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Modern Monopolies

What It Takes to Dominate the 21st-Century Economy

St. Martin's Press

PLATFORMS ARE EATING THE WORLD

When you truly see networks, it changes the way you plan and strategize. You move differently.

— Reid Hoffman, CEO and founder of LinkedIn

Software is eating the world. That was the message from former Netscape founder and renowned venture capitalist Marc Andreessen in an op-ed he penned for the Wall Street Journal on August 20, 2011. In it, Andreessen made the case that software companies were about to become a cornerstone of the world economy. "We are in the middle of a dramatic and broad technological and economic shift in which software companies are poised to take over large swathes of the economy," he wrote. In short, software was "eating" a larger piece of the economic pie every day.

Andreessen was right — software companies were already playing an enormous role in our economy. But classifying all of these new businesses simply as software companies would be like classifying every business in the Industrial Revolution as a hardware company. It doesn't tell you much about what these companies do or how they work. And, more important, it doesn't tell you much about how software is changing the way businesses succeed and grow.

Plenty of companies improved their margins and streamlined their supply chains by using software and connecting their businesses to the Internet. Andreessen named a few in his op-ed, including FedEx and Walmart. But he also named a litany of companies he saw as leading the charge of the new software economy. The list included Apple, Facebook, Twitter, LinkedIn, Google, Microsoft, Foursquare, Skype, Amazon, Flickr, Square, and PayPal. Yet Andreessen missed the opportunity to explain how different these companies were from the old-line businesses he named. Yes, each of these companies was built around the Internet. But more important, they are all platforms. Rather than merely squeezing a little more efficiency out of an existing business, these companies operate on a completely different model that truly capitalizes on the Internet's potential. Even as Andreessen wrote his op-ed, many traditional businesses were already being overtaken by their platform competitors. In fact, Apple became the most valuable company in the United States, exactly one year to the day after Andreessen's op-ed appeared.

While software may have started this economic revolution, it's platforms that are eating the world. Collectively, platforms dominate the Internet and our economy. Net neutrality proponents rightly focus on Internet service providers like Comcast, who provide and maintain the underlying technological infrastructure, as the biggest threat to a free and open Internet. And at an architectural level, the Internet is still a fairly level playing field. Anyone can start and build a business online. But as a practical matter, the open Internet is a myth. The Internet as we know it today is almost entirely dominated by platforms. For example, Facebook is responsible for nearly 25 percent of total visits on the Web. Google's sphere of influence is even larger. When the company's entire platform mysteriously went down for a few minutes in August 16, 2013, it took an estimated 40 percent of global Internet traffic with it. Search and social networking aren't the only areas of dominance. Platforms now play a major role in just about every area of commerce imaginable. In the United States during 2015, every one of the top ten trafficked U.S. websites was a platform, as were twenty of the top twenty-five.

The dominance of platform businesses isn't restricted to the United States, either. Platforms are a truly global phenomenon. In fact, they play an even more prominent role in developing countries than they do in the United States. The economies of many of these countries were growing rapidly at the same time that Internet access became widespread. And because these countries didn't have the existing commercial infrastructure that developed economies did, their industries have been molded around the Internet. China is a great example. Outside of state-sponsored industries, such as finance, construction, and oil production, many of the most valuable Chinese companies are platform businesses, like Tencent (owner of the WeChat and QQ messaging platforms) and Baidu (China's answer to Google).

China's Internet also is dominated by platforms. Platform businesses hold each of the top eight spots in Chinese Web traffic rankings. And these companies play an even more dominant role in China's economy than platforms do in the United States. Alibaba, which went public on the New York Stock Exchange in September 2014, controls 80 percent of China's e-commerce market through its Taobao and Tmall platforms. Its Alipay platform is the largest payments platform in China. Alipay also allows users to put money into its Yu'e Bao Fund. At $94 billion as of January 2015, Yu'e Bao is one of the largest money market funds in the world.

Whether you're building a platform business or not, you can't succeed in this economic environment without understanding how platforms work. Want to market your business direct to consumers online? Now you can, but you better rank well on Google. Want to get people to read your content? Well, your content better share well on Facebook. Want your app to get lots of downloads? You better rank well in the App Store (or get featured). Want to sell merchandise online? You're probably going to do some selling through eBay and Amazon. Do you sell handmade goods? Then you're probably on Etsy. If you're in China, then you're almost certainly on Alibaba's Taobao and Tmall, and you probably process payments through Alipay or Tencent's Tenpay. The list could go on and on. The Internet is allowing an unprecedented democratization of economic freedom. Anyone can start a business and succeed online. But it isn't perfectly open. Someone has to orchestrate all of this economic activity. As a result, the Internet and our economy are dominated and run by platforms. They organize commerce and information and shape the world as we know it. If you want to understand how the Internet works today and how the economy will work for years to come, you need to start with understanding platforms.

