Consumer Startups without Revenue are Products, not Businesses

Nick Bilton recently wrote about stratospheric valuations for companies that don’t generate any revenue and there has been much debate on whether or not this represents a bubble. The more interesting thing from my point of view is how the incentives of venture capital encourage consumer-oriented startups to adopt an ad-based1 business model and simultaneously set them up to fail at executing one profitably.

In the Beginning

Early in the life of a social product like Twitter or Tumblr, there are no ads. The product is conceived without advertising in mind, but rather with a very well intentioned focus on user experience.

The reasons for this focus are easy to explain. First, the people building the product have a vision that is all about end user value. They might be solving a problem for themselves, or addressing a pain point they have identified. They are not driven by the passion to create a vehicle for ads.

Second, for a small user base in the early stages of growth, it hardly makes sense to waste time thinking about selling or serving ads. And until your online business represents a lot of eyeballs, no advertiser or ad network of note is going to be interested in working with you. From my experience, and my chats with people who have much more experience than I do, you need millions of ad impressions to be interesting to a network, and millions of unique users to be interesting to the ad agencies directly.

Third, for any product idea there are soon many competitors, and it is hard to be the one investing some of your focus on ads, while your competitors focus purely on user experience.

We Can Introduce Ads Later. Right?

Maybe not. In the delicate cocktail that makes a great user experience, advertising is a powerful, overbearing ingredient. Adding it to the mix after the fact is almost impossible to do without changing the flavor to something completely different. And probably not very palatable.

Even if the new ad supported product isn’t awful, it is not the same product that users grew to love. To them the addition of ads feels exactly like the bait and switch that it actually is. At best, the ads are an annoyance that devalues the product. At worst, they are a sign of that the makers of their beloved product are “selling out” and have lost their way.

This seems obvious, so why are good product people, who are in other respects thoughtful about the minutia of user experience, so naive about this aspect of their product’s design? The answer is that they never considered it. And this wasn’t an oversight. It was intentional. Advisors and investors encouraged company leaders to delay thinking about monetization. The high order bit, in fact, the only bit that matters, is to grow the number of users and their level of engagement as quickly as possible2.

The result if the company is successful? A product that wasn’t designed to generate advertising revenue, and a company that doesn’t have any advertising DNA.

The Ads are a Lie

The startup got to this point because the focus was never on building a real business with profitable products. After all, the product that matters to early stage investors is not the one the startup is selling, it is the startup itself. History tells them that with enough traction from users, one can sell a business without a single cent of revenue for $1 billion dollars.

When the investors say “the business model can come later”, they are adding “after the exit” in mental parentheses. These days that exit most often comes in the form of an acquisition. The acquirer might want the technology, the users or just to eliminate an upstart competitor. Post acquisition, they will set about integrating the new products into their own business model, whatever that may be. All is well.

In a way, the notion of advertising as the business model has served its purpose as a way to be in denial about the absence of one.

And this is truly why the ad-based model is so popular. It is a model where entrepreneurs and investors can convince themselves and others that a bait and switch is doable. It would be much harder to accept, for example, that an online service was going to launch for free and then start charging later. The suspension of disbelief is based on the lie that ads don’t cost the user anything, when of course, they do.

The race is to get acquired before the lie is revealed. In later stage funding rounds it might be necessary to start dabbling in monetization in order to maintain the lie, but woe is the startup that runs out of growth hype, funding runway and acquisition prospects. It has to stand on its own two feet.

The Incumbents Win

For a company to be truly successful with an ad-based business model, it should start with one. After all, if the product isn’t sufficiently compelling with the revenue generating components in place, then it probably isn’t the basis of a viable business.

Sure, there is the eyeball scaling issue, but on the face of it this challenge — getting over the scaling hump into profitable territory — is exactly the sort of problem that VC money should solve. The wrinkle is that VCs focused on the exit won’t insist that their money is used to build a profitable business. They would prefer a buzz fueled phenomenon with a stratospheric valuation that preferably has no anchor in the boring reality of profit and loss.

These whacky incentives create an environment where many startups really aren’t working towards profitability, but rather towards an acquisition exit. They are building experiences, not businesses. And since they don’t have the shackles of P&L reality, they can do things that make it hard for businesses with real goals of profitability to compete.

The result is a reduced likelihood that large incumbents will be ousted by new upstarts in the consumer market. The incumbent just makes the upstart an offer. And since the upstart has no real revenue prospects on the horizon, its an offer they can’t refuse. And that’s a real pity, because large companies are where successful startups go to die.

In fact, large companies are also where many unsuccessful consumer startups go to die, via the acqui-hire. Typically these are startups that built innovative products, got some impressive user traction, but didn’t get to the nice fat acquisition before they peaked and started the decline. In this case, the acquirer gets a waning user base and some proven product talent at a bargain basement price. The founders save face. The investors get something rather than nothing. Everybody makes out ok, except… the customers.

The Customers Lose

Wherever the outcome is on the continuum from big acquisition success story, to a face-saving acqui-hire, to messy death, the customers are pretty much in the same boat. The product as they knew it, and in which they invested precious time and energy, will go away. If they are lucky, they might have the opportunity to extract their data in some way. And there might even be an alternative service eagerly welcoming the refugees. Even in the best case, however, it is not the outcome that customers hoped for.

The more this movie is repeated, the more consumers are going to take an interest in the business aspects of the services they use. The “too good to be true” spidey sense that we apply so effectively in the real world will start to get applied to online services. We will start to care that the companies we use to store our memories and connect with others are viable businesses. We will want to either pay them money, or see evidence of an advertising model that is sustainable.

That there are incentives to create companies without business models is a systemic problem. This isn’t to say that monetization-free startups aren’t innovating (they are), or that there aren’t exceptional cases where a startup finds its business model later (Google!), but if you would prefer to see a vibrant market of consumer Internet services that is less dominated by giant corporations who gobble tiny ones, then the incentives will need to change.

Fortunately, as the long term results of the current system become clear and as consumers become more savvy, the invisible hand of the market will make it so.

  1. When I use the terms “advertising” and “ad-based” I mean a broad range of business models that involve getting a third party to pay you in return for some sort of promotion to, or information about, the people who use your product.
  2. Revenue is sometimes even considered less than a “nice to have”. Without it, the sky’s the limit on the valuation of the company. With it, the valuation is brought sharply back down to earth.

Thanks to @toddwseattle and @sp990 for reading and commenting on earlier versions of this post.