21 Feb

Google’s One Pass Annoucement… yet another “Business Model as a Service.”

One Pass, Android Market and Chrome Web Store Have Broad Significance for Business On the Web – Not Just For Media

The announcement made by Google on the 16th of February in Berlin about One Pass, a micropayment and subscription payment service for newspapers and magazines, may at first glance seem like a specialized offering for the media industry.

Indeed, One Pass is an extremely interesting offering for media companies, because it charges a 10% commission payment – low compared to the 30% cut that Apple takes as a standard for being on its platform. Google also states that content providers will be able to access customer data, too. Eric Schmidt is quoted in the Financial Times (Tim Bradshaw and David Gelles, “Google’s One Pass to take on Apple,” 16.02.11) saying: “We basically don’t make any money on this.” A great message for media, because the more platform options there are, the better (as the music industry can attest to).

One Pass has a far broader significance for business on the web beyond media, however. It is only the most recent announcement made by Google regarding different payment solutions as a service. Its Chrome Web Store facilitates licence fee payments for browser-based games, Google Checkout is a unified payment system and Android Market is being extended rapidly. Not all these initiatives are faring equally well, but there is a lot happening, no doubt.

What Google is doing is a further important developent in the extention of the masheable web to include business model building blocks. The basic building blocks of internet business have been around for a long time. Our upcoming Simply Seven book provides a navigational guide to the seven different building blocks and highlights some of the main opportunities and threats associated with each. Now, a handful of powerful internet companies are offering these basic business building blocks as ready-to-go services, “business models as a service.”

Google’s many moves in this area are smart competitive reactions to the massive success of Apple in attracting developers and content owners to its App Store. What Google is doing will in turn result in reactions by others who have the ambition to extend their own business model funtionality to the web, such as Amazon, Microsoft, PayPal and also Facebook.

What Will Facebook Do?

The strategy of Facebook in the next months in this regard will be extremely interesting. Right now, the company is focusing primarily on creating a robust and sustainable social web business powered by advertising. Introducing advertising has been a learning experience for both the company and the Facebook user community. Facebook Credits, the mandatory payment system for Facebook games, is still pretty much contained to the social games area.

If the half a billion power house starts to offer “business model as a service” functionality, either through Facebook Credits or through another solution, start-ups and other internet businesses may not only see this as an interesting option, they may find that being on the Facebook business platform is a must have requirement. (By the way, this may be the reason Facebook is purposely not extending into this area just yet, because it would gain too much commercial power too quickly.)

Even without Facebook, the web has numerous ready-made business building block options available already today. Software, games and content can be sold as licences and subscriptions over App Store/ iTunes or Android Market/ Crome Web Store/ One Pass. Retailers can choose to sell their physical products over the third party marketplaces of eBay or Amazon.

Right now, these transaction platforms are available on the respective marketplace or mobile sites. We can expect these funtions to be integratable into any web site in the future, similar to the way Facebook Connect makes a user’s social graph transportable into third party web sites.

How Companies Can Take Advantage of the Emerging Business Model APIs as a “Fast Track” Business-Building Approach

Google and Apple are leading the way to build what essentially is a business model API. This is exciting for companies. We are moving from the ability to use services like SendGrid (massively scalable email service), Amazon Web Services (infrastructure web services), Force.com (enterprise applications) to yet another level. As these different internet business building blocks develop, it becomes easier and easier to launch complete web businesses from scratch very fast. However, the solutions provided by Google and Apple are not free and they do have strings attached. It is important to understand the offerings very closely especially the ownership of customer data.

The proprietary business building blocks offered by Apple and Google leverage these companies’ internet reach and ecosystem and generate sales from commissions. This should not be taken lightly. The ability to ask for significant commissions on sales of up to 30% (in the case of Apple) means that these companies are providing actual strong value add to their business partners to enable sales, in the form of reach, registered members, technical functionality and a device-based ecosystem. An important value-add is that Apple and Google provide a trusted environment – a big benefit for unknown brands. Executives from many other companies are watching Google and Apple closely saying: “I wish I could do that.” This includes media companies, mobile phone and device manufacturers and a slew of internet players.

