Ecosystem: Are You The Eco Or the System

Sometimes entrepreneurs come in with a pitch to take money and give it to someone else instead of investing it in themselves or their product. Here’s why that’s a tough pitch.

There are a few large players out there who are gatekeepers and at some point will require that you pay them money if you’re going to swim in their pond. These include the big software companies, the wireless carriers, the music industry, and I predict, the large social networks. This is reality.

• Microsoft charges customers for Client Access Licenses, or CALs, which associate customer payments with computers or users accessing Windows.
• Google effectively charges customers a percent of revenue via a split of Google Adsense revenues or through the cost of advertising via Google Adwords.

• Wireless carriers control the wireless pipes, and therefore they ultimately take a piece of money that is charged for content that passes over these pipes, or charge for access such as short-codes. In terms of startup pitches, this appears in the form of shared startup/carrier revenue. The good news is that there is a model for charging for content; the bad news for a startup is that some of that revenue must be shared with the wireless partner.

• The music industry charges royalties on music, obviously! This can come in the form of payments as you go, or as a large up front payment, or both.

• Most social networks don’t charge for access today. They primarily collect money from non-users in the form of advertising. Some are starting to collect money from their users in the form of paid online classifieds and virtual currency. In the future, I predict that at least one of the large social networks will implement a revenue sharing mechanism with its ecosystem partners, enabling them to make some money, but keeping them relatively weak. (See: top of list.)

Once in a while these companies will require large up front payments, but typically they are open to negotiation.

From an investor point of view, it’s hard to get comfortable with investing money into a company and having that money go out the door the next day, especially when there’s a lot of consumer-behavior risk involved once the product gets to market.

There are a few exceptions to this rule, of course:

• Founders taking money off the table once their business has reached some scale.
• Buying an expensive, exclusive license to something very valuable that creates a barrier to entry (such as wireless spectrum, or intellectual property).

But these are the exceptions, not the rule. Put yourself in your potential investors’ shoes: if you’re going to take money to give it away, make sure you have a really great reason for doing so.