Can Spotify Grow Its Way to Profitability?

Shira Ovide has written a good column for Bloomberg BusinessWeek regarding Spotify's IPO. In the article, she highlights a crucial difference between the Netflix and Spotify business models. It's a distinction that I've discussed in depth with my students.   It's a wonderful lesson in marginal vs. fixed costs.   Here's an excerpt from Ovide's column:

However much Spotify resembles Netflix in spirit and business approach, the services diverge in a way that makes Spotify’s path to profit significantly trickier. The video streaming company’s programming expenses don’t rise as it lures more subscribers. But as Spotify gets bigger, its streaming music costs increase; it can’t grow its way to profitability. Spotify’s product—35 million songs—costs the company more as more people sign up. 

Ovide does acknowledge that some costs will fall as Spotify continues to grow.  As the company gains more clout, it can negotiate better royalty deals with content providers.  Still, growth alone will not drive strong profits.  Marginal costs will remain positive, unlike Netflix.   Ovide argues that Spotify will have to diversify its revenue streams, as it has begun to do and as its chief financial officer discussed recently.  Ovide raises one other possibility, but she dismisses it as unlikely - that is, could Spotify develop its own content, as Netflix has done.  In other words, could it sign up musicians directly, disintermediating the record labels.  That's a highly risky strategy that could undermine the entire business though.   

The future will be fascinating to watch.  As a Spotify customer, I enjoy the service a great deal.  They clearly have lowered the cost for me to listen to the music that I love.   Will advertisting be a key revenue stream moving forward?  In the past, that has been the path to profitabilty for a number of companies.  Yet the Facebook crisis suggests that people are growing a bit more concerned about what a reliance on advertising can do to online platforms.  The Facebook mess should cause Spotify to tread carefully as it tries to drive new revenue through advertising.  The challenge will be to develop this revenue stream in a responsible manner, and in a way that does not scare off customers who are now waking up to the downside of "free" online platforms.  

Crisis Management at Facebook

Facebook executives have received a great deal of criticism for their delayed public response regarding the "Cambridge Analytica" crisis.  CEO Mark Zuckerberg and COO Sheryl Sandberg did not make any public statements regarding the situation for four days. Numerous public relations and crisis management experts have criticized top management for the lack of communication.  When executives began to speak publicly about the situation, the criticism did not subside.  Journalists, analysts, and customers demanded more information from the organization. Josh Constine at Tech Crunch wrote the following:

What’s missing from this response is any indication why Facebook didn’t do more to enforce its policy prohibiting apps from sharing user data, or why it took Cambridge Analytica at their word when they said they deleted the data without proper investigation. Or a straight-forward apology. Facebook is still playing the victim here.

Writing in the Washington Post, reporters Elizabeth Dwoskin, Drew Harwell and Craig Timberg revealed that Facebook may not have disclosed the full extent of their relationship with the researcher who gave all that data to Cambridge Analytica:

The psychologist who disseminated Facebook user data to an analytics firm working for the Trump campaign had a closer relationship with the social network than it has let on, co-authoring a research paper based on a massive amount of data that Facebook provided to him.

Undoubtedly, many crisis management lessons will be derived from this incident. Most experts will focus on the lengthy delay (four days) before Zuckerberg and Sandberg issued public statements. I think there's a related lesson though, and it has to do with people's expectations of these two executives. Before this scandal, these two business leaders had highly public profiles. They were everywhere - making speeches, participating in interviews, and being profiled in major publications. The downside of maintaining such a public profile is that people will expect much more of you if a crisis occurs. Four days of silence stands out EVEN MORE for these executives than it would for those who kept a very low profile. The lesson is clear: Be aware of what people will expect of you, bsaed on your past behavior. You will face much criticism if you seek publicity when times are good, and then go underground when scandal erupts.

How Successful Leaders Make Decisions

Lydia Dishman has written a column for Fast Company titled, "How Leaders at Google, Buzzfeed, and More Make Decisions."   She has a number of interesting tidbits from various leaders.   A few key themes emerged:

The Value of Seeking Small Wins:

In a recent report for Fast Company, Harry McCracken asked staffers of Facebook how their leader has pulled off some of the company’s recent major achievements.  "I don’t hear a lot of anecdotes about him swooping in and personally making genius-level decisions that suddenly changed everything. Instead, they praise his inquisitiveness, persistence, ability to deploy resources, and devotion to improving Facebook and himself. He has a knack for carving up grand plans into small, doable victories."  

