Five Theories About The Future Of Innovation Online

Google, Facebook, Amazon and Ebay have grown to massive online companies. The network effects of these companies might affect the trend of innovation amongst internet start ups for years to come.

Amazon buys Book Depository, Ebay buys Magneto. Google, Facebook and Yelp start Groupon style deals websites. Google starts Google +. All in 2011 and all in my short term memory.

All you need to do is read Techcrunch and within no time you’ll see many more stories along these lines. But so what right? Big companies have been buying small companies and copying the ideas of others for hundreds of years.

A history of Internet Mergers

Since the Internet began its meteoric rise in the late nineties, plenty of Internet companies have been bought and sold. It probably started with big non-internet companies buying successful Internet companies at massive premiums to try and get in the game (think AOL / Time Warner and Myspace / News Corporation). That didn’t turn out too well for the buyers but thankfully a few guys are most likely downing Caipirinhas on some Brazilian island thinking of Rupert Murdoch.

Somewhere along the line, Internet companies began buying each other or competing directly for the top spot. Think of the search engine race; Yahoo, Google, Askjeeves, Lycos, Metacrawler (click here to see where they are now). No prize for whoever guesses the winner of that battle.

Friendster, Myspace, and Facebook…. I could put a “click here to login to Facebook” button to show who won that one.

For a more complete look at the online landscape of buyouts and mergers see this brilliant mashable post.

Network Effects Emerge

However, until the last few years, I couldn’t have confidently said very many Internet companies had won their respective battles (though I could have predicted some were likely to win – Google, Amazon, Skype and eBay come to mind).

It is true that these companies will still have to hold their position due to the very low switching costs online. But, the winners of the Internet game (so far) have grown to sizes where another factor really starts coming into play. That factor is network effects.

Network effects increase the value of a product or service as more people use it. They create barriers to entry for competitors looking to break into the space. And finally they provide a platform for these massive companies to break into new markets.

How the Internet Landscape could change

Seeing the very fast movements that great start up ideas can make on the Internet has interested and inspired me for years. Think Google Maps, Facebook, Tripadvisor, Airbnb, Groupon, online travel booking, Evernote, Twitter, Kickstarter. If you don’t know any of them, Google them. The speed at which good ideas have been able to get going has also increased as the Internet has grown older.

But now that Google, Amazon, Ebay and Facebook (amongst others) have grown to the sizes that they have, they have the customers, cash flow and technological edge to run the show unless start ups really put up a fight (that they may be unable to win). They could emulate most of the ideas above if they wanted to and then expand them onto their network of users.

5 Theories about Innovation Online

When Amazon recently bought Book Depository, I was genuinely a little annoyed. Book Depository had a completely different business model by offering free delivery worldwide and cheaper books. They also didn’t ream Australians for living far from the US. Now that Amazon owns them, this may still continue but only if Amazon allows it to. Whilst the Depository family might be on an island spending the purchase price (and good on them), this example shows the extent of Amazon’s power. And with little in the way of a multinational anti-competition organisation, who will stop them?

Theory 1 – If you do something interesting online and want your idea to go to completion, you’ll may have to withstand the forces of multimillion dollar offers to get it there.

Theory 2 – The Internet superstars can set the course for a large proportion of online innovation.

Facebook deals, Google offers are both direct copies of Groupon’s business model (which is probably a direct copy of someone else). Thankfully for the social networking giants, copyright protects the form and not the idea.

So if you’re a start up with ideas in the making, do it knowing that if one of them does take off, it is now very simple for Facebook or Google to copy the idea, maybe do it better and then launch it to a worldwide audience. If you’ve managed to grow a start up that has 10,000 users and $1M a year in revenue, your idea could be worth massive multiples of this to a company like Google or Facebook.

Theory 3 – If you have a start up idea that is likely to succeed, consider your launch plan carefully.

Theory 4 – It is perhaps easier and cheaper for them to simply copy your idea and trial it on their network than to buy your company.

