Economics 101 for Technology Investors

I usually stay away from the more tough discussions on the land speculation in the Second Life® world. The major reason for that is truly believing that land, in Second Life, is a pretty good example of a free market, where demand and supply are two key factors, but the ability to set your own price and reap a profit due to your selling skills and ability to manipulate the market is way more important. This is the good, old, capitalist free market at play. And, from my point of view, this is exactly how it should be.

Yesterday morning I got to attend a 2-day international conference on Venture Capital, where I happened to be one of the very minor speakers on pitching Second Life as a valid investment opportunity, but being realistic about its advantages and pitfalls. The audience were all veteran businesspersons, I would not be able to get away making promises — I would need to present statistics, metrics, and how to get a return on investment. I believe I made a serious effort to explain that any business in Second Life is risky — and that anyone claiming otherwise is simply a fool, an ignorant, or a plain liar.

Of course I had seen the recent announcement on Linden Lab®’s plan to drop the cost of entry for new islands — both on the auctions and for private islands. I was so glad! Finally, nobody could complain about a decrease on the pricing. Everybody wishing to buy an island now to create a new project in the Second Life environment, would be able to do so at a much reduced investment. These were good news!

The keynote speaker at the conference used to be a CEO of a major financial group, and I had the opportunity to listen to him and pay very close attention to the points he was making. He is someone who is not afraid to announce bad news and speak bluntly. He was never famous for painting rosy scenarios. When he was still CEO, he couldn’t possible understand what people meant with “strategic investments”. For him, there are just profitable investments — people would be thrown out of his office if they mixed “strategic” and “investment” on the same sentence. And he was not unafraid to quote Darwin to the audience and applying it to businesses: the economy is a beast with ever-changing conditions, and the rate of change is accelerating. There were 10 times more technological developments in the past 10 years than in the past 100. But it’s exponential: in the past 100 years, there were 100 times more developments than in the past 10,000 years. This is not expected to change.

And the final sentence: business will have to adapt or die in the attempt. It doesn’t mean if you’re big and have a lot of resources. If you can’t adapt, you die. It’s worthless complaining about “the state of the economy”. You can whine and weep, but adaptation to change is the buzzword. And — it has always been like that. We just feel it more acutely now because the rate of change increases so quickly.

Commuting back from the conference, I reflected a bit on those words of solid, good common sense. What can I do for my own business to make it more adaptive to change? What style of management do we need to have? What products and services will have to be offered to deal with change? I was remembering how everybody cried out loud when the Electric Sheep Company fired 1/3 of its workforce, and recently announced that they will start developing Flash games instead of focusing on Second Life. Why were they “forced” to such drastic measures? Why didn’t my company not feel the same pressure? Are we blind to change and refuse to adapt — and it would mean that our end is near — or are we actually much more flexible and try to deal with the huge changes and have a better model that doesn’t require such drastic measures? How can we tell?

And then I thought about how all the oil companies and energy companies in Europe (another strong topic at the conference), knowing very well that the price of oil was rising (at least in US$; when comparing it in Euros for a period of 8 years, the price has actually fallen slightly, but of course the nasty European media never tell us that), did suddenly make a 180º turn in their investments a few years ago. They all turned to “green energy”. All of them. Not a single one tried to cling to “the old oil economy”. It’s incredible to think that just a few years back we would have predicted the end of their cartel since it was clear that the new economy — an oil-free economy — would render them obsolete. Well. They adapted. So quickly that it was uncanny. Now these are giant, lethargic monsters worth trillions of dollars and employing hundreds of thousands of people. The decision hierarchy is vast and completely impossible to understand by a tiny business owner like me — too many processes, too many levels, too many variables.

How they managed to adapt so quickly remains a mystery to me.

All this, obviously, was in my mind when I logged in back again, and saw the comments on LL’s blog. And, there it was, unbelievable to my eyes, 130 comments or so on people complaining and protesting about LL’s price decrease of the islands.

I blinked in complete surprise.

These are the very same people that yell at me and call me a communist, a bolchevist, or even worse (a sad label for someone who stood against communism all her life, but such is the irony of this world). These are the ones that promote capitalism, free market, free initiative for business owners. These are the ones that set market prices at whim and speculate on land. These are the people that make thousands and thousands of dollars per month by “day-trading” on land. These are the very people that give people like me the example that there are two successful business types in the Second Life world where you can, actually, make a huge profit — real estate is one (content creation is another).

And they were demanding that Linden Lab freezes prices. They wish that LL controls the economy. They wish LL to protect the market. They wish, in fact, that LL acts as a communist government controlling the supply and demand and setting prices at a fixed level. All this in order to guarantee their investment.

The feeling I got from listening to the rambling was definitely one of my weirdest moments since I logged in to SL in July 2004. Sure, I’ve seen land owners always complaining about everything — mostly, very rightfully so, on issues like the telehub removals, ad farms, extorsion, or, like in the Bragg vs. Linden case, hacking the auction system. They’ve complained — very rightfully — when Linden Lab broke features on the Land Store (which I still find impossible to use) or on other things. They’ve complained when Estate Tools didn’t work as expected; or when the delivery time of new sims took too long; or when LL made mistakes, assigning sims to the wrong people; or inappropriately removing listings from the auction store. All these are valid complaints, and I’m the first to admit that some of them are pretty esoteric to me, but nevertheless very important and valid complaints. As said, I’m no day trader in land speculation — it makes as much sense to me as Wall Street yuppies complaining if the transaction costs for [insert complex financial operation here] have been increased by 0.01% and turned their investment in [insert even more complex financial term here] unprofitable. But this doesn’t mean that the yuppies complain when, say, the Google shares abruptly drop. They have to live with it. The stock market is constantly changing and is impossible to predict accurately. They adapt very quickly — in matter of minutes — to the changing conditions, and reap a profit — both when prices rise and when they fall (if you wish to test this out for yourself and earn a few L$, just jump over to the Saxo Bank island and join the Saxo Bank Trading Game. You’ll see that you can earn quite a lot of L$ by betting on currency exchanges that are going to fall. It’s very educative.)