In an interview for the upcoming book Simply Seven, Roland Manger, Managing Partner of the European venture capital fund Earlybird differentiated between two kinds of start-ups. Those which will attempt to independently build up their own user base and those companies, let’s call them “fast track start-ups,” which leverage existing platforms populated with users and built-in business model functionality. “Companies need to make a choice fairly early on in their lifetime,” Manger says, “if they want to make a good living with a smart idea on the back of a proprietary platform or if they want to own their whole value chain.”

But being a “fast track start-up” does not have to be a one-way street. Zynga is a powerful example of a highly successful company which initially leveraged the Facebook platform to make its social games popular. In the past months, it went beyond Facebook with independent web- and mobile-based games.

In fact, launching “fast track start-ups” based on a unique idea, but built on pre-existing business platforms, is a great way to test new concepts. Some of these will graduate to “whole value chain” status. One of the challenges is to integrate the different web services driven technologies and building blocks into a working and scalable system.

It is this “fast track” path to success which new style seed initiatives such as Y Combinator, TechStars, The Founder Institute and others are taking advantage of. (Everybody avoids using the term “incubator” these days.)

The ecosystem of leading internet platform players and new businesses is evolving extremely fast and resulting in significant opportunity. The power to facilitate business transactions is being added into the mix as efficiently as it is to integrate into the social web and build on other pre-developed web services.

Thank you Roland Manger for taking the time for an interview in the midst of your busy schedule and thanks Gabriel Matuschka for adding important insight to this blog. Roland Manger’s own blog can be found under “Bird’s-Eye View.”

03 Feb

Yesterday’s Launch of “The Daily” and Apple’s Fear of “Russian Doll” Business Models

Yesterday’s launch of “The Daily”

Yesterday, The Daily was launched by Rupert Murdoch at the Guggenheim New York. Everybody talked about it. Some called it a second rate iPad magazine rather than a newspaper. Everyone praised the quality of the journalists, hired away from some prime publications like The Economist.

Today, The Daily is old news. Perfect for me. I took the time to search yesterday’s articles and blog entries for some hints about how much commission Apple is taking on the $39.99 annual The Daily subscription and other similar subscriptions.

TechCrunch reported on Apple Executive Eddy Cue’s statement about enabling subscriptions, but nowhere does it say how much Apple takes. It can’t be 30%… I am sure it can’t… this is why…

“Russian Doll” Business Models

Just a few months ago, Apple added In-App purchases which are essentially license sales within the App (Google has followed up with Android). It’s a purchase within a purchase. Granted, many Apps which feature In-App purchases are free. All in all, this is great for Apple, because it gets it’s 30% cut – inside and outside of the App.

http://commons.wikimedia.org/wiki/File:Russian-Matroshka_no_bg.jpg#file

Image of Russian matroshka doll (Permission to use under Creative Commons license)

These payment functions behave like “Russian Dolls;” it is possible to trigger a business model within a business model. And adding Matryoshka Dolls themselves is the best defense Apple has against someone else’s Matryoshkas. What Apple wants to hold onto by all means is its commission on all sales. Covert business models inside it’s own and an erosion of it’s control over sales… these are the things Apple really fears.

Covert Licence Stores within Licence Stores

If Apple can do the Matryoshka trick, so can others. Just a few days ago, on the 1st of February, The New York Times reported that Apple pulled the Sony Reader from its App Store. The conflict between Apple and Sony was about which shop gets to sell which licences. Licences are sold by Sony for books outside of the Apple platform, but they be read with Apple-enabled iOS Apps on Apple devices – without Apple getting a share.

In this example, the licence shop of alternative providers is wrapped inside a Matryoshka available in the Apple licence store. Amazon’s Kindle reader for iOS works in a similar way and directs consumers away from Apple to buy books over Amazon directly.

