Blitzscaling: The Lightning-Fast Path to Building Massively Valuable Companies. Reid Hoffman
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Second, high-gross-margin businesses are attractive to investors, who will often pay a premium for the cash-generating power of such a business. As the prominent investor Bill Gurley wrote in his 2011 blog post, “All Revenue Is Not Created Equal,” “Investors love companies where, all things being equal, higher revenues create higher profit margins. Selling more copies of the same piece of software (with zero incremental costs) is a business that scales nicely.” Appealing to investors makes it easier to raise larger amounts of money at higher valuations when the company is privately held (we’ll delve into the details of why this is so important later on), and lowers the cost of capital when the company is publicly traded. This access to capital is a key factor in being able to finance lightning-fast growth.
It’s important to note the difference between potential gross margin and realized gross margin. Many blitzscalers, such as Amazon or the Chinese hardware makers Huawei and Xiaomi, deliberately price their products to maximize market share rather than gross margins. As Jeff Bezos is fond of saying, “Your margin is my opportunity.” Xiaomi explicitly targets a net margin of 1 to 3 percent, a practice it credits Costco for inspiring. All other factors being equal, investors almost always place a much higher value on companies with higher potential gross margins than companies that have already maximized their realized gross margins.
Finally, most of a company’s operational challenges scale based on revenues or unit sales volume, not gross margin. If you have a million customers who generate $100 million per year in sales, the cost to serve those customers doesn’t change whether your gross margin is 10 percent or 80 percent; you still need to hire enough people to respond to their support requests. But it’s a lot easier to afford good customer support when you have $80 million in gross margin to spend rather than $10 million.
Conversely, it’s a lot easier to sell and service 125,000 customers who generate $12.5 million per year in sales and $10 million in gross margin than it is to have to sell and service a million customers who generate $100 million in sales to achieve that same $10 million in gross margin. That’s eight times as many customers and eight times the revenues, which means eight times as many salespeople, customer service representatives, accountants, and so on.
Designing a high-gross-margin business model makes your chances of success greater and the rewards of success even greater. As we’ll see in a later section, high gross margins have helped even nontech businesses, such as the Spanish clothing retailer Zara, grow into global giants.
GROWTH FACTOR #4: NETWORK EFFECTS
Market size, distribution, and gross margins are important factors in growing a company, but the final growth factor plays the key role in sustaining that growth long enough to build a massively valuable and lasting franchise. While the past twenty years have driven improvements in the first three growth factors, the rise in Internet usage around the world has pushed network effects to levels never before seen in our economy.
The increasing importance of network effects is one of the main reasons that technology has become a more dominant part of the economy.
At the end of 1996, the five most valuable companies in the world were General Electric, Royal Dutch Shell, the Coca-Cola Company, NTT (Nippon Telegraph and Telephone), and ExxonMobil—traditional industrial and consumer companies that relied on massive economies of scale and decades of branding to drive their value. Just twenty-one years later, in the fourth quarter of 2017, the list looked very different: Apple, Google, Microsoft, Amazon, and Facebook. That’s a remarkable shift. Indeed, while Apple and Microsoft were already prominent companies at the end of 1996, Amazon was still a privately held start-up, Larry Page and Sergey Brin were still a pair of graduate students at Stanford who were two years away from founding Google, and Mark Zuckerberg was still looking forward to his bar mitzvah.
So what happened? The Networked Age happened, that’s what.
Technology now connects all of us in ways that were unthinkable to our ancestors. Over two billion people now carry smartphones (many of them made by Apple, or using Google’s Android operating system) that keep them constantly connected to the global network of everything. At any time, those people can find almost any information in the world (Google), buy almost any product in the world (Amazon/Alibaba), or communicate with almost any other human in the world (Facebook/WhatsApp/Instagram/WeChat).
In this highly connected world, more companies than ever are able to tap into network effects to generate outsize growth and profits.
We’ll use the simple layman’s definition of network effects in this book:
A product or service is subject to positive network effects when increased usage by any user increases the value of the product or service for other users.
Economists refer to these effects as “demand-side economies of scale” or, more generally, “positive externalities.”
The magic of network effects is that they generate a positive feedback loop that results in superlinear growth and value creation. This superlinear effect makes it very difficult for any node in the network to switch from an incumbent to an alternative (“customer lock-in”), since it is almost impossible for any new entrant to match the value of plugging into the existing network. (Nodes in these networks are typically customers or users, as in the canonical example of the fax machine, or the more recent example of Facebook, but can also be data elements or other fundamental assets valuable in a business.)
The resulting phenomenon of “increasing returns to scale” often results in an ultimate equilibrium in which a single product or company dominates the market and collects the majority of its industry’s profits. So it’s no surprise that smart entrepreneurs strive to create (and smart investors want to invest in) these network effects start-ups.
Several generations of start-ups have tapped these dynamics to build dominant positions, from eBay to Facebook to Airbnb. To accomplish these goals, it’s critical to develop a rigorous understanding of how network effects work. My Greylock colleague Simon Rothman is one of the world’s premier experts on network effects from building eBay’s $14 billion automotive marketplace. Simon warns, “A lot of people try to bolt on network effects by doing things like adding a profile. ‘Marketplaces have profiles,’ they reason, ‘so if I add profiles, I’ll be adding network effects.’” Yet the reality of building network effects is a bit more complicated. Rather than simply imitate specific features, the best blitzscalers study the different types of network effects and design them into their business models.
Five Categories of Network Effects
On his industrial organization of information technology website, the NYU professor Arun Sundararajan classifies network effects into five broad categories:
1) Direct Network Effects: Increases in usage lead to direct increases in value. (Examples: Facebook, messaging apps like WeChat and WhatsApp)
2) Indirect Network Effects: Increases in usage encourage consumption of complementary goods, which increases the value of the original product. (Example: Adoption of an operating system such as Microsoft Windows, iOS, or Android encourages third-party software developers to build applications, increasing the value of the platform.)
3) Two-Sided Network Effects: Increases in usage by one set of users increases the value to a different set of complementary users, and vice versa. (Example: Marketplaces such as eBay, Uber, and Airbnb)
4) Local Network Effects: Increases in usage by a small subset of users increases the value for a connected user. (Example: Back in the days of metered calls, certain wireless carriers allowed subscribers to specify a limited number of “favorites” whose calls didn’t count against the monthly allotment of call minutes.)
5) Compatibility and Standards: The use of one technology product encourages the use of compatible products. (Example: within the Microsoft Office suite, Word’s dominance meant that its document file format became the standard; this has allowed it to destroy competitors like WordPerfect and fend off open-source solutions like OpenDocument.)
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