And I’ve seen the left-wingers claim for free land and the abolishment of money. No comment on that; fortunately they’re all having fun on OpenSim and letting the rest of us to enjoy a free market.

So now we have a lot of people very angry at Linden Lab because of the “sudden and unexpected” price drop. They’re losing “thousands of dollars” (or even “dozens of thousands of dollars”) and furious about “how LL treats customers”. They wish “compensation” from LL — and they want it now or they’ll sell all their “investments” in Second Life, pack and go, never to return.

I took a deep breath to calm myself.

Business is about risk

It’s clear that all these people have been “deluded” in thinking that Second Life is the place for “making money fast”. Buy cheap, sell fast, then buy more, sell even faster, and you’ll be very rich soon. Yes, of course, this is what some people have been telling their friends. “Just buy 10 sims and sell them for twice the price, you’ll see how easy it is, all you need is to be quick and clever about it. There is no risk, the SL population grows, and if you’re lucky, you’ll be selling your land at exactly the people that are just coming in. There is plenty of space for all those newbies!”

Well, the first lesson you learn that there are, indeed, high yield opportunities for business in Second Life, but they’re also high risk. People are adults on the main grid, so it’s obvious they’re supposed to know that. If you wish to start a business of high yield — and land speculation on an open market where the number of new registrations grows by around 10,000 every day is high yield  — be prepared to take the risk.

Very bluntly said, if you’re not prepared to take risks, don’t open your own business. Place your money in a savings account and watch it slowly grow with interest. You won’t get rich that way, but you won’t lose any money. This is plain common sense.

I’ve learned a lot in my time as a business manager. It was scary, ages ago, when I left my first day job, where I got a regular salary, no matter what happened in the place I was working for. It now meant that all my income would come not only for my work, but by factors like luck and chance and the ability for my own company to sell products and services. The Internet was young at that time and nobody seemed to believe much in it, except a few geeks and long-bearded Unix gurus. It was risky, very risky. I had lots of qualms and doubts. I didn’t leave my day job immediately, but only after a year or so, working 12-16 hours a day on both jobs until the company made enough money to be able to pay the salaries of all the employees including the founders’ (there were not many — but each and every one was crucial to the company).

I also had no experience. One semester studying economics at college just gives you a rough idea on how the market works. There was nobody holding hands on us. The Government would not help me if I failed; in fact, in my country, when you start your own business, you forfeit a lot of “privileges” that are given to regular employees. If your company fails and you’re unemployed, you won’t get any State subsidies until you get a new job. You pay usually more taxes and have less expenses to file a tax return on. Health care is just at the basic level; if you wish more, you have to pay it out of your own pocket (while employees get all the protection that companies have to provide them by law). Sure, as your own boss, you can set your own salary — but like every good start-up owner knows, first you pay the employees, then you pay yourself — and sometimes, not at all. You’re in for the long haul — employees may come and go, but you wish to be around for decades, not a few months or years. So it won’t be uncommon to be earning far less than your employees for several years. And failure, in my country, is very harsh; you may lose your bank credit immediately. Potential investors will frown upon you; and if you leave everything and have to look for a job, your potential employer will frown upon you, too (who wishes to hire a director who had a bad track at running a company? — that’s how people think around here). Thus, in my country, if you open up your own business, it’s a one-set track: you will never be able to turn back again.

And risk will be at every corner. Every day you’ll think if you did the right decision of abandoning your old steady job and jump into the unknown of owning your business.

No matter how innovative your idea is, people will copy it very fast, have more money, more time, or more contacts than you. If you take one year to turn a successful idea into a profitable business, your competitors, knowing that it works, will do the same in 2-3 months. Proof of concept is key; early adopters will have to bear all the costs of making something new that works, exploring a niche that nobody believes in. You’ll be risking in new, unproven technology; developing new management techniques, that might not be in the textbooks; you’ll be hiring people you have no idea if they’re good at what they need them to do, and bear the risk of having just the wrong team and having to start from scratch — or decide to use them to the better of their abilities after all. You’ll have customers wishing the impossible — the old saying of “better, faster, cheaper — take two” will be ignored by all your customers, who obviously will want all three. And you know that if you can’t provide that, you’ll be losing customers to the competition.

The technology business

If you’re in the technology area (and I although I ran other businesses to get the hang of different markets — but I’m sticking to technology for now. I failed utterly on the other areas), you’ll slowly get used to two things. First, that the price of technology is always dropping. You can buy now, say, a router or a switch for a tenth of the price that you bought one in the mid-1990. They’re available on supermarkets and are consumer products. They have nifty web-based configuration interfaces that even a kid can understand. But the early adopters had no other option but to buy them expensively, and make their business model work with what they had — hiring expensive techies that understood how to configure them. When prices started to drop, you would see that as an opportunity: either you’ll make more money out of your existing customers, or you would be able to offer your services cheaper, thus undercutting the competition. But the second thing was that the competition was going to do exactly the same — and from any start-up’s point of view, the competition is always bigger, better, faster, with unlimited funds, with special agreements with vendors and suppliers, with more contacts, a lot of money to spend on marketing and advertising, and far more customers, potential or real. They will buy cheaper technology before you had a return on the investment on your existing one. It’s an arms race — who is going to buy the cheaper technology first, reap the profits, lower the prices, make more customers happy?

And then you would have external conditions popping in: the Government can suddenly start to regulate your business, and suddenly you might not have money to buy a license (while your competitors will do that easily). Or a new technology is introduced (in my time, it was the Web — selling access to email services wasn’t enough) and suddenly you have to very quickly provide that service as well — or forget your business, because you’ll be shadowed by your competitors very quickly. Or the pricing structure might dramatically change — some people remember when basic access to the Internet was for free in the last years of the 1990s, since operators expected a return from providing additional services. The small startups had no way to compete with that (they were all indexing prices closely to cost), and had to hope to survive. Unless they changed their business models or their pricing structures, or chose another market to operate (going from residential to business, for example).

At all these stages, newcomers in the market would suddenly pop up, loaded with money, backed up by solid investors that have seen what the start-ups were doing, deploy incredible infrastructures in months that you could even dream about, and start selling to tens of thousands of clients after a first month of hitting the media with their advertising.

