How to Regulate Big Tech

There’s been a fair amount of talk lately about proactively regulating — and maybe even breaking up — the “Big Tech” companies.

Full disclosure: this post discusses regulating large tech companies. I own shares in several of these both directly (in the case of Facebook and Microsoft) and indirectly (through ETFs that own stakes in large companies)

Source: MIT Sloan

Like many, I have become increasingly uneasy over the fact that a small handful of companies, with few credible competitors, have amassed so much power over our personal data and what information we see. As a startup investor and former product executive at a social media startup, I can especially sympathize with concerns that these large tech companies have created an unfair playing field for smaller companies.

At the same time, though, I’m mindful of all the benefits that the tech industry — including the “tech giants” — have brought: amazing products and services, broader and cheaper access to markets and information, and a tremendous wave of job and wealth creation vital to may local economies. For that reason, despite my concerns of “big tech”‘s growing power, I am wary of reaching for “quick fixes” that might change that.

As a result, I’ve been disappointed that much of the discussion has centered on knee-jerk proposals like imposing blanket stringent privacy regulations and forcefully breaking up large tech companies. These are policies which I fear are not only self-defeating but will potentially put into jeopardy the benefits of having a flourishing tech industry.

The Challenges with Regulating Tech

Technology is hard to regulate. The ability of software developers to collaborate and build on each other’s innovations means the tech industry moves far faster than standard regulatory / legislative cycles. As a result, many of the key laws on the books today that apply to tech date back decades — before Facebook or the iPhone even existed, making it important to remember that even well-intentioned laws and regulations governing tech can cement in place rules which don’t keep up when the companies and the social & technological forces involved change.

Another factor which complicates tech policy is that the traditional “big is bad” mentality ignores the benefits to having large platforms. While Amazon’s growth has hurt many brick & mortar retailers and eCommerce competitors, its extensive reach and infrastructure enabled businesses like Anker and Instant Pot to get to market in a way which would’ve been virtually impossible before. While the dominance of Google’s Android platform in smartphones raised concerns from European regulators, its hard to argue that the companies which built millions of mobile apps and tens of thousands of different types of devices running on Android would have found it much more difficult to build their businesses without such a unified software platform. Policy aimed at “Big Tech” should be wary of dismantling the platforms that so many current and future businesses rely on.

Its also important to remember that poorly crafted regulation in tech can be self-defeating. The most effective way to deal with the excesses of “Big Tech”, historically, has been creating opportunities for new market entrants. After all, many tech companies previously thought to be dominant (like Nokia, IBM, and Microsoft) lost their positions, not because of regulation or antitrust, but because new technology paradigms (i.e. smartphones, cloud), business models (i.e. subscription software, ad-sponsored), and market entrants (i.e. Google, Amazon) had the opportunity to flourish. Because rules (i.e. Article 13/GDPR) aimed at big tech companies generally fall hardest on small companies (who are least able to afford the infrastructure / people to manage it), its important to keep in mind how solutions for “Big Tech” problems affect smaller companies and new concepts as well.

Framework for Regulating “Big Tech”

If only it were so easy… Source: XKCD

To be 100% clear, I’m not saying that the tech industry and big platforms should be given a pass on rules and regulation. If anything, I believe that laws and regulation play a vital role in creating flourishing markets.

But, instead of treating “Big Tech” as just a problem to kill, I think we’d be better served by laws / regulations that recognize the limits of regulation on tech and, instead, focus on making sure emerging companies / technologies can compete with the tech giants on a level playing field. To that end, I hope to see more ideas that embrace the following four pillars:

I. Tiering regulation based on size of the company

Regulations on tech companies should be tiered based on size with the most stringent rules falling on the largest companies. Size should include traditional metrics like revenue but also, in this age of marketplace platforms and freemium/ad-sponsored business models, account for the number of users (i.e. Monthly Active Users) and third party partners.

In this way, the companies with the greatest potential for harm and the greatest ability to bear the costs face the brunt of regulation, leaving smaller companies & startups with greater flexibility to innovate and iterate.

II. Championing data portability

One of the reasons it’s so difficult for competitors to challenge the tech giants is the user lock-in that comes from their massive data advantage. After all, how does a rival social network compete when a user’s photos and contacts are locked away inside Facebook?

While Facebook (and, to their credit, some of the other tech giants) does offer ways to export user data and to delete user data from their systems, these tend to be unwieldy, manual processes that make it difficult for a user to bring their data to a competing service. Requiring the largest tech platforms to make this functionality easier to use (i.e., letting others import your contact list and photos with the ease in which you can login to many apps today using Facebook) would give users the ability to hold tech companies accountable for bad behavior or not innovating (by being able to walk away) and fosters competition by letting new companies compete not on data lock-in but on features and business model.

