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August 10, 2008

Too Much Revenue, Not Enough Growth

Jeff Jarvis posted a comment on my post In Praise of Revenue:

"I'd also like to see you reprise your lesson (from the Union Square event some time ago) on extracting minimal value from the network you create so the network grows as large as possible and the value you've created and can extract in the end is greater than if you had tried to extract more value at the beginning. Did I get that right? I quote you to that effect all the time. Did it just the other day with a big publisher whose blog ad network is taking too high a cut. I told him to just cover his costs for the first year - or less - and he'd end up growing something bigger that would be more valuable to each member, thus bigger, thus more valuable to him. Eh?"

Jeff remembers quite accurately that I advocated optimizing for growth rather than revenue – in the extreme forgoing revenue. Jeff's advice to the publisher was right on. If you simply solve for maximizing revenue, you can end up with little growth – and little future revenue opportunity. Note, though, that Jeff did not advocate forgoing revenue; in fact, he did advise the publisher to cover costs, presumably so that growth can occur without needing to raise more capital or so that there will be a solid basis for raising capital when it can be put to good use.

The case Jeff presents of an ad network is particularly straight forward. It is difficult if not impossible to sell ads which will be seen by only a few number of people. The cost of selling the ads is too high to justify the effort; advertisers are not interested in taking the trouble to investigate a tiny potential market or put any creativity into reaching it. Other than in strictly local markets, there need to be millions upon millions of impressions AND data to do targeting with before advertisers are interested. So it is not practical for any but the very largest blogs to sell their own ad space – and even they usually don't. There is an opportunity for ad networks which aggregate advertisers and advertising on one side and an inventory of space ads can run on the other side. The network matches the ads to the blogs, typically collects from the advertiser, and pays the blogger. Google is the most successful example of an ad network but the ads it aggregates appear in many more places than just blogs. Federated Media, the ad network to which Fractals of Change belongs, is an example of a blog-based ad network.

If you're an ad network, the more page views you have to sell, the more and better the advertisers you can attract. The more advertisers and the higher the rate for page views you can achieve, the more bloggers you'll attract to make their page view inventory available through you. You obviously have to scratch to get started, need to have some credibility or an existing inventory of ads to start with, and are going to lose some money getting going. But now you've got traction: how much of the ad revenue should you share with the bloggers and how much should you keep? Your investors may be pushing for some return on their capital (profits); your compensation might even be tied to your margin on sales rather than just your gross sales. Nevertheless, charging more than you have to, even if you can for a while, is a mistake.

Charging too much stunts growth so you'll have fewer units to charge for in the future. Charging too much opens the door to competition.

The more that bloggers make from your ads, the more space for ads you'll have available as bloggers tell their friends which ad network to use. The more ad space you have, the more ads you'll get and – on the average – the more you'll be able to charge for ads because you'll have better opportunities to target and you'll have more advertisers interested. The more ads you get and the more you can charge for them, the more money bloggers in your network can make.  You want to keep this virtuous circle of growth going as long as you possibly can.

If you are extracting profits before you have to, you're forgoing future growth. In any sort of competitive market, profits attract competitors. Big profits attract lots of competitors. Would-be competitors can point to your profits and easily get funding. Funded competitors can undercut your rates and "steal" your bloggers. Whoops; the circle is now turning in the non-virtuous direction. If you're doing well but running at or close to breakeven, you've made it impossible for anybody to undercut you without running at a deficit which is hard to get funding for – at least in this market. The biggest danger to you is someone who finds a way to substantially cut costs or to deliver a better product. Obviously you've got to be vigilant about that and ought to lose some sleep over these possibilities – but keeping prices down keeps a plague of me-too competitors from cutting off your growth.

This logic goes well beyond ad networks, they just make a good example.

Craig's List has the successful strategy of forgoing revenue for MOST listings it runs and MOST markets that it's in. That strategy helped it attract a critical mass of listings and a critical mass of listings meant a critical mass of ad readers which attracted more ads etc. etc. If Craig now attempted to maximize revenue by charging for a substantially higher percentage of ads, a door would be cracked open for competition. There is no chance at current rates for a competitor to steal Craig's listings (and readers) by charging less. If and when Craig's List is bested, it'll really have to be by something which delivers a better way for listers and readers to communicate.

Unless you are a protected monopoly, high prices are a recipe for losing whatever lead in the market place you have. Low prices are the engine of growth.

The strategy Jeff suggested to the publisher and that I'm recommending here is to keep revenue as low as it can be and still fund growth. No revenue is a different strategy that I'll post more about.

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