The question of when to jump in to digital media investments is only partly answered by the Double Bubble analysis. The way to play these opportunities is also related to the market structure and to the venture's leverage or market power. Laid out in this post is one model that is a shorthand for the relative power of the industry structure vs. any particular venture. The various industry types can be simplified to a Rule of N, meaning how many likely winners emerge after the war of attrition in the early going. Like all such models, exceptions abound, but it does provide guidance for when to jump into a new venture based on likely resulting industry structure.
To summarize investment strategies:
Rule of 1 ventures: invest early, before the leader emerges. Use marketing to create the leader.
Rule of 2 ventures: invest late, often very late. Pick the leader.
Rule of 3 ventures: invest late. Pick #1 or #2, or get out.
Rule of 5 ventures: invest early, based on IP/hits and distribution scope.
Rule of 8 ventures: don't bother
There are at least five industry models that digital media companies will be competing in:
- winner take all (Rule of 1)
- oligarchy governs success (Rule of 2)
- normal markets (Rule of 3)
- media markets (Rule of 5), and
- professional or personal service markets (Rule of 8).
Rule of 3. Normal businesses tend toward the Rule of 3 markets: as markets mature, there tends to be three major players. GM, Ford, Chrysler. Kellog's, General Foods, Post. Coke, Pepsi, RC. This was first posited by Dr. Jagdish Sheth of Emory, when he found that as markets mature the leading companies tend to get to 50%, 30% and 10% share, with the third player only marginally profitable. The under 10% "losers" need to focus on profitable niches, and often can do better than the poor #3 stuck in the middle. Much of business strategy comes from the implications of this: Scale wins, or focus wins. Profit goes to one or the other. Jack Welch says, be #1 or #2 or get out. The small, focused players at under 10% share can be more profitable than the big guys. Investment strategy: invest in #1 or #2 or stay out.
Rule of 1. Technology in contrast is a winner-take-all game. The network effect of a core technology creates a positive feedback loop that drives one to win. Microsoft. Intel. IBM mainframes. Cisco. Lotus 123. This effect has been explored at depth in an analysis of why VHS beat Beta. Theories abound, including: VHS allowed porn, Sony (Beta) did not; VHS had a broader alliance, Sony waited too long to license Betamax; VHS had a 2 hour tape, while Beta with its vaunted better technology had only 1 hour during the critical early stages of market acceptance. While it is oft stated that: "the best technology does not always win", this is usually more due to a marketing failure than a lament about the randomness of technology markets. Put simply, what engineers deem best is seldom what the customer deems best. What made Beta better, the smaller tape, simpler transport mechanism and higher resolution than VHS, was largely irrelevant if you wanted to record a 2 hour movie. Consequently, with good marketing, a technology can often be made to win early in the game when the winner is still in flux. Lotus 123 is instructive, in that it toppled Visicalc from being the dominant spreadsheet on the PC in part due to an early marketing blitz (only $4M, but that was big in the early days of software). An early market advantage often steamrolls to a sustainable architectural lock, and from there into a scale advantage that is impossible to overturn until the game shifts. Investment strategy: must get in early, before the feedback loop commences. That is the inflection point after which valuations pop.
Rule of 2. For technologies selling to oligarchical markets, such as to phone companies, this effect does not occur. Instead, there tend to be two winners - one strong, and one weak, in every segment. The carriers' market power governs success, and keeps a weak sister around to hold the stronger player honest. The new ventures emerge and then get consolidated into diversified equipment suppliers who hold positions in most segments, sometimes the lead and sometimes not, and it can vary carrier to carrier. Investment strategy: wait as long as possible, and pick the leader per segment. This is more difficult than it sounds, as early traction (trials, tests) mislead, and one needs to wait until a major carrier deployment is likely. That is the inflection point after which valuations pop.
Rule of 5. Media companies follow a different pattern. They are hits-driven businesses. Their core need is to develop or acquire a few hits, own the IP, and sustain them as long as possible. Sequels, anyone? The leader one year can be the follower the next. Often their core advantage is scope of distribution - their ability to make a hit happen, or drive maximum profit from a hit. In media markets there tend to be around four to five leading players with sustainable franchises. For many years there were five major music labels, six major studios, three broadcast networks, and five major video game publishers. These numbers fluctuate - we are now at four music labels; we still have six major studios; and the three networks grew to four with Fox in the '80s and now sport six, although the final two are mighty weak. Interesting, in the incipient mobile game market there is coalescing a leading group of five players. In the Internet portal market, four leaders have emerged: Yahoo, MSN, Google, and AOL. Investment strategy: invest early once distribution scope is achieved, and use early hits to gain scale in titles and distribution.
Rule of 8: For completeness, because counter-examples abound of fragmented markets, there are also industries which sustain many players. Usually ventures will not emerge in too fragmented markets, unless they can use technology to aggregate across the fragmentation, as eBay did so successfully. In many cases the inefficiencies which allow to many players dissuade smart money from chasing new ventures. The one exception seen repeatedly are professional service firms, such as the many Internet consulting companies of the dot-com craze: US Web, Scient, Viant, et al. For convenience, call these Rule of 8 markets, after the Big 8 accounting firms of the long-lost '80s, now aggregated into a Big 4, which has turned out to be too few for a robust accounting services business. One could also look at the 8 or so Bulge Bracket investment banks for another Rule of 8 example. Professional service firms tend to be based on relationships and need to avoid conflicts, and this tendency limits the aggregation to a Rule of 3 market - if they get too aggregated, spin-off's re-invent the model. In digital media, it is unlikely these segments are worth investing in.
In digital media markets, new ventures will fit in the first four categories. The hardest to pull off is the Rule of 1 technical lock, since the oligarchical forces of studios, labels, carriers and cable MSOs will all push for licensed standards such as the MPEG4 video codec. The exception to this is the developing world of Internet distribution, uncontrolled by the oligarchies. We have seen early winners gain scale remarkably quickly on minimal marketing: Napster, Skype. We see the possibility of proprietary technology gaining sufficient share to withstand standards and lawyers: Divx and Microsoft's WM9/VC1 in video codecs, for example. We are also seeing early indications that the studios will support digital distribution of video over the Internet much more quickly than the music labels did. So get ready, for here they come ...
To summarize investment strategies:
Rule of 1 ventures: invest early, before the leader emerges. Use marketing to create the leader.
Rule of 2 ventures: invest late, often very late. Pick the leader.
Rule of 3 ventures: invest late. Pick #1 or #2, or get out.
Rule of 5 ventures: invest early, based on IP/hits and distribution scope.
Rule of 8 ventures: invest very very late ie. never.