III. Preventing platforms from playing unfairly

3rd party platform participants (i.e., websites listed on Google, Android/iOS apps like Spotify, sellers on Amazon) are understandably nervous when the platform owners compete with their own offerings (i.e., Google Places, Apple Music, Amazon first party sales)As a result, some have even called for banning platform owners from offering their own products and services.

I believe that is an overreaction. Platform owners offering attractive products and services (i.e., Google offering turn-by-turn navigation on Android phones) can be a great thing for users (after all, most prominent platforms started by providing compelling first-party offerings) and for 3rd party participants if these offerings improve the attractiveness of the platform overall.

What is hard to justify is when platform owners stack the deck in their favor using anti-competitive moves such as banning or reducing the visibility of competitors, crippling third party offeringsmaking excessive demands on 3rd parties, etc. Its these sorts of actions by the largest tech platforms that pose a risk to consumer choice and competition and should face regulatory scrutiny. Not just the fact that a large platform exists or that the platform owner chooses to participate in it.

IV. Modernizing how anti-trust thinks about defensive acquisitions

The rise of the tech giants has led to many calls to unwind some of the pivotal mergers and acquisitions in the space. As much as I believe that anti-trust regulators made the wrong calls on some of these transactions, I am not convinced, beyond just wanting to punish “Big Tech” for being big, that the Pandora’s Box of legal and financial issues (for the participants, employees, users, and for the tech industry more broadly) that would be opened would be worthwhile relative to pursuing other paths to regulate bad behavior directly.

That being said, its become clear that anti-trust needs to move beyond narrow revenue share and pricing-based definitions of anti-competitiveness (which do not always apply to freemium/ad-sponsored business models). Anti-trust prosecutors and regulators need to become much more thoughtful and assertive around how some acquisitions are done simply to avoid competition (i.e., Google’s acquisition of Waze and Facebook’s acquisition of WhatsApp are two examples of landmark acquisitions which probably should have been evaluated more closely).

Wrap-Up

Source: OECD Forum Network

This is hardly a complete set of rules and policies needed to approach growing concerns about “Big Tech”. Even within this framework, there are many details (i.e., who the specific regulators are, what specific auditing powers they have, the details of their mandate, the specific thresholds and number of tiers to be set, whether pre-installing an app counts as unfair, etc.) that need to be defined which could make or break the effort. But, I believe this is a good set of principles that balances both the need to foster a tech industry that will continue to grow and drive innovation as well as the need to respond to growing concerns about “Big Tech”.

Special thanks to Derek Yang and Anthony Phan for reading earlier versions and giving me helpful feedback!

Snap Inc by the Numbers

A look at what Snap’s S-1 reveals about their growth story and unit economics

If you follow the tech industry at all, you will have heard that consumer app darling Snap Inc. (makers of the app Snapchat) has filed to go public. The ensuing Form S-1 that has recently been made available has left tech-finance nerds like yours truly drooling over the until-recently-super-secretive numbers behind their business.

Oddly apt banner; Source: Business Insider

Much of the commentary in the press to date has been about how unprofitable the company is (having lost over $500M in 2016 alone). I have been unimpressed with that line of thinking — as what the bottom line is in a given year is hardly the right measure for assessing a young, high-growth company.

While full-time Wall Street analysts will pour over the figures and comparables in much greater detail than I can, I decided to take a quick peek at the numbers to gauge for myself how the business is doing as a growth investment, looking at:

  • What does the growth story look like for the business?
  • Do the unit economics allow for a path to profitability?

What does the growth story look like for the business?

As I’ve noted before, consumer media businesses like Snap have two options available to grow: (1) increase the number of users / amount of time spent and/or (2) better monetize users over time

A quick peek at the DAU (Daily Active Users) counts of Snap reveal that path (1) is troubled for them. Using Facebook as a comparable (and using the midpoint of Facebook’s quarter-end DAU counts to line up with Snap’s average DAU over a quarter) reveals not only that Snap’s DAU numbers aren’t growing so much, their growth outside of North America (where they should have more room to grow) isn’t doing that great either (which is especially alarming as the S-1 admits Q4 is usually seasonally high for them).

Last 3 Quarters of DAU growth, by region

A quick look at the data also reveals why Facebook prioritizes Android development and low-bandwidth-friendly experiences — international remains an area of rapid growth which is especially astonishing considering how over 1 billion Facebook users are from outside of North America. This contrasts with Snap which, in addition to needing a huge amount of bandwidth (as a photo and video intensive platform) also (as they admitted in their S-1) de-emphasizes Android development. Couple that with Snap’s core demographic (read: old people can’t figure out how to use the app), reveals a challenge to where quick short-term user growth can come from.

