Why Google's Business Model Works

The internet giant gets the new world of commerce.

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In this Nov. 18, 2010 file photo, a magnifying glass is used to illustrate an excerpt from the Top Internet Service Google Maps.

In our last entry,"Why iTunes Works," we used the example of Apple to illustrate how innovators can hit home runs by focusing on activities that have become inexpensive or free and finding alternative ways to monetize the core value associated with these activities.

In the Apple (and Beats by Dre) cases we introduced, hardware brands effectively captured premiums previously commanded by content producers. A component of the total value enjoyed by the consumer (music content) became widely available, and those who had controlled it could no longer charge a premium for access to it. Ultimately, newly digitized music left spending to be captured by the hardware brands.

In the earlier piece, we challenged readers to think of other instances in which previously expensive items left value out there to be captured. In Acceleration Group's work with innovators and investors, we call this dangling value. Often it arises due to an abrupt change in the availability of one component in the value chain. Capturing dangling value frequently spells the difference between innovation base hits and grand slams.

If solid technology, design and service innovation support a strategy that captures significant dangling value, the wins can be extraordinary. Consider the strategy Google has pursued to expand its access to the user data it depends on to support its targeted ad platform. Google consolidated its success by zeroing in on functions that used to command premiums large enough to power companies like America Online and Microsoft. (These companies maintain robust businesses today; our point is simply that in the areas we're focused on here significant value has been drawn away). Google offers these services at no cost to the user, capturing the dangling value by monetizing user data.

[See a collection of editorial cartoons on the NSA.]

Take, for example, Google's Gmail service, Google Docs platform and Chrome operating system. There was a time when many consumers paid monthly fees to providers like AOL for the use of email and other online services. When it comes to documents, of course, in the era before cloud computing, Microsoft built one of the most successful businesses in history, in no small part by charging users a pretty penny to keep up with the latest versions of its Office Suite software and Windows Operating System.

Google was a relative latecomer to the game of capturing dangling value by offering free email, of course, but it did come to dominate this game. When it comes to documents, whatever one might say about the functional limitations or collaborative advantages of Google Docs, the fact is that for users, they are free. And a growing number of users are happy to let someone else pay for our use of these tools, as long as all that's asked of us is that we give that someone access to our information when we press "I accept.

This is a powerful case of dangling value captured. Google makes the vast bulk of its revenues from AdWords. These are at the heart of the company's model, which makes it possible for advertisers to reach users who have shown, through the words they use across Google's platforms, that they are likely to want what those advertisers are selling. This is why you're offered functional incentives for signing in when using the Chrome browser, and for extending your use of Google's platforms onto an Android phone. Integrating all of your digital activities gives Google a more complete picture of your preferences as a user. This in turn enables Google to further differentiate its targeted advertising proposition.

[See a collection of political cartoons on Chinese hacking.]

Even if you've never clicked on one of the paid search results in a browser, remember that in the direct marketing game, even small increases in response rates are significant. And for many niche providers, targeted "pay-per-click" advertising enables them to reach their customers directly in ways they never could before, since they only pay when a user clicks through.

Google bases its targeting on the words a user enters, whether they are search terms in a browser or words written in an email or document. Google's computers are watching your searches and reading what you write. This helps folks who might never have otherwise known you were interested in vintage Siberian hunting caps give you a link on which you're likely to click. Often enough, to matter to vintage Siberian hunting cap merchants, these clicks from people who were already talking about such caps lead to purchases. Add this up across all the products looking for interested customers, and it represents a lot of money.

Yet Google was hardly the first to try to capture dangling value once commanded by the likes of AOL or Microsoft. So why did its model become so powerful in the areas we're discussing?

Lest we be misunderstood, we're not arguing that there's any natural trend away from fee and subscription models to advertiser-supported ones. In fact, one could make a strong case that Netflix has convinced many viewers who might once have been happy to watch free, ad-supported television to pay monthly fees for the privilege of viewing serialized episodes. What the winner does is find the new sweet spot associated with consuming what users want cheap or free. (The dangling value that Netflix originally captured through its DVD-by-mail service lay in Blockbuster's movie rental and late fees, which consumers were only too happy to stop paying.)

[Check out our gallery of political cartoons.]

When it comes to email, advertising and content partner supported services like Hotmail captured dangling value for a time by offering free accounts, and attracted major investment and user bases in their era (Hotmail was purchased by Microsoft in 1997 for an estimated $400 million). Meanwhile, groups of programmers developed free operating systems and basic document software. But the providers of these alternatives failed to monetize their solutions as effectively as Google did. Their revenue models could not compete with Google's capacity to capture the value latent in users' emails and documents by offering advertisers targeted access to these users.

It is this monetization of dangling value that enables a business to sustain itself, compete for market share, and grow. Without this kind of monetization, a business seldom generates enough cash flow to justify successive investments in innovation, not to mention build customer relationships and the like.

Google's founders' real genius, like that of the founders of Apple and Beats by Dre, was in building a business model based on an alternative way of monetizing an activity for which we had been only too happy to stop paying. In each of these cases, the winning firm not only recognized dangling value – it found a way to be the sole provider of something else in the value chain that met its customers' pressing needs. For music hardware, this meant becoming the key purchase associated with the deeper needs music meets. For documents and email, it meant giving advertisers access to users who had shown they were likely consumers through the words they used in otherwise private communications.

To be sure, Google's technological innovations are powerful. PageRank changed the game for search engines, making results far more relevant. Apple, for its part, has innovated time and again in its design of devices and interfaces customers love to use. Yet, if you're accustomed to thinking innovators make the most money when they build the better mousetrap, remember that value added is not the same as value taken out. Generating significant returns is about controlling the point in the value chain where there's one of you and many of them. It's about making sure the people selling to you and buying from you need you more than you need them.

[Read the U.S. News Debate: Should Americans Be Worried About the National Security Agency's Data Collection?]

To take a classic example, Coca Cola's bottlers and distributors maintain capital intensive businesses (some of which Coca Cola has been known to buy up and sell off in turn). But in the end, there's always another bottling company, but only one brand and secret formula. This is why Coke can charge the premium that's helped make the likes of Warren Buffet so rich (Coca Cola is Berkshire Hathaway's second largest holding). To capture dangling value, focus on businesses where this sweet spot, this point of scarcity where there's one of you and many of them, can change in your favor.

Next week, in our third installment on this topic, we continue the story of dangling value and how savvy innovators make extraordinary amounts of money by capturing it. We look at companies that captured dangling value by taking advantage of reductions in the costs of inputs to their products and services.

We'll introduce the Curious Case of the Device Sold at a Loss, in which Amazon, instead of charging a premium for hardware, makes it available below cost, as part of a complex strategy for capturing dangling value.

We'll also examine the Case of the Gas Pump and the Big-Box Store, in which a well-known company brilliantly captures the value left dangling by the society's investment in keeping transport cheap.

Alejandro Crawford is a senior consultant at Acceleration Group, and also teaches innovation, enterprise growth and digital strategy at NYU's Polytechnic Institute and Baruch's Zicklin School of Business. He graduated from the Tuck School of Business in 2003.

Lisa Chau is a private consultant focused on social media and cross-platform marketing. Previously, she spent five years working for her alma mater Dartmouth College, as Assistant Director of Alumni Affairs and Assistant Director of PR for the Tuck School of Business.

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