Theory 5 – Your idea is worth more to them than it is to you. If you’re going to sell, don’t sell cheaply.

As an aside, I’m not certain any of these theories are anything but adaptations of ideas already visible in the real world. But I do feel that there are very few ideas that a company like Google or Facebook couldn’t go after online.

How a Trip to Antarctica Can Show You How Not To Spend Your Time

Some people spend upwards of 60% of their young lives working in a job that they don’t enjoy with the purpose of making alot of money.

These people may be exchanging time for the ability to purchase products and services now, or perhaps to achieve status or secure future riches for retirement. If you fall into one of these categories and don’t enjoy what you’re doing, consider thinking about the following. If you enjoy what you’re doing, this probably isn’t very relevant.

Your Hypothetical Trip to Antarctica

Imagine you have been given an offer. If you choose to accept the offer, you’ll be taken on a hypothetical trip to Antarctica and you’ll be given an endless supply of  money. However, as with most hypothetical amateur thought experiments, there is a catch. Three in fact. They are as follows:

  1. There are no other people in hypothetical Antarctica and you are not allowed to communicate with any people back in the hypothetical country you live in. No internet, Facebook, Twitter, Forums, or communication of any kind
  2. Hypothetical Antarctica has a limitless supply of your favourite brands, products, property, and services (and you have endless money to purchase with)
  3. You cannot visit hypothetical Antarctica, save some money and return to the country you are from.

Do you accept the offer?

My guess is that most people would not and I think there are a range of reasons why. Boredom, no interaction with people, no purpose in life, no sex, and no ability to have children all come to mind (and I’m sure there are many i’m not thinking of). However, if you exclude most of these reasons and just think about the loss of interaction with people, one issue becomes pretty clear for me.

Brands, products, expensive cars and status would all shrink heavily in value with no one around to witness them. For me, only truly useful goods would hold their value. As much fun as driving a Lamborghini through a crevasse in Antarctica might be, if people had to give up time with their friends to make it happen, selling one-way tickets on the hypothetical Alaska boat  would become alot harder.

To me, this illustrates that our friendships are ultimately more important than our desires for material possessions, status, and future riches (if given the choice of having one or the other). Yet, some people choose to work 60+ hours a week during the best years of their life doing something they don’t enjoy while their friendships suffer and the years of their life tick away. What they are saving for and who will share it with them is anybody’s guess.

There are so many what ifs and other rebuttals that come to mind that could weaken this argument and I might be completely off the reservation here but I think the basic gist is interesting. So, if I find myself not enjoying large chunks of my time on a regular basis and effectively find myself sacrificing something I enjoy (like time with friends) for material possessions that are not useful, status or future riches, I’ll think of Antarctica.

Why Facebook and Linked In IPOs Might Scare Users

For some reason, I think I felt comfortable that my personal data was controlled by a small collection of private companies. Facebook, Google, Linked In are the big three that come to mind.

Linked in header image

Google has been public for several years and knows alot about me. And you. What web sites you browse, what you write in your emails, your preferences, your phone number, your personal details. The fact that they also know this about the rest of the world for some reason gave me comfort.

The fact that they also had hundreds of millions and now billions in search revenue also made me feel good. Would they bother jeopardising that in order to sell my data to people? I doubt it but maybe.

I’m also generally not too worried about it which helps.

That said, Linked In’s IPO and Facebook’s coming IPO have got me thinking. Linked In’s first day multiple of 300-600 times earnings implies that public shareholders either plan on making a lot more money than they currently are from these companies or that they love losing buckets of cash in the near term. Or that they’re speculating it will go up more like in the 1998-2001 internet boom.

What i’m wondering is what are they going to have to do to raise earnings in the manner they’ll need to to justify their valuation? Surely they’ll have to start making some decent money somehow?