As a result, Snap’s growth in the near term will have to be driven more by path (2). Here, there is a lot more good news. Snap’s quarterly revenue per user more than doubled over the last 3 quarters to $1.029/DAU. While its a long way off from Facebook’s whopping $7.323/DAU (and over $25 if you’re just looking at North American users), it suggests that there is plenty of opportunity for Snap to increase monetization, especially overseas where its currently able to only monetize about 1/10 as effectively as they are in North America (compared to Facebook which is able to do so 1/5 to 1/6 of North America depending on the quarter).

2016 and 2015 Q2-Q4 Quarterly Revenue per DAU, by region

Considering Snap has just started with its advertising business and has already convinced major advertisers to build custom content that isn’t readily reusable on other platforms and Snap’s low revenue per user compared even to Facebook’s overseas numbers, I think its a relatively safe bet that there is a lot of potential for the number to go up.

Do the unit economics allow for a path to profitability?

While most folks have been (rightfully) stunned by the (staggering) amount of money Snap lost in 2016, to me the more pertinent question (considering the over $1 billion Snap still has in its coffers to weather losses) is whether or not there is a path to sustainable unit economics. Or, put more simply, can Snap grow its way out of unprofitability?

Because neither Facebook nor Snap provide regional breakdowns of their cost structure, I’ve focused on global unit economics, summarized below:

2016 and 2015 Q2-Q4 Quarterly Financials per DAU

What’s astonishing here is that neither Snap nor Facebook seem to be gaining much from scale. Not only are their costs of sales per user (cost of hosting infrastructure and advertising infrastructure) increasing each quarter, but the operating expenses per user (what they spend on R&D, sales & marketing, and overhead — so not directly tied to any particular user or dollar of revenue) don’t seem to be shrinking either. In fact, Facebook’s is over twice as large as Snap’s — suggesting that its not just a simple question of Snap growing a bit further to begin to experience returns to scale here.

What makes the Facebook economic machine go, though, is despite the increase in costs per user, their revenue per user grows even faster. The result is profit per user is growing quarter to quarter! In fact, on a per user basis, Q4 2016 operating profit exceeded Q2 2015 gross profit(revenue less cost of sales, so not counting operating expenses)! No wonder Facebook’s stock price has been on a tear!

While Snap has also been growing its revenue per user faster than its cost of sales (turning a gross profit per user in Q4 2016 for the first time), the overall trendlines aren’t great, as illustrated by the fact that its operating profit per user has gotten steadily worse over the last 3 quarters. The rapid growth in Snap’s costs per user and the fact that Facebook’s costs are larger and still growing suggests that there are no simple scale-based reasons that Snap will achieve profitability on a per user basis. As a result, the only path for Snap to achieve sustainability on unit economics will be to pursue huge growth in user monetization.

Tying it Together

The case for Snap as a good investment really boils down to how quickly and to what extent one believes that the company can increase their monetization per user. While the potential is certainly there (as is being realized as the rapid growth in revenue per user numbers show), what’s less clear is whether or not the company has the technology or the talent (none of the key executives named in the S-1 have a particular background building advertising infrastructure or ecosystems that Google, Facebook, and even Twitter did to dominate the online advertising businesses) to do it quickly enough to justify the rumored $25 billion valuation they are striving for (a whopping 38x sales multiple using 2016 Q4 revenue as a run-rate [which the S-1 admits is a seasonally high quarter]).

What is striking to me, though, is that Snap would even attempt an IPO at this stage. In my mind, Snap has a very real shot at being a great digital media company of the same importance as Google and Facebook and, while I can appreciate the hunger from Wall Street to invest in a high-growth consumer tech company, not having a great deal of visibility / certainty around unit economics and having only barely begun monetization (with your first quarter where revenue exceeds cost of sales is a holiday quarter) poses challenges for a management team that will need to manage public market expectations around forecasts and capitalization.

In any event, I’ll be looking forward to digging in more when Snap reveals future figures around monetization and advertising strategy — and, to be honest, Facebook’s numbers going forward now that I have a better appreciation for their impressive economic model.

Why VR Could be as Big as the Smartphone Revolution

Technology in the 1990s and early 2000s marched to the beat of an Intel-and-Microsoft-led drum.

Source: IT Portal

Intel would release new chips at a regular cadence: each cheaper, faster, and more energy efficient than the last. This would let Microsoft push out new, more performance-hungry software, which would, in turn, get customers to want Intel’s next, more awesome chip. Couple that virtuous cycle with the fact that millions of households were buying their first PCs and getting onto the Internet for the first time — and great opportunities were created to build businesses and products across software and hardware.

But, over time, that cycle broke down. By the mid-2000s, Intel’s technological progress bumped into the limits of what physics would allow with regards to chip performance and cost. Complacency from its enviable market share coupled with software bloat from its Windows and Office franchises had a similar effect on Microsoft. The result was that the Intel and Microsoft drum stopped beating as they became unable to give the mass market a compelling reason to upgrade to each subsequent generation of devices.

