Serious Simplicity

In trying to figure out how to bail-out the financial institutions and avoid a global economic meltdown, finger-pointing and blame-laying has been a standard dish these last few weeks.

However, blame is seldom one-sided. Governments may have allowed it to happen and banks may have been greedy and irresponsible, but consumers have been foolish too. As UK top-job hopeful David Cameron said last week, “we have not been living within our means”. How has all this happened?

1. The Executive Story: Flawed Business Model

One one side, seriously bad decisions have been made by financial institutions and policy makers. In a bid for national economic growth, governments deregulated the financial industry allowing more lenient credit policies. Or, passed up the opportunities to introduce new regulations. Given this “freedom”, investment banks set about lending more money than they owned. Not just a little, but large amounts. Somewhere close to $700B apparently. However much economists and apologists want to complicate the explanations, this is simply a case of “truly bad business model”. That is, 1) selling something that doesn’t make you money and, 2) selling lots of it. Banks behaved just like a person on the dole signing a lease for a Hummer: can’t afford to pay for it and can’t even afford to fill it up with gas.

2. The Consumer Story: Misaligned Motivations

On the other side of the fence, consumers bought into this stuff (i.e. taking loans/mortgages they can’t afford to pay back) because of a few gross misperceptions:

1. Misperception #1: Property is an investment.
   Property is an investment but it is not the same kind of investment to everybody. If you’re buying a place to do it up and sell it off within 6 months then yes, it is a financial investment and taking a risk *may* be justified. If, however, you are buying a house because you want a home then the return on your investment is not financial. Therefore, buying a home you can’t afford is plain, er, silly, because your financial risk is not based on a financial return. Your anticipated return is security, a nice place for your kids to grow up in, or a place to relax in. This does not balance out your financial input.
2. Misperception #2: Property is safe.
   Property may be a ’safe’ investment to the extent that people always need somewhere to live in or operate from. The property market is however not immune to the standard supply/demand economics. If (based on misperception #1) you buy a large family home that you can’t afford and you find yourself in financial difficulties, your property will not provide a safety net because: a) since you want to sell fast, buyers will take advantage to pay you less, and b) family homes might not be in high demand (smaller families, aging populations, etc may be indicators here)

So everybody involved has been living beyond their means and making decisions based on tangential data. Was it so hard to predict and avoid? No. Some thoughtfulness and foresight would have saved lots people lots of time, money and aggravation.

What interests me now however, is whether this same flawed approach can be averted in some other sectors. In Part II of this riff (tomorrow?) I will analyse why I believe similar factors are leading towards a Travel Bubble (crisis/meltdown/crunch) and what can be done to avoid it.

In an earlier post I mentioned Twitter as an example of a “Bubble 2.0″ company because it has a seemingly flawed (or no) business model. My (rhetorical) question was “How do you make money by sending free text messages to people?”

Well today Twitter announced it is stopping the UK outgoing SMS service beacuse it can cost up to $1,000 per user per year and they simply can’t afford it anymore. Well, the comments on Techcrunch aren’t pretty which is no big surprise.

If this isn’t an example of how the “get a community and then find a way to make money” approach is flawed then I don’t know what is. By not having a clear business model (=how Twitter makes money; =how Twitter survives) at the beginning, Twitter has now irreversably put itself in the unenviable position where it must alientate users to survive.

I hope I’m wrong (because I love Twitter) but it seems that the company might be slowly inching itself towards the Dead Pool.

What are your thoughts?

Update: I don’t mean to say that it’s impossible to make money by sending free text messages to people. I can immediately think of a few ways off the top of my head. I just think that Twitter didn’t really think it through in the beginning that’s all.

If you’ve ever read Carlota Perez’s work, and/or are endowed with an average amount of common sense, you will know that like many other things, economic life cycles follow certain patterns. So do technological innovations. Some people call them ‘revolutions’. Like the Industrial Revolution or the Internet Revolution.

Very often, the climate (economy, markets, investors, …) must ’storm’ before it can ‘form’. And many times this storm takes the form of a financial ‘bubble’.

Financial bubbles are periods during which companies are over-valued. Essentially a form of inflation but instead of currency-based it is business-based. Investors and entrepreneurs (and, sadly, the general public) are misled into believing that a company is worth many more degrees of magnitude than it actually is. Very often, it’s worth would actually be negative, meaning that it loses money. That’s why it’s called a ‘bubble’ – because the investments look large and shiny from the outside but in effect are as empty as hell on the inside (no clients, no sales, no products).

This is what happened at the turn of the millennium in the infamous Dotcom Bust. Hundreds of companies were perceived to be worth millions for the wrong reasons. The ‘wrong’ reason was mainly that entrepreneurs and investors got all excited about the possibility of selling stuff using the Internet instead of the regular brick-and-mortar store. In all this enthusiasm, they forgot to take a good look at how the companies were supposed to make money… what used to be quaintly called a ‘business model’.

By burning up an approximate $4 trillion, investors and entrepreneurs found out the hard way that there is only one real way to value a company, and that is by how much it sells. They re-learned to think in terms of “Income minus expenditure”. Units sold minus cost per unit. They learned that whatever business you’re in and however much cool technology you have, you need a decent business model.

Or did they?

Just six years later, there is a disturbing resurgence of the same feeling disguised as something different. Under the guise of the ubiquitous – and almost meaningless – “Web 2.0″ label, companies are getting funding, or being acquired, simply based on the fact that they have a ‘community’. The approach of “get traffic and then try to monetize” is starkly reminiscent of the “put it on the Internet and you’ll make money” tagline that was the 1999 motto.

And it’s not working out too well.

Youtube and Postini are not making money and Digg is finding it impossible to sell itself. Twitter is raising money but they’re not sure how to go about making it. (How do you make money for sending free text messages to people? Anytime now, Twitter will begin ramming adverts down peoples phones. A guaranteed audience loser.) Facebook stumbled upon a community and is now desperately trying to justify all it’s VC funding by foisting ads on its users. The chaps at Facebook apparently have such a hazy idea of how to make money that they’re becoming “VCs” themselves, expecting Facebook developers to come up with ways of making money for them. These are just the big names of course, although there are countless other start-ups who received funding and went bust.

Sometimes, history can repeat itself much faster than we expect. If you’re a budding entrepreneur, have a good hard think and make sure you have a clear idea of how you expect to make money. And if you find a VC who thinks it’s a good idea to give you money just because you have traffic and ‘an audience’, run as fast as you can. You may think its cool to get the millions, but when the Bubble version 2.0 bursts, you’ll be left standing in the middle of a very empty space.