P3.1. Chapter 1

Prosumers and the Third Wave

Offline do-it-yourselfers are well known. One of my executive M.B.A. class members asked me whether online DIY uploaders were related to the prosumers talked about in Alvin Toffler's Third Wave. In the strategy field, W. Chan Kim and Renée Mauborgne (both of the business school INSEAD) have written the Harvard Business Review (HBR) article "Value Innovation: The Strategic Logic of High Growth," in which they discuss the customer becoming an integral part of the value chain, not just the receiver of an end product or service. Their HBR article discusses the impact on competitive strategy in a range of offline, consumer-focused businesses, from hospitality, to movie theaters, to retail furniture stores. These new user-producers, as in the case of IKEA, are willing to become coproducers and home-based constructors of home furnishings, contributing their valuable time and effort in return for company-offered service and brand features such as personalization, style, immediacy, and convenience.

Online DIY and the experience economy

B. Joseph Pine and James Gilmore's book The Experience Economy: Work Is Theater & Every Business a Stage (Harvard Business School Press), was an early prediction of a major shift in society and business markets toward active participation—experiencing, doing, seeing for yourself, and personalizing. Max Lenderman's book, Experience the Message: How Experiential Marketing Is Changing the Brand World (Carroll & Graf) looks at the implications of this social shift within marketing.

Uploaders

Kevin Kelly, author of the prescient Out of Control (Addison-Wesley) and the classic New Rules for the New Economy (Penguin), wrote a must-read article in Wired for the 10th anniversary of the Web, dating the Web from Netscape's IPO in 1995. In the article, "We are the Web" from Wired 13.08, he noted that we had reached a "crossover point" in 2005 at which there was more digital content being uploaded to the Web than downloaded. That implied that active uploaders—givers, creators, and contributors—were finally taking over from passive downloaders—takers, readers, and viewers.

Collective user value

In his book the Wealth of Networks: How Social Production Transforms Markets and Freedom (Yale University Press), Yochai Benkler, a Yale law professor, explores the social and economic implications of a "gift" economy, in which intangible and tangible monetary rewards influence our behavior. In a very similar vein, Steven Weber, professor of political science at U.C. Berkeley, examines the complex social, political, and economic interactions underlying open source communities in his book, The Success of Open Source (Harvard University Press).

With a very different framework and approach, Rick Levine et al.'s The ClueTrain Manifesto: The End of Business as Usual (Perseus) and Eric Raymond's The Cathedral and the Bazaar: Musings on Linux and Open Source by an Accidental Revolutionary (O'Reilly)—books that were themselves products of collaboration and interactive feedback online—argue that markets are not company-controlled seats, eyeballs, end users, or consumers—but human beings, individuals, equals with a voice, all conversing and interacting. And by doing so, they irreversibly scramble and remix the number and power of linkages away from the typical company-to-customer, buyer-seller business transaction and one-way communication.

Freemiums

The conversation that created the word "freemium" took place on venture capitalist Fred Wilson's blog (http://avc.blogs.com/a_vc/2006/03/my_favorite_bus.html). Katherine Heires also wrote on related subjects in "Why It Pays to Give Away the Store," in the November 2006 issue of Business 2.0 (http://money.cnn.com/magazines/business2/business2_archive/2006/10/01/8387115/index.htm).

Public and open sharing of online digital content, trust, and communities of practice

Larry Lessig's framework presented in The Future of Ideas: The Fate of the Commons in a Connected World (Vintage) explains how the explosion of innovation on the Web relies on it being an open forum for ideas, and a community and ecosystem of knowledge creators, thinkers, and combiners. This is the basis for the movement behind Creative Commons.

The Semantic Web and metadata

Tim Berners-Lee in his book Weaving the Web (HarperCollins) writes about the Semantic Web as one of the paths toward "scaling intuition" (or allowing group intuition) because individual readers notice relevant relationships and create a shortcut link to record it so that creativity, feedback, and knowledge about any problem or idea can occur across larger and more diverse groups and be stored across time. Metadata, like hyperlinks, are a kind of human-added information shortcut, indexing, or annotation that allows information links and knowledge synapses to be integrated and multiplied.

Digital photo ecosystem and flickrized ecosystem

The linear value chain is compared to the value constellation or the more transient online value clickstream talked about by Nick Carr, former Harvard Business Review editor, in his blog (http://www.roughtype.com/). Of course, open APIs have a key role in supporting this system and will be discussed in later chapters.

Flickr's founders

Josh Quittner wrote "The Flickr Founders" for TIME (http://www.time.com/time/magazine/article/0,9171,1186931,00.html).

Contexts for interaction

See John Musser's book Web 2.0 Principles and Best Practices (O'Reilly), page 72 and surrounding.

Business model analysis for the entrepreneur

After using several different textbooks and articles for teaching my M.B.A. classes in entrepreneurship and venture capitalism, I can highly recommend Richard Hamermesh's "Note on Business Model Analysis for the Entrepreneur" (Harvard Business School). It is the only business model framework that seems to work equally well in conveying the basics of how to analyze offline versus online as well as hybrid business models. It does a stellar job of focusing attention on the cash flow curve and individual customer profitability analysis rather than trying to generate a product-based balance sheet and pro forma. The two illustrative but brief cases he uses—the Grateful Dead and 7-Eleven in Japan—are always favorites.