Subscriptions within Licence Stores

What about the Apple sales shop being (mis)used to sell subscriptions? In theory, publishers could offer Apps over the App Store for free or for a nominal fee, but use this App as a reader for a subscription sold elsewhere. This way, Apple loses out on continuous revenue streams enabled by its ecosystem. Effectively, a publisher’s subscription business model is embedded in software sold in Apple’s licence store.

Apple’s position is obvious – get into the game of offering subscriptions. But I believe publishers will really, really cringe at the prospect of giving Apple a share of continuous revenue streams generated by subscriptions. This would be far more painful than sharing 30% for enabling licence sale.

Why it just can’t be 30%

Subscriptions are a really hard sell, since customers are committing themselves to some type of contract over time. Nobody likes to be chained to a wall. To be successful, subscriptions have to be compelling and exclusive (like a club) or need to be perceived as a necessity one cannot do without. Best is both.

All this and also the sheer costs of providing a compelling continuous service mean that publishers are not too keen on providing Apple with a revenue share over time. In fact, they probably can’t even afford it. Surely, 30% is out of the question. In BuzzMachine, Jeff Jarvis estimates 25% (still very high) and provides some clear back-of-the-envelope calculations.

What type of deal Mr. Murdoch has is unclear. This is why I searched all day today to find some hints about the revenue share that Apple gets. Unfortunately, despite the fact that we are living in in a leaky, digital world, this specific piece of information seems to be tightly held.

Link to image source (Russian Matroshka doll used under Creative Commons Attribution-Share Alike 3.0 Unported License – Thanks, Creative Commons and GNU)

09 Jan

Stress-Testing the Simply Seven

Time for a stress test

The Simply Seven framework of seven business models emerged out of our practical work with internet businesses since the mid 1990s. After agreeing on an initial framework in a moderated series of discussions, we used the approach in our daily work for several months. Our understanding had slightly evolved, but not that much. We were happily surprised by the resilience of the approach. Now was the time to put the Simply Seven through a numbers-based stress test.

It took some effort to arrive at a representative group of significant internet companies. A combination of the Nielsen Global Top 100 with additional selection criteria finally did the trick. As shown below, we were able to generate a rich cache of data for the more popular internet business models. The fact that there was less data on some of the others, however, indicates that the internet economy has not reached maturity yet.

Our main objective for the stress test was to see if we were right in our assumption that there are exactly seven business models. No more, no less. We also wanted to check how the different internet models compare to each other using some basic financial indicators.

The selection criteria

To arrive at a consistent set of comparable information, we selected the companies for our so-called “internet universe” according to three different parameters:

(1) The company has to be present with its internet presence on the January 2010 list of Nielsen Top 100 Global Websites (See: http://news.bbc.co.uk/2/hi/8562801.stm). We chose the Nielsen Top 100 list to arrive at a group of significant internet companies in a non-arbitrary way. We figured, if you are a global internet leader, you are on that list. One problem with using this list is that it is prejudiced against B2B companies, including some prominent ones, such as Salesforce.com. B2B companies simply do not attract as many users to their web sites, compared to consumer businesses. While it is much harder for a B2B company to make the list, nevertheless, some are included. These companies have a significant base of small and medium-sized businesses as clients. Examples are both of our service sales representatives, Experian and Vistaprint. Experian provides credit information, Vistaprint a printing service.

(2) The company has to be listed on a stock market. The reason for this is simple: We need reliable financial information. Specific company financial information used came from the Annual Reports of these companies. Basic financial information (Enterprise Value, CAGR, Sales, Operating Income) came courtesy of Yahoo! Finance (finance.yahoo.com, sourced from Capital IQ and other information providers such as CSI Commodity service or Morningstar) and Etrade (www.etrade.com).

