Shrink a Market!

On the First Round Capital website we write that: "We love investing in technologies and business models that are able to shrink existing markets. If your company can take $5 of revenue from a competitor for every $1 you earn – let's talk!"  I’ve often been asked what we mean by that – so I thought it would be a good topic for a blog post.
 

My first company, Infonautics, was an online reference and research company targeting students (mostly high school students). While I was there, I got a firsthand education on “asymmetrical competition.” In 1991, when we started Infonautics, the encyclopedia market was approximately a $1.2 Billion industry. The market leader was Britannica - with sales of approximately $650 Million, they were considered the gold standard of the encyclopedia market containing “over 44 million words” written by scholars and “more than 80 Nobel laureates”. World Book Encyclopedia was firmly ensconced in second place. Both Britannica and World Book sold hundreds of thousands of encyclopedia sets a year for over $1,000.
 

However, in 1993, the industry was permanently changed. That year Microsoft launched Encarta for $99. Encarta was initially nothing more than the poorly regarded Funk & Wagnall's Encyclopedia repackaged on a CD – but Microsoft recognized that changes in technology and production costs allowed them shift the competitive landscape. By 1996 Britannica’s sales had dropped to $325 million - about half their 1991 levels – and Britannica had laid off its famed door-to-door sales staff. And by 1996 the encyclopedia market had shrunk to less than $600M. In that year, Encarta’s US  sales were estimated at $100M.

So in just three years, leveraging a disruptive technology (CD-ROM), cost infrastructure (licensed content versus in-house editorial teams), distribution model (retail in computer stores versus a field sales force) and pricing model ($99 versus $1000), the encyclopedia market was cut in half.  More than half a billion dollars disappeared from the market.  Microsoft turned something that Britannica considered an asset (a door-to-door salesforce) into a liability. While Microsoft made $100M it shrunk the market by over $600M. For every dollar of revenue Microsoft made, it took away six dollars of revenue from their competitors. Every dollar of Microsoft’s gain caused an asymmetrical amount of pain in the marketplace. They made money by shrinking the market.

[It is also interesting to note how distruptive business models have continued to impact the encyclopedia market - anyone care to guess what Google and Wikipedia have done to Encarta sales in the last few years?]
 

At Half.com, we tried to do the same thing. We quickly learned that most readers of fiction books finished reading the book within two weeks after purchase. So we launched a very simple feature on our site. Say you purchased a John Grisham book from half.com for $15 (versus a market price of $30). Two and a half weeks later you would receive an email from Half.com offering “your money back” – users simply had to check a box and we would list their book for sale for $15. The vast majority of users would relist the book for sale -- and we found that for best selling books, we would sell the exact same copy of a book four times. That is, Buyer A would buy the book for $15, read it and sell it to Buyer B for $15, who would then read it and sell it to buyer C for $15, who would read it then sell it to Buyer D. Of course, we would take commissions from every sale – say $3 – and shipping charges – say $2 – from each sale. So for the four transactions, the out of pocket cost to the buyers would be $20. Now if half.com didn’t exist, you can assume that the books would have been purchased through traditional channels for $30 each – for a total out of pocket cost of $120. Think about it. For every $1 of sales on half.com, we took $6 away from the existing traditional channel - another example of  asymmetrical competition.
 

This is the reason why I’m so excited about our recent investment in Jingle Networks. Jingle is the owner of 1-800-FREE411 – the country’s first nationwide provider of free directory assistance. Launched late last year, the 1-800-FREE411 service offers consumers a free alternative to the high cost of 411 service provided by traditional carriers. By including a ten-second advertisement before giving out a phone number, 1-800-FREE411 saves consumers on average $1.25 each time they look for a phone number from their telephone. Since American consumers use traditional 411 services 6 billion times a year, 1-800-FREE411 has the potential to shrink an $8 billion market. I believe (and hope) that as consumers shift to ad-supported directory assistance, we will take a significant share away from the entrenched carriers.

 

If you have a business that will shrink an existing market, allowing you to take $5 of revenue from a competitor for every $1 you earn, let’s talk!

 

For a great inside look at the creation of Encarta - I'd suggest "The Microsoft Way" by Randall Stross.  Just $0.75 on Half.com...