Burn rate and J-curve cash flow analysis

As Figure 1-8 shows, the burn rate is the negative slope of the curve and the rate that investment dollars are flowing out or being "consumed" by the entrepreneurial bonfire per unit time. In my teaching, I tend to call the cash flow curve a J-curve—not only because of its distinctive shape, but also in honor of the well-known venture capitalist Steve Jurvetson's J-curve blog. Several of his classic venture capital investment insights are captured in the HBR article "Bringing Silicon Valley Inside," in which he argues for the strategic borrowing of venture-capital-style thinking for managers in large corporations and multinationals.

Netflix financials and new customer acquisition cost

The HBS case Netflix.com is a gem because it was written for M.B.A.-level finance and accounting courses to illustrate how to calculate individual subscriber cash flow curves over time as well as customer retention (usually in percent of total retained at one month, three months, six months, and yearly) so that these calculations can be used to generate aggregated (over total subscriber/customer numbers) and discounted cash flows to come up with average customer lifetime values. I present only a simplified and nondiscounted calculation to show that the new customer acquisition cost can be estimated as the cost of 3 DVDs and shipping or 3 × 20=$60 of DVDs + $3 of shipping, but free customers bring in only $20/month if they stay past the first free month. The HBS case presents enough quantitative data and market information to calculate or perform sensitivity analyses for three or four strategic scenarios—dropping the free-month trial, raising the subscription fee, lowering the number of free DVDs from four to three to two, etc.

Single customer/subscriber cash flow analysis

Per user revenue, average lifetime value, customer profitability analysis, and brand equity are metrics used in individual subscriber economics and can be easily translated for use in online user economic analysis and profit and loss (P&L) business plan financials. See HBS notes Customer Profitability and Lifetime Value and Subscriber Models (Elie Ofek). The key importance of loyalty or customer retention in online customer-focused businesses is discussed in the HBR article, "E-Loyalty: Your Secret Weapon on the Web" (Frederick F. Reichheld and Phil Schefter). The HBR article "Diamonds in the Data Mine" (Gary W. Loveman) provides a compelling real-world example of how HBS professor-turned-CEO of Harrah's used individual customer analytics for both profitability and competitive advantage.

S-curve, new technology adoption, and crossing the chasm

S-curves and technology diffusion follow a similar path and have a similar shape as infectious or viral disease epidemics. New technology adoption is explained in Everett Rogers' classic work, Diffusion of Innovation (The Free Press), in which he first introduces the concept of different groups of the population having distinctive behaviors and attitudes toward technology—early adopters, mainstream users, laggards. A good summary is available in the HBS note Note on Innovation Diffusion: Rogers' Five Factors (John T. Gourville). But the original book is well worth reading in its entirety.

In his bestseller on high-tech marketing, Crossing the Chasm (HarperBusiness), Geoffrey Moore introduces the strategic concept of the "chasm." This gap in usage and expectations between early technology adopters and mainstream users turns out to be the downfall for many high-tech companies that look quite promising in their early stages but fail to "cross the chasm" to build and sustain a mainstream market.

There is much more on this subject in Chapter 3.

Company financial valuation methodologies

See William A. Sahlman's HBS note Venture Capital Valuation Problem Set; also see Michael Mauboussin's Legg Mason Analyst Report "Valuing Customer-Focused Businesses," available at http://www.lmcm.com/search/default.aspx?qt=exhibit.

Entrepreneur/founder's net worth at exit

Again, see William H. Sahlman's HBS note Venture Capital Valuation Problem Set, specifically the section on dilution and IPO value. There's clearly a significant structural shift in the venture investing and private equity environment due to large Internet players like Google and eBay snatching up YouTube and Skype at IPO-level public market valuations. The shift is also evidenced by Microsoft ratcheting up the value of Facebook, buying minority stakes at levels that would put the total market capitalization of Facebook at a lofty $15 billion (similar to an Intel or Oracle). This section doesn't include any inside information on the actual net worth of these different founders, but it does provide a perspective on the relative difficulty of IPO as an exit for online companies after the dot-com boom compared to the frothy and active acquisition market available for Web 2.0 companies.

The following HBS notes show how venture capitalists value their portfolio companies and the process of dilution through different stages of investment funding: How Venture Capital Works (Bob Zider); The Process of "Going Public" in the United States (Gregory Miller); Introduction to Valuation Multiples (Robin Greenwood and Lucy White); A Method for Valuing High-Risk, Long-Term Investments: The Venture Capital Method (William A. Sahlman and Daniel R. Scherlis); and The Basic Venture Capital Formula (William A. Sahlman and R. Matthew Willis). I haven't used the HBS note Funding New Ventures: Valuation, Financing and Capitalization Tables (Michael J. Roberts), but it sounds like it might actually provide a set of cap tables to use, so you don't have to calculate them out.

Funding requirements of Web 1.0 versus Web 2.0

For some background on venture financing, take a look at the James McNeill Stancill HBR article "How Much Money Does Your New Venture Need?"

Also see John Heilemann's article "Retooling the Entrepreneur," Business 2.0, November 1, 2005 (http://money.cnn.com/magazines/business2/business2_archive/2005/11/01/8362816/index.htm), for an interesting interview with Joe Kraus, cofounder of Excite (Web 1.0) and JotSpot (Web 2.0).