Ellen Badinelli started off by introducing her business, ScanAvert. This is a mobile dietary application that scans products' barcodes and alerts the consumer to dietary incompatibility based on their user-created profile. For example, if you are following a gluten-free diet or avoiding certain ingredients that may cause a bad reaction to a drug you take, you can scan the bar code and quickly find out if the ingredients you are avoiding are in a given product.

There have been 5,000 users so far, giving Ellen a good idea of who the best demographic is for this product right now. She is looking to get financing to beef up PR efforts as recommended by some angel investors. Unlike advertising, you don't get more PR by spending more money. I recommend she does some more guerilla PR herself Using the demographic information learned from the 5,000 customers who have already downloaded the app. She should target the top bloggers and media for each of the largest segments. I would like to see Ellen ramp up a bit more and get more conversions. As long as she can continue to bootstrap, she will improve the valuation. 

In Search of Profits

Ten years ago, web companies didn’t generate much revenue.   These days, web companies are some of the most profitable around.  Online video is where the Web was ten years ago: in investment mode as video companies that are generating high revenue are not necessarily the most profitable.

Are those companies suffering low margins because they’re investing in the future or are they fundamentally lower-margin businesses?

Ad Networks Are Low Margin Businesses

This week, video ad network Brightroll raised $10 million from Scale Venture Partners.  Ad networks aggregate audiences and sell ads to marketers, sharing the proceeds with publishers/producers.  Scale’s Rob Theis’ argues: “the most strategic Internet investments are those that compete not with other Internet businesses, but with the much larger amount of money still being spent offline.”

Brightroll’s CEO Tod Sacerdoti added: “I think by this time next year the majority of the top five to ten video properties by any measure will be aggregator networks.  The best example for this is display advertising.”  Indeed, networks have an unmatched ability to scale but can also crash to the ground awfully fast.

The low margin is the least of their problems; differentiation and defensibility are.  Blue Lithium and Right Media hit jackpots by selling to Yahoo!  But those who didn’t sell (Tribal Fusion, Valueclick) suddenly found themselves under pressure from search advertising on performance and video on branding.

Content Networks Have Little Differentiation

Similarly, aggregators gather videos from content providers, sharing ad revenues.  iFilm (sold to Viacom, renamed Spike), Guba, Grouper (sold to SONY, renamed Crackle), Revver, YouTube (sold to Google), Veoh, DailyMotion, Metacafe, Viddler, blip.tv, are all vying for content, audiences and dollars.

YouTube is master of this domain.  Hulu is giving YouTube a run for its money, but the business model is anything but certain and its long term exit strategy is murky (Disney, News Corp. and NBC Universal/Comcast are shareholders but also competitors).

Ultimately, ad and content networks operate in a high-risk, winner-take-all game.   For publishers, it’s a lower risk world.  Consider the two acquisitions News Corp. made in 2005: Rupert Murdoch paid more for IGN ($650M) than for MySpace ($580 million), but MySpace’s subsequent growth made him look like a genius (for a while).  Today, MySpace is searching for its raison d’etre while IGN treks along as an unstoppable force in its sphere.

The Myth of Hyper Distribution?

In online video, producers are agnostic to distribution channel or platform.  To reduce risk, they diversify distribution, but the jury’s out on whether hyper distribution bears fruit.  Hyper distribution refers to syndicating one’s content as broadly as possible with little or no restrictions.

When it comes to generating revenues, is hyper-distribution wise?  Not according to Chris Pirillo, a prosumer video producer who leverages video to promote his empire but only counts YouTube as a commercial platform: “YouTube offers the largest audiences and generates most the revenue.  If you’re not YouTube, you have challenges in creating value for content producers”.  If that changes, look out for Freewheel, which according to CEO Doug Knopper allows “media companies and content owners to be able to monetize their video libraries across multiple channels and devices”.

Advertisers Follow Audiences…

Ex-Disney CEO Michael Eisner doesn’t pretend to know how the industry is going to play out, but he’s got no doubts what the end result will be: “I don’t know if the growth in content made for the Internet will be evolutionary or revolutionary, but it can’t not happen: a death march has been going on for other media who are in trouble because there is a more efficient way to share content around the world with the Internet.”

Business Models Take Time to Develop

Eisner made his fortune in television.  One VC who’s made his online has another opinion.  In Fred Wilson’s influential 2005 post “The Future of Media (aka Please Take My RSS Feed)”, he suggests to:

1 – Microchunk it – Reduce the content to its simplest form. 2 – Free it – Put it out there without walls around it or strings on it. 3 – Syndicate it – Let anyone take it and run with it. 4 – Monetize it – Put the monetization and tracking systems into the microchunk.

In theory, in the future when video streams monetize the way search queries have (whereby a search query is always associated with some kind of paid listing) then perhaps Wilson’s thesis will prove right.  But in practice, at least in the five years that have passed since the post, it’s been a recipe for financial disaster.

