdrawn from the service.

It’s possible that the best structure in the future is PPV (pay-per-view) or different tiers of content pricing (i.e. new arrivals plus library versus just library) or even create channels (i.e. kids movies priced as a separate package). Who knows?

Separate businesses allow them to play around with different pricing models without affecting the other business line.

5. Transparency for investors – I also love the transparency that is created when you have two businesses that will move in opposite directions, have different strategies and different economics. For investors this is huge. As Dan Frommer pointed out, all of the news reports on Netflix said that they had lost 1 million customers from their recent price increase. In fact, they are projected to only lose 200k streaming customers (800k DVD).

6. Positioning for the Future - It’s rare in business to see somebody like Reed Hastings tackle the massive changes happening to their businesses and deal with them before they’re too late. Imagine if the record labels had been as bold. By making the separation Reed can now point the Netflix business squarely at the future. Netflix can stop having to answer questions about its DVD business.

A note for industry

I argued ages ago that Yahoo! should have come out early and say, “we lost the search war to Google but we still have a have a great media business and we’re going to focus on that.” They dithered for years. Imagine if Carol Bartz or the Yahoo! board had had Reed Hasting’s clarity and boldness.

When Fox first hired its triumvirate of CEO’s to run MySpace after the founders’ departure, I argued the same.  Announce you’ve lost the social networking battle with Facebook and that you’re now focused on a narrower business for gamers and for music. In stead the press story for 2 years was about how they were losing to Facebook and continuing to hemorrhage revenue and people.

Reed is showing the cojones that so many others haven’t.

Any Hollywood studios taking notice?

==> What do you think about the Netflix decision?