A Blog by Jonathan Low


May 10, 2017

Why Some Digital Companies Should Delay Profitability As Long As They Can

Technology has changed the rules of operations and competition. Smart companies recognize that means it has also changed the rules of financial returns. JL

Maxwell Wessel and colleagues report in Harvard Business Review:

When the great companies of the industrial era were founded, economists believed in the law of diminishing marginal returns. In a tech-enabled world, some industries demonstrate increasing returns (due to) network effects and feedback loops. When your product becomes more valuable over time, the way you prioritize building features and harvesting profits needs to change. AWS is a more valuable for long-termism. So is Facebook. So is Google. If you play by the rules (of) most investors, you’ll underinvest in the things that matter and lose focus.
When most of the great companies of the industrial era were founded, even the most brilliant economists believed deeply in the law of diminishing marginal returns. At its core, the principle means that the more of something that is made, the less valuable each incremental unit of that something becomes. If there were one pound of chocolate in the entire world, only the wealthiest individuals could afford to taste its unique flavor. If our oceans suddenly turned to chocolate, the incremental value of that volume would plummet — we’d truly have more chocolate than we really needed. The law of diminishing marginal returns held firm throughout the industrial era. The more of something we made, the less valuable it was to each incremental user down the demand curve.
That all changed in the internet era.
In the early 1980’s, Brian Arthur began speculating that in an increasingly tech-enabled world, the principle failed to capture something. He speculated that some industries actually demonstrated increasing returns. The more of something you distributed, the more valuable each incremental piece became. Arthur’s thinking ultimately led to our understanding of network effects and feedback loops. In the world of technology: the more of something you make, the more valuable it can become. Facebook becomes more valuable as more people in your network join. Messaging apps become more valuable as more people sign up. Marketplaces like eBay or Etsy become more valuable to each new member every time a new seller signs up and lists their wares.
When Patrick Collison, CEO of electronic payments company Stripe, helped kick off our second-year strategy course at the Stanford Graduate School of Business this year, he observed that this has created one of the most profound differences in decision criteria between leaders in industrial-era and internet-era companies. When your product can become more valuable to your customers over time, the way you prioritize building features and harvesting profits within a business needs to change.
For leaders that truly understand the implications of increasing returns, a natural deprioritization of profit harvesting should emerge. Consider a business like Amazon Web Services. For years, AWS has invested in driving developer and company adoption of its platform by driving down prices and introducing low cost features to make developer’s lives easier. This has led to high levels of AWS specific investment from innovators like CloudHealth Technologies, Qubole, Mapbox, and the like. That ecosystem investment reinforces the value proposition and drives more developer adoption.
While there are likely lists of hundreds of potential ideas for Amazon to “harvest” value from its existing customers, it will always be better to harvest value after further increasing the stickiness of the platform. A smart leader (and AWS’s Andy Jassy most certainly is one of those) would naturally defer these profit harvesting maneuvers if they were to slow down his roadmap of building other features and services that better supported AWS’s vast ecosystem.
This is a hard concept for leaders of industrial-era businesses to understand. How can you continuously defer short term profitability to grow your network effect? When does your business actually make money? But as long as there is stickiness to be created, it’s a sensible strategy. As long as there are strong increasing returns to create, it’s possible that the net present value of my profit harvesting is indefinitely larger if deferred to the future. Today, AWS is a much more valuable business for the company’s long-termism. So is Facebook. So is Google. The list goes on.
Collison suggested that companies keep a list of ideas that could be pursued now, on behalf of short term profitability, but without obvious benefit to their customers or ecosystem. Call this parking lot “Next Year’s Strategy,” he suggests. Why “Next Year’s Strategy?” The answer is actually pretty simple. Companies with rich customer data and relationship insights can always monetize those assets — but it will be easier (and more profitable) to do so when customers are even more invested in the products they’re using. Invest today to build an ecosystem, demonstrate value, drive network effects, and create customer loyalty. Only then worry about the incremental product introductions that are subject to the law of diminishing marginal returns.Most companies don’t think this way. Most companies can’t. Most companies have investor bases that demand profit maximization today. They won’t tolerate the patient delay of profitable activity in exchange for potentially more profitable activity in the future. And that is a very important difference driving the behavior of managers in industrial era firms. As long as upstart vendors can secure investor bases and management teams that are satisfied with profitless growth, they can prioritize short term investment that is explicitly designed to undermine their incumbent competitors in the future.
For any CEO pushing a strategy of digital transformation, understanding this change is critical. Understanding the parking lot that is “Next Year’s Strategy” allows a business to focus available investments on the things that deliver long-term results. As long as there is capital to be deployed, a leader can avoid turning towards that parking lot after their increasing return yielding roadmap is depleted. But this also presents a dangerous challenge. If you embrace the parking lot that is next year’s strategy, you’ll inevitably suboptimize on short term profitability, anger your investor base, and risk a revolt. If you play by the rules you’ve agreed on with most traditional investors, seeing all these angles won’t matter… you’ll be forced to underinvest in the things that matter in 10-years and lose focus.
Risk losing short-term. Or almost certainly lose long-term. Most of the companies that have undergone dramatic transformations in today’s business world have chosen the former. But it’s not an easy path and it’s a far from certain one.


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