Hyper distribution is great for promotional purposes but not necessarily for commercial purposes.  Marketers do pay more attention as an audience grows, but they also pay a premium for scarcity and exclusivity.

This is the fundamental conundrum facing new media producers who rely on hyper-distribution to build brands and audiences but who weaken their pricing power and ability to secure guaranteed dollars by giving away their videos.  This can work if you can build ad-supported businesses, but that takes time and money.

Today, a few new media producers have managed to build ad-supported businesses, namely Revision3 and Next New Networks.  But between the two, they have raised over $30 million in venture capital.  Most producers don’t have that luxury.  For those others, I recommend creating content that other media companies will pay for, to buy them enough time to build a syndication business and eventually, a fully ad-supported business which commands the large ad dollars.

An imperfect but useful analogy I use is the banking model, where retail, corporate and investment banking fees can create a large business.

This diversified strategy provides:

• a safe income stream:  licensing, like retail banking, provides a recurring and non-volatile revenue base.
• a growth business: syndication, like corporate banking, requires other companies in the ecosystem to do well.  This can provide higher CPM rates by placing content in the right context.
• a wildly lucrative stream: advertising, like investment banking, takes time to develop, is speculative and seasonal, and risks drying up abruptly.  Notice how advertising revenue spikes each fourth quarter, for example.

The reason why I place content producers in the highest Profitability circle over time  in the first chart above is because only they can build such a business.  (The Profitability Index represented in the chart takes into account operating margins and total return on investment, including likelihood of a liquidity event).  And, yes, I am completely biased, since this is the kind of business I am trying to build with WatchMojo.  Aggregators and networks are solely advertising based businesses; just ask YouTube who generated $10,000 in a paid model test, even though it can generate billions in simpler ways.  Video advertising will be a bigger business, but not necessarily a higher-margin business.

Video will be Everywhere: on all Websites

Video on the Web is no longer just about entertainment.  It is also about marketing, instruction, and conveying information of all kinds.

• Content bellwether Wikipedia announced it will be rolling out videos soon enough.
• e-Commerce leader Zappos encourages users to submit their video experiences which increase sales 6% to 30%.  In 2010, it will create 50,000 videos.
• It won’t be long before organizations feature their accountants, lawyers, management, VCs in videos too.

Video will be Everywhere: in Ads

Videos won’t simply be on all websites; video ads will converge with rich media and display banners.  Publishers and ad networks will swap out low yield ad placements for videos that sell at a premium.  Rupert Murdoch is right to say that there isn’t enough advertising to make all publishing online profitable, but if you insert a video-enabled ad where a display banner exists today, maybe it will become more profitable, as video rates tend to generate a tenfold premium over display banners.  Of course, the flip side of that argument is that if video ad inventory lost all scarcity as display banners have, then it rates would also see a steep drop.

Video is the Anti-Search

Google’s dominance of the Web today stems from a perfect storm.  Search benefitted from low expectations.   Whereas Google’s competitors threw in the towel to focus on portaldom (or outright handed them the business), online video companies’ war chests seemingly have no bottom as they wage the war for the online audience.

With YouTube being a unit of Google, it’s hard to compete being a pure video aggregator.  Those who have tried are flailing badly.  Yet video’s expectations have always been high and will only get higher.

History Repeats Itself

Video will follow search in two ways though.

Search is software and Google is the only successful ad-supported technology company.  Video is media, which has a natural disposition to embrace ad-supported models.  As such, advertising will monetize video streams.  In fact, as large ad agencies and marketers shift online, they’ll embrace branding campaigns and push video advertising could eventually top search advertising.  Once that starts, online advertising will surpass television, it’s already happened in the UK.

Search for The Leading Ad Format

Everyone agrees that video advertising will be huge but what will the prevailing ad format be?

Stakeholders are obsessed with finding the ad format likely to follow television’s 30-second ad spot and search’s paid listings.

What might lead the way?

Pre-rolls are the equivalent of pop-ups (and mid/post rolls the equivalent of pop-unders) in that users hate them, but unlike pop-ups, I actually think pre-rolls won’t disappear, mainly because

• They’re the most in-demand ad format (according to Brightroll CEO Tod Sacerdoti)
• It is easier to include a pre-roll when you’re syndicating to other websites and platforms (says blip.tv co-founder Dina Kaplan)
• But largely because they’ll get more user-friendly: the 30-second ad will make way for 5-10 second interactive pre-rolls (SpotXchange CEO Michael Shehan).

However, there will always be properties which will forego pre-roll revenue to improve the user experience in order to build audiences, and all else being equal users will migrate to those sites.  So I’m not sure the pre-roll will remain all that ubiquitous.  The other problem with pre-rolls is lack of attention.  When a pre-roll starts, I tune out and look for my headphones or go grab a coffee.