Unfair? No. It’s all part of the business. It’s all part of managing risk. It’s also all part of managing expectations — understanding what you’re in — and having an exit strategy, if needed.

It is, also, very hard. Nobody will tell you at college how hard it is. It’s far better to be an employee somewhere and put the money into a savings account 🙂 You’ll work 7-hour days, have the weekend free and enjoy some vacations every year, get a comfortable living, have lots of free time, and a nice pension when retiring earlier. What a wonderful world 🙂

Learning to fail

One of the lessons I’ve learned in the past was also how important it is to study other cultures — even business cultures — and see what they’re doing right. I might not be a big fan of the US government and the way it works — people have known me to speak against it quite often — but I was always a huge admirer of the American people. They have energy beyond measure: Americans are workaholics and have a culture centred in working hard. And it’s not only about “money” — if you’re a hard worker, you’re well respected, and for some that’s more important than being filthy rich. (You’re not a commie if you work hard for earning respect!!) They’re also organised, dedicated, good at finding solutions, and, generally, nice, friendly, and informal. This is naturally my own, personal experience when dealing with them.

Most of them also have two characteristics which, I think, are very important for successful business owners. They don’t mind taking risks. And they’re not so afraid on failing. In fact, business angels and venture capitalists frown upon people that pop up with a bright idea and come for some funding, and give as a reference their own company as a proof of success. Almost all will ask if they have failed at some point — and demand an honest answer. If you brightly smile and say: “No, never!” they will shrug you off.

You need to fail to understand the consequences of taking a risk. It’s part of being a successful business owner. You have to feel what it means to lose money — your own money, not other people’s money. And you have to be able to deal with it on a rational level — learning how to cut losses, learning how to deal with an exit strategy (that thing you’ve postponed and filed away in the deepest recesses of your memory, never to be brought to the surface — until it’s really needed). You have to feel in your bones what it means to lose your company, your job, your friends, your money — and perhaps even your shiny new car, your fantastic home, and all the nice Van Gogh paintings you’ve bought. And, obviously, you have to learn from that experience.

The few that are able to raise themselves back after losing everything, learning why things went so wrong, and preparing themselves for never repeating the same errors again, are the ones business angels will look as successful business owners. They will be the ones that will only tell the public how good and successful they are — you’ll remember them for the companies they created and had success, not for the failures! — but their funders will know that they’re fine in surviving a catastrophic failure. Learning that in college is also impossible. You have to go through it — alone, by yourself, losing your own money — and learn from it. It’s a very tough lesson.

Americans are, for me, the people that have learned this lesson best (and that’s why the American economy, as a whole, is usually the first to raise itself from the deep pits of despair, by sheer will of force and hard work), and that’s the lesson that I have personally learned from them. Failure is not a disgrace. Being unable to cope with failure and turning your back, shaking your fist at the “evil market forces” that are responsible for your failure — that is, indeed, disgraceful.

Thus, the Steve Jobs and Bill Gates of this world — and that includes, of course, our own Philip Rosedale — are successful entrepreneurs, because they all learned (the hard way!) how to deal with technology costs going always down, market conditions always changing, customers always demanding more, better, and cheaper, and, most important than all, they dealt with failure — sometimes in a catastrophic way — and are still around to smile and talk about it. They’re the very stuff of role models for every business owner to adopt, or at least to learn from, no matter how much we might like or dislike them individually as personalities.

Entrepreneurism in the Second Life® World

We come now to the point. As said, Second Life® is often announced to new users as the “miracle of free-wheeling capitalism”. A place where the economy is in an almost “pure” state: buy cheap, sell high, and you’ll be rich in a few months. A market where things are usually stable (financially at least) and where demand is ever-increasing, so that suppliers will always make a deal with prospective customers.

Well, of course that’s an utopia, too. Content creators well know how the technology affects the whole business, besides the competition. When LL introduced flexible primitives, the careful designers of Linden mesh skirts suddenly went out of fashion. They had quickly to adapt — learning to do creations with prims, instead of Photoshop templates — or be out of business. They did not whine and complain that Linden Lab, by introducing flexible prims, was destroying the skirt business. Instead, they adapted, learned quickly the new techniques, and did that better and faster than their competitors, in order to survive. Then Linden Lab introduced sculpties — a far different technique, requiring far more knowledge of professional 3D modelling tools. This time, there were a few complaints. Perhaps even more than a few. But the content creators split among two groups — the ones that focused on non-sculpty items and still filled a niche, and continued to make money there; and the others that bought Maya licenses and took a crash course in Maya modelling in order to remain competitive with the new technology. When WindLight started to be tested, more than half a year ago, content creators saw suddenly how awful their creations looked like. The most clever ones understood that the new lighting models would require new techniques to allow clothes and accessories to look “as good” under WindLight than on the old renderer. They prepared themselves and weathered the storm of “old ugly creations”. The same, of course, happened to vehicle builders and other physical-based SL devices. The ones with a strong business sense were on the early Beta tests of Havok 4, and worked closely with Linden Lab to make sure their creations would work once it got released on the mainland. Scripters that depend on their programming skills to make a profit are now on the Beta grid testing their scripts under Mono (mine, unfortunately, all fail utterly — I already know that I’ll have to fix them all, or lose that slow trickle of income from my animated, scripted devices). In the future, avatar meshes might change, and content creators will need to see if their clothes still “fit”.

And, in the mean time, content creators are launching new things all the time. Nobody buys “Linden hair” or “Linden shoes” these days. If you were in that business, you’re broke and out of SL by now. Nobody will buy them, when the competition designs lovely prim hair and outstandingly good prim shoes. There is no amount of whining for the “Linden shoes” creators about how their competitors with their prim shoes are “stealing their business”.

A lot of content creators didn’t care. They were unaware of market changes. They preferred to steal and copy what they could, use simple templates, and push them as their own “creations”. Others stubbornly refused to learn new techniques and complained — very loudly — how LL was “destroying their business”. Most of them shut down their stores and went away in disgust and told everybody how evil LL was (or how disgustingly clever their competitors were). You see them still complaining in the forums of MMORPG.com or similar ones.

