What can we learn from Facebook’s acquisition of WhatsApp, a fast-growing messaging service? Does it have anything to teach us about the new economy? I think it does. Basically, I think we have a bifurcated economy in which the high tech sector is full of terrified companies that believe they have to innovate or die and a non-tech sector full of complacent companies that are goosing profits, squeezing workers, and cozying up to lawmakers and regulators in the hopes of being shielded from robust competition. If we want a more prosperous American economy, we should, to the extent possible, get the non-tech sector to look more like the tech sector.
Many people are reacting with incredulity that Facebook was willing to pay $16 billion in cash and stock and $3 billion in restricted stock units for a company that is still in its infancy, and which generates only a modest amount of revenue. But if you’re the kind of person who believes that Twitter is not a completely worthless fad, like me, you might appreciate this neat little chart which I found via serial entrepreneur Tariq Krim:
We’re living in what you might call the post-Christensen era. In The Innovator’s Dilemma, the Harvard management theorist Clayton Christensen famously observed that many great companies stumbled not because they were lazy or incompetent, but because they were reluctant to pursue new markets if doing so would undercut their lucrative existing businesses and make it harder for them to goose short-term profits. But in the years since Christensen’s groundbreaking book, Christensen-inspired entrepreneurs, like Jeff Bezos of Amazon.com, have embraced Christensen’s advice to, for example, set up entirely autonomous business units that are dedicated to (if necessary) destroying the company’s existing business model. Brad Stone’s The Everything Store describes how Amazon quite literally tasked members of its Kindle team with behaving as though they wanted to “put everyone selling physical books out of a job.” Some management theorists, like Larry Downes and Paul F. Nunes, argue that we’ve entered a new era of “big-bang disruption.” According to traditional disruption theory, markets are divided into high-end segments that prize quality and that want more feature-rich products, even if it means paying more, and low-end segments that care about price most of all. Disruptive innovations are, in essence, really cheap products that turn non-consumers — the folks who can’t afford to buy the product in question — into consumers. These cheap products aren’t very attractive to high-end consumers, and serving high-end consumers is how you make fat profits. Incumbent firms that have thrived by serving the high-end market can ignore the low-end segment for a while and let various bottom-feeders play in that space. The problem, however, is that the bottom-feeders and their crappy products don’t stand still. As they conquer the low-end market, they can climb the value chain, using the tools and techniques they’ve developed to serve the low-end segment of the market to be cheaper, faster, and eventually better than the incumbents, until the incumbents find themselves blind-sided. This is a scary scenario for an incumbent firm, no doubt. But the the threat of big-bang disruption is even scarier — the idea here is that disruptive entrepreneurs might attack not just the low-end segment with a feature-poor cheapo product; they might attack the low- and the high-end segments of the market with feature-rich cheapo products that appeal to everybody. Downes and Nunes use the example of Google Maps, a free tool that is actually a lot better than many of the expensive GPS devices that used to command a big chunk of the market.
Like Bezos, Facebook CEO Mark Zuckerberg is keenly aware of the threat of disruption from below. But he is also away of the threat of disruption from above or from a lateral direction. Facebook is a “free” service that captures value from its users by capturing their attention, and so some of the chief threats to Facebook are rival services that do a better job of capturing attention. The acquisition of Instagram is best understood through this lens. One of the reasons Myspace declined (or so I’m told) is that it came to be seen as a chaotic free-for-all, and it didn’t help that its technology infrastructure was pretty lackluster. When Facebook acquired Instagram, the latter had just acquired a substantial amount of new funding, and it seemed well-placed to attack Facebook laterally; with its culturally-savvy, youthful following, it had the potential to leapfrog Twitter in the cultural imagination, and to capture some share of the attention that would otherwise be devoted to Facebook. With the Instagram acquisition, Facebook entered the business of disaggregating its offering. Whereas it has previously acquired start-ups and integrated their technology into its central offering, it now saw the value of operating a portfolio of brands, all of which would share the infrastructure and expertise Facebook has built up over time, but which would be free to pursue different strategies to grow in different markets.
In recent years, messaging services have grown explosively in East Asian markets where broadband-penetration is near-universal and customers are very technologically savvy. They’ve also captured the imagination of middle-income consumers in Latin America, South Asia, and elsewhere. Messaging services in China, South Korea, and Japan are evolving into full-scale competitors to Facebook, Amazon, and eBay, among other tech giants, as they’ve become marketplaces and platforms. Messaging services have also taken off in the United States, though they have yet to achieve the same level of ubiquity. It used to be that the future happened first in the United States and then in various other developed markets, and then in emerging markets and so on. (I remember when Titanic came out in my parents’ native country about a year after it came out in the United States. Middle-class Bengalis were going nuts.) We’re now in a world in which innovations often take off in emerging economies first. So Facebook had good reason to invest in its messaging capability. That is part of why Facebook created a separate Facebook Messenger app, which is tightly-integrated into its core offering, yet which has the functionality of some of the fancy new real-time messaging services.
