Act 1: From Linear Businesses to Aggregators and Back
Lessons of History
Historically, most businesses operated like a German razor factory. Businesses transformed inputs into products and sold them downstream to wholesalers, retailers, or customers. In Modern Monopolies, Nicholas L. Johnson and Alex Moazed call these businesses “Linear Businesses.”
Consider Germany’s Feintechnik. The company purchased steel, transformed it into razor blades, and sold them downstream to private label razor wholesalers in Europe. Feintechnik was a linear business.
“Integration” for linear businesses meant owning more pieces of the supply chain. Maybe the blade manufacturer bought a steel company, or Gillette built its own razor manufacturing plant. This is largely what Clayton Christensen means when he talks about integration: the integration of the various pieces of the supply chain. For example, should Compaq make its own chips or buy from Intel?
Linear businesses integrated their supply chains to varying degrees, but allowed demand to be largely controlled by third-parties. This created a feedback lag between company and customer, and opened a crack that a new crop of companies could break through by owning the customer relationship.
The Rise of the Aggregators, the Death of Linear Businesses
In Modern Monopolies, Johnson and Moazed write that linear businesses are walking dead. They are living out the last of their days before they are replaced by platforms. “Platforms don’t own the means of production. They own the means of connection,” claim Johnson and Moazed.
The success of platforms like Facebook, Google, Amazon, Netflix, Zillow, Uber and Airbnb has ushered in the Era of the Aggregator, the ultimate expression of the internet’s power to put control of demand in the hands of the platform instead of a third-party.
To get a better sense of what that means, let’s look at some examples of how Aggregators have traditionally operated (we will revisit how these companies operate today a little later on):
Airbnb does not build hotels or lease apartments. It is the site that travelers turn to when they are looking for a place to stay.
Uber does not own cars or hire drivers. It is the first app that people open when they need to get somewhere.
Amazon doesn’t manufacture products. It is the first destination for customers looking to buy almost anything.
Zillow doesn’t own homes or employ realtors. It is the listing site homeowners turn to, and therefore, it is where realtors list when their clients want to sell.
Netflix doesn’t create content. It is what people turn on when they want to be entertained.
Note: In this post, we will not cover the Super Aggregators, Facebook and Google. They operate multi-sided markets with at least three sides and are outside the scope of this post.
Because customers turn to Aggregators first when they are looking to get certain jobs done, suppliers need to adapt to the rules and preferences of the Aggregators. Airbnb hosts optimize their homes, listings and pricing based on what Airbnb’s customers prefer. Uber drivers are friendly, reliable and even provide snacks in hopes of 5-star ratings. Demand gives Aggregators unprecedented power over commoditized suppliers.
The internet enables Aggregators to shift the chokepoint in the value chain from supply to demand. The monopolies of the 20th centuries - U.S. Steel, Standard Oil, American Tobacco - exerted power through their control of supply. The largest companies in the 21st century are winning by first controlling demand, and using the strength and scale of their customer relationships to bend supply to their will.
So What are Zillow, Airbnb and Netflix doing?
If linear businesses are dead, and platform businesses are the future, then why are all the Aggregators suddenly building their own supply?
In a response to a critique of Aggregation Theory, Ben Thompson wrote “And sure, at some point the Aggregator may integrate backwards into distribution or supply, but the foundation of their power comes from aggregating demand, something that was not possible before the Internet.” I agree that these companies’ power comes from aggregating demand, but I also think that this is too dismissive a take on what is clearly becoming a trend: backward integration into supply.
What explains this trend? There are three main reasons that an Aggregator integrates backwards into supply: Data Advantages, Superior Customer Experience, and Better Economics.
1. Data Advantages
Aggregators have proprietary visibility into millions or billions of transactions. No one has more complete data on home prices than Zillow, a deeper understanding of which content users want to watch on Netflix, or where people like to stay than Airbnb.
This data gives Aggregators proprietary insights into inefficiencies in the market that they can exploit by integrating more of the value chain.
Zillow Becomes an iBuyer
Zillow bills itself as the “leading real estate marketplace.” In Making Uncommon Knowledge Common, Kevin Kwok highlights how Zillow has grown to become the market leader. They:
Take advantage of Data Content Loops, exposing previously-obscure data, like home prices,
→ To attract more people to submit more data,
→ In order to generate content at scale (listings + Zestimate for every home),
→ In order to attract demand cheaply through superpowered SEO,
→ In order to own the demand side of real estate.
As Kwok put it, “even before consumers decided to buy or sell, they went to Zillow.”
