The Aftermarket Economy

Insights February 7, 2012

So Facebook filed its IPO papers, and the numbers are eye-popping.  The company appears to be worth about $100 billion, or a bit more than the GDP of Tunisia.  Others shade it a bit lower, but one thing is certain: it’s good to be Facebook.


Facebook is special because, in network economic terms, its product is a platform, and successful platforms are few and far between.  For all its bells and whistles and features and privacy policies, Facebook remains—at heart—a place that people hang out.  As the proprietor of a popular hangout, Facebook gets to write the rules guiding all the folks who think it’s a good place to pitch their businesses or to make some sales.  In network economic terms, these businesses operating inside Facebook’s business comprise an aftermarket.

In a very real sense then, Facebook operates as a private-sector regulator of a vibrant commercial marketplace—the Facebook aftermarket.  Vendors in this marketplace develop and launch “apps,” literally software applications that run atop the Facebook platform.  Facebook has a symbiotic—and asymmetric—relationship with these Facebook app companies (or FBapps).  The symbiosis is clear: the more people who like Facebook, the bigger the potential audience upon which each FBapp can draw; the better the FBapps, the more popular Facebook will become.  The asymmetry is equally clear: each individual FBapp needs Facebook more than Facebook needs it.

The single most successful FBapp provides the clearest illustration of this asymmetry—and perhaps the single best justification of Facebook’s value.  Zynga created a suite of wildly popular social games running atop the Facebook platform.  Zynga worked hard to launch its games and to build a following.  To generate revenues, Zynga decided to sell game credits to its players.  That idea succeeded; players showered considerable real dollars on Zynga in exchange for those game credits.  Zynga excitedly projected its revenues forward and developed business plans capable of making investors salivate.

Investors were not the only ones to notice, however.  Facebook also noted Zynga’s success, and asked for a piece of the action.  Zynga demurred.  So Facebook announced that anyone selling credits inside an FBapp must sell Facebook credits—which, by the way, carry a 30% commission.  What did Zynga do?  The answer is in Facebook’s IPO filings: commissions from Zynga’s sales of Facebook credits generated $445 million in 2011 revenues for Facebook, or roughly 12% of Facebook’s total.

This story contains some key lessons for the modern economy.  First, it’s good to be a platform.  Second, aftermarket players need to pay closer attention to their platform providers.  It’s easy enough to cast Facebook as the villain in this tale—the larger company preying on its smaller symbiote—but that characterization misses the point.  Facebook worked hard to create an attractive platform.  Facebook let Zynga come hang out with a couple of hundred million of its closest friends.  Facebook handed Zynga a sizable potential customer base.  There’s no question that Facebook deserved some compensation for this work.  The only real question, then, is how much compensation Facebook deserved.

Anyone who understands and appreciates markets knows the answer to that question, too.  Facebook deserved whatever it could negotiate with Zynga.  From a consumer standpoint, as long as both Facebook and Zynga retained enough earnings to stay in business, the details of the negotiation are irrelevant.

Still, it’s hard to hear this story without concluding that Facebook played its hand very well while Zynga played it poorly.  By all public accounts, Facebook caught Zynga by surprise.  Zynga developed its entire business model and revenue projection unaware that Facebook could erode 30% of it overnight.  Why?  While it’s hard for an outsider to know, the most likely answer is also the simplest: fast-growing startups are understaffed, and they can’t see everything that might come their way.  Zynga’s attention was likely focused elsewhere, and Facebook exploited a blind spot.

That blindness should serve as a cautionary tale.  Today’s tech sector is dominated by aftermarket players—software and hardware developers toiling on applications or add-ons dependent on someone else’s platform.  Relationships between platform owners and the players in their aftermarkets can be tricky.  Rules governing patents, copyrights, antitrust, unfair competition, encryption, and circumvention all come into play in curious ways.  Strategic negotiations and contracting can all play critical roles.  And as the folks at Zynga can attest, getting caught blind can cost you a half billion dollars a year or so.  After a while, that sort of money can add up.

Welcome to life in the aftermarket economy.