Earlier this week, Ben Thompson of Stratechery described messaging as mobile’s “killer app,” prompted not by the WhatsApp acquisition, but rather by the Japanese e-commerce company Rakuten’s more modest $900M acquisition of Viber. Thompson’s take is that the path to a purchase goes like this: Awareness > Interest > Desire > Action. Google’s success flows from the fact that it helps consumers turn their Desire for a thing (a new humidifier, a news article) into Action (I will buy a humidifier, I will read a news article), which makes it a really attractive advertising platform. If you’re selling something, Google is identifying people who already want to buy the thing you’re selling, so you’re golden. But most advertising spending focuses on generating Awareness and Interest. This is why you make a witty beer commercial starring Anna Kendrick — to get people to be aware of and interested in your beer. But how do you get people to go from Awareness and Interest to Desire and Action? If you could figure that out, you could become really rich.
This, according to Thompson, is where messaging comes in. It allows marketers to reach consumers at the right time and perhaps even in the right place, if the messaging service knows your location. Thompson uses the example of an ice cream promotion sent out on a hot day to people who’ve already “liked” a particular ice cream company. Better still, imagine if the message only gets sent if your device knows you’re within walking distance of one of the ice cream chain’s retail outlets. Pretty neat stuff. I have no idea if WhatsApp intends to evolve in this direction. Thompson explicitly notes that WhatsApp has yet to build a true platform for advertisers, commerce sites, and developers. That is potentially where Facebook comes in, as Facebook has a great deal of in-house expertise as to how to go about building an attractive platform.
So hopefully I’ve convinced you that Facebook isn’t crazy to have acquired WhatsApp. I promised that I’d get to why you should care. As The Economist recently argued, the tech sector has entered a “Cambrian moment“; the building blocks of new ventures are cheap and ubiquitous:
Some of these building blocks are snippets of code that can be copied free from the internet, along with easy-to-learn programming frameworks (such as Ruby on Rails). Others are services for finding developers (eLance, oDesk), sharing code (GitHub) and testing usability (UserTesting.com). Yet others are “application programming interfaces” (APIs), digital plugs that are multiplying rapidly (see chart 1). They allow one service to use another, for instance voice calls (Twilio), maps (Google) and payments (PayPal). The most important are “platforms”—services that can host startups’ offerings (Amazon’s cloud computing), distribute them (Apple’s App Store) and market them (Facebook, Twitter). And then there is the internet, the mother of all platforms, which is now fast, universal and wireless.
Startups are best thought of as experiments on top of such platforms, testing what can be automated in business and other walks of life. Some will work out, many will not. Hal Varian, Google’s chief economist, calls this “combinatorial innovation”. In a way, these startups are doing what humans have always done: apply known techniques to new problems. The late Claude Lévi-Strauss, a French anthropologist, described the process as bricolage (tinkering).
The gap between starting a tech business and a non-tech business is getting bigger and bigger over time, particularly if you intend to actually hire people. WhatsApp employs 32 engineers, and Instagram had six employees as of the end of 2011. Navigating the regulatory thicket is difficult and expensive, and it blocks innovation. Tech start-ups are (relatively) easy to launch, and they hold out the promise of big payoffs because they are (relatively) easy to scale. There are lots of useful business ideas that might offer smaller payoffs, and that might be a lot harder to scale, but that would do wonders for U.S. productivity, and for U.S. job growth. But if these lower-payoff, harder-to-scale opportunities are much harder, and much more expensive, to launch, you’re not going to make much headway.