(3) The company has to generate approximately 50% of its revenues through internet business. This is tricky, but absolutely necessary. While a company that has a strong web site and generates some of its sales on the internet is, of course, employing an internet business model, its financial profile will reflect the whole business (unless the internet part is separately identified in its financial reports, which is seldom the case). Comcast is on the Nielsen Top 100 list because it has a popular web presence, but it is mostly a cable TV and telecommunications company. The same applies to Time Warner. Netflix just barely made the list of internet companies. It is included because it has successfully transformed a significant proportion of its subscription business in recent years from a postal-based DVD rental offering to a streaming-based internet service. Netflix’ Annual Report mentions that 48% of its 12m subscribers watched streaming video over the internet in Q4 2009 (2009 Netflix Annual Report and Proxy Statement, p. 1, 27).

Initial results: Seven confirmed

We were left with 21 companies in our universe, which were on the Nielsen Top 100, were listed on a stock exchange somewhere in the world and generated around 50% or more of their sales over the internet. We cheered when we found out that each of our seven internet business models was present with at least one company. We also could not identify an eighth business model. Nor was a model redundant.

There were big differences, however, to what extent the different business models were represented. The advertising and commissions categories were the strongest with eight and four companies represented respectively. Here, we could carry out some pretty solid analysis. Subscriptions, service sales and retail were OK, with three to two companies each.

The listing of the first pure play internet company, the Netscape IPO, happened over 15 years ago. Since then, thousands of internet companies have been founded and several dozens of internet companies have listed, each of them generating a long trail of financial information. One would expect that every business model would be represented several times on the Top 100 list and also be listed on a stock exchange. Not so.

The weakest categories each had only one representative company. They were unsurprisingly, financial risk management, and, surprisingly, digital license sales. The only financial risk management candidate, IG Group, is a strange creature, part foreign exchange spread betting service, part sports betting.

Apple is the 1,000-Pound gorilla of the digital license sales business model at the moment – but it hardly is an internet company. We would have loved to have seen this innovative company included in the financial analysis, but Apple still makes far more than 50% of its revenues off hardware and devices. The company we were left with, Real Networks, had dismal financial results in 2009 and 2008. Just one company in the digital license sales category and that one loss-making on top of it; this does not really give us much to base our comparative analysis on.

We expect many more internet businesses working with the models license sales or financial risk management to enter our universe of significant companies in the next months and years. We are not there yet.

A note on Dell. While Apple was grudgingly removed from our universe of internet companies, we did include Dell. Dell is known for being the classic direct sales company – without a bricks-based retail presence (although Dell very recently has begun to enter the classic retail channel, especially in emerging economies). Unfortunately, there is no confirmed information from Dell about the proportion of direct internet and phone sales compared to indirect retail channel sales. Also, we know that 54% of Dell’s total worldwide sales in 2009 was to large enterprises and to the public sector; in these cases, the internet is used to support the order process, but not facilitate the business model. The remaining 46%, however, is almost evenly divided between small- and medium-sized companies and consumers. In the end, it was a very close call. We decided to include Dell in our universe of internet companies. It is a listed company, of course, and also is present on the Nielsen Top 100 List.

Our 21 companies

Grouping into one of the Seven

Most of the 21 companies were a no-brainer to group into one of the Simply Seven categories. Google is a thoroughbred advertising company – at the moment, at least. The year 2010 was great for Google’s mobile operating system Android and with it comes Android Marketplace, a digital license sales platform. And Google is making progress selling its office software as software-as-a-service subscriptions to companies. So far, however, a vast majority of Google sales still come from the advertising model.

We had to look up the revenues of some companies. As mentioned, Netflix just scraped by into our universe with its expanding online user base. Reed Elsevier actually is a long established company – several constituent parts of which long predate the World Wide Web. But two of its main businesses, LexisNexis (42% of revenues in 2009) and Elsevier (33%) are classic subscription models (Reed Elsevier, 2009 Annual Report and Financial Statements, page 11). LexisNexis, the legal database, is completely online and Elsevier, die academic publishing arm for scientific and health journals, almost entirely so.