Ask Good Questions

Mark Parker, CEO of Nike: "You can’t always predict the winners. I end up asking a lot of questions, so the team thinks things through. I don’t say, ‘Do this, do that.’ I’m not a micromanager. I don’t believe in that. My father, when I was growing up, would say to me when I had to make a decision, ‘Well, what do you think?’ And I’d say, ‘Well, I think this.’ And he’d say, ‘That seems like a good idea.’ And over time, I started picking for myself. I didn’t need to go to him. At Nike, we have incredibly strong people. They know what to do."

Step Out of Your Functional Shoes:

Ursula Burns, CEO of Xerox:  We don’t want to compartmentalize people’s expertise based on their internal organization alone. We try to give individuals parity–-equality-–in the discussion. In our leadership team, I expect all of them to check at the door their function as the primary thought process by which they give me input. I expect them to think more about the customer, competitors, employees, and shareholders. So, I give everyone parity to speak about an issue.

Test Your Hypotheses: 

Dao Nguyen, Publisher of Buzzfeed:  Publishing volume is actually really important. It's not that we want to crank stuff out there for no reason at all. The more you publish, the more opportunities you have to look at things that are happening, read comments, have a new hypothesis, test a hypothesis. And if you can do that relatively quickly, then you remember what you were testing.

Why Lock-In and Switching Costs are More Substantial at LinkedIn than Facebook

Network effects exist when the value per user rises as the number of users increases.   In a situation where strong network effects exist, we often see high switching costs and a lock-in effect.  Take eBay, for example.  Why has eBay remained so dominant for so long in the online auction market?   Well, compare the value per user at eBay to the potential value per user at a startup that might challenge them.   Users place a high value on eBay because the existence of many fellow buyers and sellers makes it likely that they can find someone with whom they can engage in a mutually beneficial transaction.   They would have a much harder time making that match on a new auction site with  a limited number of users.  For that reason, the network effects create switching costs for users, and a lock-in effect emerges.   That's all good news for an incumbent player with high market share, such as eBay.

Ok, so clearly LinkedIn and Facebook benefit from strong network effects.  Does that mean that they will remain as dominant for as long as eBay has in the auction market?  I would argue that Facebook and LinkedIn face quite different levels of switching costs and lock-in effects.   Consider the cost of switching from Facebook to Instagram or Twitter.  What's keeping you on Facebook?  Well, it's probably that circle of fairly close friends and relatives with whom you keep up to date and exchange photos and messages via the social network.  Suppose that a critical mass of that small circle of friends defects from Facebook to another social network such as Snapchat or Twitter.  Would it be costly for you to switch as well?   Well, as long as a critical mass of friends has left, then your switching costs are rather low.  Yes, you have other acquaintances who might still be on Facebook, but are they really going to keep you there?  Perhaps not. 

Now compare Facebook to LinkedIn.  What's keeping you from potentially switching from LinkedIn to another prospective professional social network?   You should recognize rather quickly that your small circle of close friends is not what is keeping you on LinkedIn.  Instead, you derive value from a much wider range of users on LinkedIn.  Many of those folks are not people with whom you communicate often.  They might be former classmates, co-workers, and the like.  They are people with whom you share weaker ties, but maintaining a connection to them has potential value to you professionally.  Now suppose that a few close friends defect from LinkedIn. Would you consider defecting?  Well, the problem, of course, is that all those acquaintances and former associates remain on LinkedIn.    In short, the switching costs are higher on LinkedIn.  The lock-in effect is stronger.   You would be much more reluctant to abandon that expansive "rolodex" that LinkedIn has become for you professionally.  

Why the discussion today about LinkedIn vs. Facebook?   Consider the latest news from an iStrategyLabs report.  It found that the number of Facebook users ages 13-17 have declined by 25% in the past three years.  The number of users ages 18-24 has declined by 7.5%.   These young user defections show that Facebook's lock-in effect may not be as strong as people once thought.  We've seen the story before of a social network losing traction; remember MySpace?  I'm not saying that Facebook will face that fate, but it's worth noting that network effects don't guarantee that an incumbent will remain on top forever. 

Network Effects in Reverse: Facebook's Problem with Teens

Facebook spooked investors yesterday when it announced earnings.  Actually, profit levels themselves were not the problem.  Facebook reported robust financial results.  However, management informed investors that the number of teens visiting the site declined in this recent quarter.  What's happening?   I believe that teens are migrating to other social media sites, one of which Facebook now owns (Instagram).   I hear many parents of middle school and high school students noting that their kids are not asking first to join Facebook.  Instead, they are first asking to join Instagram or some other social media sites.   