But, in general, content creators are only furious about one thing really — how Linden Lab refuses to protect their content and allows everybody to copy it using permission bugs or libSecondLife. This is, indeed, a good cause for complaining. On the other hand, the most successful content creators are not the ones that are more worried about it — because they know, unlike the content pirates, that they can always create more and more designs. Content pirates can only copy what they see; original creators can capitalise on novelty and originality and come up with new ideas. This is exactly what happens in the content industry where fashion creators really copy each other’s ideas, or music bands will get ideas from other groups. The successful ones will fight piracy, but really focus on creating something new. All the time.

Still, there is a risk — and most of the successful content creators know that. They see the risk every day when walking around and understanding what the market wishes — and knowing suddenly why nobody is buying their products. They also know that as a content creator you need to be working creatively all the time. The fast, accelerated changes in SL demand a constant output of creativity. A lesson some RL fashion brands learned when coming to SL is that you don’t have “two seasons per year” — nobody will come back to your shop if you have just released a collection last summer and have the same things on display for 6 months. You need to be constantly outputting new content — or your business will be lost, and your skills and talents quickly forgotten.

Again, no serious content creator will complain about this. They know their market demands it; so they either adapt — and are willing to do so — or they will be quickly forgotten. The market forces in SL are dynamic, but, more important, they’re ruthless (pun intended!).

But finally we come to the other successful business model in SL: land development. This is actually two different types of business. On one hand, you have the high-yield, high-risk business of land speculation, which works exactly like a stock exchange: the growth of the number of residents and Linden Lab’s introduction of more sims will establish a base price for land. If the growth on the number of residents falls or rises, or if LL adds too much land (or too little), the price fluctuates. On top of that fluctuation — entirely driven by external forces not under the speculator’s control — you also have market price setting. And here, if you hear the speculators talking, they’re not Wall Street yuppies discussing prices. They’re a cartel. They wish the “land standard price” to be something fixed by them in order to reap a maximum profit without the least investment — in time or money. This is not new; it started when LL allowed land to be sold and re-sold, eons ago.

There is a different model of dealing with land — developing it. It requires more investment: you need to buy the land, terraform it, build it (either on your own or outsourcing it), have some sort of parcel management utility, advertise for it (outside the land auctions…), get your tenants, and then maintain your community of tenants happy, by launching events, keeping your land away from griefers, and making sure that things are generally flowing nicely.

This kind of business takes a lot more time and money — and effort — than speculating on the ‘real’ estate market. It needs middle-to-long-term planning. But it has an advantage — people will pay you for your added value. The better you manage your community of tenants, the more likely they’ll stay. And a good business owner will know that the more tenants they have, the easier it will be to spread the infarstructure costs among all of them — so you can drop prices and still remain competitive. More competitive, in fact, than the land speculators.

An important thing to understand is that land developers are service providers. They buy a technological infrastructure (sims), they develop content, they manage a community of tenants, and they add value. So they are the ones that will always be looking for ways to reduce costs, be more efficient in managing their services, and be able to fight the price war on the tenants’ rental fee. If you’re unable to control your costs — one of your competitors will, and they will be able to drop prices before you do. And your tenants will run away. Unless, of course, you can compete on better services. A few of the land management communities are not competing on price. They keep them high, but offer more and better services instead. There is a huge difference in competing on price or on services, and the strategy you pick for your business is one that you’ll have to decide at a very early stage and be able to stick with it — your competitors will affect you more or less depending on what you do.

But — for both types, one thing is certain: if infrastructure prices drop, they’ll have less costs, and they’ll have higher profits (or be able to lower prices, increase their offerings, or whatever they wish). I’m quite certain that they’ll enjoy the benefit of cheaper sims.

The land speculators are a different crowd. Since they don’t provide a “service” — but only day-trade on the market — any fluctuation on the price that comes from external market forces (in this case, reduced infrastructure costs) will affect their margins. I’ve listened to them talking on public discussions. If you’re a believer on the free market, and used to deal with the way technology infrastructure always gets cheaper over time, you would be shocked at what these people are proposing. They want LL-controlled price setting. They want long-term compromises by LL that LL won’t drop prices “overnight”. They demand compensation from “loss of income” due to price changes.

What happened to the advocates of the free market??

I’m a bad judge of people (one of my many shortcomings), but when I hear these people complaining — and, mind you, they are clever people, full of spreadsheets and market data, with lots of connections in their cartel, always snooping upon others, launching their buy-bots and whatever technological advances they have in order to have an edge of their competition — I can only believe that these people have zero or little business experience. They have definitely no idea of what it means to run a business (speculative or not) that is linked to technology advancement. They have probably for the first time in their lives invested money — and many invest tens of thousands of dollars, sometimes monthly — on high-yield, high-risk technology-connected ventures. They might scorn at the Wall Street yuppies, but they’re the Prim Street yuppies of Second Life, although they refuse to accept the consequences.

So their whining and complaining comes, in my opinion, from an utter lack of experience and a strong misbelief that money is easy to make, if LL does not allow a free market, but protects their investment by setting prices as they see fit. You’ll see them all raising the argument: “we’re the ones paying to Linden Lab, if LL refuses to listen to us, we’ll go elsewhere and SL will be doomed, without LL earning an income”.

Yeah, right. What they totally fail to realise is that you can “play” being a yuppie and whine about the high risks that you refused to believe in, but removing yourselves from this market will only mean that people with more business sense will fill the niche you’ve left for them. And this market will be filled, so long as, indeed, it continues to be a free market. There will always be experienced businesspersons willing to step in and run a high-risk operation, now free from the young amateurs. This is, sadly, the harsh lesson that every self-styled yuppie will learn — very fast — when losing a lot of money at the stock exchanges. You can’t blame “the market” for changing. You can only blame yourself for your unability to cope with change. The ones learning the lesson will know how to deal with it — again, adapt or die.

So, why the “sudden” price change?

Obviously you’ll read all over the SLogoshpere (now a forbidden word, but I’ll risk using it for another 75 days 🙂 ) how evil Linden Lab is to drop prices, how desperate they are in cashing in more money, how nobody buys sims and LL is forced to lower prices on them, or any other far-fetched reason, like LL’s “imminent IPO requiring a lot of cash flow in the next few months”.

