Always ask about the business model

By Aaron Williamson | October 16, 2012

The New York Tech Meetup is an impressive gathering of the guiding lights (and hopefuls) of the so-called “Silicon Alley” community. With over 27,000 members, NYTM is the largest meetup in the world and has become so influential that it’s attracted guest appearances by New York Mayor Michael Bloomberg and United States CTO Todd Park, and coaxed statements from both 2012 presidential candidates about how their policies will benefit the New York tech community. Every meetup follows a simple format: several New York technology startups present demos of their products and then answer questions from the audience.

NYTM audience members are told there is only one rule about questions: don’t ask about the business model. The stated reason for this is to maintain a focus on tech; the presenters’ business models tend to be familiar—advertising, freemium, etc.—and so aren’t the interesting aspect of their products.

“Don’t ask about the business model” could also be called the founding ethos of this community: what you’re building is the important thing, how you’ll make money is a distant second. Facebook and Twitter didn’t have business models when they built the most popular social networks in the world. IFTTT doesn’t have an obvious business model and it’s the talk of the tech press. With an awesome idea and Series A funding, there’s plenty of time to figure out a business model once you’ve realized your idea.

But “don’t ask about the business model” is beginning to sound like a Freudian slip: Don’t ask, because if you examine the business models too closely, what you find might make you uneasy. We’re far enough into the second dot-boom to see the business models that time and over-reliance on venture funding produce, and there’s plenty of reason for discomfort.

Patents: polluting the software ecology

VC funding, like all free money, isn’t free. Investors are interested in startups not only for their technical excellence but also for their profit potential. They may be willing to give startups without a ready-made business model time to figure one out, but usually only if they believe their investment will be protected until it pays off. And (with few exceptions) that means taking Warren Buffet’s advice and building a “moat” around the business—in most cases, a moat made of patents.

By now, most software developers are aware of the tremendous harm that software patents are causing to the software ecology. Software giants are wasting hundreds of millions of dollars every year suing each other and fending off attacks from patent trolls—holding companies whose sole purpose is to acquire patents and use them to extract royalties from software producers. And while trolls were once mainly concentrated on deep-pocketed players, they increasingly target smaller companies that will go down easy and boost the perceived value of their holdings. As a recent study found, startups fare much worse than established companies in these battles and are likelier to sustain lasting damage or even shut down as a result.

Despite these grave problems, startups feel like they have no choice but to seek patents, because VCs demand it. Maybe they try not to think about it, or maybe they believe they’re not part of the problem, that they’d never use their patents to keep other developers down.

But this misses the point. VCs don’t want their startups to get patents to keep other software companies from beating them to market. A startup’s meager portfolio—at best a handful of patents—won’t deter a troll or stand up against the war chest of a large company like Google or Apple. Even against a smaller competitor, a couple of patents aren’t much use, because the legal fees required to assert them can swallow even a decent Series A round whole.

The truth is that the patents aren’t a moat around the startup’s product, but around the VC’s investment. As every VC knows, a huge proportion of startups fail—as many as 90%. Given this high failure rate, VCs don’t see startups as investments in themselves, but as pieces of an investment portfolio; they’ve placed bets across the board, expecting most of them to lose.

Patents are VCs’ hedge against these inevitable losses. When a startup with patents fails, its patents become the property of its funders, compensation for the unrecouped startup capital. The funders have little use for the patents once the startup that produced them is out of the picture, so the patents become commodities to be sold to the highest bidder. Increasingly, the highest bidders are patent trolls, and the failed startup has inadvertently made the environment for software innovation more radioactive by exactly one (or two or seven) patents.

Strip-mining user data

If 90% of startups fail, then 10% succeed and need a business model to ensure their continued growth after the VC money runs out. Startups without a built-in business model have a few established paths before them: a handful of direct-payment models (pay-per-play, subscription, e-commerce, etc.) and advertising.

Depending on the startup, some of these options are a tough sell. Those that target professional users or businesses can put a price tag on their services without too much grumbling. But social media services (like Twitter and Facebook) and convenience services (like bitly) can typically only attract enough users by starting out free, and users used to free service can rarely be convinced to pay up later. The time-honored solution to this problem is to trade in the currency that users have been paying you all along, but don’t particularly value: their personal information.

Facebook, Twitter, Foursquare: all of the most successful social media services have ultimately balanced their books by ratcheting up their exploitation of users’ data bit by bit. Each gathers an ever-more-detailed profile on every user and sells advertisers the ability to target highly particularized user demographics. Each exploits sharing between users to derive their social networks and learn how information—product preferences, political affiliations, news items—propagates through those networks, all to improve advertising partners’ results.

As with software patents, the problems with commoditizing user data are well-known. The hidden nature of the bargain is problem enough: most users do not fully understand what they’re giving away to these free* services, and fewer still comprehend that merely by tagging their friends or uploading photos of them, they’re giving as much away on behalf of others.

More troubling is the tremendous value of this data to governments eager to understand the social links between persons of interests: terrorists, say, or just troublemakers or dissidents. Facebook and Google, to name just two examples, routinely comply with requests for user data from governments without demanding a warrant. While these problems seem distant to most Western users—at best a concern for criminals here, at worst an unfortunate reality for protesters in Cairo—they’re nonetheless the product of the business models we’re not asking about. And they’re really not so far off, as the US Justice Department demonstrated when it demanded that Twitter turn over private usage data on Americans associated with Wikileaks.