AOL used to be the best-known company around for the subscription model. In 2006, AOL generated 75% of its sales from longer-term contracts as an online service provider. The degree of competition in the ISP (internet service provider) space was so tough in recent years that AOL was forced to become an advertising-based company. 56% of revenues were generated from advertising in 2009. The sad part of the story is that the switch of business models was not achieved by a strategic transformation but by sheer financial erosion of subscription sales. In 2009, AOL generated roughly the same sales from advertising as in 2006, but only a fourth of its subscription revenues (AOL Inc. Annual Report 10-K, 02.03.10, page 35).

Amazon historically is one of our most active companies when it comes to testing different business models. For now, at least, Amazon stays retail. Amazon.com’s initiatives with digital license sales (downloads for the Kindle reader and sale of music and video downloads) and commissions (third party marketplaces) are still developing. Amazon is moving into license sales and commissions to decrease its reliance just a little on its costly real world warehouse and shipments business. Amazon shares the retail group with Dell, incidentally.

From a classic bricks and mortar perspective, Dell and Amazon do not have the same business model. With a few exceptions, Amazon sells stuff created by other companies; Dell sells its own stuff. Amazon is a retail company; Dell is IT.

For the purposes of our business model framework, both companies belong to the same group. The customers of both companies go to their respective web sites to buy physical items, which are subsequently shipped to them. Amazon and Dell face many of the same challenges; they operate an online storefront, they manage shipments and returns. Whether one company makes its own stuff or not, is not relevant for our framework since it does not change what the customer is getting for her money (a physical product). In fact, Amazon has started to introduce its own range of products, called AmazonBasics.

Indie bands selling their own music directly over the internet and an aggregator such as Apple also share the same digital license sales business model, while in real life they are perceived as running very different businesses.

Our business model framework was created with a single perspective in mind – the customer perspective. And with a single question: What exactly is the customer buying? The customer perspective makes things very simple.

Of course, the customer will be very interested in the ease of use of the shop and the quality of the service. And she will need to find the shop in the first place and the product she seeks. Amazon or Dell may have different advantages and disadvantages in providing these services – based on the fact that they are a retailer or a direct brand owner and manufacturer.

In a way, we were very fortunate that the internet flagship companies, such as Google, eBay or Amazon, still generate most of their sales with a single internet business model. We are not sure how this will pan out in the future. Google may very well continue to be successful with its Android Marketplace – which is based on a digital license sales model. Amazon is moving more and more into this direction as well, with digital books and music. The most likely outcome is the following: Some significant pure play companies will successfully stick to a single business model. There will be others, however, which increasingly mix the models.

At the moment, however, we can still compare basic financial information of our internet universe companies to each other and get a good indication of the performance of particular business models.

The Retail business model clearly leads in sales

The inclusion of a large IT manufacturer in the category of internet retail does mean that the total amount of revenue generated in this category is high. Retail clearly leads the pack in the amount of revenue generated by each category and the amount of monthly revenue per unique user. Dell and Amazon also lead the Top Five list of companies in our universe with the highest revenue in 2009.

It is easy for Dell to lead the list of sales generated per unique internet user. Dell has the highest revenue of all our companies ($52bn) but has relatively few unique users (23m per month). Compared to other companies in the Nielsen Global 100, it is on rank 57 for the number of unique website users. Obviously, the users that Dell has on its web site are there to buy computers and accessories, which are pricy ticket items. Also, as discussed earlier, a 54% of Dell’s revenues are generated through large enterprises and the public sector. To arrive at our statistic, we divide the average monthly sales in 2009 by the number of unique monthly users determined by Nielsen in January 2010.

While advertising dominates the other lists, that there are no advertising-based companies on the top five list for revenue per unique web site user. Obviously, this is because advertising has a small value contribution per unique web site user compared to all other business models. The client of the advertising business is not the web site user itself but a business; the web site user is not buying anything at all. Google leads the pack with $5.64 monthly revenue per monthly unique user; the average for all advertising internet companies (per company) is $2.14.