Or, well, just the usual complaint that LL does not listen to their best-paying customers and is scaring everybody out of SL.

All this is, obviously, wild speculation, and invented excuses to cover up one’s own tracks. A businessperson that blames the market on their inability to cope with it is, bluntly said, a poor businessperson.

LL is a technological company. They buy infrastructure to run a business based on technology — hardware, software, bandwidth — and resell it, for a profit, by adding value. In this case, it’s mostly the software and the management of a complex infrastructure. The management, of course, requires more technology (automated software to deploy the grid infrastructure, monitor it, raise alerts, try to self-correct itself, or have failback mechanisms) — but it also requires human labour.

Now, as technology advances, it becomes cheaper. There are tons of reasons for that, but one of them has to do with reaching critical mass on a new product. Once that happens — either through an improvement in a production process; lowering costs on materials; or more efficient employment of the same people — prices drop. Sometimes dramatically.

Linden Lab has gone a long while since they started their Second Life Grid®. From one-server sims which needed to have manual software installation and people in front of the racks to reboot the servers — when the grid was small and had just a handful of servers — they have gone to a point where they remotely administrate thousands of servers, are able to allow residents to reboot their own virtual machines (the simulator reboots from the Estate Tools), can deploy software automatically without having to stop the grid, and, recently, they can even have different software versions running on the same grid, upgrading simulators, one by one, without interrupting overall service. They have semi-automated backups that one day will even be in the hands of the sim owners (by selecting a list of recent backups from the Estate Tools). All this lead to a dramatic improvement in efficiency on the way they can deal with an ever-increasing number of servers — while keeping the same amount of people doing that work. And, of course, they are now able to run several simulators per server — and server prices are constantly falling, or, more realistically, they remain the same (US$5k-7k for a rack-mountable server is a good average estimate for a server — people believing that they’re using cheap US$400 PCs are so very wrong) while giving more CPU power per US$ — and thus allowing a higher density of simulators per server for the same cost. And, finally, the costs of aggregating bandwidth are also helping out LL’s budget calculations. Twice the bandwidth does not cost twice the price; the more bandwidth you buy, the less you’ll pay per Mbps. So, as SL grows, a lot of LL’s direct infrastructure costs do not grow at the same pace. LL is now able to negotiate better pricing in servers and bandwidth, since they’re reasonably good customers of both technologies — and buy a lot of machines and a lot of bandwidth.

Put this all together, and what this means is, when you’re in this business sector, the more you grow, the less costs you’ll have per client. This is, in fact, the attractive side of being in the hosting business — which is, in fact, what LL does. At some point, you’ll reach critical mass — where a sustained growth will always mean less and less costs per client. And you can do a lot when you reach that point.

A year ago or so, what LL did was to dramatically increase the number of people working directly with them. This allowed them to focus on a lot of things simultaneously — not an easy thing to do for a small company, even with adequate funding. But right now, they face the difficulty that every company in the technology business faces: the people they need to hire are not available for the values they wish to pay them (nobody will leave Google, with its 750,000 servers, to go to work for LL, with its “few thousands” of servers — unless you are willing to pay them a lot. Your career at Google is guaranteed, while at LL, it’s still too early to say). So they have to keep the ones they’ve got, and just increase their efficiency with better tools, so that the best ones among them are free for other products. Put into other words: you don’t wish Andrew to go over to the server racks and do manual reboots of the servers. Andrew has to be free from correcting bugs, which can be left to other members of the team, and work on other things. I believe there might be a big reshuffling at LL internally, as automatisation has increased productivity and released otherwise occupied developers to focus on new projects instead.

On the other hand, they have to “face competition”. Unexpectedly, perhaps, their “competition” is not exactly the upcoming virtual worlds (who will have a much harder time to attract customers than everybody wishes us to believe in) or the existing ones (which compete on other market segments — not LL’s, which is the market of 3D content hosting for user-generated content). Surprisingly, the “competition” will come from “SL-compatible grids”. For the same cost of half a dozen sims, a university or a corporation can now buy a container full of cheap PCs and deploy OpenSim on them. For most of their projects, the lack of certain features on OpenSim will not be an issue. And they don’t need to pay for any licenses — Linden Lab’s open sourced client is for free, and the OpenSim software is naturally free as well. So this means that corporations needing a lot of sims do not need to buy them from LL any more.

But also a few thousands of users — mostly very active users — are registering on the OpenSim-based grids, too. They’re not “free” in the sense people like Adam Zaius would like them to be. They’re run by small businesses, usually with a handful of people, enough to manage a few hundred sims. They have much lower costs than LL. They have zero development costs. They just install the free software and allow access to their servers for very low fees. Still, some charge US$500 for a sim on “their” grid.

I think this might have the business managers at LL thinking a bit. People are fine in paying more for more services. But as the gap between what OpenSim can provide now (almost all types of content can be deployed on OpenSim in terms of prims and textures; scripting is limited, but rapidly advancing — it’s also already based on Mono, while LL has just released their first versions of the Mono-enabled scripting engine, and there is still some months of debugging ahead; there are no permissions and no money) and what LL can provide narrows down, they will become a serious alternative, since they’re so much cheaper.

Now if LL has managed to increase the efficiency of their operation — basically, managing more sims with the same people with reduced technology overhead costs — they have a margin here to lower prices.

Which, I believe, is what any sensible technology provider would do. They know they can’t remain competitive — knowing that there are working alternatives already — and keep their prices up indefinitely. The market for sims is not infinitely elastic, but a reduction in price will make wholesale buyers of sims to think twice about the alternatives. If you wish to have your own free OpenSim-based grid, you need PCs, bandwidth, maintenance, and a team to support it. You can outsource all that to the small startups that are doing all that for you, for a reduced price per sim. But if LL drops the prices as well, they’ll continue to be a valid alternative. In this year, they might be releasing 16-core “Class 6” servers allowing them to continue to increase the density of the sims-per-server ratio, thus reducing server costs further — and bandwidth will continue to be cheaper. They might introduce even better management software (they have already hinted at that, with the current releases of new server software which happens every week) and keep the number of current system administrators and operations team small. This will allow them to continue to be a profitable company, and reduce prices even further.

