The Long Tail of Venture Deals

  back to the future 
  Originally uploaded by jpjd.

Tom Evslin makes an interesting observation in his post about The Long Tail.

Tom says:

The power law also explains why it is bad idea to be the twentieth social networking site or VoIP phone company even if #1 was just purchased for a gazillion dollars.  Let’s assume that a gazillion means a $24 million just to make the math easy.  Power law says that #2 is worth  $12,000,000 (still not bad), #3 is worth $8,000,000 (you’d get by even after your VCs’ cut).  But #20 is worth only $1.2 million.  When you check the liquidation preference (see Brad Feld on this) in your financing, you’ll find that you don’t get any of that – it all goes to the investors and they won’t even be happy.

The lengthening tail affects copy-cat entrepreneurs as well as authors.  The ever lower cost of starting and running an Internet business means that #20 will always have to contend with #21 through #50 if it looks like any money is going to made in the category.  Tough to get the investors’ money back.  Actually, since so much of the value is at the head of the curve when talking about network businesses, it is impossible for any but a handful of network business to succeed within a category.

I've always felt this way about venture deals, long before Chris Anderson coined the term Long Tail. I dislike copycat deals because for one, they are not likely to produce big gains for anyone, but also because, as Clay Shirkey explained in 2003:

“We also know that as the number of options rise, the curve becomes more extreme. This is a counter-intuitive finding - most of us would expect a rising number of choices to flatten the curve, but in fact, increasing the size of the system increases the gap between the #1 spot and the median spot."

So the more copycat deals there are out there, the harder it is for the second and third players in a market to make it. Competition is good for sure, but too much copycat competition is problematic.

Comments

[Megan Cunningham]

The other issue with copycats is the commonplace team and laissez-faire attitudes that are inevitably part of your development culture. When you're pioneering a disruptive technology, you attract top talent, and everyone who is part of that project is gripped with a quality of ambition that propels the entire endeavor forward. Even when it's stressful, it's constantly energizing. When you're taking part in a follow-on idea, you're often looking to your competition to lead your feature-development. That's never good for developers, the best of whom are often smart, very creative people.

[Miles Shapiro]

I became quite enthused reading the various articles on Reeds law and the Long Tail etc... . Having worked on a similar formula for a site I'm working on which encorporates heavily the viral nature of social networks, I was fascinated to see there were so few elaborate equations to account for the successes of MySpace and others like it. The law indicating that there's simply an exponential function when it comes to social networking seems kind of obvious. If two people are on a social networking site, they'll tell one other person, and suddenly there will be 4 on the site. Yeh, I get that. Then utilizing the Affinity factor as a constant is curious to me however. So let's say then, there is a factor of .002 because the site may well be social networking but it's social networking for sweater knitters and the research tells us that only .2% of sweater knitters like to hang out online, then there's your afffinity factor. But... this is a narrow set of assumptions.

What we've decided is to shoot for women 18-54 on our website-to-be. Big group, and it is the fastest growing segment of the population of online users. So there's all that to consider. What about other factors? Affinity doesn't remain static and there are obvious factors which can change that side of the equation. For instance... MARKETING!!! What's that numerical value work out to? Simultaneously, costs increase with marketing/advertising. What are the relative values there? If you look at the original equation (C^N:N--AN^N, or something like that), take into the account the decreasing value of costs over time, throw in a marketing factor, and then you have a nice intimidating equation like CMNt/2:N--AMN^N. That looks something like it. I'm sure I screwed something up, but the basic point is that theoretically if you market the social network outside the internet, let's say on packaging of some sort, then that factor will raise costs but also multiply the number of users exponentially as well. As a website creator, this is a good thing, just as long as there are numbers that legitimize the cost of the entire enterprise. What we've tried to do is create a website that melds marketing and social networking into a smooth package. What we haven't come across is others who have tried to meld the viral nature of social networking inside the computer and social factors outside the computer. Anyone have info/input about all this?

[M]

So was Google a copycat deal? I think many in the venture community believed so at the time.

And MySpace...see Friendster

[John Dodds]

Multiple copycats are obviously to be avoided but this sounds worryingly like a restatement of the mythical first mover advantage theory.

[David G]

Interesting simplification but powerlaws measure the utility of the network - and not necesarily to its economic valuation. I think that this is the same mistake made by the IEEE in their criticism of Moore's law. This math around network effects should only be applied to the number of participants in the network and then the result factored out to a valuation using conventional economics. If you did that in this example, you'd probably find the value of the 20th network is far less than this.

[Peter Bowen]

Some of my favorite first movers are Zauction, Excite, CyberCash, and an oldie but a goodie Intergalactic Digital Research. Are they number one? No, they've been overcome by some lower tail company. The successful market leaders are Ebay, Google, Paypal, and Microsoft... These guys weren't first. They were better. Some had better products, some operated better, some innovated better, but in the end they're winning.

Some would argue that the winners were on differnt tails, and I can buy that. BUT... How many times does "pattern recognition" put companies on the wrong tail? Do investors (VCs and angels specifically) leave money on the table when they try to get a first mover instead of a BETTER mover?

-Peter

[Lalit Sarna]

As an avid user of various social networks and social media platforms, for me the issue boils down to my switching costs.
Switching costs for me are composed of various factors
1. The relationships I develop on a social platform
2. Utility
3. User experience

I do not like Myspace user experience, there is too much spam and it’s hard to make sense of my bazillion “friends”. When I started on MySpace 3 years ago, I was primarily using it to promote my charity fundraisers. Currently I do not have the time to keep up with those efforts. So I look for other interesting networks to join, however I have yet to find a network where other users stick around. As users are not invested in upcoming networks, they abandon them easily for the next new thing. Due to the lack of a better alternative with scale, I keep going back to MySpace.

As an impassioned technologist, it was hard for me to realize that consumers do not care for delayed gratification. They need to get instant value. Since “copy cats” do not have scale, a defendable differentiation strategy and compelling value proposition for the consumer that cannot be easily duplicated is the only way to create high switching costs for users. Without high switching costs, it may be very hard if not impossible to sustain growth and achieve scale.

To make things more difficult, there is always a conflict for startups between creating something that cannot be duplicated and time to market.

I am sure this will prove to be a career suicide but I posted a link to my myspace profile.