Note: This post was originally published on Medium on November 19th, 2020.
Your profits never come from the same place as your recognition.
All warfare is based on deception. — Sun Tzu, The Art of War
Comparing business to warfare is very cliché. But there is a reason that things become cliché: they have a truth to them that endures.
The boardroom does in fact resemble the battlefield. But in business, the most important war you’ll fight won’t be with competitors or with suppliers, it’s with obscurity.
As Al Ries, one of the most brilliant business minds of the 20th century once said:
“Everyone talks about why their brand is better. But prospects have an open mind… Everyone is interested in what’s new. Few people are interested in what’s better.”
We crave what is “new” and “different.” Starbucks is said to have 87,000 possible drink combinations. Yet new, successful, coffee franchises are still growing by the sackful.
With six billion inhabitants on this planet, surely there are enough people out there who would be happy to buy your new product or service. The only obstacle is identifying and reaching enough of these people in a profitable way.
Enter what I call the “hidden hand” that’s at play behind all successful businesses.
Billion-dollar ballad
In 2002, a young man in Sweden had an idea: what if instead of buying our music, we could simply rent it?
Up until then, the music business relied on a cycle of one-off purchases. If someone liked a song they’d buy the single or the album. End of transaction. There was no reliable way to predict whether they’d buy again. This created lots of variability in revenue month-by-month. In business, variability is risk. And managing risk decreases profits.
But this young man in Sweden, named Daniel Ek, saw a better way. His thoughts were something like “if we just put all of recorded music in the same place for people to stream on their devices, then listeners would gladly pay a monthly fee for access to this database.”
And that was the birth of Spotify. A company now worth over $45 Billion dollars.
Spotify solved problems for both consumers and sellers of music. Consumers now have access to any song ever made, and they don’t have to choose between buying album X and album Y. They can listen to both for the same price: their monthly fee to access the database.
For sellers of music, Spotify made users essentially “renters,” which means record labels now have a better grasp of their upcoming streaming revenue.
But Spotify wasn’t the first streaming company. They were simply the first ones to make streaming profitable.
How did they accomplish it?
History teaches that the only thing that works in marketing is the single, bold stroke. Furthermore, in any given situation there is only one move that will produce substantial results. — Al Ries in The 22 Immutable Laws of Marketing
Spotify succeeded because they pulled off their version of the single, bold stroke no other streaming company had dared attempt before: the “Freemium” business model.
Freemium means that you give users access to your stuff for free, but if they want a “Premium” experience they will have to pay a fee every month. For Spotify, this meant that a free user would hear advertisements between songs and that they would be limited in how many songs they could skip at a time.
Freemium is what you would call a “loss leader.” You take a loss on the front end to attract a large number of customers, with hopes that enough users buy the premium upgrade to turn a profit overall. It’s a risky move, but just like war, business isn’t for the faint of heart.
The secret behind good business
The hidden hand isn’t used by everyone because it requires courage. The courage to make a big bet.
Today’s global marketplace is too complex to allow a straight-up revenue model to succeed. Instead, it calls for subtle maneuvers that are initially hard to replicate. Not impossible to replicate, just hard enough to buy you some time until you can establish your reputation with your target audience.
Because that’s the ultimate end-goal: to gain some brand loyalty and command a premium for your products or services. The hidden hand gets you to that goal.
Seth Godin once wrote “you’ll serve many, you’ll profit from a few.”
According to Seth, most of your customers will be a drain on your bottom line, but if you’re able to wow the small minority of non-draining customers, the business they bring you will more than make up for the loss you take on the majority. He puts it as “the whales pay for the minnows.”
‘Working out’ your profits
I’ll share a personal anecdote.
Back in 2012 I joined Equinox corp to help them expand their Blink Fitness chain of gyms. I managed and marketed their first gym in Queens, NY and I quickly learned about the gym business model.
Gyms make no profits from people who have basic memberships. The entire pool of members’ fees only cover the business overhead: leasing of gym equipment, paying rent, keeping the lights on, etc.
How a gym really makes money is from the people who buy the expensive personal training packages and from the yearly “maintenance” fee they charge. If they can sustain enough paying members to keep the lights on, the ancillary revenues net them a nice 20% return per location yearly.
This creates a line in the sand: a gym’s best customers aren’t the ones who go daily to simply use the machines. These people drain money because their “per visit” revenue decreases each time they show up. The person who pays $20 a month and uses the gym 20 times a month is technically only paying $1 per visit. On a different per-visit range, the group of people who pay $20 a month and show up only once are paying $20 per visit. Meanwhile, the person who goes 3 times a week and works with a trainer is now contributing over $50 per visit. Once you factor in the yearly maintenance fee, you have a thriving business.
The whales pay for the minnows.
It all comes back to Pareto
Seth Godin’s phrase is simply another term for the Pareto Principle.
The economist from the 19th century discovered that approximately 80% of results are obtained from a mere 20% of inputs. As it relates to business: 80% of your revenue will come from 20% of your most popular products. Similarly, 80% of your profits will come from 20% of your best customers.
You will take a loss on the thing that brings you most attention in order to profit heavily from your top-tier fanatics.
Even the most valuable brands on the planet rely on this strategy somehow. Apple is notorious for rarely ever doing promotional pricing or “sales,” so you’d be surprised to learn that they employ loss leader strategies as well.
In 2004, as the iPod was hitting its stride in sales, they teamed up with Hewlett Packard to produce a co-branded iPod. Due to high manufacturing and marketing costs, the iPods were sold at near-cost, but the wide reach of the HP infrastructure helped Apple introduce its product to more middle-market households. Meanwhile, HP made its profit margins from the customizable skin-printing service the iPods created.
Ryan Holiday in his fantastic marketing book Perennial Seller gives an example of how creative industries employ a hidden hand to stay afloat:
“Most of the real money isn’t in the royalties or the sales. For authors, the real money comes from speaking, teaching, or consulting. Silicon Valley entrepreneurs might do well by their business, but they might do even better investing in their friends’ companies. For musicians, the money isn’t in records; it’s in touring, T-shirts, and eventually endorsements and other products.”
Holiday then continues his dissection of the music sector:
“With this in mind, they pursue other businesses and fund those ventures with their royalties. When you make your money on fashion lines or in movies or club appearances or endorsements or creating your own label — Jay Z, for example, has made far more this way than he has from album sales — then the music becomes a branding device. It becomes a way to reach people. It becomes a loss leader.”
The hidden path
This indirect approach is what trips up most first-time entrepreneurs.
We often think too directly, and when we inevitably encounter that wall of obscurity we try harder and harder to break through it or climb it with brute measures. Instead, we’d be best served to create our own subtle maneuvers to go around it.
To put it in blunt terms, the entrepreneur that wins is the one who is willing to let themselves be exploited by most of his customers, while giving the fanatics the chance to keep him in business.
Austin Kleon echoes this sentiment in a much nicer way. He says that you must “give away your best stuff, and then sell souvenirs.” The money is not in your best stuff. If you truly love what you do you should be happy to do it for free for as long as you can. The real money is in the souvenirs of your work. The souvenirs are the whales that pay for the minnows.
That’s the dirty secret of business.