This is not news for anyone who is used to technology prices usually falling regularly. In fact, there is Moore’s Law applying to economics in the tecnology sector as well: prices drop to half every 18 months, or, more likely, you get twice the service/product for the same price after 18 months. We’ve seen LL reducing prices (and increasing prims) on the “void” sims first, and now on the rest of the sims as well. This is, after all, what you expect from a technology provider that is running successfully.

Now the land speculators will have to grow up, too, and accept change as being inevitable. And the change, in the technology market, comes unexpectedly and suddenly. You just have to be able to cope with it.

Whining for LL to control the economy instead of relying on the free market which gives people better products for a lower price is simply — out of fashion.

Then again, if you really believe in the free market, you have to understand how it works, and the more crucial two points: business is about managing risk, and adapting to ever-changing conditions not under your control is what it takes to run a successful business. This is specially true for high-yield, high-risk, technology-based investments.

About Gwyneth Llewelyn

I'm just a virtual girl in a virtual world...

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    12 April 2008 at 8:04am
    Second Life News for April 12, 2008... From: Digital Trends Second Life ...
  • The Grid Live
  • Gwyn I’m sorry but you’re wrong on so many levels on this issue.

    Let’s deal with where you’re right, technology prices do indeed fall. My day job includes this and I know that my half a million pounds goes much further these days than it did five years ago.

    However whereas you say lower prices will lead to higher margings, hell no, not unless they drop tier.

    When you say that land speculators don’t add a service, you’re incorrect. I know it’s fashionable to dislike land speculators but if they didn’t buy whole sims, chop them up and resell then people wouldn’t be buying small parcels. LL traditionally sell full size sims, new people can’t afford those generally, first land went the way of the dodo.

    However I’m not a speculator, I’m a landlord. I buy to let. Price fixing? LL fix prices, they just fixed island prices, that devalued my island by around 40%. Your focus only on tehcnology costs is completely ignoring the inworld economics of this fact. I’m not looking to sell and anyone with half a brain knows that land costs are going to decrease, but 40% overnight? My island asset is worth 40% less than it was at the weekend.

    Of course this does teach one a valuable lesson, you can’t make medium to long term plans in the land market in SL, you have to ensure a return of investment asap.

    People who purchased islands recently have every right to be miffed and what about those who purchased open sims, the new ones, it looks like their pricing structure will change soon too. This doesn’t actually inspire confidence that LL know what their doing and being surprised that people complain about a 40% decrease in their assets beggars belief.

    This isn’t like the stock market, estate land’s benchmark is the price LL sell their islands for. People who add much value get LL price +, people who have standard type estates get LL price -.

    I viewed (incorrectly it would appear) my island as an asset that would depreciate slowly over time, snowballing if you will into a steady and ever increasing decrease. I did not expect, and nor did most of the people complaining, to find my asset devalued by 40% by LL themselves.

    The majority of the people complaining are complaining about the devaluation of assets. I don’t see why you as a business woman are missing this point.

    If stocks fell by 40% overnight, you can rest assured that people wouldn’t be happy with the CEO of that company, even though they know stocks are a risky business. If the price of your house falls by 40%, you’re going to be unhappy with someone for such a rapid decrease. You know the risks, but it doesn’t make it any easier to swallow.

    LL’s action on this was rash and short sighted. They could have been much more creative in passing on price reductions, offering better deals to existing estate owners than new estate owners. Extending the free tier period, offering free island after you’ve purchased three new islands, bundling in an open space sim, having a limited offer sale yadda yadda yadda.

    LL’s move has made people angry, undermined confidence and created bitterness due to a rash action.

    I fully support your call for people to adapt, when the dust settles estate owners will adapt, but they will adapt in a fashion that casts eyes of suspicion at Linden Lab’s actions in fixing the economy.

    As for content creators, some of them have short memories. Plenty were positively outraged when Anshe announced items were overpriced and she was going to sell quality cheap items, why were they outraged? They were outraged that they felt their items would be worth a lot less.

  • An Utterly Bored Doyle

    I can’t wait for P.Neva’s long winded reply/rant and a new record for most words per single page on the interwebs with the least content. There is no way this is going to get beat.

    Markets change, good business adopt, bad businesses blame someone else. Is it really worth spending spending 5.000 words of self reflection and generalizations to say SL has a lot of bad businesses. What’s the news here?

  • No need to be “sorry”, Ciaran! Your opinion is more than welcome.

    To make it perfectly clear, I’m not against “land barons” who buy wholesale and split parcels to sell them to newcomers and call that a service. I was in that business once, too — only in 2D, not in 3D! So, obviously the business is valid, important, and necessary. Not everybody is able to buy their own servers and can only pay to have a tiny bit of it.

    There are, however, as I pointed out, two different types of services here. One is the pure slice & dice land speculator — the person who buys wholesale and reaps a profit by selling slices of a simulator. They’re not different from people who just buy a server in a rack and provide access to it to several users, possibly through some cool-and-easy-to-use web tool. Of course they’re “service providers” too.

    And then there is a different class of business — the ones that don’t simply give you access to a slice, but add services to it. On the web, they might, for instance, give you access to applications (example: Flickr, MySpace, YouTube…). You’re still getting the same thing: access to disk space, bandwidth, and shared servers. But you’re paying for the service, not for the disk space.

    Is that clear?

    When I say that lowering the prices can lead to higher margins is that successful business owners on online services will try to lower the costs of their infrastructure as much as possible but keep the price of their services as high as they can. If the service is good, people will pay for it what it’s worth — and not what your costs actually are.

    Naturally competition will tend to make prices fall down. The more people are providing the same service, the less likely you are to be able to charge your customers the same thing, specially if they perceive that your costs are going down — and if your competition drops prices accordingly. You can, however, refuse to accept the price war. Instead, offer more (or better) services for the same prices. Some customers are more sensitive to price changes; other to what services they can get for the same amount of money. Juggling between the service-vs.-price issue is where a business manager will be making their qualified decisions.

