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Margins count!

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The only thing better than losing money is . . . losing other people’s money!

During the dot com days, I misspent my middle age at a marketing communications firm that kept the lights on servicing a passel of dot com dreamers, drudges, and outright phonies. They were, I admit, all well-funded startup phonies, but two or three minutes of talk dimly lit by their low-watt business planning made manifestly clear that there was no future in their future.

There was the free online accounting software system that would pay its bills entirely from the interest on user funds float (of course, it would take millions of small business users to make the company profitable, but none of the business’ investors seems to have done the math on that one). The health-system online video trainer and tutorial for big businesses to use to motivate employees to be healthy — using A-list movie stars at A-list prices (never asking the question why any business would pay Avatar-sized prices for an online health motivation whatsit). The RFP marketplace for funeral companies, connecting cemeteries and vendors more efficiently and cheaply. I used to joke that the dot com industry was the revenge of the Trotskyites — finally, someone had figured out how to redistribute wealth from the rich to the poor with the full, voluntary participation of the rich! Welfare, bad, dot com investment, good. Neither produced a return, but the rich, who will always be with us, could be duped into the latter.

And now we have Foursquare, yet another variation on the social networking one-note song. As with just about every piece of nonsense that passes for news, it has taken The Onion to be the only one to get the story right. Now, Foursquare is a well-funded company, but a couple sentences describing the six-month old company particularly stand out:

So far, Foursquare has no revenue, and the company is still developing its business model. Mr. Crowley and Mr. Selvadurai say they are focusing on trying to build up the infrastructure, expand the user base and develop a database of locations.

Now, most entrepreneurs — folk like you and me — aren’t in the business of bilking money off of dumb rich people who hope to bilk money off of other rich people a couple years into the future, so “having no revenue” and “still developing a business model” aren’t luxuries we can afford. The electric company isn’t going to accept a 60,000-user base in lieu of a check. The reality is this: revenues count. Margins count. And the first rule of startups is this: find the margins and protect as much of those margins as possible.

The core of every business, including a shoestring startup, is a financial strategy which seeks to produce and protect profits. There are, of course, as many financial strategies as there are businesses, but “growing your customers and finding out how to make money later” is not — I repeat, NOT — a workable business strategy. You start with the financial strategy and build the business model off that. To illustrate this, I’m going to briefly talk about two companies, Hulu, with a stupid financial strategy, and Apple, with a brilliant one.

Much has been made of Hulu recently as well as the big brains that founded it. But those big brains never seem to have thought about profitability. But Hulu started with a financial model that made them less profitable the more successful they became. The more users they attract, the more money they lose. Is it any wonder that they’ve had to backtrack and start charging users?

The basic financial strategy of Hulu is to combine the revenue model of broadcasters (paid advertising) with the cost model of cable or Internet providers (where each user or audience member incrementally increases their costs).

Broadcasters have fixed costs no matter how many viewers they attract, so they can sell a fixed amount of advertising inventory relative to fixed cost projections for the year. If 30 million people watch the last episode of Lost on Sunday, this will cost ABC no more than if 10 million people watched the same episode.

Cable providers and Internet services, however, sustain incremental costs as they add viewers, but cable providers generate revenue through subscriptions. If Comcast adds 10 million viewers to is customer base on Sunday, the subscriptions (and set-up fees) these new viewers pay will cover Comcast’s additional costs per viewer plus a healthy margin.

So, you see, all broadcasters have to do is meet their fixed costs and their SG&A by selling enough advertising inventory at a certain average price to reach profitability. All a cable provider has to do is, once they’ve built a certain subscriber base, generate enough money with an individual subscription to cover the additional costs, the overhead, and a nice little margin. Because cable companies operate as monopolies, that margin is not insignificant.

Hulu unwisely combines the revenue model of broadcasting with the incremental cost model of cable. Like cable, each additional viewer incrementally increases costs (royalties and technology costs, such as bandwidth, storage, and transcoding). Like broadcasters, revenues are more or less fixed from advertising sales. To meet the increased costs, Hulu must sell more advertising inventory.

There comes a point where selling all this additional inventory is either not possible or puts Hulu in an aggressive competition with broadcasters, the latter a losing proposition since Hulu depends on content from those very same broadcasters. If any of the smaller cable companies playing ball with Hulu ever conclude that they’re losing advertising inventory to Hulu, the jig is up. Simply put, the only rational revenue model for an Internet service like Hulu is one that autmatically scales with viewership, such as membership or premium membership fees.

Just to show you, I took out my Excel and ran a few numbers from Hulu in 2008. The graphic below shows the number of impressions (in thousands) that Hulu had to sell from May 2008 to January 2010 just to meet the estimated costs of streaming the content (royalties and technology), just to meet the costs of the technology and the royalties. SG&A (overhead) isn’t included.

The critical growth period was between May 2008 and January 2010. Just to meet costs (see note below) — and I have assumed royalty costs remaining constant at 60% of potential royalties — Hulu needed to sell 350% more advertising in May of 2009 than it needed to sell a year later. And that number had to double (189%) in the seven short months between May of 2009 and January of 2010 — a whopping 840% increase in ad sales just to meet costs in just 21 months.

That, of course, is the price of “free.”