Will Linked In start calling me and offering me jobs? Will Linked In or a post IPO Facebook sell my data to companies to advertise to me? I was less worried about these things with their private company CEOs at the healm and a smaller group of VC investors and rich Goldman Sachs clients as shareholders. But trading at multiple hundreds times current earnings, I’m not so sure. The profit growth has to come from somewhere.

With the post IPO Google, I not only didn’t think about much about this but I effectively didnt’ have a choice unless I wanted learn Chinese and try out Baidu.

With Facebook and Linked In I do have a choice. I guess less so with Facebook because it is a great tool for staying in touch with people. Linked In, however, I would happily ditch in a heartbeat if the concerns above worried me.

Luckily, they don’t worry me too much so i’m unlikely to leave these sites.

But I imagine there are millions of people out there that these concerns do worry. Will people use these sites the same way now that they’re publically owned? Should they? Will they do things differently? Are Linked In and Facebook less valuable as public companies at such high valuations?

Either way, Goldman Sachs who has already unloaded its Linked In shares and the pre IPO shareholders look likely to profit.

Users of Facebook and Linked in? I wonder.

The Expert Dilemma – Just Google it

It doesn’t come as any surprise to most of us that from time to time, we all seek the help of experts.  But, how would a cave man have felt about needing to consult another cave man about his sore back or needing to attend a popular cave convention to improve his hunting skills?

Between now and whenever then is, something has changed. The caveman was in control of his own destiny.

So what’s changed?  We now have very different living standards. I’m typing this in an apartment 60 odd metres off the ground on a windy night and I’m quite comfortable. And warm. Would I know how to build this shelter for myself if relied upon? No. Am I happy someone knows how to? Yes.

The obvious answer is specialisation. Knowledge specialisation if you like. Certain people I know know more about molecular biotechnology or Russian literature respectively than the caveman probably knew about the world around him. But could they survive if left in the jungle? I’m pretty sure they wouldn’t want to try.

But why write this now? Wondering this myself, I questioned what made me think about the issue. Everyday, people seem to be looking to others for the answers to problems that they should probably try to solve themselves. I think this is more the case now than 10 years ago but realistically my 16 year old self probably wasn’t the best judge.

I notice myself doing it these days. More so than I used to. Thinking back again, the caveman probably still learnt some skills from a small group of others but to imagine him needing to spend 5 years studying before he felt competent to go about his life is a little unbelievable. Similarly, 50 years ago I’d say people still sought out the confirmation of experts. In a book called Influence, the author labels one of his 8 main tools of persuasion as authority. So there is evidence that people have a tendency to both seek and submit to the authority of experts.

But I think it is changing. Becoming further entrenched. Everything now needs to be backed up by a source. By an expert. By Google. Just Google it. At lunch today, instead of remembering the French translation of scallops (don’t ask), I nearly got my iPhone out and Googled it. When I was in Perth recently and the Budget car rental was out of Navmen, I was genuinely worried until my 14 year old self’s navigation skills kicked in.

So we’re super specialised. Super technologised. Yes, we benefit from it. I love being able to perfect my fruit ninja skills in my iPhone dojo on the bus home. But is it worth it? If asked to recreate the gadgets of the world we live in without the proprietary knowledge of the world’s biggest companies, I know I couldn’t. Cameras. LCD screens. Computers. Mobile Phones. Best of luck with that.

In my opinion, we’re now on more of a roller coaster ride than past generations used to be. Somewhat out of control but enjoying it. Less time to think for ourselves. We need degrees to say we know how to do something. To imply to others we’re worth listening to. People cling to intelligence like it is the passport to a secret cave of untold riches and happiness when it is available in spades.

I’m not necessarily saying that we’re not still in charge of our own destiny or that we’ve lost control. But I am saying that my preference over the coming years is going to be to understand things myself and rely on my own abilities. You get one life, I don’t think I want to spend mine following others.

Only comment below if you’re doing it from a prereleased iPhone 5 in the middle of a desert somewhere.