IPO, PLEASE DON'T GO

If you were one of the millions of U.S. TV viewers who tuned into the Super Bowl on January 30, 2000, you were treated to an unusual sight.

No, we don't mean the St. Louis Rams picking up the franchise's lone Super Bowl victory. As always, the real show was the commercials. That year, they didn't disappoint. During one commercial break, an ad opened with the sad face of a dog as it watched its owner pull out of the garage to drive to the pet store. Then a crooning sock puppet came into view. It belted out an off- key version of Chicago's "If You Leave Me Now" for some 30 seconds, imploring you to buy pet food online. Why? So that you wouldn't have to leave your heartbroken pet at home when you go to the store.

The company, of course, was Pets.com, then at the pinnacle of its reign atop the dot-com pyramid. Following the football game, the USA Today's Ad Meter ranked the sock puppet's Super Bowl commercial number 1 in its list of Super Bowl ads. Pets.com was the most memorable company from what would come to be known as the dot-com Super Bowl. The commercial, which cost $1.2 million, was a runaway success, as was the company's mascot. The sock puppet even made an appearance on ABC's Good Morning America and gave a long interview on Live! with Regis & Kathie Lee. And just months earlier, it had appeared as a thirty-six-foot float in the Macy's Thanksgiving Day Parade.

Founded in August 1998, Pets.com launched with an aggressive marketing plan and the goal of getting big fast. This was the M.O. of many Internet companies at the time, for which scale was the business model. Pets.com went public less than two years later on February 9, 2000, shortly after its Super Bowl commercial aired. Its public offering raised $82.5 million and the stock began trading on the NASDAQ at $11 a share under the symbol IPETs.

Despite its mascot's enormous popularity, Pets.com had a problem: Its business model was broken. Its assumption, one shared by many prominent venture capitalists who invested in Pets.com and similar companies, was that if the company got big enough fast enough, it would be able to turn a profit. First-mover advantage was everything, or so the theory went. This strategy gained currency as the then-vague idea of "network effects" caught on, popularized by a 1994 academic paper published by W. Brian Arthur. Arthur's view of network effects suggested that whomever got big first would always win.

But for Pets.com, the numbers just didn't work. For one, at the time the market for people wanting to shop online only for pet food and related products was smaller than the company had estimated. Pets.com also invested in a large warehouse to store its products, meaning the company had high fixed costs. Even worse, Pets.com had to price low to compete with existing pet stores, even though many of these stores already had razor-thin margins on pet food. As a result, the company actually lost money on most of the sales it made. This combination of high costs and nonexistent margins was ultimately unsustainable. And it didn't take long for the company and its investors to figure this out.

On November 6, 2000, Pets.com declared bankruptcy — only nine months after its initial public offering. The company had burned through $300 million in investor money in less than two years. The day of the announcement, the company's stock had declined from its opening price of $11 a share down to just $0.19. It's now a perennial on "biggest investment bombs in history" lists.

But while Pets.com was undergoing its meteoric rise and equally rapid fall, another dot-com company was launching its own, very different story. On Labor Day weekend in 1995, a computer programmer sat down to write code for his new website. Called Auction Web, the website was designed to be a digital marketplace where people could buy and sell anything over the Internet. The creator wanted to create a "perfect market" that could be used by everyone.

Apparently, other people wanted the same thing. A lot of other people. The company grew quickly. In 1996, Auction Web hosted 250,000 auctions. In January 1997 alone, the site hosted 2 million. Its revenue grew by 1,200 percent in its first year, from $350,000 to $4.3 million. That September, the company changed its name to eBay.

Shortly thereafter, the site's founder, Pierre Omidyar, decided it was time to look for a CEO. He hired Meg Whitman in March 1998. She took the company public six months later, on September 21. The stock debuted at $18 per share and rose as high as $53.50 in its first day. Omidyar became a billionaire overnight.

