“The worship of premium pricing always creates a market for the competitor. And high profit margins do not equal maximum profits. Total profit is profit margin multiplied by turnover. Maximum profit is thus obtained by the profit margin that yields the largest total profit flow” Peter Drucker: #1 of his 5 deadly business sins
Bill Gurley – a highly successful venture capital investor, and blogger- wrote a piece called The Rake Too Far, discussing the optimal pricing strategy for internet platforms. The “FANG’s” (Facebook, Amazon, Netflix, Google) are the most famous variants of these business models today.
So what does he mean by “The Rake Too Far”?
Taken from the casino industry, the “rake” is the share that a player must pay the house to participate. It’s what you have to pay to play. The more attractive the game is, the more tempting it is for the house to increase their rake.
Bringing it back to internet platforms, you can imagine that given the huge network effects and potential for global scale the internet can offer, it must be very tempting for a successful platform to increase its rake. As Gurley explains though, this can be exactly the wrong thing to do if you want to build the most profitable business model.
“There is a big difference between what you can extract and what you should extract” Bill Gurley
When the world is your oyster (i.e. you have a scalable platform and a very large addressable market) the key goal should be to minimise transaction friction. The rake is a form of friction. Too much friction and transaction volume will fall. Alternatives will be sought. It may be very difficult to find an alternative, but as I mentioned in my previous blogs in this series (Part I and Part II), unhappy customers are spring loaded to go elsewhere when they are being taken advantage of.
“A sustainable platform or marketplace is one where the value of being in the network clearly outshines the transactional costs charged for being in the network…. Everyone wins in this scenario, but particularly the platform provider. A high rake will allow you to achieve larger revenues faster, but it will eventually represent a strategic red flag – a pricing umbrella that can be exploited by others in the ecosystem, perhaps by someone with a more disruptive business model.” Bill Gurley
Whilst the rake charged by many internet platforms is high (often 20-30%), the most extreme example highlighted by Bill Gurley (in this table below from 2013) is Shutterstock, which took an astounding 70% rake from its customers in 2013.
Source: Above the Crowds: A Rake Too Far, 2013
That is vicious and the market has been equally vicious in return. Gurley was spot on – looking at how this has played out, there seems to be clear link between excessive rake and platform failure. Whilst Apple’s iOS remains a dominant platform, it could arguably have been a much larger portion of Apple’s profits (whilst also more effectively containing competition from Amazon and Google) had they not been so greedy with their unnegotiable 30% rake. Note, OpenTable was acquired by Priceline (now called Booking Holdings) in 2014 at a 46% premium.
Greed is obviously not good. Building a sustainable business and maximising your total profits and returns over the long-term requires fairness and respect for your customer. These are valuable lessons for any business manager or investor. This might seem obvious but the key point is that it’s actually very difficult, and is thus a way for companies and investors to differentiate themselves. It requires the courage to think strategically (i.e. long-term) rather than thinking tactically (i.e. short-term). Long-term sustainable thinking involves sacrificing near-term profitability to maximise total profitability in the long-run. Gouging your customer is a risky business, as is chasing short-term returns if you are an investor. Perhaps it is best summed up by a pithy quote from the disruptor-in-chief and leader of the biggest platform winner in of all.
“Your margin is my opportunity” Jeff Besos