My favourite parts of Warren Buffett’s 2011 Letter to Shareholders

Every year since 2008, i’ve been reading Warren Buffett’s letters to shareholders. They are an excellent source of investing and business intellect and usually pretty funny as well.

You can download the 2011 letter to shareholders or visit the letters archive.  Interesting quotes from this year’s letter are below:

Page 4, paragraph 1:

Don’t let that reality spook you. Throughout my lifetime, politicians and pundits have constantly moaned about terrifying problems facing America. Yet our citizens now live an astonishing six times better than when I was born. The prophets of doom have overlooked the all-important factor that is certain: Human potential is far from exhausted, and the American system for unleashing that potential – a system that has worked wonders for over two centuries despite frequent interruptions for recessions and even a Civil War – remains alive and effective.

Page 7, paragraph 3:
This “what-will-they-do-with-the-money” factor must always be evaluated along with the “what-do-we-have-now” calculation in order for us, or anybody, to arrive at a sensible estimate of a company’s intrinsic value. That’s because an outside investor stands by helplessly as management reinvests his share of the company’s earnings. If a CEO can be expected to do this job well, the reinvestment prospects add to the company’s current value; if the CEO’s talents or motives are suspect, today’s value must be discounted. The difference in outcome can be huge. A dollar of then-value in the hands of Sears Roebuck’s or Montgomery Ward’s CEOs in the late 1960s had a far different destiny than did a dollar entrusted to Sam Walton.

Page 7, second last paragraph:

Our second advantage relates to the allocation of the money our businesses earn. After meeting the needs of those businesses, we have very substantial sums left over. Most companies limit themselves to reinvesting funds within the industry in which they have been operating. That often restricts them, however, to a “universe” for capital allocation that is both tiny and quite inferior to what is available in the wider world. Competition for the few opportunities that are available tends to become fierce. The seller has the upper hand, as a girl might if she were the only female at a party attended by many boys. That lopsided situation would be great for the girl, but terrible for the boys.

Page 8, paragraph 2:

In addition to evaluating the attractions of one business against a host of others, we also measure businesses against opportunities available in  marketable securities, a comparison most managements don’t make. Often, businesses are priced ridiculously high against what can likely be earned from investments in stocks or bonds. At such moments, we buy securities and bide our time… We have been able to take money we earn from, say, See’s Candies or Business Wire (two of our best-run businesses, but also two offering limited reinvestment opportunities) and use it as part of the stake we needed to buy BNSF.

Page 9, paragraph 3:

GEICO also jump-started my net worth because, soon after meeting Davy, I made the stock 75% of my $9,800 investment portfolio. (Even so, I felt over-diversified.)

Page 14, paragraph 4:

A housing recovery will probably begin within a year or so. In any event, it is certain to occur at somepoint… At Berkshire, our time horizon is forever.

Page 16, 3rd last paragraph:

Our borrowers get in trouble when they lose their jobs, have health problems, get divorced, etc. The recession has hit them hard. But they want to stay in their homes, and generally they borrowed sensible amounts in relation to their income. In addition, we were keeping the originated mortgages for our own account, which means we were not securitizing or otherwise reselling them. If we were stupid in our lending, we were going to pay the price. That concentrates the mind.

If home buyers throughout the country had behaved like our buyers, America would not have had the crisis that it did. Our approach was simply to get a meaningful down-payment and gear fixed monthly payments to a sensible percentage of income.

Home ownership makes sense for most Americans, particularly at today’s lower prices and bargain interest rates. All things considered, the third best investment I ever made was the purchase of my home, though I would have made far more money had I instead rented and used the purchase money to buy stocks.

But a house can be a nightmare if the buyer’s eyes are bigger than his wallet and if a lender – often protected by a government guarantee – facilitates his fantasy. Our country’s social goal should not be to put families into the house of their dreams, but rather to put them into a house they can afford.

