The Shift Away From Ad Supported Business Models

A clear shift is happening. A few years ago, this shift was viewed as impossible. The growth stage of the Internet, while it was still a bit immature from a global viewpoint, was driven by free services subsidized by ads. Pundits and experts believed that not only was this the best business and the only one which could achieve scale but that it was the one consumers preferred. The common sentiment was that consumers did not mind ads, or in some cases even liked ads but certainly, the very least tolerated them. For this reason, it was firmly believed the only way to grow a consumer business was with advertising. It seems that entire theory is now being challenged data point, after data point, emerge to show the mature stage of the Internet leading back to business models where the customer pays for something they value rather than get it for free and tolerate ads.

Looking at a recent ad-blocking research report I received, 40% of the global Internet population now use ad-blockers to block ads. And this trend is not standing still but growing quickly each year. There is a popular phrase that states ads are a tax on the poor. Meaning lower-incomes can’t afford these premium paid services, therefore, they are stuck with ads. Interestingly, the report’s research indicates the amount of people blocking ads that fall into the bottom 25% of income is only one percentage point off from the number of people blocking ads who fall into the top 25% of income. The data is clear, the desire to purge ads from your life is consistent across all incomes. The report’s data also highlights how the under 35 age group is by far the largest cohort who is actively blocking ads in as many areas as they can.

Kleiner Perkins General Partner Eric Feng wrote an excellent essay talking about the flaws in ad-based business models and how the best business model is a transactional one. I strongly encourage anyone interested to read the full essay but this part stood out to me:

What if instead, you had a business model that could maximize revenue from your best customers, and then share that value across all your customers, while not annoying users in the process? Sounds good right? Not only does such a model exist, but it’s being used by many companies to great success. I’ll call this strategy shared-value transactions.

To understand shared-value transactions, let’s use free mobile games as an example. Free mobile games dominate the most downloaded app rankings each week, as well as the top grossing app rankings each week. In other words, free games are both incredibly popular (makes sense — they’re free) and incredibly profitable (how?). Because of in-app purchases. Users can optionally pay inside the game to enhance their gameplay. Less than 2% of free mobile game players end up making in-app purchases. And of these users who pay, the top 10% of them drive an astonishing 50% of all revenue for games. So an entire industry is mostly built off of a tiny fraction of a percent of its users. How? Because their very best users are delivering 1,000 times more value to their business than their average user.

His point is well made, and a fascinating way to think about this business model dynamic. Even those playing the free game benefit from the small percentage of users who are willing to pay and thus the developer is maximizing value from the best customers to benefit the entire product. In a slightly similar way, let’s look at Apple in this lens. You can use this thinking to point to Apple’s maximizing of its most valuable customers with the top of the line iPhone models to fund the development of premium innovations that eventually trickle down the lineup so even those customers who can’t afford a $1000 smartphone will benefit from innovation as it eventually makes its way into products that cost $500-$700. While the iPhone is not free, the point remains in Apple’s case that maximizing their value with the best Apple customers benefits the entire ecosystem. If all Apple was selling was selling was $300-$400 iPhones, which would get much higher overall volume, and would come with a significant margin hit, they would not be able to invest in leading-edge innovations and thus the entire ecosystem would suffer.

In the many years, I’ve been writing about the business side of this industry, I’ve often talked about how maturity in a product or industry cycle causes the behavior to change. The core behaviors which drive a product, or category to maturity change once that product or category reaches maturity. We have seen this happen in PCs, smartphones, tablet, consumer electronics, consumer packaged goods, automobiles, and we are now seeing it in the broad sense of the Internet business. As consumers mindset matures with something they know what they value and they know why they value it. When this mindset emerges it generally leads to more premium, often niche, experiences. This is the fundamental reason why categorical maturity leads away from general purpose or one-size fits all strategies which are common while the category is immature. Essentially, the market in question moves from a standardized model to a more segmented one. There will still be free services, subsidized by ads, but those experiences will become less valuable and a core conclusion I’ve drawn is products or services that are subsidized by ads will be things that are a commodity. Commodity businesses, which I’m arguing Google’s services and Facebook’s services are, will not be as valuable to the end user because they are commoditized. Things consumers find valuable enough to pay for will have a much more deep, lasting, and significant overall value to the consumer. Companies who figure this out will be much more insulated from disruption, as I’d argue disruption will more easily target commodity experiences than premium ones.

The arc of my point here is the paradigm shift happening with regards to the business model. Both will exist, but in all the areas that matter, one will be more valuable than the other.