🎓 mental model: commodifying your technology
Hi all,
Hope you’re well and enjoying your new found freedoms :) I took a few months from writing due to workload.
Though now back with a counter-intuitive strategy model I’ve been thinking about for a while. One which platform companies often use to derive monopoly-like pricing power. This model has also helped me think through startup assessment and technology risk in my day to day.
Strategic commodification of technology
Why commodifying your technology can be a source of competitive advantage, market expansion and can create deep moats. Analysts often cite a technology being a commodity as a negative - though more often than not correct, this can be short-sighted.
Traditional, ‘old world’ business relies on deriving profits from selling products or services for more than they paid for them. The internet has changed this paradigm, the nature of 'value' and how companies are scaled and monetised. Critically, the internet has near-zero marginal cost to replicate and distribute products. Commodity technology implies that a product or technology that has no comparative or competitive advantage to derive profitability from, whilst also potentially having low barriers to entry. Your competitors can get to feature parity also, they can replicate and distribute a similar product eroding your margins to near zero.
Jeff likely just about to commodify your market
Let’s explore how most of the large scale technology platforms such as Microsoft, Google and Amazon have used product commodification as a key competitive advantage. Often to gain monopoly power (call the FTC!), constrain competition and expand their own market. We’ll cover the four most prominent forms of technology commodification which are often deterministic to outcome;
Commodify your core product, monetise entry points or complements
Commodify your product's entry point, monetise core product
Defensive commodification, acquire adjacent competition and provide to end users for free
Commodity product, with poor market entry point = you're dead
Core product commodification
Amazon is one of the best known examples of this strategy - the company turned its core product, in this case first party eCommerce, into a commodity, killed competition early on and used market position to monetise and capture value through adjacent products.
It was a Bezos strategic masterclass which allowed Amazon to do this - they took a number of calculated long-term strategic decisions to make this happen; 1) consistently reinvesting their margin into growth instead of profitability 2) selling goods at low price points for near zero margin 3) using points 1 & 2 to reiterate a narrative within the market that there is no margin in eCommerce
That last point is key, eCommerce was a wide-open market in the late 90s/00s, with a number of scaled retail incumbents ready to move into the space such as Sears and Walmart (Sears may have had a chance had they not been besieged with Eddie Lambert’s activism). Amazon effectively set up a narrative in the early 2000s that ‘there is no margin in e-commerce’. This did two things, it served to put off potential competitors from entering the market, allowing Amazon to gain market share and trust from consumers, who loved cheap pricing.
It also allowed them to lock in their power consumers through Prime membership, which offered unlimited shipping for a fixed fee, further locking in power users. As of today, the Prime bundle has 200m customers and Amazon has a 50% market share in US eCommerce. This stronghold has allowed them to build other products such as Prime, their third party marketplace, advertising and AWS, where most of their gross margins (appox. 40%) are derived from. Their low gross margin eCommerce offering served as the market entry point for these. Bezos gives an insight into this strategy in his 2005 Annual Letter.
Other more recent examples of this would be emerging platforms such as Stripe and Carta, who have commodities at the atomic unit of their industries, payment rails and equity cap tables, allowing them to build and monetise adjacent products and services, and staving off competition.
Entry point commodification
Commoditising your product’s entry point is in many ways, the inverse of commoditising your core product, the best example of this is Microsoft’s aggressive pursuit and dominance of the PC market.
A company concentrates on making adjacent entry points to their product a commodity by doing three things 1) destroying your competitors core business and profitability in another part of the value chain by making their product available for free 2) expanding the overall market by lowering prices 3) concentrating and capturing consumer surplus at your product layer.
There are many examples of this but none is more illustrative as Microsoft’s dominance of the PC market. Microsoft and Gates were aggressive in their pursuit of commodifying their complements. The 90s was a time where decreasing hardware prices allowed for increased consumer appetite and the expansion of the PC operating system market, which was still a relatively open field.
This best explained by Joel Sponsky who originally hypothesised around strategic commodification way back when;
“Microsoft’s goal was to commoditize the [physical] PC market. Very soon the PC itself was basically a commodity, with ever decreasing prices, consistently increasing power, and fierce margins that make it extremely hard to make a profit. The low prices, of course, increase demand. Increased demand for PCs meant increased demand for their complement, MS-DOS. All else being equal, the greater the demand for a product, the more money it makes for you. And that’s why Bill Gates can buy Sweden and you can’t.”
This was also a time when the prevalence of the Web was increasing and companies such as Netscape were riding on a prevailing sentiment that they might become dominant as a new OS. The fear was that cross-platform browsers and the internet would reduce Windows to nothing
Heck, even VC content marketing is an example of entry point or complement commodification - where playbooks and insights are shared for free, with the cash for equity product acting as the value capture mechanism.
One of the evident large scale examples of commodification is the philosophy of open source. Open source as an example of part of the stack being offered for free (=commodity), more on this below.
Defensive Commodification
This is when a company acquires a company in an adjacent space, where competitive counter positioning is important, a prominent example is Google’s acquisition of Android.
They then effectively provide the acquiree’s product for free - often confounding “accretive” hungry public market analysts. A key aspect of commodification is that the “commodity price” should be where consumer demand and marginal cost to the producer meet. Often market dynamics are such, it makes sense for technology companies to acquire companies with flailing fundamentals. This is often the genesis of strategic (v economic) acquisitions.
Google acquired Android in 2005, in what is a case study in both defensive commodification and Open Source.
Google's core business is serving people ads - they do so best by expanding their surface area whilst aggregating data on users in order to serve ads. Google was early in understanding the need for an independent mobile OS. They launched Android in 2007 through the Open Handset Alliance, which had 34 partners such as Intel, Motorola, Samsung etc. The objective was clear; monetise mobile advertising by having the largest install base, do so by providing the underlying software for free. Android now has 72% market share with smartphones. (They have similar incentives with Chrome, who incidentally displaced Internet Explorer, which itself was bundled free in Windows to displace Netscape and sell more PCs)
Another more recent example would be Microsoft acquiring GitHub for $7.5bn, they made the product free for individual contributors in order to monetise developers through cross selling other products.
Competition, layers and the ‘M word’
Free markets are such that competitors will arise where excess profits exist. Profits are eroded as competition enters the market, thus companies need to avoid or eliminate competition. This is also another way of saying that you can derive monopoly-like profits by effectively monetising a tech stack where it makes little sense for competition to enter. At its core this is what strategic commodification looks to achieve, whilst obviously no company comes out and says this.
You can see commodification across both the layers of the tech stack and within layers. "Freemium" often provides a product for free whilst gating some functionality, acting as a mousetrap. This can be seen within the music industry where historically they monetised by selling IP on CDs. This was upended by iTunes partially and Spotify completely. Spotify effectively provides all of the world's music for nothing on its "freemium" tier, to anyone with an internet connection. Today, the music industry derives most of its profits from complements, such as concerts and merch. Music is much like software, infinitely reproducible at near-zero marginal cost, therefore on its own effectively worthless (note: software and SaaS are different).
In a lot of these cases, the key question becomes whether your product and market entry point allows you appropriately move across the tech stack, value chain or into adjacencies. Sometimes market entry point is more important than your early product (more on that soon!). Importantly, to enact these strategies, you have to be very long term focused, brave and able to convince employees and investors of the potential payoff. Naturally, this lends itself to founder-led and controlled companies (v hired CEO), which most of the referenced companies in this piece are.
So as a founder or VC it’s less about understanding whether the product will be a commodity and more about understanding where you sit in the value chain.