A VERY SHORT HISTORY OF BUSINESS MODELS

For many, Pets.com is the classic example of dot-com-era excess. Those people are not wrong. The company spent millions on marketing without having a sustainable business model or a proven target market. Since many investors at the time weren't sure how to price Internet companies, lots of startups received valuations and investments that seem laughable in hindsight.

Most of these failed companies made the same mistake. Like Pets.com, they took an old business model and slapped the Internet on top. The promised benefits of network effects and lower costs never materialized. But when the bubble popped and many dot-com darlings crashed and burned, eBay was still profitable and going strong. Over time, eBay grew into a company with a market cap of more than $66 billion. It was one of the few success stories of the dot-com era. And that's no accident. The difference is the business model.

Companies like Pets.com made the mistake of choosing a linear business model in the age of the platform.

What is a linear business model? It's the model that has dominated in various forms since the Industrial Revolution, when new technologies like steam power and railways gave rise to the large, vertically integrated organization. All of the titans of industry from the early twentieth century were linear businesses, including Standard Oil, General Motors (GM), U.S. Steel, General Electric, Walmart, Toyota, ExxonMobil, and on and on.

Each of these companies created a product or service and sold it to a customer. In all of these examples, value flowed linearly and in one direction through the company's supply chain. Hence the term "linear business." In this supply chain, to the left of the company was cost and to the right was revenue. Linear companies created value in the form of goods or services and then sold them to someone downstream in the supply chain. (See Figure 1.1.) Historically, there were two main types of linear businesses.

The first is your classic product company. Think Lenovo in consumer electronics. Lenovo makes and sells physical things. It builds physical assets, such as factories and distribution centers, in order to make its products and get them to consumers. Almost all manufacturing has worked in this linear fashion over the last century. So have distributors and resellers, which are companies that build or lease physical assets or technologies in order to distribute and sell physical products. Examples include resellers like Walmart, Best Buy, and Target.

Many of today's software companies also fit in this group, including most software-as-a-service (SaaS) companies. Even though their products are digital, these companies still function linearly, with value flowing from the companies to their customers. The only difference is that software companies benefit from the low marginal cost of digital distribution.

The second type of linear business model is a services company. Examples range from Oracle to JP Morgan to Jiffy Lube. These companies hire employees who provide services to customers. Generally, services companies fall in one of two camps. The first kind makes and sells physical services. Your car mechanic and plumber both fall into this category. The second builds human capital or intangible assets, like intellectual property, and uses those assets to sell specialized services. This type of services company includes everyone from tax attorneys to investment bankers or management consultants.

These models dominated the twentieth century for a good reason: They can be very efficient. Premised on top-down planning and hierarchical organizational models, these businesses create value and distribute it efficiently to their target customers. They achieved this efficiency via the supply chain, a highly structured system for organizing activities and resources that moved a product or service from the company to the customer.

The supply chain is also linear, consisting of processes that are repeated over and over again to create value. Products move from the manufacturer downstream to distributors and then to customers. For example, a car manufacturer like GM buys parts from its suppliers, which in turn may have bought parts or raw materials from another supplier. GM then takes these parts and creates a finished product, in this case a car. From there, GM sells the car to a dealership, which finally sells the product to a consumer. In this chain, value flows linearly through the supplier to the manufacturer and eventually all the way down to the end consumer of the product. At each step in the supply chain, someone adds value to the product or service and then moves it on to the next link in the chain. Information in this process has a similarly linear flow, with top-down forecasting typically filtering down to eventual production. These linear flows of value and information are what make up a company's supply chain. (See Figure 1.2.)

The supply chain was one of the major areas of competitive advantage throughout the twentieth century. The efficiency of a company's supply chain could make or break a business. That's why many of the great business innovations of the last century had to do with improving supply chains and making them more efficient.

Henry Ford's assembly line is a classic example. By adopting a continuously moving assembly line, Ford cut the typical production time of a car from 12 hours to 90 minutes. This supply-chain innovation had an enormous impact on the industry. Because it enabled the mass production of cars for the first time, it drove down the price of a good that was once available only to the very wealthy and made it widely available to average consumers. More recently, Toyota's lean manufacturing process disrupted the automobile industry with its just-in-time production and focus on eliminating waste. By creating a more adaptable and efficient supply chain, Toyota was able to leapfrog previous industry leaders, like Ford and GM.

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Excerpted from Modern Monopolies by Alex Moazed, Nicholas L. Johnson. Copyright © 2016 Applico, LLC. Excerpted by permission of St. Martin's Press.
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