May 30, 2011

Winning through simplification

Filed under: pricing, strategy — Rakesh Agrawal @ 7:16 pm

Temporary housing site Airbnb is raising a $100 million round at a valuation exceeding $1 billion, according to TechCrunch. Airbnb is a great example of creating new markets through simplification.

People have been selling rooms and temporary space through sites like cragislist. But it has been a fragmented market with difficulty in information discovery, reputation risk and transaction risk. Airbnb addresses these issues.

Here are some other examples of companies and products that are succeeding through simplification:

StubHub. StubHub is the most similar in dynamics to Airbnb. It simplified two big elements of the ticket purchase experience. One is information discovery. Unlike craigslist, where you have to decipher hundreds of listings (many with incomplete information) and then pull up stadium maps, StubHub lets you pick your game and see available seats right on a map of the stadium.

You can also complete the transaction through the site. This eliminates two problems: flaking and bad tickets. Because you have a completed transaction, you don’t have to worry about whether the buyer or seller will participate. I once arranged for a last minute craigslist transaction for a Coldplay concert at Shoreline Amphitheatre. We had agreed on a price, but up until the moment we met, we didn’t know if the transaction would complete. He could easily have sold them to someone at a higher price or I could have purchased from someone else at a lower price before we met.

StubHub also guarantees that the tickets are good. That’s a risk that people tend to overestimate; in more than a decade of regularly buying tickets from scalpers, I haven’t once purchased a bad ticket. But the guarantee is something that people are willing to pay for. I once did a test of craigslist, eBay and StubHub for the same set of tickets. If the buyer had found me on craigslist, he would have paid a lot less.

AT&T Digital OneRate. A long time ago in a telecom galaxy far, far away, you had to worry about roaming charges. If you were traveling, you didn’t use your phone out of fear of getting a bill for hundreds or thousands of dollars. Networks were spotty enough that you often didn’t know when you were roaming. Phones came with roam guards that essentially disabled your phone if you were out of your home area. As a result, people didn’t use their phones very often. Then AT&T came out with Digital OneRate. You didn’t have to worry about who you called and where you called from. Every call was the same price regardless of whether you were in your home area, regardless of whether you were calling local or long distance.

Even today, there is a lot of complexity in underlying telecom pricing. Calls to Iowa cost your carrier a lot more than calls to New York City. But the carriers have abstracted that complexity away. As a result, people don’t worry about whether to make a call — they just make it. The simplicity has two other benefits: Wall Street likes predictable revenue streams. And Sprint has reported lower customer supports costs because people aren’t calling in about bill shock.

Square readerSquare. Credit card pricing has historically been incredibly complex. Rates vary based on the type of business you run, the average value of each transaction, your overall transaction volume, the brand of credit card (VISA/MasterCard/AMEX), whether the card is a rewards card and other factors. There are upfront fees, monthly minimums, statement fees, etc. It’s all enough to make someone’s head spin. Small merchants often don’t bother, simply because it’s too hard to even begin to figure it out. Square has simplified all of this into two rates that are predictable: one if you swipe a card, a higher rate if you don’t. Although many have focused on the physical device, the real innovation is Square’s model for selling payment services. This simplification has caught the attention of more than 300,000 businesses and Square is on a run rate of $1 billion in annual transactions.

Costco. Costco makes shopping simpler. You know that if you buy something from Costco, you will get a very good price. It may not be the best price in the market, but it will be a very good price. Unlike other retailers, Costco doesn’t do high/low pricing, where some items are deeply discounted while others are priced high. Costco’s generous return policy virtually eliminates buyer’s remorse. Decide you don’t like it? Bring it back. For items other than electronics and cigarettes, the return policy is virtually unlimited. I know I’ve purchased a lot more as a result.

USPS flat rate shipping boxes. Mailing a package has historically been a pain. You have to find a box, then wait in line at the post office to have it weighed and stamped. (If your post office experience is anything like mine, that alone is a reason not to do it.) The post office has made this a lot simpler — if you use their standard boxes, whatever you can fit into it ships for a set price. Adding to the simplification, you can get prepaid boxes delivered to you and the postage is good forever, even if rates go up. And your package can be picked up by your postal carrier. Not only does this simplicity expand the market, it reduces operational costs for the post office.