On April 13th, 2018, Zillow made an unexpected announcement. The company would begin buying houses. The market hated the news, and the stock tanked 9%. Investors bought Z as an Aggregator, not a home buyer. They expected their money to go to scalable, high-ROI, high-upfront cost, low-marginal cost products like a listing platform and the Zestimate. Buying houses takes piles of upfront capital and is not infinitely scalable.
In the context of Zillow’s data advantage, however, the backward integration into home-ownership is a smart bet. Zillow has more top-of-funnel demand, more home pricing data, and the closest thing the housing market has to a stock price, the Zestimate.
If successful, leveraging data advantages will transform Zillow from a company that takes a small marketing fee on listings to one that takes a meaningful cut of most consumers’ biggest purchase in a multi-trillion dollar market.
2. Superior Customer Experience
For all of the power that owning demand gives Aggregators over suppliers, the truth remains that platforms don’t directly control supply. By extension, they don’t fully control the customer experience. Mechanisms like rating systems and search result ranking guide modularized suppliers to behave in the ways that the Aggregator wants, but platforms cannot train workers, hire the perfect actor for a role, or enforce a listing price on a home.
For example, Puja and I recently listed a house in Athens, NY on Airbnb. We quickly realized that Airbnb’s Smart Pricing set rates that would maximize the likelihood that guests would book within the Airbnb ecosystem at the expense of hosts’ ability to maximize revenue on an individual home. We turned off Smart Pricing within six hours and raised our price 20% higher than their suggested rate because our desire to maximize our own revenue outweighed our desire to maintain homeostasis in the Airbnb ecosystem. Enough people making that same decision means that Airbnb creates a suboptimal experience for guests, who may decide to just stay at a hotel.
Turns out, it’s easier to modularize computer chips than it is to modularize humans, movies or apartments.
Backward integrating into supply gives Aggregators complete control over their product and create a more cohesive, superior customer experience. Generally, a better customer experience leads to higher customer loyalty, better retention and increased word-of-mouth, all of which support a healthier business.
If Airbnb owned the home instead of Puja and me, they could set a price that would maximize conversions, delight guests and inspire them to tell their friends. That’s just what they decided to do.
Airbnb is Going to Build Airbnbs
By allowing anyone to list their home, Airbnb has grown its supply of available rooms to over five million across 81,000 cities in just 10 years.
But Airbnb, and by extension, Airbnb’s customers, are dependent on the design aesthetics, standards of cleanliness, location, pricing choices, availability, and booking windows of its hosts. Airbnb can implement a rating system, highlight spaces that customers love to serve as examples, and ask users to turn on Smart Pricing, but since they don’t own their supply, they are ultimately unable to ensure the cohesiveness and quality of the customer experience across their ecosystem.
So in November 2018, Airbnb announced the launch of Backyard, “an endeavor to design and prototype new ways of building and sharing homes.” In announcing Backyard, Airbnb co-founder Joe Gebbia said that Backyard “gains vast insight from the Airbnb community to thoughtfully respond to changing owner or occupant needs over time.” Gebbia went on to hint that Backyard units will adapt to each user’s specific needs. In other words, Backyard gives Airbnb complete control over each guests’ experience - across search, discovery, pricing, booking, and now, the stay itself.
Backyard enables Airbnb to leverage its data advantage - no one knows more about where customers want to stay than Airbnb - to put supply in the right location, at the right price, and to create superior customer experiences. And in turn, the spaces that they control can signal to hosts around the world what Airbnb, and its customers, value.
3. Better Economics
Aggregators can leverage their demand ownership, data advantage, and superior customer experiences to capture more of the profits in their value chain.
This concept is important to understand, so it is worth a more detailed explanation, told, of course, through the story of a banana stand.
Imagine that you own a banana stand, Benny’s Bananas (as we know, there’s always money in the banana stand).
People are bananas for bananas, and they know that if they want bananas, Benny’s Bananas is the place to go. You spent $100,000 to open your banana stand.
Briana owns a faraway forest full of banana trees, and lives a happy life, picking bananas, eating some, and selling the rest. Miles is the middle man. He lives closer to people who love bananas and sees an opportunity. He buys bananas from Briana for $1 per banana.
But none of the people who love bananas know that Miles has bananas. They only know about your banana stand. So you make a deal with Miles. You will sell Miles’ bananas at your banana stand for $4 per banana, and you will take 25% of the total banana sales. You don’t have to take the risk on an inventory of bananas, that’s Miles’ job.
