Don’t Believe Everything You Hear About Platform Businesses
Platforms are no panacea
PHOTO CREDIT: Getty Images
When Enron was formed in 1985 through the merger of two natural gas pipeline companies, it became the second largest gas marketer in the America. Over the next decade the firm grew to be a dominant force in the industry and built a sophisticated trading operation that could compete with the biggest New York banks.
It soon became clear that trading could be incredibly profitable. Unlike marketing physical gas, you didn't have to invest in expensive physical assets. In the years that followed, Enron's financial wizardry made it a Wall Street darling until, of course, it was all revealed as smoke and mirrors. A scandal erupted and Enron went bust.
Today, once again physical assets are going out of vogue. Pundits preach that instead of building things in the real world, business should "harness the power of networks." and create platforms based on "digital, intellectual, and relationship assets." Make no mistake, this is just a different version of the Enron pixie dust of 20 years ago. Real businesses have real assets.
The Wall Streetization Of America
The downfall of Enron, in many ways, was a long time in coming. It all really started back in the 1950s when the economist Paul Samuelson rediscovered an obscure paper by a little known French mathematician named Louis Bachelier. The paper argued that "the mathematical expectation of the speculator is zero" and modern mathematical finance was built on that simple assumption.
Once you assume that everything washes out in the end, things take on a specific mathematical structure called a random walk which is, within certain parameters, highly predictable. That's what allowed economists to come up with concepts like the efficient market hypothesis, the capital asset pricing model (CAPM) and the Black-Scholes pricing model for options.
What made these mathematical constructs so valuable is that they allowed business to quantify and account for risks. Once risks were hedged, it became almost like they didn't exist. So many firms felt free to increase profits through leverage -- basically by borrowing money. It was essentially a perpetual motion machine for profits.
Unfortunately, the initial assumption was not quite accurate. While it is true that things usually even out in the long term, the real world is far more volatile than the models accounted for. When the dot-com crash came, Enron was exposed and collapsed. Seven years later, a similar set of events took down the housing market and led to the Great Recession.
Why Platforms Aren't What They Seem
Today, many pundits are touting a new rosy scenario. They point out that Uber, the world's largest taxi company, owns no vehicles. Airbnb, the largest accommodation provider, owns no real estate. Facebook, the most popular media owner, creates no content and so on. The implicit assumption is that it is better to simply make matches than to invest in assets.
Economists have begun to develop complex mathematical models to describe the behavior of platforms, which they often refer to as "multi-sided markets." As with Bachelier's "random walk," these have a strong element of truth, but are misleading because of what they leave out.
To understand why, just look at the successes they tout. Sure, Facebook is a great business, but there were many firms building social networks a decade ago. Most failed. Uber has had massive growth, but has also lost billions in fending off rivals. AirBnB represents less than 1% of the hospitality industry. Clearly there is a lot more money to be made in the other 99%.
That is the essence of the platform fallacy. Platform businesses tend to result in "winner take all" markets, which leaves a lot of losers behind. They also have low barriers to entry, so firms need to invest so much money to compete that the path to profitability becomes extraordinarily difficult. Some make it out okay. Most don't. Platforms are far from a sure thing.
What Successful Platforms Do Differently
To understand how a platform becomes successful, just look at Amazon. As Brad Stone explains in The Everything Store, despite founder Jeff Bezos's considerable business acumen and drive for efficiency, the company struggled for years to be profitable. In the end, it was its heavy investment in logistics assets that allowed the Amazon to become a true force in retail.
Today, almost 90% of the firm's profits come from its its cloud computing unit, AWS, which provides computing infrastructure for other enterprises. More recently, it bought Whole Foods and opened its first Amazon Go retail store. The more that you look, Amazon looks less like a platform and more like a traditional "pipeline" business.
Or consider Elance. As I explain in my book, Mapping Innovation, the firm started in 1999 with a vision of making matches between outside contractors and companies that wanted to hire them. It failed. Later, it learned how to service relationships after the match took place and succeeded brilliantly. In 2013 it merged with rival oDesk to form Upwork to become the largest freelancing platform in the world.
Everywhere you look, platforms are investing real assets because any business without them is not defensible. It is, of course, possible to establish a profitable platform business model, but once you do it is easily copied and there's no guarantee that you will achieve critical mass in time to fend off competition, or even if the much talked about "network effects" will emerge as a decisive competitive advantage.
Overcoming The Platform Fallacy
Like most bubbles, the current hype around platforms has a strong undercurrent of truth. Platforms built on digital technology create enormous value by facilitating access to ecosystems of talent, technology and information. That, in itself, doesn't make a great business, but it can prove to be a tremendous business asset.
To understand why, consider the open source movement. It's almost impossible to use any form of digital technology today -- including this website -- and not rely on open source technology. Technology firms not only build their products on top of open source code, but routinely donate their own patents and expertise to strengthen them.
The reason why isn't a excess of altruism, but clear-eyed profit seeking behavior. When a firm open-sources its technology, it gains access to enormous ecosystems of talent that far exceeds internal resources. For similar reasons, they make their products easy to use with those of other companies, so customers can access an entire ecosystem of technology and form consortiums to share information.
And that's the true value of platforms. Competitive advantage is no longer the sum of all efficiencies, but the sum of all connections. Strategy, therefore, must be focused on deepening and widening networks of talent, technology and information and we do that by accessing ecosystems through platforms.