That’s why I like the contextual display banner (and not necessarily the companion banner).  A companion banner comes bundled with the video pre-roll, but sits alongside the video  A contextual banner comes without the pre-roll.  Whereas most banners disappear quickly next to text with one downward scroll of the mouse, alongside a video player, that banner becomes quite valuable and top-of-mind since people are just staring at the video.

We’ve also seen the rise (and fall) of overlays, which is basically an expanded Picture-in-Picture (PIP) format; we know how that fared.

Of course, content producers are also salivating over branded content (more than product integration and product placement, the brand becomes central to the story) or outright sponsorships.

Finally, there’s the Web’s favorite offspring: the viral video.  Viral video is not an ad format, of course, but it is not quite branded content nor is it supported by ads.  As these become more common, achieving success with content alone becomes a sure-fire recipe for failure.  All content will need to be supported by a media buy or some kind of promotional push.  After all, on TV you spend millions creating an ad but you need to buy media spots to promote it.  It’s not going to be that different online.  Yes, it’s a meritocracy, but it’s a loud, cluttered one.

KISS: Keep It Simple Stupid

There won’t be a single dominant ad format but the holy grail will prove simpler than expected.  It always does.

Remember Don Lapre’s infomercials?  He would go on and on about placing “Tiny Classified Ads” in newspapers.  I never thought much of those ads until Google’s adoption of (essentially) little text ads next to search results led to their explosive growth.

Sometimes in business, the solution is simpler than you can imagine.

The Three Types Of Scalable Information Technology Companies

 

 

[click on image to enlarge]

When I was in business school at Columbia I took a class taught by Bruce Greenwald. Bruce may be to strategy what Einstein was to Physics. Ever since Michael Porter unleashed his Five Forces on the world, that model has been the de-facto framework for thinking about a company’s strategic position. That is, until people hear or read Bruce Greenwald’s take on the world of competition.  Unfortunately, Greenwald and his framework are far less well known.

In his class and in his book, Competition Demystified: A Radically Simplified Approach to Business Strategy, Greenwald rationalizes Porter’s 5-part framework for strategic competition down to one consideration: barriers. Porter’s model included threat of substitutes, degree of competition, buying power and selling power. To give you the Cliff’s Notes version of Greenwald’s book:

1)  The threat of substitutes and competition are in no small part determined by the extent to which the company has barriers.

2)  Selling and buying power are largely driven by the company’s market share which is ultimately determined by barriers.

Greenwald goes on to argue that if a company’s barriers are limited, management becomes the only medium-term differentiator, a differentiator that fades in relevance as the period of evaluation is extended. Greenwald calls companies that don’t have barriers “efficiency plays,” as the determinant of the company’s success is the efficiency of the management team. In this model, the way to determine who is going to win in a marketplace is either by picking the business with the most viable barriers or, if no barriers exist, the best management team.

Few things in life can be described by just one framework. For example, in this case, VCs would not invest in a company that has great barriers but a product that nobody wants to buy - patenting something useless is not an equation for making money. While Greenwald’s framework doesn’t indicate the viability of a product or service, I have found it to provide a useful perspective for trying to assess the extent to which a company is poised to scale.

Using barriers as the means for determining a company’s ability to scale, I have created a simple framework for evaluating which information technology companies have the chops to become big players in their respective markets.

In the IT space there are two key categories of barriers – those related to information and those related to technology.

 

Key information technology barriers generally include:

1)  Data scale: building a repository of data that enhances the underlying service and is difficult to replicate (e.g., Yelps' user review data or LinkedIn's connection data).

2)  Network effects: aggregating nodes in a network to increase the value of the service (a la LinkedIn and Facebook).

 

Key technology barriers include:

1)  Cost-side economies of scale: Leveraging scale to reduce the average cost of delivering the service – typically an advantage when technologies are expensive to develop.  For example, while Tesla's technology and infrastructure may have been expensive to develop, the average cost per unit declines as they sell more cars making it difficult for new entrants with low volumes to compete with their prices).

2)  Intellectual property protection: Patents and trade secrets that can actually provide meaningful business protection (Imagine if Google's proprietary algorithm wasn't defended by a patent).

I dryly refer to companies that can exploit information barriers as information businesses and companies that can exploit technology barriers as technology businesses. While some companies are poised to exploit one category of barriers or the other, other companies are uniquely positioned to leverage both types of barriers. For example, Microsoft Office has both cost-side economies of scale (a technology barrier) and network effects (an information barrier) working in its favor; it's expensive to replicate and the files are useful when everyone is using the same software to create, view and edit.  I call these hybrid companies.

 

This framework should be useful for entrepreneurs who are trying to understand the scalability of a given opportunity. At the end of the day, whether we invest capital as VCs or time as entrepreneurs we’re all investors – and to investors scalability is an important consideration.