Here's the potential bigger problem coming down the road for Facebook.  When you are growing as a social media site, you have network effects in your favor.  The more users on the site, the more value per each user - it's a virtuous cycle.    However, when the number of users begins to decline, you have the potential for a downward spiral to begin.  As someone's friends leave Facebook (or don't join in the first place), he or she derives less value from the platform.  Then that person defects perhaps.  Their friends now derive even less value from the site, and they may defect.  We've seen this story before, of course... just ask the folks at MySpace.  Now, I'm not predicting such a dramatic fall for Facebook, but I am suggesting that investors have a right to be worried about the drop in teen usage.  It will be an interesting metric to watch going forward.

Facebook and Instagram: Where was the Board?

The Wall Street Journal reports today that the Facebook Board of Directors was not involved until very late in the process with regard to the Instagram acquisition.  According to the article, "By the time Facebook's board was brought in, the deal was all but done. The board, according to one person familiar with the matter, 'Was told, not consulted.'"  Later in the article, it describes an amazing meeting that took place at Zuckerberg's home:

At around 6 p.m. that evening, Facebook board member Marc Andreessen showed up at Mr. Zuckerberg's house for a regular meeting. What he didn't know was that Mr. Systrom was in another room, getting his own board to sign off, people familiar with the matter said. Mr. Andreessen, whose venture-capital firm was the second to invest in Instagram, cutting a $250,000 check before the service launched, was surprised when Mr. Systrom walked into the room about an hour into his meeting with Mr. Zuckerberg, the people said.

You can imagine the reaction of corporate governance experts!    Most people have pointed to the fact that the Board and Mr. Zuckerberg will have to interact much differently when Facebook becomes public.  If not, minority shareholders will be quite concerned.  It's interesting, of course, because agency theory says that we ought to like it when CEOs own lots of shares of a company. In those cases, according to theory, there's less divergence of interests between shareholders and executives as opposed to publicly traded companies in which top executives own a tiny ownership stake.  The theory says that we like it when CEOs are playing with their own money, not other people's money.   While I generally agree with that theory, there are limits to the applicability in the real world.   In particular, the interests of minority shareholders need to be considered, particularly when a founder is CEO.   Good governance processes matter, even if we assume that the CEO generally is trying to do right by all shareholders.  Moreover, founder/CEOs rightfully should get held to a different standard when a company goes public.  

The Facebook-Instagram Deal

Wow! What else can you say?  Facebook pays $1 billion for a company with 12 employees and no revenue.   I'd love to see the discounted cash flow model that my students could come up with to determine that valuation! 

What's going on with this acquisition?  First and foremost, we have to remember that photo-sharing is a crucial element of the Facebook experience.  As my former colleague Mikolaj Jan Piskorski likes to say, Facebook made it socially acceptable for all of us to become exhibitionists and voyeurs to some degree!   In that sense, Instagram has emerged as a major threat to Facebook.  As people spend more time sharing their photos via Instagram's mobile app, they are likely to spend less time on Facebook.   That reduced time on Facebook will cost the social media heavyweight a significant amount of advertising revenue.  Moreover, rumors of a possible link-up between Twitter and Instagram (or perhaps even Google and Instagram) surely made Mark Zuckerberg more than a bit nervous.

What challenges will Facebook face with this acquisition?   Zuckerberg has announced that he intends to continue operating Instagram as an independent company with relationships to other social media platforms such as Twitter.  Users will still be able to post photos on other social media services, follower users outside of Facebook, and can choose not to share photos on the Facebook platform.   In some sense, this move is a type of vertical integration.  When that happens, firms also face the challenge of competing with their customers.  Instagram will now be competing with its customers - i.e. Twitter and Google Plus compete with Facebook.  Will that cause friction?  Will it cause Instagram competitors such as Hipstagram and PicYou to steal away users?  Facebook will have to be quite careful as it manages those relationships.

Some experts have wondered why Facebook could not have achieved some of the same benefits without having to acquire Instagram. Could they have formed an alliance or partnership with Instagram?  Perhaps they could have.  However, such an arrangement may have made it more difficult to engage in the type of close coordination required to integrate Instagram more deeply into the Facebook platform moving forward.  If Instagram simply were to remain an independent company, then an alliance might have made more sense.  However, I think more intense coordination and integration is coming... and a merger probably makes more sense in that instance. 

Will Facebook Acquire Zynga?