Many users and rapid growth – the advertising business model

Advertising is about reaching the highest numbers of people. It also is about the quality of those people, if they are in the right target group or not. As a general rule of thumb, however, the more the better. And advertising also is the most popular business model in our internet company universe. This explains the massive lead the advertising business model has before all others in the amount of monthly unique users. Next to the mega gorilla Google, there are some other 1,000-pound specimens in this group, such as Yahoo!, AOL and Monster.com.

The advertising business model does not just benefit the company offering advertising as a product to its business clients itself, but also many other popular publisher web sites which use advertising as their revenue stream. Jointly with commissions, the advertising business model is very good at integrating different types of internet companies in a business ecosystem.

The success story of Google in the time period we are examining is without parallel. Google generates $1.0m sales per employee – the highest of all companies in our universe. It grew a whopping 40% annually each year from 2005 to 2009, a spectacular record in itself. Google’s growth is even more impressive given the fact that the global internet, according to the web site Internet World Stats, grew a mere 15% in the same period year on year (from 1.018bn in December 2005 to 1.802bn in December 2009) (Internet World Stats: www.internetworldstats.com).

All other Top 5 CAGR companies are miniscule in terms of their sales compared to Google. It is no surprise then, that this is recognized by the stock market. Google also clearly leads the list Enterprise Valuation over Sales.

Market valuations – Advertising, again

We already discussed why Google is the hero of our internet company universe. It is surprising, however, that two other advertising-based enterprises make the top EV/R list. Is this only because the stock market is deluded by advertising and Web 2.0 hype? We don’t think so. WebMD and Monster are companies that do not only reach significant amounts of people, they are specialized players with a clear profile: Job search and health. Both of these are huge real world markets. As more business goes digital in these segments, these companies will benefit.

We have removed IG Group from the EV/R consideration because its EV/R ratio (500x) was distorted due to small trading volume and a significant cash pile the company has collected relative to its sales.

Margins – The beauty of aggregation

Advertising- and commission-based companies lead the list for the highest margins. This is because, as classic aggregator-type, purely digital businesses, they tend to have far lower cost bases than most others.

Other businesses models cannot compare to these two in terms of margins. Retail companies have to deal with shipment and warehousing costs. Amazon’s operating income margin in 2009 was only 5%. Subscription-based companies usually have higher customer service costs and often need to provide a continuous stream of value to their customers to justify the subscription contract. In terms of their margins, they linger in the middle of the pack. Netflix, which runs a very tight ship, achieved a margin of 11% in 2009. Reed Elsevier generated a margin of 13%.

Service companies sell unique products or services, which also can be quite costly unless you have scalability worked out. We have two services companies in our universe. Vistaprint provides a printing service. Experian offers credit information. Both services can be automated to a high degree, resulting in margins that are not altogether bad. Vistaprint’s operating income margin is 12%. Experian’s is 16%.

There is an exception on the top, however. It is an indication of things to come, that our only financial risk management company, IG Group, leads the margins list. By offering foreign exchange spread betting and sports betting, IG Group is able to generate dream margins. We are sure that the financial model will become more attractive with growing liquidity on the internet.

Summary – Key financial indicators

To conclude the analysis of the universe of internet companies, we created a bubble chart showing three important financial valuation parameters: Total sales, margins and growth.

We picked out the two top companies in the EV/R ranking for each business model, for financial risk management and license sales we had only one company each. These companies are regarded by investors as the best in their class.

The summary chart shows that the selected companies vary strongly regarding to the growth they achieved in the last years. This was to be expected.

The summary chart also confirms yet again the heroic position of Google, which gets everything right: Sales, growth and margins. IG Group, the lone representative of financial risk management is up there, too, albeit with a far smaller revenue base than Google and therefore much less impressive in terms of sheer achievement.