So everyone is happy: Briana has to pay the upfront costs to produce bananas and picks them herself, so she gets $1 per banana. Miles puts up some capital and takes the banana inventory risk, so he makes $2 per banana (the $3 he gets from his cut of the sale minus the $1 he paid to Briana). And you make $1 per banana for owning the place that people know to go to buy bananas. Seems like a pretty great deal!
Woah, wait wait wait. Miles is profitable from the first banana sold, and you don’t make back your investment until you’ve sold one hundred thousand bananas! What’s worse, the gap between Miles’ profits and yours only gets wider over time!
You’ll show him. You raise prices to $5 per banana, and then to $6 per banana. The customers are still eating your product up, and now it only takes you 80,000 bananas, and then 70,000 bananas to make your initial investment back. But the gap between your profit and Miles’ keeps widening!
Through your price changes, you get better and better at understanding just how many bananas, and what type of bananas, your customers like to buy, and when. All of that risk that Miles is taking doesn’t seem so risky to you anymore, and Miles is taking the biggest piece of the banana profits.
So you drop your price back to $4 and you call Briana. Because you have become such a famous banana seller, she swings down from a banana tree to take your call. “Briana,” you say, “what if I paid you $1.50 per banana if you gave me your best bananas exactly when I need them?” Briana buys in.
Miles has been cut out. He was so excited about his $2 that by the time he started thinking about buying a banana stand of his own, it was too late.
You’ve integrated the part of the banana chain that Miles used to profit from. As a result, Briana makes $1.50 per banana and you make $2.50 per banana. You only need to sell 40,000 bananas to make back your investment, your customers are happy getting better bananas at lower prices, and you are making almost 2x the profit you made before.
You are on your way to becoming the world’s first banananaire!
Just like your banana stand, platform businesses depend on third parties like Miles to make transactions happen, and those third parties all want a cut. Third party suppliers can derisk the business early on - you only pay for your supply when someone pays you! But reliance on third-parties means:
Margins are limited by the agreements you’ve cut,
Lower unit margins from each transaction makes paying off fixed costs and marketing spend take longer,
Third-parties can renegotiate and hold you captive,
The money you spend leaves the company instead of building internal capabilities.
Let’s take a look at how the world’s largest studio deals with that problem.
Netflix: The World’s Largest Studio
Netflix became a dominant player in entertainment by buying existing content from studios and delivering it to a growing subscriber base - first via DVD-by-Mail, then digitally. Netflix had to pay studios huge sums of money to get access to non-exclusive content, giving the studios leverage over Netflix that they exercised by charging higher rates and not renewing or expanding deals.
But since the successful release of House of Cards in 2013, Netflix has been creating its own content at an increasing rate. In 2018, Netflix spent $12 billion to create 345 original titles - 1,500 hours worth of original content. By comparison, the studio with the biggest slate of film releases in 2018 was Warner Brothers, with 23. In 2019, Netflix is set to grow its spend on content by 25%, to $15 billion.
All three factors - data advantages, superior customer experience, and better economics - explain why. Netflix famously collects mountains of data on its subscribers’ viewing habits. As a pure aggregator, they used this data to recommend new shows in order to keep you watching. Like The Rock? You should check out other Nic Cage movies, like Face/Off or Con Air.
But the bigger vision is to turn this data into content to provide a superior proprietary customer experience.
Like Adam Sandler? Cool, not everyone does, but we know that some of you LOVE Adam Sandler, so we paid him over $200 million to make movies that you can only watch on Netflix.
You loved Gossip Girl, right? Me too. Great, we made a creepy show called You starring that guy from Gossip Girl, and you need to subscribe to Netflix if you want to watch it.
All of your co-workers talking about the money being in some banana stand and you feel left out? No problem, we produced new episodes of Arrested Development and you should probably pay us $12.99 per month to fit in. (Yes, it used to be $9.99 per month, but you want to be part of the conversation, right?)
Netflix uses its understanding of customers to create niche and water-cooler original content to attract marginal subscribers and retain existing ones. Which means that Netflix is able to spend on huge upfront costs, amortized over tens of millions of customers, and distributed at near-zero marginal cost.
More content begets more users begets more content and on and on. Netflix turns its data into a better customer experience into more customers and into better economics, giving it an accumulating advantage over competitors.
So there it is. We have figured it out. Go forth, launch a new platform, get big enough to become an Aggregator, and when the time is right, use your data advantage to create a better customer experience and ultimately, better economics. Make billions. Right?
Not so fast. In Act 2, we will explore why there won’t be any new Aggregators.