The Wall Street Journal has a good article describing the co-dependency that has evolved between Facebook and Zynga.  The paper reports the following statistics about the two firms:

"Facebook, based in Menlo Park, Calif., derived 12% of last year's $3.71 billion in revenue from Zynga, according to the social network's IPO prospectus released Wednesday.  Meanwhile, Zynga, the San Francisco-based social gaming company that makes many games that are played on Facebook, received 93% of its revenue last year from virtual goods it sells on the social network."

Economic theory suggests that the two firms may be headed for a merger.  Why?  Oliver Williamson, the Nobel-prizing winning economist, has argued that companies consider transaction costs when determining how to organize themselves.  Put simply, firms compare the efficacy of using the market to organize economic activity to the efficacy of organizing such activity within the firm.  Often, companies establish contracts, strategic partnerships, or formal alliances with other firms if the arrangement provides value to both parties.  However, these market-based transactions sometimes become problematic.  Why? One reason is that the potential for opportunism and hold-up occurs.  That is, the firms may try to take advantage of each other.  Such holdup tends to occur in situations of co-dependency. 

Let's take a classic example from Williamson's work.  Imagine an oil refinery adjacent to a pipeline, each owned by separate parties.  What if the refinery and the pipeline each had no alternative uses.  That is, the only way to ship the oil from the refinery was from the pipeline, and the only use of the pipeline was to ship that refinery's output.  In that situation, each party would be beholden to the other, and they might find it hard to work together amicably via contract or alliance.  Merger tends to be an outcome in such circumstances.

We had a similar situation in the entertainment business recently.  Disney and Pixar had worked together through a contractual relationship for many years.  Then, Disney and Pixar entered into contract renewal negotiations in 2005, and the relationship became strained.   Why?   I would argue that the two firms had become co-dependent over time.  Disney needed Pixar, because its own animation studios had fallen on hard times.  Meanwhile, Pixar needed Disney because the original contract had given Disney certain rights even if Pixar terminated their relationship.  Disney could continue using the characters from the early Pixar movies, and they could make sequels to those movies, even if Pixar partnered with someone else in 2006.  Pixar really didn't want to see that happen to their beloved characters.  Not surprisingly, Disney acquired Pixar in 2006, thereby choosing horizontal integration over a market-based relationship - just as Williamson's theory would predict.

Now, we could have a similar co-dependency emerging between Facebook and Zynga.  Could a merger be in the cards?  It's certainly something to watch.  On the other hand, Zynga has been working to diversify its revenue base lately.  That may lessen the co-dependency over time.

The Facebook - Zynga Relationship

As the Wall Street Journal notes today, Zynga has embarked on a strategy to become less dependent on Facebook. To date, the firm has ridden the coattails of Facebook, with its social games doing incredibly well on the social network's site.   However, as the firm approaches an IPO, investors expressed concern with the dependency on Facebook.  Zynga now has begun to pursue a strategy of offering games directly to consumers through its own site as well as through mobile platforms. 

The issue of dependency raises an interesting question.   To what extent is Facebook dependent on Zynga?  To date, the dependency has been mostly one-directional.   However, if Zynga does succeed in developing its own route to market, then we may see a bit more of a co-dependent relationship.  Why?  Well, Zynga certainly helps Facebook a great deal, not only through the direct revenue that Facebook generates from the relationship... but also because heavy Zynga users tend to spend a great deal of time on Facebook.  As a result, Facebook has an opportunity to sell more ads.   If we end up with a situation of co-dependency, then I would look for rumors to begin to swirl regarding a Facebook acquisition of Zynga.  That's what tends to happen when two firms become dependent upon one another.   Each side worries about being "held up" by the other, and therefore, a merger often resolves the conflict and enables the two parties to cooperate more effectively.   We are far from that point, but we may be headed in that direction with the latest Zynga strategy moves. 

Facebook: Comparing Different Marketing Strategies

Gregory Ferenstein has written a new column over at Fast Company about an interesting new study regarding Facebook marketing strategies.   NYU Professor Sinan Aral and Research Associate Dylan Walker examined two versions of a Facebook app used by a company (whose name was withheld).  The passive version posted automatically to an individual's newsfeed if they engaged with the brand in any way.   The active ersion also enabled consumers to send personalized messages to their friends about the brand.  Professor Aral summarizes the key finding: "Passive features are better for spreading a product widely and for quick adoption. Active features, on the other hand, are better for building a loyal customer base and make a product stickier."  Moreover, the scholars found that viral strategies, whether active or passive, proved much more effective than traditional banner ads and email advertising.