July 28, 2010

The Phony Scalability of “Local,” and “Long-Tail.”

VCs throw money at startups because they’re scalable. With the right model, the thinking goes, you can double your revenue while your expenses rise 10%. Then, you can do it again.

This works pretty well for some companies. Facebook, for example, hit 100 million users in mid 2008, with “more than 600″ employees. Now they have 500 million users, and 1400+ employees. 400% growth in users; 130% growth in employees. That’s exactly the kind of math VCs like to see, and it’s why they were willing to fund Facebook generously in the early stages. Facebook will run into scalability barriers after a while. At some point, the limiting factor is not engineers (a scalable resource) but customer service reps and servers.

For many of the current crop of hot companies, the end of scalability is coming much faster.


Long-Tail = Labor-Intensive

Google wants to organize the world’s information, period. Demand Media wants to create every single piece of content for which there’s demand. Enumerated.

Google’s technique involves aggressive automation: spidering, creating indices, weeding out link farms and spam, and automatically analyzing content. When humans interact with that process, it’s generally at the margin: tweaking an algorithm here, fiddling with backend infrastructure there.

Demand Media requires consistent human interaction at every level. They do have an algorithm, but it spits out data that need digesting: title editors turn search query snippets into headlines, then content writers create them, then editors review them. If Demand Media wants to grow (and of course they do!), they need to crank up their inputs.

It’s the same for any other business that wants to hand-craft content for a niche audience. It takes continuous input to get continuous growth. And even increasing the growth rate is labor-intensive; Demand Media screens every applicant, and you can find plenty of stories of journalism majors getting rejected.

It might be a fantastic business, but it doesn’t scale the way the last generation did. No wonder they’ve raised $355 million. The real question is: why are they raising equity? They have immediate, predictable cash flow; they might as well replace their operating leverage with the old-fashioned kind.

Local Marketing = Telemarketing

If you’re going to talk about massive money raising, you’ll have to talk about Groupon. $173 million, including a big check from Digital Sky Technologies. They’re also in an established space, with lots of competition, including companies that have recently gone public. And why did Reach Local go public? So they could hire more sales reps!

A surprising fraction of my friends work for companies that do group buying or location-based marketing. And there’s a reason for that: once you have your platform and your userbase, the big obstacle is signing up new small business customers. And so far, nobody has found a better way to do that than hiring lots of salespeople and getting them on the phone.

Even Foursquare is growing into that situation. They’ve done some big, showy deals, but I bet the main value they’ll see from them is that they can call up the local coffee shop and say “Wouldn’t you like some of those customers who order the $5 Venti at Starbucks?”

The VC Overhang: Cause or Effect?

It can’t be a coincidence that VCs have raised too much money since the late 90′s, and there are now startup-looking businesses that can (and must) deploy huge amounts of capital.

It’s hard to say which is cause and which is effect, though. Groupon’s founders stumbled into their business—no cynical ploys there. I wouldn’t put it past Demand Media’s CEO, Richard Rosenblatt, to have planned this out (he knows how to sell high).

But my best guess is that it’s more complicated, because you can reframe the question: what these companies have in common is that the limiting factor for their growth isn’t technology, or brand recognition, or network effects. It’s capital. And for once, at least in part of the economy, capital is overabundant.

You should subscribe to my feed or follow me on Twitter.

I’m currently the Co-Founder and CEO of a startup providing equity research and M&A due diligence to investors analyzing online businesses.

  • http://twitter.com/benjamindblack benjamindblack

    Great piece. One additional observation to this statement regarding distribution to SMBs: “nobody has found a better way to do that than hiring lots of salespeople and getting them on the phone.”

    Two companies have significant competitive advantages in this reaching SMBs.

    (1). Yelp has direct access to SMBs with user generated content and hence can already outperform groupon in SF for their daily deals.

    (2). Facebook.

    That is why long term Groupon is not in as good a competitive position. The daily deal business should ultimately be won by Yelp or Facebook (if they want it).

  • http://www.byrnehobart.com/blog/ byrneseyeview

    That’s a good point. Yelp appears to have tons of salespeople, or at least
    sales and marketing people:

    http://www.linkedin.com/company/yelp.com/statistics

    But they do have a competitive advantage because business owners know who
    they are. It will be interesting to see if that helps them compete with the
    other group buying sites.