Tuesday, November 11, 2008

On the Knocking at the Gate, VCs, and a Math Problem


This economy may be the wakeup to VCs (and CEOs alike) that their future isn't what they want. But the murder happened years ago, and the "I don't want yes men, but strangely I don't listen to much else'" hivemind has just woken up.

The IPO window isn't shutting or recently shut -- it never re-opened after the dot-com meltdown. A handful of IPOs (including a Google) doesn't make a "window." Whether you blame SarbOx, or a trend of investing in companies with a wink-wink style of sustainable competitive advantage, that could not produce high enough valuations to warrant a public offering, there were to be few IPOs.

The startup and VC world started getting this idea a couple of years ago, when they realized that at the smaller exit values (for the exits that were to be had), in order to get a high multiple return, the initial investments would have to be so small that the venture fund couldn't afford to service the quantity of investments. That is, the investment would have to be too small to be worth the firm's time. Uh-oh. A few innovative programs came out of that realization. But for the most part everyone acted like this was just a bad dream.

Moreover, the vaunted "get acquired" exit that appeared to be the next-best exit option, has been rather overrated. The real acquisition numbers for the most part are not what investors (or founders) would like. Not to mention the acquisition could well mean the end of the road for the business (Google is the most famous for this) which is the opposite of what founders should want, and so produces some strange incentives. Yes, YouTube and Skype ... but the curve falls off quickly.

The bad news is that this pile of trouble has been sitting in the corner stinking up the room for years.

The good news is that it's not a sudden crisis, and may well be correctable by VCs who are willing to, um, take some risk (this means getting out of their comfort zone in terms of rituals and assumptions, or expanding said zone) which is, ironically, what they are supposed to be doing for their investors.

But what about all of that advertising? Isn't there money in all of those targeted ads? Or, at least, wasn't there supposed to be until the advertising market started downhill?

In the short term, maybe ... but in the long term, the model doesn't work at the macro level and here is some math that suggests why.

Showing ads is kind of like printing money. You can show as many as you like up to a function of your pageviews. In order for the ad-economy to grow, the attention economy has to grow. That is, the aggregate amount of attention-hours spent against ad-supported pages needs to grow. Ok, there's definitely evidence for that (GMail, etc.)

But what about the ratio of the ad growth rates to attention growth? Attention growth has real-world limits (number of people, amount of time, ad-blockers, desensitization to ads) while theoretical ad supply does not. The limit on attention growth does not limit real-world ad growth. For example, if I view 50 GMail pages where I used to view 15, it's entirely possible that the same amount of attention is now divided across more ads -- or that the total spent attention is even smaller.

In the long run, the ad-value growth is smaller than the application-value growth. So the deficit of uncaptured value for businesses relying on ad revenue grows larger over time.

We can check this analysis by looking at the numbers from another point of view. Start with the raw resource itself -- a piece of a data center that includes a unit of compute power, storage, bandwidth, and hosting.

Hosting and displaying ads is relatively less expensive (in units of the resource) than hosting application functionality. So the very resource which makes the ad-supported model plausible will supports growth on the ad side that is at least as strong as growth in hosted functionality, which is the attention-harnessing product. That is, the resource availability supports growing the supply of units for spending attention as fast or faster than the supply of units for capturing attention. Again, over time, in the aggregate, more ads are powering less features. The value of each ad goes down.

This has nothing to do with the overall economy, consumer spending, etc. It's simply a side-effect of the coupling between the monetization mechanism and the product.

If, at the same time, the "real-world" spending that is driven by even successful ads is flat or in decline, you have an even bigger problem.

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