The result was a hollowing out of the hardware and semiconductor industries tied to the PC market that was only masked by the innovation stemming from the rise of the Internet and the dawn of a new technology cycle in the late 2000s in the form of Apple’s iPhone and its Android competitors: the smartphone.

Source: Mashable

A new, but eerily familiar cycle began: like clockwork, Qualcomm, Samsung, and Apple (playing the part of Intel) would devise new, more awesome chips which would feed the creation of new performance-hungry software from Google and Apple (playing the part of Microsoft) which led to demand for the next generation of hardware. Just as with the PC cycle, new and lucrative software, hardware, and service businesses flourished.

But, just as with the PC cycle, the smartphone cycle is starting to show signs of maturity. Apple’s recent slower than expected growth has already been blamed on smartphone market saturation. Users are beginning to see each new generation of smartphone as marginal improvements. There are also eery parallels between the growing complaints over Apple software quality from even Apple fans and the position Microsoft was in near the end of the PC cycle.

While its too early to call the end for Apple and Google, history suggests that we will eventually enter a similar phase with smartphones that the PC industry experienced. This begs the question: what’s next? Many of the traditional answers to this question — connected cars, the “Internet of Things”, Wearables, Digital TVs — have not yet proven themselves to be truly mass market, nor have they shown the virtuous technology upgrade cycle that characterized the PC and smartphone industries.

This brings us to Virtual Reality. With VR, we have a new technology paradigm that can (potentially) appeal to the mass market (new types of games, new ways of doing work, new ways of experiencing the world, etc.). It also has a high bar for hardware performance that will benefit dramatically from advances in technology, not dissimilar from what we saw with the PC and smartphone.

Source: Forbes

The ultimate proof will be whether or not a compelling ecosystem of VR software and services emerges to make this technology more of a mainstream “must-have” (something that, admittedly, the high price of the first generation Facebook/OculusHTC/Valve, and Microsoft products may hinder).

As a tech enthusiast, its easy to get excited. Not only is VR just frickin’ cool (it is!), its probably the first thing since the smartphone with the mass appeal and virtuous upgrade cycle that can bring about the huge flourishing of products and companies that makes tech so dynamic to be involved with.

The Goal is Not Profitability

I’ve blogged before about how the economics of the venture industry affect how venture capitalists evaluate potential investments, the main conclusion of which is that VCs are really only interested in companies that could potentially IPO or sell for at least several hundred million dollars.

One variation on that line of logic which I think startups/entrepreneurs oftentimes fail to grasp is that profitability is not the number one goal.

Now, don’t get me wrong. The reason for any business to exist is to ultimately make profit. And, all things being equal, investors certainly prefer more profitable companies to less/unprofitable ones. But, the truth of the matter is that things are rarely all equal and, at the end of the day, your venture capital investors aren’t necessarily looking for profit, they are looking for a large outcome.

Before I get accused of being supportive of bubble companies (I’m not), let me explain what this seemingly crazy concept means in practice. First of all, short-term profitability can conflict with rapid growth. This will sound counter-intuitive, but its the very premise for venture capital investment. Think about it: Facebook could’ve tried much harder to make a profit in its early years by cutting salaries and not investing in R&D, but that would’ve killed Facebook’s ability to grow quickly. Instead, they raised venture capital and ignored short-term profitability to build out the product and aggressively market. This might seem simplistic, but I oftentimes receive pitches/plans from entrepreneurs who boast that they can achieve profitability quickly or that they don’t need to raise another round of investment because they will be making a profit soon, never giving any thought to what might happen with their growth rate if they ignored profitability for another quarter or year.

Secondly, the promise of growth and future profitability can drive large outcomesPandora, Groupon, Enphase, TeslaA123, and Solazyme are among some of the hottest venture-backed IPOs in recent memory and do you know what they all also happen to share? They are very unprofitable and, to the best of my knowledge, have not yet had a single profitable year. However, the investment community has strong faith in the ability of these businesses to continue to grow rapidly and, eventually, deliver profitability. Whether or not that faith is well-placed is another question (and I have my doubts on some of the companies on that list), but as these examples illustrate, you don’t necessarily need to be profitable to be able to get a large venture-sized outcome.

Of course, it’d be a mistake to take this logic and assume that you never need to achieve or think about profitability. After all, a company that is bleeding cash unnecessarily is not a good company by any definition, regardless of whether or not the person evaluating it is in venture capital. Furthermore, while the public market may forgive Pandora and Groupon’s money-losing, there’s also no guarantee that they will be so forgiving of another company’s or even of Pandora/Groupons a few months from now.

But what I am saying is that entrepreneurs need to be more thoughtful when approaching a venture investor with a plan to achieve profitability/stop raising money more quickly, because the goal of that investor is not necessarily short-term profits.