One promising development is that non-tech businesses are converging with tech businesses in at least some respects. Non-tech businesses are continuing to integrate technological tools into every aspect of their operations, and this is enabling productivity increases and much else. This is making non-tech businesses more productive, and that is good news. But because it’s really hard to launch non-tech businesses, the benefits of these productivity increases are flowing to the owners of non-tech businesses. Ashwin Parameswaran’s extended essay, All Systems Need a Little Disorder, helps explain what’s going on:
Incumbent firms have very little incentive to invest significant resources in risky initiatives that aim to displace their existing cash-cow businesses. In many instances, they may face resistance not only from internal departments that feel threatened by the potential success of new products but also from customers who are reluctant to embrace disruptive change. In fact a great deal of the uncertainty in new product innovation arises from the fact that it is almost never driven by the customer. As the old adage goes, customers rarely know what they want unless they see it, a principle embodied by Steve Jobs’ time at Apple Computers. New product innovation requires constant trial and error and most of these trials are bound to fail. Incumbent firms are, quite rationally, primarily focused on protecting their existing source of profits and minimising the risk of failure rather than undertaking speculative risks where the odds of failure are greater than the odds of success.
In the absence of new firm entry, even a competitive industry with many players will focus on process innovation and cost reduction and avoid any potentially disruptive product innovation. When incumbent firms do undertake product innovation, they do when their existing source of super-normal profits is threatened by disruptive products from new entrants. In an environment where product innovation is high, not undertaking new product initiatives is the riskier option. Simply protecting existing revenue streams rarely works out. Despite this, many incumbent firms are rarely able to respond effectively to new entrants, primarily due to organisational rigidity. New entrants on the other hand face a different set of incentives. Having no existing profits to protect, the lure of capturing such super-normal profits drives their actions far more than the much larger possibility of failure.
In other words, unless incumbent firms face the threat of failure due to the entry of new firms, product innovation is unlikely to be robust. The role of failure in fostering product innovation has sometimes been called the ‘invisible foot’ of capitalism. Process innovation being a lower-risk endeavour is not dependent upon the threat of failure. Simply instituting a regime where firm owners and employees are incentivised to seek higher profits is sufficient to encourage process innovation. In other words, the positive incentives of Adam Smith’s invisible hand are sufficient to give us a high level of process innovation but disruptive product innovation requires the negative incentives of the fear of failure i.e. an invisible foot of dynamic competition from new entrants.
To get more product innovation and job creation, we don’t need more subsidies for existing businesses. We need them to fear the prospect of going out of business. That means making it much easier for new competitors to emerge. And that means, among other things, streamlining the process of starting new businesses, addressing the regulatory accumulation problem, and (perhaps) reforming the tax code to reduce the huge advantage we give to highly-leveraged incumbent firms over start-ups that raise equity. Frightened business owners will hire workers to fend off competitors. They will make investments to make sure that they create the next big-bang disruption that would otherwise leave them in the dust.
Despite its formidable position, Facebook is afraid. It is afraid because it is keenly aware of the Cambrian explosion of start-ups, and that even though it has built an enormous platform, it is still entirely possible that some other company can do the same at astonishing speed. Facebook’s response has been to acquire promising competitors, and we’ll see whether or not it does a good job of making the best of these acquisitions. But Facebook is also investing in new product innovations in areas like artificial intelligence, which is why it is aggressively expanding its workforce. It is trying to use product innovation to serve as the moat that defends its business, just as Amazon uses product innovation and its unparalleled logistical sophistication to do the same. No, Facebook will never employ as many people as the old-line industrial giants. But wages for software developers are quite high as Facebook, other publicly-held tech giants, and a wave of start-ups bid them up. A similar dynamic could obtain in the wider economy if we could drive down the cost of new firm entry and if we could reduce the barriers to growth. That can and should be the central domestic policy issue, and it is part of why new labor market regulations and new hiring burdens need to be viewed with the utmost suspicion.
(For more, I recommend Brink Lindsey’s essay on “Frontier Economics.” He perfectly distills the dilemma facing the U.S. economy, and what we ought to do about it.)
P.S. Tim Lee has a different angle on the WhatsApp acquisition that is well worth reading. Though he cares about the same things I do (promoting a more innovative entrepreneurial ecosystem), he sees the acquisition as bads news:
WhatsApp is the kind of unconventional startup that could have changed the world if it had grown into an independent public company. It might have been able to attract some of Silicon Valley’s most talented engineers and pioneered new business models that don’t rely on intrusive ads and pervasive data collection.
But now WhatsApp CEO Jan Koum works for Mark Zuckerberg. He may still have a lot of freedom in developing his core messaging app. But any new products he launches will be shaped by Zuckerberg’s vision for the web, not his own. And that’s a shame.
Tim makes a strong case. The point I’m trying to make, however, is that in the non-tech economy, we aren’t seeing enough start-ups that can even reach the point of becoming a potential threat to large incumbents. (And it should go without saying that tech sector incumbents aren’t immune to the charms of using government to their advantage. The wars over software and business method patents are a good example of how misguided regulation can stack the deck against start-ups in tech.)