In designing a simpler product, here are some things to think about:

Figure out the obstacles
Faced with a lot of choices, people will often do nothing. Faced with a lot of work to find a reasonable solution, people will look for (and be willing to pay for) a simpler way. You don’t have to find the perfect solution for someone — just one that allows them to reach an acceptable solution in a reasonable amount of time.

Win most, lose some
In designing simplified offerings, it’s important to focus on the big picture, not individual transactions or customers. The point of simplification is to expand the market and encourage adoption. It’s possible that you will lose money on an individual transaction or customer.

If someone calls free Iowa conference call numbers on weekends and talks for hours, AT&T will likely lose money on him. Egregious exceptions can be dealt with in fine print. (Most unlimited roaming plans have fine print that says if a certain percentage of your calls are roaming for consecutive months, they can terminate your service.)

Price based on averages, not worst case scenarios
Square could price their service based on a worst case scenario, like the average transaction being $3 using an American Express Platinum card. This would reduce the likelihood that you’d lose money on an expensive transaction. But it would also significantly reduce the likelihood that anyone would adopt the product.

Take the risk
The ridiculous amounts of money spent on things like loophole-laden travel insurance and extended warranties are a clear indication of the  degree to which people overestimate risk. To the extent that you can take on or mitigate  that risk, you will increase adoption. You’ll also be able to capture a premium (either explicit or implicit) for taking on that risk.

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May 22, 2011

Why Netflix is killing it — and what startups can learn from its success

Filed under: netflix, startups, television — Rakesh Agrawal @ 3:33 pm

Netflix just became the number one provider of subscription entertainment content in the United States, with 22.8 million subscribers. Comcast now comes in at number 2, with 22.76 million. And the trend lines indicate that Netflix will continue to grow.

In the process, Netflix has eviscerated Blockbuster and fought back an attempt at its space by Wal-Mart. Netflix shareholder returns far outpace Google, up 2800% since inception vs. 380% for Google.

How did Netflix do this?

Not getting too far ahead of the market. This is a mistake many entrepreneurs make — looking around at their needs and the needs of their friends and building for them. That’s great if your product is targeted at the Silicon Valley geek market. Not so much if you’re trying to reach the mass market.

Only 14 years later is Netflix offering streaming only plans in the U.S. But the dream has been there since the beginning. (The company isn’t called DVDFlix.) Reed Hastings was smart enough to realize that DVDs were an important transitional technology and Internet delivery wasn’t something that would work in 1997.

If you’re building a mobile product for small businesses and you require that everyone have an iPad, you’re asking too much. Think about whether you can accomplish your goals with email, SMS, voice or even fax.

Sharpness of focus. The market for video entertainment has a lot of players, each with its own twist. There is free content (YouTube, Vimeo), purchased movies and TV (Amazon, iTunes), ad-supported TV and movies (hulu, various network sites), new-release movies (cable pay-per-view), Redbox. Netflix could have gone in any of these directions and tried to compete aggressively for them. But it hasn’t. It has focused on a low-price subscription service featuring premium content.

That focus keeps the company from chasing every shiny new object — which has been the downfall of many startups.

Aggressive acquisition marketing. If there’s a better acquisition marketing company out there, I don’t know who it is. Netflix advertises across a variety of media, including search, online display, partnerships (e.g. airline miles programs), print, direct mail and TV. As successful as AOL was in the 1990s, Netflix is now. About the only thing they haven’t done is carpet bomb mailboxes with free DVDs.

A key to being successful at acquisition marketing is having tools to analyze performance by channel — key metrics like acquisition cost, ARPU, average customer lifetime and churn rate. If you know these numbers, you can make better media buying decisions and use that to grow your business.

Another important part of Netflix’s success is keeping the offer simple. If you haven’t done it recently, go through it. There aren’t six different plans to read and understand. Netflix picks a likely one and tries to get your credit card as fast as possible. The only plan-related question I found was “Do you want DVDs with that?” When faced with a lot of choices, many people will choose to do nothing at all.

Aggressive A/B testing. Netflix A/B tests everything, including pricing, features and user interface. I wrote about a Netflix test of its streaming only pricing before it was released as a new product.

