Getting to Critical Mass And Ignition!

What's Next In Payments®
1:32 PM EDT November 9th, 2010

MPD Payments Innovation Institute

Cambridge: November 4, 2010

Every new business needs a startup strategy: every new payments business and, more broadly, every new platform business needs its startup strategy to be an ignition strategy. I want to focus today on what sets ignition strategies apart from ordinary startup strategies and why they are so important for payments businesses.

Let’s first think about the restaurant your brother-in-law wants you to invest in. Before investing, you’d probably like to know the answers to two important questions:

First, what’s the value proposition? Once his restaurant is up and running, once most of his target customer group know about it, what will the restaurant offer – in terms of price, food, décor, service, whatever – that will induce enough people to eat there to keep the restaurant in business in the long run?

Second, what’s the startup strategy? Any restaurant is likely to have to sink costs in renovation and to incur certain minimum fixed costs whenever it is open, regardless of the level of business. A successful restaurant startup strategy needs to build a large-enough informed clientele before those costs burn through the available cash.

Neither in the restaurant business nor in any other business does having a good value proposition alone guarantee success, or even survival.

A good startup strategy is particularly important – and often particularly difficult to devise – for businesses that rely on what economists call “network effects.” The simplest form of these are “direct network effects,” which imply that the more customers a business has, the more attractive it is to both old and new customers.

To see what direct network effects imply, think back to the launch of the first local telephone systems. Each system generally had a good value proposition – cheap, easy, immediate communication throughout the town. But if system A, say, couldn’t get enough customers who wanted to call each other, a critical mass, it couldn’t deliver that value proposition. Most actual and potential customers would find the system didn’t really provide value and would lose interest. System A would decline and die.

In order to become viable before the cash ran out, therefore, early phone systems had to have a startup strategy that enabled them to sign up a lot of good, talkative customers quickly. Informing them about the system would not be enough; they would only add to the system’s value if they actually signed up.

But if system A pulled this off, good things would happen. Once an early phone system had a critical mass of customers, it would likely get most other potential customers quickly and without much marketing effort. After critical mass had been attained, direct network effects would drive organic growth: a critical mass of customers would make the system attractive enough to induce more sign-ups, which would make the system even more attractive, which would drive even more sign-ups, and so on.

The critical mass of customers is thus truly critical: get more and prosperity follows; get fewer and the system is not attractive enough to survive.

Now, let’s turn to platform businesses, which include payment businesses. Platform businesses add value not by selling to a single group of customers, like a restaurant or phone company, but by making it easier for members of two or more groups to interact – merchants and consumers in the case of payment systems. Platforms generally exploit what economists call “indirect network effects“: the more customers in at least one of the target groups, the more attractive the platform is to members of the other target group. Like restaurants and phone systems, platform businesses need both value propositions and startup strategies. And like phone systems, the value they offer will depend on how many customers they actually attract.

But devising value propositions for new platform businesses is more complicated than for restaurants or phone systems: two-sided platforms need to offer value to both their customer groups. New malls need to provide value to both stores and shoppers; YouTube needed to attract both video creators and video viewers. And payment systems need to give value to both consumers and merchants.

At the dawn of the payments industry, Diners Club offered consumers ease of payment at many restaurants, and it offered restauranteurs incremental business from card-carrying diners. To deliver on this value proposition, of course, Diners Club needed to attract both enough restaurants and enough diners. This is the two-sided version of the proposition that an early phone system needed a minimum number of subscribers to be attractive enough to any of them to be viable.

(It’s worth noting, by the way, that plenty of failed payment systems since haven’t followed this model: their value proposition addressed only one side of the business; they apparently assumed that if they delivered enough to merchants, say, consumers would simply follow along. But they almost never do.)

Just as devising a good value proposition for a new platform business is more complicated than for a new restaurant or even a new phone system, so is devising a good startup strategy. Like these simpler businesses, a new platform must of course get to profitability before the cash drawer is empty.

But unlike them, reaching the business’s full potential – or even just surviving – generally requires an ignition strategy: a strategy to attract a critical mass in both customer groups so that the attraction of the two groups for each other will catalyze organic growth. This is the two-sided version of the notion that getting enough subscribers to a new phone system will more or less automatically drive growth until most potential customers have signed up. The critical mass constraint for two-sided platform businesses is two dimensional: satisfy it for both customer groups and growth, sometimes explosive growth, is catalyzed; fall below it, gravity takes over, and you may need a job in your brother-in law’s new restaurant.

There are plenty of examples of successful ignition strategies in the payments business and beyond. For instance, Diners Club and, later, Bank of America, initially gave cards away to consumers who had not requested them and used the resulting cardholder bases to persuade merchants that accepting their card would be profitable.

Once Diners Club had critical mass on both sides of its business, ignition occurred, and the business grew explosively, apparently without huge marketing effort. Growth on the merchant side persuaded more consumers to carry Diners Club, and more consumers carrying the card induced more businesses to accept it, which attracted more consumers, and so on until saturation. This sort of catalytic reaction is a beautiful thing – particularly when it is growing your business!

Sadly, of course, this particular ignition strategy won’t work anymore: it’s now illegal to mail cards to those who don’t request them, and the competition is no longer just cash and checks.

The number of failed platform businesses makes clear that there are even more examples of failed ignition strategies – what David Evans has nicely called “wet match” strategies. They just don’t get as much ink.

During the 1950s, for instance, when giving away unsolicited cards was still legal, many banks – including one in my small home town – started card systems with the same basic value proposition as the BankAmericard’s and tried to execute similar ignition strategies. Almost all failed. Unlike Bank of America, most other banks simply didn’t have the scale or scope of operation necessary to get either merchants or consumers to critical mass.


 

A global authority on market design and structure, Richard Schmalensee is the Chairman of Market Platform Dynamics, John C Head III Dean, Emeritus, of the Massachusetts Institute of Technology (MIT) Sloan School of Management, and Howard W. Johnson Professor of Management and Economics at MIT. He, along with colleague David Evans, has helped develop a new area of research in the field of economics known as multi-sided platforms. Read More. Click here to email Richard.


 

PYMNTS.com Blog Entries from the Innovation Institute

Day 1

  1. David S. Evans: Why the Time Is Right for Innovation (and Cash Is Not Dead) (9 a.m.)
  2. No Need to Give a Eulogy for Venture Capital (10 a.m.)
  3. There’s Two Sides to Every [Payments Platform] Story (11:30 a.m.)
  4. The Key to Igniting and Launching Mobile Payments Platforms (12:30 p.m.)
  5. Fed’s Proposal for Interchange Rates to Be Announced Within a Few Weeks (2:30 p.m.)
  6. What Payments Professionals Can Learn from FarmVille (4 p.m.)
  7. Driving Network Effects with Platforms (4:30 p.m.)
  8. What Is The Next Great Payment App That Has Yet To Be Created? (5 p.m.)

 

Day 2

  1. Can the U.S. Replicate Japan’s Mobile Payments Success? (8:30 a.m.
  2. POS Opportunities around Social Networking (9:30 a.m.)
  3. POS Innovation in the Cloud (10:30 a.m.)
  4. American Idol: Payments Innovation Style (Noon)
  5. Federal Reserve: Cash Usage Increased in 2009 (1:30 p.m.)
  6. Tips for Catering to Consumers’ Payment Preferences (2:30 p.m.)
  7. How Walmart Views Consumer Payments Behavior (3 p.m.)

 

 

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