What is interesting overall is that there seems to be some correlation among the business models based on margins. The highest operating income margins are achieved by financial risk management, advertising and commissions, followed by services and license sales. subscriptions and retail are at the bottom. The margin of WebMD disappointed as an advertising company. We were surprised by how well the services companies did and by the lackluster performance of subscription. Obviously, with just 21 companies, we have to tread carefully. The analysis of basic financial information was carried out to complement and stress-test our practical observations of the Simply Seven.

Note: The authors would like to thank Michael Heim for creating the Simply Seven universe of internet companies and for the number crunching.

21 Nov

The Battle of Business Models in Music

License Sales vs. Subscription

The battle of business models in internet music has the license sales model of Apple iTunes, Amazon and WalMart pitted against the subscription model of Spotify, Rhapsody and MOG. The two different business models represent very different ways of consuming music. Buying and owning a music title is different from being a member in a music club. We use the Simply Seven business model framework to highlight these differences.

If we were to place bets, we would say subscriptions will be the big winner in the end. This is because subscription services with their members-based approach to consuming music have the power to eat into illegal music consumption. We know that this is a very bold statement to make; indeed, digital music has been a graveyard for new ventures. SpiralFrog is just one of the many new businesses with brilliant founders that have failed in the digital music space.

The winner needs to be superior to illegal music consumption

A lot has been written in recent months about Apple vs the European streaming service Spotify. But the two contenders are not just racing against one another. There is a dark horse on the track, too: Illegal streaming and downloads. We all should all be less concerned about which of two paid models will win, but mainly about how successful the two legal models will be in persuading consumers to shift from illegal to paid music. This is a point that Will Page, Chief Economist of the UK licence collection authority PRS makes (link). He is joined by many others, such as Mark Dennis, head of digital sales at Sony in Sweden (link). It is all about beating the dark horse.

To make things even more complicated, next to the two legal horses and the dark horse, there is a grey horse, too. Grooveshark is hugely successful with its advertising based approach. But unlike Pandora and Last.fm, which are sticking to internet radio, Grooveshark offers individual track selection. It has an agreement with EMI but is being attacked by Universal, which means among other things having to live though the misfortunate experience of being pulled from Apple’s App Store (this happened in August 2010) because of Universal’s pressure.

And digital music is going to get even more unpredictable soon, if Google indeed launches its own music service – perhaps in Q1, 2011. This could be game changing, but it is too early to make any conjectures. Let’s get back to Apple and Spotify.

Using the Simply Seven framework

Our minds try to comprehend internet businesses in real world terms. This is one of the main points of Simply Seven. Buying digital music licenses over iTunes is like buying music in a store. We feel like we own the music we buy. If we own it, we want to be able to carry it around and play it everywhere. The key to success with this internet business model is building a seamless and easy-to-use ecosystem based on the idea of ownership consisting of a shop system, content management, players, devices and payment providers.While the sale of MP3s on Amazon and Wal-Mart is significant, the biggest player in this space by far is Apple. 70% of all digital tracks sold in the U.S. are downloaded from iTunes (link). And Apple has been the ecosystem wizard.

By providing devices, the shop as well as the proprietary music format, Apple is covering a lot of ground. Apple has sold over 275 million iPods. But even Apple cannot do it alone. Part of the attractiveness of the iTunes proposition is undoubtedly the vast array of other products out there that plug into this music universe, to sleek Bose players to the iPod connector jack in the BMW Mini. The New York Times counted 2,000 iPod add-ons in 2006, including a python-skin iPod case for $200 (Damon Darlin, “The iPod Ecosystem,” The New York Times, 03.02.2006) (link).

Two things that could slow Apple down

There are only two things that can slow Apple down. One is that Apple gets distracted. The major competitive war Apple needs to win now is with its iPhone mobile platform, which is being seriously challenged by Google Android on HTC and other devices. Android powered devices outsold Apple iPhone in Q2 2010. And Microsoft and RIM have not jet given up either. According to The Economist, the number of smart phone related lawsuits rises steadily by 20% per year (“The Great Patent Battle,” The Economist, October 23rd, 2010, page 69). This is probably what keeps Apple management awake at night, not the state of the music industry.