Traditional methods of market research like focus groups and user surveys work OK if it costs you tens of millions of dollars to retool production lines. But they have many problems:

  • Users don’t always act like they think will act.
  • Some people will say what they think you want to hear.
  • Users are incredibly bad at estimating their own usage. (Every time I’ve asked users how many times a week they’d check movie listings, inevitably about 30% of them say they would check daily.)

In the online world, it’s easy enough to test variations based on real users. Let data, not egos, make decisions.

Not being held hostage by power users. Netflix hasn’t gotten as far it has without some controversy. Power users complained about issues such as throttling and deals that delayed availability of some new releases for 28 days. Many also complained about the removal of social features. There will always be requests for more features.

Yes, Netflix could have done things to placate these users. But those would be expensive and detrimental to the vast majority of Netflix customers.

The best example of a Web company that fell into this trap is Digg. A small cabal of users controlled the site experience. By the time Digg got around to fixing this, Twitter and Facebook had displaced it as a leading news source.

There is always the temptation to add power-user features under an “advanced” tab. Don’t do it. It will cost you in consumer confusion, team focus and support costs.

Relationships. Many in the technology world think that Hollywood is backwards and that all they have to do is build better technology. But that won’t matter without content to flow through that technology. Netflix, more than most companies in the space, has spent time building relationships with Hollywood.

Studios have learned from the mistakes of the music industry and haven’t been taking the sue-first-ask-questions-later approach. (Unless you’re egregiously stealing content.)

Unlike some in the industry, Reed doesn’t go around aggressively thumbing his nose at studios and cable companies.

Distribution everywhere. It’s getting harder and harder to find a consumer video device that doesn’t come with Netflix. You can get Netflix connected to your TV almost by accident. Blu-Ray players, video game consoles, dedicated media streamers, iPhones, Android phones, iPads, Internet-connected TVs. Even products from companies that are directly competitive with Netflix, including Apple and Google, offer Netflix streaming.

Consumers electronics is a notoriously low-margin business with a lot of risks. Netflix had a device team in-house, headed up by ReplayTV creator Anthony Wood. Staying on focus, Netflix never launched its own device. But they worked closely with Wood at Roku, who will sell you a box that streams Netflix for as little as $60. (See this deeper discussion on Roku.)

Instead of competing directly with consumer electronics giants like Sony, LG and Philips, they helped a company show how Netflix streaming could be done. And Netflix has managed to do this without expensive SiriusXM-type device giveaways.

Shaping demand. One thing that Netflix rarely gets credit for is the degree to which it can shape demand. Netflix has successfully changed the value proposition for Web video from “any movie, any time” to “something entertaining, any time”. This is a great 90% solution that results in lower costs and happier customers.

Looking for a movie that isn’t available on Netflix streaming but is on DVD? Netflix will suggest alternatives that you can watch right away. If you agree, Netflix just saved about 95 cents and you are happy because you found something to fill that time. In theory recommendations for streaming movies could be based on operational factors, with utilization-based content shown below content with an unlimited license.

Operational efficiency. Netflix spends about $600 million a year on postage. That number would be significantly higher if it weren’t for a recent invention called “Permit Reply Mail”. It’s a category of mail that I’ve only ever seen used for one purpose: returning DVDs.

In the Business Reply Mail category typically used for postage-paid mail, the recipient pays a premium because each returned mail piece needs to be accounted for. This arrangement works because only a small portion of direct mail gets returned. With Netflix, the return rate is close to 100%. With Permit Reply Mail, Netflix prepays the return postage.

The lesson for startups here is to work with your partners to figure out ways to reduce costs. There may be things that you could do easily that would eliminate a step that’s really hard and expensive for them or vice versa.

AOL offers an interesting comparison to Netflix. Neither company owned the content or the pipes that delivered the content*. But Netflix found a way to create experiences that strengthened its consumer relationships. At its peak in 2002, AOL had 26.7 million subscribers. As AOL’s paid subscribers asymptotes to zero, Netflix is poised to surpass the 26.7 million number before the end of the year.

* Technically, the combination of AOL and TimeWarner did also own content and distribution (at least within the Time Warner Cable footprint) but they never acted like one entity.

See also:

The Silver is the New Black Theme. Blog at


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