Henry Ford and The Microeconomics of Free (aka... Dear Hank...)

When I was in 8th grade, I had a zit on my forehead.

It was small, but I started messing with it.  I tried to pop it, but I made it worse.  It sort of semi-popped and then I went in digging the rest out and.... well,  it just got from bad to worse.  I needed a band-aid to cover the gaping hole I'd dug.

I should have left well enough alone, because no good can come from trying to dredge up what should obviously be ignored.

It's really too bad I never learned that lesson, because then I wouldn't be writing this post in response to Hank's "Blame the VC's" post.

Hank's post is misguided from the start:

"I believe it should be possible to start a small business and to have a small number of profitable customers, and to earn a living. From there, it should be possible to work hard, and to grow your business into something substantial. Until recently, this was the American way..."

Actually, "small number" and "profitable customers" rarely go hand in hand unless you run an ultra-premium high-end service--mostly because of this big ugly thing we economics minors like to call "overhead".  While the number may be larger or smaller depending on your business, I know of very few businesses that achieve profitability without some kind of scale. 

I suppose if you were painting people's houses, you charge them more than the paint and your labor cost you, and you're profitable after Customer #1, but that's not really a scalable business. 

And as for the American way, it certainly didn't work for Henry Ford. 

To my knowledge, he didn't charge the first Model T owner the entire cost of the factory.  He lost money at first, only making money when he found a way to innovate, bring costs way down, and achieve scale.

And on who's dime?

The Wikipedia entry on Henry Ford cites several early investors--VCs if you will, or certainly angels--who foot the bills until Ford finally figured out a way to lower the bills enough to pay them... and he seems to have failed several times before finally succeeding.

"- Backed by the capital of Detroit lumber baron William H. Murphy, Ford resigned from Edison and founded the Detroit Automobile Company on August 5, 1899. However, the automobiles produced were of a lower quality and higher price than Ford liked. Ultimately, the company was not successful and was dissolved in January 1901.

- Ford also received the backing of an old acquaintance, Alexander Y. Malcomson, a Detroit-area coal dealer. They formed a partnership, "Ford & Malcomson, Ltd." to manufacture automobiles. Ford went to work designing an inexpensive automobile, and the duo leased a factory and contracted with a machine shop owned by John and Horace E. Dodge to supply over $160,000 in parts.Sales were slow, and a crisis arose when the Dodge brothers demanded payment for their first shipment."

Noticing a trend here?   Ford went out of his way to get these cars as cheap as possible.  It's not a stretch to think that if Ford would have thought of a way to make money giving cars away for free to get scale (maybe make money just on replacement parts or gas or something) he would have done it--and he would have tried doing it on the backs of his investors, too.

Hank blames VCs for essentially breaking this tride and true apple pie model of business.  The reality is that, for years and years, outside investment has enabled businesses to fill the gaps between overhead and incremental revenue until scale has been reached. 

What Hank fails to realize is that profit and revenues aren't the same thing...so, just because you make revenues doesn't necessarily make you a better business nor does it preclude the need for outside capital.

Amazon didn't turn a profit for years... and now they're making lots of money.  Without not only venture capital, but public market investment, that business would have never existed... and they were making revenues, just not at a profit.

Today, what has changed is that outside investors don't need to fund nearly the same amount of overhead... and no one likes funding overhead.  You could pour tons of money into the overhead of a company and never turn a dime of revenue or profit.  That's what the semiconductor business is like.  It can cost millions to develop a chip that just doesn't wind up working in production or that gets leapfrogged by a competitor. 

So, when VCs fund a free model, they're still doing the same thing they always did... fund the gap between incremental revenues and overhead... but those numbers look way different than they did previously.

Here's the difference:

- First, investment financing goes into a much higher percentage of variable cost than it used to.  You are at least funding businesses that has costs because people are using the service.  That's a step up from funding a business before you had a clue as to whether anyone wanted the service in the first place.  Your overhead is lower, and even some of your variable costs are lower.  In the "old days", the amount of dollars it took to create a business online was a lot larger than it is now.  Servers were more expensive.  Bandwidth was more expensive.  You paid Microsoft for all sorts of stuff that is now open source--free not because VC's foot the bill, but because thousands of individuals got to got together to collaborate and donate their labor to solve collective problems.   So, you can turn a profit with a lot less cash.

- We also have new opportunities for revenue that didn't exist before.  Indeed, for example, is profitable.  They've got 50 employees and they've got a helluva lot less overhead than Monster.  You can get your job crawled for free there.  Their model is that it's easy to get your job in their index, but they charge for sponsorship and placement.  So, basically, most of the people who get value from the service don't actually pay for it.  That's only possible when you're not hiring a bunch of salespeople to charge $300 to post a job on the site. 

Lowering barriers to usage and participation, for them, creates a highly scalable, lower overhead revenue opportunity.  Of course, they needed some outside investment dollars from Union Square Ventures to help them get there and now they've got a strong business.   

This is something Twitter is bound to take advantage of.  If you ever use the "track" feature on a brand, like I do with "jamba", you'll quickly get a sense the data coming off of that thing is way more valuable to brands and marketers for research purposes than it probably is to individual users. 

With costs so low and new data-driven business models emerging, people are trying to launch venture backed businesses that look very different than old business models, and perhaps look, to the untrained eye, like businesses that crashed in the late 90's. 

Some will succeed.  Lot's will not.  That's the way it's always been, so to portray the current situation as being something vastly different problematic is naive. 

When cellphone companies give away free phones to make money on minutes, should we cry out that outside investors are funding a broken business model?  After all, it's debt and capital markets financing that makes this delayed cashflow possible.

What about LinkedIn?  What percentage of their userbase pays for that service?  Yet, they're on track for $100 million in revenues this year.  I'm quite sure David Sze would be happy to "blame the VCs" for that!

Hank, you're way off on this one...  but you certainly started a conversation... I'll give you that.

Good luck if you ever need venture financing for your business, btw...   Regardless of whether you're right or wrong, ripping VCs isn't generally a good business model for financing your business.

"Hey, aren't you the guy that..."

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