The second challenge for Apple is that people actually take up the subscription based business model for music. In Europe, this is happening. Spotify use so far is restricted to the UK, France and some other countries and iTunes sales are still going strong. But people who start to subscribe to Spotify may stop buying as many iTunes tracks as before. If this were true, it would be bad news for the music industry – they want to increase the pie, not decrease it. “We’re eating our young,” is what an NPD analyst, Russ Crupnick, told a music industry conference (link).

Why Spotify has the power to eat into illegal consumption

In Europe, Spotify is seen as the hero, not the villain. The Spotify team spent two years developing their software and creating a great player. Spotify made a massive bet by spending millions of their own, angel and venture capital money buying legal music licenses and giving them away to jump start free listening and conversion. Their business bet was that the free service would get so huge that a low percentage conversion rate for a premium subscription would eventually create a tipping point and the service would become profitable. Conversion rates indeed seem to be improving from a base of 5 to 6% (link). In Europe, a continent otherwise known for its smug complacency, people are cheering about a set of daring Swedes making huge business bets.

From a Simply Seven perspective, it is amazing Spotify, or for that matter anyone else, has gone for a subscription model. Subscription business models are extremely difficult to realise, because people generally don’t want to make binding commitments to pay in the future. People will only do this for two reasons: (1) Necessity – think electricity in your home – or (2) Exclusivity – think premium golf club full of business networking opportunities.It will be hard for Spotify to be a utility. There are other ways to acquire music online. If you manage to pull off offering a premium service, however, then you have it made. If you happen to be in a premium subscription segment, it actually makes sense to charge more to build up an aura of exclusivity. Of course, this is relative and depends on the wallet size of your target group. What seems premium to teenagers may not seem terribly expensive for a white-collar employee (do they still exist?).

Up price, don’t down price

What Spotify needs to do is make sure its premium service actually is premium. This is what golf clubs do. Premium subscriptions work in this way for diverse digital services like Bloomberg financial information or Blizzard’s World of Warcraft game. People subscribe to these services not because they are forced to, but because they feel like they are in a special club and provided with special access to something that excludes others. The members are an important differentiator for any club.

Music as a common experience

Indeed, Spotify is heavily investing in its social networking features like Facebook integration and a music “Inbox” which allows Spotify members to share music. Spotify CEO Daniel Ek was quoted saying (link):“If we can enable sharing of music on the internet, that application is going to be huge. That could be bigger than uploading your photos on the internet. Hundreds of millions of people want to share music with their friends . . . It would be as big if not bigger than what Facebook or Twitter is. Our ambition is to be one of those players that drives that.”

Apple considers the Spotify model a serious threat. From the iPhone, they know exactly how great it feels to own a premium service. Apple has responded by launching a social network focused on music called Ping, has invested in a large server farm in North Carolina and has bought Lala, a smaller streaming provider. In fact, there is a cutthroat war going on in the background surrounding Spotify’s planned launch in the U.S. with record labels not sure whether they should provide Spotify with U.S. licences and at what price (link). The music labels do not want to risk cannibalizing Apple’s sales and do not yet believe the story that Spotify will enlarge the market of legal music consumption.We think Spotify will be able to pull it off.  What Spotify changing the experience of music consumption from buying in a shop to being part of a club. In a way, this is a return to the future. Before music could be pressed into records and sold as a product, music was a shared experience. Common people would hear it in a church or create it together in choirs. This is what Spotify is returning to. If they are successful, Spotity will create an experience that may be superior to the experience of owning music, be it legal or illegal downloads.

If Spotify and the other subscription services can pull this off and be successful, it is not about beating Apple. It is about how music will be consumed in the future.