    Now, I see you’re shaking your head and saying: “but Second Life is not the Web, everything is so different here, we’re a community of users, we are LL resellers, and we’re being undercut with our wholesale provider!” I’ll maintain my claim. This only happens because you wish so. In fact, if you’re providing a service that is not seen as “valuable”, since you’re stating that when LL drops prices dramatically, landlords have no choice but to do the same.

    Why?

    The answer can only be one: because tenants don’t value your service at all — they only value price 🙂

    Now I agree that this is naturally one way of making business as a landlady — basically, adding little value to the service, because “every other landlord is doing the same”. But that’s a choice. It’s not “ignoring in-world economics” (which are, btw, the same as any kind of economics — just with less variables to play with). It’s claiming that just “because everybody else does the same I have to do it too, or lose money”. Not at all! Innovative services will be able to fill in the gap nicely.

    I can give just one example of many possible. Let’s assume you refuse to drop the prices on your sim. Tenants will complain, since they know that sims are cheaper, and that everybody else is dropping their prices. What will you answer them? “You’ll have to face griefing, ugly builders, no urban planning, no events, and no technical support from the other landlords. I provide all those additional services for you — for a price. The choice is yours.” Sure, a few will always go away and search for cheaper land. But the ones that stay will be the ones interested in buying a better service and pay premium for that.

    You might also claim that this is simply not how it works! In fact, I know that high rotativity is good for landlords that charge an upfront fee — the more quickly people leave their lands for others to buy, the more you gain. I’ve seen some landlords offering plots for below-average pricing, thus attracting new customers quickly, then actually ignoring griefers deliberately (or, who knows, hiring them) to quickly buy the land back (or even reclaim it when the resident simply quits SL in disgust) and sell it again as fast as possible. It’s not nice, but it’s also an alternative way of running a business.

    And then again, I know of communities where the price of land remained stable over three years, no matter what the actual price of the original islands was. They’re profitable. They even offer things like plots at twice the prims. They get their tenants in, paying the same values, above what others are doing — just because they’re better at providing services that their competitors. They’re not happy; they’re jubilant that they can grow their offerings at almost twice the rate as before!

    They are, of course, very few. If I could hazard a guess, based only on the comments I’ve heard, it’s about one in hundred. Then again, these landlords do not usually vent their opinions publicly. They’re silent and plod on, gathering more and more customers — slowly.

    If the one in hundred ratio is correct (and I hope it’s not!) this is actually a very bad sign. It’s impossible that these few service-oriented landlords are able to absorb all the tenants vacated by the people that are complaining now and will very likely cut their costs and leave SL — dumping their sims in the process. And this, of course, is worrying.

    Finally, a last comment on the content creators. First, they are far many than the landbarons — their major investment is mostly in labour, not money, although at some point they’ll also need to figure out the costs of paying for their shops’ rent, licensing costs for the software they use, and promotion. Still, granted, it’s a lower cost of investment.

    Content creators have short memories? Oh sure, they have. You’ll see that the biggest complainers are the oldest creators, who are still stuck with the “glory of the past”, where competition was small and they could set the prices they wish — and get a moderate income from 3 or 4 year old designs, thanks to the influx of newbies. These were naturally the ones worried when prices started to drop — since they had no patience (or time) to continue to produce a steady stream of new, fresh content, and relied on “established sales” on existing content. Again, we’re talking about a type of business that relied on building up a reputation when SL was young and get a regular income from that past effort.

    Those were the content creators that were scared off the “competition”. New, talented designers have an incredible energy in producing content weekly — and all of it is very high quality. These don’t worry about Anshe’s announcements — they know they can produce more, better, and probably even faster than Anshe. If you’re good in what you do — and have a solid model based on constantly exceeding your customers’ expectations — you don’t need to “fear” competition from the cheap copycats.

    Speaking of which, there I see a major problem — pirated content. It’s more a question of principle than an issue of losing sales. Your established customer base knows who you are and where your legitimate shops are. However, the pirates can hurt your reputation — they might illegitimately claim they’re your agents (which they aren’t). They can sell lower-quality products — and the customers will complain to the original creator, not to the pirate. They can dump and flood the market in certain areas, pushing your content as “freebies” or at very low prices — transforming an otherwise high-quality product into one that has no value. And this definitely hurts reputation — and through it, it hurts sales. Worse than that, there is no “technological” solution for the problem, only a social one — either LL forbids piracy through a rigid enforcement of the ToS, or you, as a content producer, need to file lawsuits against the pirates. A complex, morose procedure, that will hardly have a successful outcome, wasting your time and money, and dragging your issues into the public sphere.

    In conclusion (this is a long comment!), I’m really not convinced by your arguments, except in one major point:

    Linden Lab is not good at communication.

    And they haven’t learned to get better at it.

    I think this is the root cause of all evil, and I hope to address it on a new post…

  • @2 Doyle, because I reserve 160-character comments for Twitter, and 5000-word essays for my blog 😉 Different technologies, different audiences, different attention spans, different purposes.

    Oh, and Prokofy’s article (which predates mine) is here.

  • And Prok calls it communism. Surprise, surprise. In Prok’s world, there’s communists, terrorists, and his small circle of friends… or shall I say ‘fanboys ‘n’ girls’.
    Must be easy to be Prok – you have answers for everything, and insults for everyone.

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  • Whoa hold your horses there Gwyn. How on earth has my infrastructure got cheaper? My tier is the same. The first thing you look to cover is tier, if tier prices drop, then rental prices drop. My island cost me 1675, it doesn’t suddenly cost me 1000 now, if it did you’d be right about tenants expecting cheaper land because prices had dropped, but you’re wide of the mark with that assumption, my costs haven’t dropped.

    I own estate and mainland, my mainland rentals are naturally cheaper, because mainland tier is cheaper.

    I had to adapt when VAT arrived. Prices had to change, but not to existing renters, that would have been a bad business move. There are also ways and means of tempting your returning customers with discounts and offers. Valuing your existing customers is a very important factor in any business, in the rental business it’s extremely important because returning customers lower my overheads (no need to keep advertising plots for example).

    Poor customer service lasts a lot longer in the memory than good customer service, it’s a lesson LL need to learn.