So it really wasn’t until late 2009 that the folks at Hulu figured out the Titanic had a rip in it. So after throwing all the biggest minds they could find at the problem, they came up with . . . a user subscription revenue model to augment the advertising model. Now, it remains to be seen how many people will pay to use what they can get for free and whether this new subscription model will produce the same problem they’ve been having. For instance, all the nice content providers will want a chunk of those subscription fees. If they want too big of a bite, then Hulu’s back to square one in terms of financial strategy — if the subscriptions don’t cover costs, adding subscribers means losing more money.

Readers of this blog know that I’m not a huge fan of Apple, but that’s neither here nor there. No matter what you read in the press or business press about Apple and innovation, marketing, or product development, the fundamental business strategy at Apple is a financial one. Apple’s fundamental strategy is to squeeze as much profit as humanly possible from every sale it makes.

Apple’s financial strategy, then, is to maximize its margins, a financial strategy it has pursued single-mindedly since Steve Jobs returned to the company.

This foundational financial strategy informs every other aspect of its business model.

Product development — to maximize margins, Apple has to offer products that consumers can buy nowhere else. This involves one part cutting-edge design, one-part unique, hard-to-emulate features, and several parts marketing.

Always be launching – A standard truth about marketing is that early adopters are willing to pay the highest prices – and highest margins. The Apple launch strategy involves super-hyping products in order to build the largest army of early adopters possible. All those nice people who stood in line for an iPad on the day of its launch were willing to pay a pretty penny to get their hands on the device. The second part of the strategy is to continually relaunch products. The Apple financial strategy – maximize margins as much as possible – is wedded to a marketing strategy of maximizing early adoption.

Why is Apple so secretive to the point of insanity? Because you can’t maximize early adopters if your product is old before it’s launched.

Keep the cash coming – All the press you read about Apple’s product strategy frequently misses the most important point – Apple doesn’t just want to sell you an iPod or iPhone or iPad and bank the shekels; rather, the company wants you to keep buying stuff through their devices and services. And like the famous cake metaphor in Bonfire of the Vanities, Apple takes a big, big bite out of that cash as it passes it on to the real seller. iTunes, iPhone apps, and Apple’s deal with AT&T means that every device they sell promises – nay, practically guarantees – a continuous revenue stream from selling content, apps, and, of course, kickbacks for every dollar an iPhone customer spends on their AT&T cell phone service.

Every product put into the pipeline at Apple has to pass this continuous revenue stream test. If the cash doesn’t keep coming, the product isn’t worth developing.

Force customers to upgrade – Apple’s best-selling products all have one feature in common – they’re designed to be unusable long before their feasibly useful life is over. Ever wonder why you can’t change the batteries in an iPod or iPhone? Why iTunes doesn’t work with your old iPod? Apple wants you to buy a new iPod, which it helps along by constantly introducing new iPods.

Apple didn’t invent this strategy. But Apple combines forced obsolescence with top-notch new product development, so they can be far more blatant about it (unchangeable batteries, for instance) than other companies and get away with it.

Squeeze your partners and vendors – Everything Apple has said about Flash and the iPad is untrue. The real matter is this: Adobe wants too much money to license a Flash install into the iPad. It’s not like Apple is cutting margins to the bone and can’t accommodated Adobe. Apple’s strategy is to take as much margin as humanly possible, and you can’t do that by dribbling away a penny here and a penny there to your vendors and partners.

I need to stress that none of this is criticism of Apple, it is simply a description of their fundamental strategy and how all the parts fit into that strategy. If they were not world-class at product development and new product launches, then built-in obsolescence and continuous revenue generation would not work.

What does this mean for your startup?
Which brings us back to Foursquare. By lacking a revenue plan, they are way behind the ball at figuring out how to maximize revenues. Foursquare, like Facebook, has the same cost model as Hulu.

The margin question involves two related issues: how do you meet costs and how do you scale to sales? Revenues need to meet and beat costs, obviously (and “we haven’t figured out how to generate revenues” is probably the worst strategy for meeting costs). But revenues also need to scale with the incremental costs of sales. If your business succeeds, will that very success run your business into bankruptcy?

This is particularly important if you have significant constraints built into your business. Suppose, for instance, that your startup is a blog (plenty of people make a good living off their blogs). Now suppose that your blog traffic doubles in a month and your shared hosting service boots you off for the unsupportable bandwidth (no shared hosting service that offers “unlimited bandwidth” actually means “unlimited”). Now you have to graduate to a dedicated server and your server costs jump from tens of dollars a month to hundreds or thousands. Have you planned for the transition, or, like Hulu, do you take the hit and scratch your head?

Employees are another constraint. Suppose you run a one-person design company and your project load triples. Rather than turn down the money, you hire employees or bring on contractors. Because of this, project cost overruns – based simply on paying employees or contractors for their mistakes or lack of knowledge – suddenly makes most of your jobs unprofitable. You forgot, in other words, to build in to your billing the costs of employee and contractor inefficiencies.

Buybacks are a possible constraint. Suppose you develop a great new organic supplement and your retail orders triple in a month because Von’s and Whole Foods and Target all decide to stock your product. Even if you can make the orders in a shortened timeline, chances are you’re saddled with buyback provisions in each of these contracts. It may be great to sell 5,000 units to Target, but what if they don’t sell within the provisions of the buyback? Do you have the funds to refund Target if you have to buy back 4,000 units from them?

There’s a general rule that you should always follow when planning your business, startup, or marketing campaign. Everything you plan to do should be confronted with two questions:

Where are the margins coming from?
What can I do to maximize those margins?

Play the game any other way, and your business, like Foursquare, will have no future in its future.

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