Page 18, paragraph 2:

Even before higher rates come about, furthermore, we could get lucky and find an opportunity to use some of our cash hoard at decent returns. That day can’t come too soon for me: To update Aesop, a girl in a convertible is worth five in the phone book.

Page 18, paragraph 5:

Within ten years, I would expect that $376 million to double. By the end of that period, I wouldn’t be surprised to see our share of Coke’s annual earnings exceed 100% of what we paid for the investment. Time is the friend of the wonderful business.

Page 18 to 19:

It’s easy to identify many investment managers with great recent records. But past results, though important, do not suffice when prospective performance is being judged. How the record has been achieved is crucial, as is the manager’s understanding of – and sensitivity to – risk (which in no way should be measured by beta, the choice of too many academics). In respect to the risk criterion, we were looking for someone with a hard-to-evaluate skill: the ability to anticipate the effects of economic scenarios not previously observed.

The hedge-fund world has witnessed some terrible behavior by general partners who have received huge payouts on the upside and who then, when bad results occurred, have walked away rich, with their limited partners losing back their earlier gains. Sometimes these same general partners thereafter quickly started another fund so that they could immediately participate in future profits without having to overcome their past losses. Investors who put money with such managers should be labeled patsies, not partners.

Page 19, paragraph 3:

Over time, we may add one or two investment managers if we find the right individuals. Should we do that, we will probably have 80% of each manager’s performance compensation be dependent on his or her own portfolio and 20% on that of the other manager(s). We want a compensation system that pays off big for individual success but that also fosters cooperation, not competition.

Page 21, paragraph 1:

We have that flexibility because realized gains or losses on investments go into the net income figure, whereas unrealized gains (and, in most cases, losses) are excluded. For example, imagine that Berkshire had a $10 billion increase in unrealized gains in a given year and concurrently had $1 billion of realized losses. Our net income – which would count only the loss – would be reported as less than our operating income. If we had meanwhile realized gains in the previous year, headlines might proclaim that our earnings were down X% when in reality our business might be much improved. If we really thought net income important, we could regularly feed realized gains into it simply because we have a huge amount of unrealized gains upon which to draw. Rest assured, though, that Charlie and I have never sold a security because of the effect a sale would have on the net income we were soon to report. We both have a deep disgust for “game playing” with numbers, a practice that was rampant throughout corporate America in the 1990s and still persists, though it occurs less frequently and less blatantly than it used to.

Page 21, final paragraph

Part of the appeal of Black-Scholes to auditors and regulators is that it produces a precise number. Charlie and I can’t supply one of those. We believe the true liability of our contracts to be far lower than that calculated by Black-Scholes, but we can’t come up with an exact figure – anymore than we can come up with a precise value for GEICO, BNSF, or for Berkshire Hathaway itself. Our inability to pinpoint a number doesn’t bother us: We would rather be approximately right than precisely wrong.

…(I always love explanations of that kind: The Flat Earth Society probably views a ship’s circling of the globe as an annoying, but inconsequential, anomaly.). You can be highly successful as an investor without having the slightest ability to value an option. What students should be learning is how to value a business. That’s what investing is all about.

Page 24, paragraph 2:

Furthermore, not a dime of cash has left Berkshire for dividends or share repurchases during the past 40 years. Instead, we have retained all of our earnings to strengthen our business, a reinforcement now running about $1 billion per month. Our net worth has thus increased from $48 million to $157 billion during those four decades and our intrinsic value has grown far more. No other American corporation has come close to building up its financial strength in this unrelenting way.

By being so cautious in respect to leverage, we penalize our returns by a minor amount. Having loads of liquidity, though, lets us sleep well. Moreover, during the episodes of financial chaos that occasionally erupt in our economy, we will be equipped both financially and emotionally to play offense while others scramble for survival. That’s what allowed us to invest $15.6 billion in 25 days of panic following the Lehman bankruptcy in 2008.

Opinions are my own – mostly.