    Plots at twice the prims have to be more expensive. You get the same amount of prims per sim. The books have to balance.

    LL should have a responsibility on both the economy and land to ensure that the economy reflects service, not that Johnny come lately can undercut existing customers because he gets a better deal on his purchase. That’s simply the rocky road to ruin.

    Hosting deals generally aren’t lifetime deals. If I were paying LL every year to own my land then you’d be right about infrastructure costs, so it cost me say $500 to own land in 2007 and due to lowered costs it costs me $300 in 2008, there would be no issue there. I paid more in 2007 like everyone else, now I’m paying less in 2008, like everyone else.

    I went to Jack’s office hour and someone claimed their land was devalued, Jack asked why? Was this person buying and selling islands? No was the reply, it was an asset value issue. LL simply do not have seemed to have considered that people value their assets, but people do value their assets.

    The bottom line is LL should have been more creative in passing on price cuts, they should have taken into consideration their existing customers. They could have cut the entry fee to new customers by $200 and then offered existing owners a $900 sim. Some people would still have complained but quite simply the discounts on expanding would have meant that it appeared like they were taking into consideration existing customers. Quite simply that would have meant a lot less criticism of LL’s practices.

    Let’s not forget that the original blog said that those with existing orders would have to pay 1675 for their islands, how on earth did they think that was going to go down well? They of course made changes to this policy after receiving complaints but it was yet another example of LL not thinking things through.

    When VAT was introduced the first I found out about it was when I checked my account page, I discovered the increase before LL had the courtesy to inform me they had jumped over the threshold whereby VAT had to be included. LL seemed surprised that we were complaining because hey it was the law, but we were complaining at how it was introduced, not that they had to charge it.

    Of course if LL allowed me to pay tier inworld by L$ I wouldn’t have to pay VAT at all, but that’s a whole different story.

    You see Gwyn the issue is with customer service, you keep saying that service is an important factor, time and again LL’s is lacking, they alienate their customers at their peril and that’s bad for everyone, you, me and Dupree :p

  • Ciaran, you’re so right on bad communications being the major problem that I decided to dedicate a whole essay on it.

    That is, indeed, the major issue.

    As for viewing servers as an asset, well, there’s a lot to be said about it. You really don’t “buy” a server, you pay a setup cost — a practice that is slowly fading out of fashion on web hosting.

    Perhaps Linden Lab is planning to reduce setup costs to zero and just have people pay leasing costs (“tier”), and this is one of the first of many steps to do that. How can we tell? They’re so bad at communicating what they intend to do — we can only speculate.

    In any case, I view “buying an island” as exactly the same thing as “buying a car”. The moment I drive it out of the stand, its value has gone down by 30% immediately. But it’s worse: a new car might come out the next week, with more features for a lower price, and people will not be interested in my second-hand car, unless I sell it for even less. Sure, private islands are not cars, since newer private islands don’t have “more features” but exactly the same features they had 6 or 36 months ago.

    But I agree with you. Poor communication from LL, badly addressing customer’s needs and ignoring complaints, will be bad for everyone — in the short term and the long term. And there’s where the crux of the matter lies. Price cuts are just another of several badly announced things lately.

  • Well the same model car wouldn’t come out and be 40% less but I take your point.

    LL’s pricing model is indeed a bit problematic. I think some of the point with land as a value rather than a service is exemplified with the class 4/5 issue. Class 5 offers better technology, but its worth isn’t tempting due to the grandfathered tier prices. Not many people are going to be tempted to upgrade.

    I’m not sure how LL can address that issue. You have to give something else in value to tempt people to upgrade.

    I’ll save my comments for communication for the appropriate entry.

  • Excellent post and comments, Gwyneth. Sorry to be six weeks late in reading it and responding!

    I was one of the land owners that cried foul when LL dropped their prices – and made a couple of comments to that effect on a few forums and blogs – but it was more of a spinal reaction than a thoughtful one. Having considered an ordered withdrawl from the land business – I was disappointed by the announcement. Although overall my land business has been profitable, my little “nest egg” suddenly dropped in value by 40%! 50% if you consider the first month’s tier included in the price.
    However, I am in a specific situation – someone wanting to slowly sell off my holdings in order to move onto something else in Second Life.

    However, after some sober reflection on exactly the issues that you outlined – I’d have to say that I have come around to your way of thinking on the issue of land and prices. Overall, the price change IS a good thing – it makes it possible for people to get their own sim more cheaply – which is good – and it had only a marginal effect on profitability since rents are typically linked to tiers (as opposed to setup fee), which did not change.

    Still, I have seen a number of large renters leave in the last six weeks – they have purchased their own islands and moved on, or have taken advantage of one of the Openspace sims to build their dream home.

    But, as you say, the basics of a free market are supply and demand – and the demand for land in Second Life, particularly as you say, land with added value, is still high. The vast majority of people cannot afford $1000 any more than they could afford $1675, and want to find a small place that they can call home or build their dream. So, in the end, I have shelved my plans for a withdrawl, and have in fact antied up and increased my holdings at the lower price – in effect doing some dollar cost averaging so that the average price I have paid over time for my islands has dropped – and in fact on the new ones, the “payback period” – the time it takes to recoup the setup fee – has dropped significantly.

    Your comments to the effect of “adapt or die” are spot on. I spent about 48 hours moaning and feeling sorry for myself, before seeing the possibilities that were opened up by the new pricing policies implemented in April. So, I have adjusted my plan – and have spent more time keeping my finger on the pulse of the land market. I had become complacent – my islands were mostly full and I had no reason to keep pushing the envelope to remain competitive. The new prices have simply changed things – not made them worse.

    In fact, it has been quite energizing – running a business in Second Life has always been about the challenge for me and not the money – I have never actually taken any money out of SL – just kept reinvesting and seeing what I could build.

    And it has taught me a lesson – one which I seem to have been quite slow to learn – that change is inevitable – and in the SL context, somewhat unpredictable. If I am not prepared to roll with the punches, then I should probably get out of the fight. I have to build a business based on the fundamentals of customer service, honesty, and sound financial management. Then, it has a fighting chance no matter what comes.

    dd