[I really meant to write this in a longer post because it’s arguable and I like to argue. But while this is timely because of the excitement around Pokemon Go, I’m working on something else and only had a few minutes to put it down.
Not sure why I’m apologizing for not giving you another 25-page, massively footnoted post…]
I don’t believe virtual reality is a good area to venture invest. I do believe augmented reality is a good place to venture invest. There is a key distinction between the two in terms of the chokepoints in the value chain.
Every media needs several components to work: the medium itself, the content, content distribution, monetization, and content discovery. Each of these pieces has its own economics, depending on the medium. The different economics leads to a different propensity to be controlled by a small group of companies.
Note that by medium I mean here the means by which content is presented to the user. So the medium for a newspaper is the printing press and paper. The medium for the internet is the network, etc. By distribution I mean the means of getting the medium to the user, not the act of doing so. So record labels may have a distribution function, but iTunes and Amazon are the means of distribution.
The radio industry had radio sets as medium, radio shows as content, distribution through radio broadcasts, and branded networks to facilitate content discovery and sell advertising. The cost of broadcasting and the economies of scale of content discovery and ad sales meant that the radio industry quickly became dominated by the networks, who owned these things, and the content creators were usually poorly compensated. The radio sets themselves were subsidized to build the audience needed to create the economies of scale for the networks and radio manufacturing was a break-even business.
This model, similar to what later happened in television, would have been a bad place to venture invest. The networks were built by companies that already had complementary assets and, more importantly, the cash and political power to establish dominance. The winners did not need venture-type financing (as it existed then) and companies that did need outside financing were inevitably destined to go out of business.
The movie industry developed differently. In its golden age it was dominated by the movie studios, who were primarily content creators. (The movie theaters were the means of distribution, not the studios.) This is similar to the record industry through most of its history. But because of the disaggregated nature of distribution and monetization, movies and music could be made outside of the studio/label system and occasionally make money (the “indys.”) Whether these were a good bet for outside financing is arguable, but the odds may have been no worse than VC if you knew what you were doing.
The internet is, again, different. Because there wasn’t a single chokepoint in the value chain, opportunities flourished in all sectors. Startups made (and make) money in the medium itself (meaning, here, companies like Cisco and AOL), content distribution, monetization, and discovery. There was some dominance in distribution, discovery and monetization over content creation, and this lead to early concentration at discovery companies like Google and monetization companies like DoubleClick. It has also lead to a very difficult environment for content creators1
In analyzing any new medium, it pays to figure out the various pieces of the delivery value chain and which ones will have the ability to take whatever share they desire of the overall margin available. These will be the one that become the valuable players in that market.
Virtual reality’s value chain is going to be dominated by content creation. Somewhat like the movies and more like computer gaming. The cost of creating VR content will be high so content creation will economically dominate distribution and discovery. The high cost of creating quality content will mean that less quality content is created, allowing discovery through typical marketing/PR and word of mouth (like how movies are discovered now.) Because recouping the cost of high-quality content will require large audiences, VR headsets will need to be cheap. They may at first be subsidized, but will eventually be required by the content makers to be high-volume, low-margin hardware. Expensive, and thus scarce, content will tend towards the lowest common denominator (like console computer games) so risk can be managed through a portfolio approach (like music and movies.) This suggests that VR content will eventually be dominated by a few very large companies, and probably mainly companies that enter from adjacent industries (my bet would be on EA.)
There may be other uses for VR other than the mass media/broadcast model I describe, such as in business. But because the largest piece of the market will drive revenue in the rest of the value chain down, any other value chain that avoids the chockpoint but uses the other pieces will have very low barriers to entry because its suppliers will have no bargaining power. For instance, the creation of training films for businesses avoided the content creation chokepoint in the consumer media business and benefited from the lower cost of movie-making equipment and talent. But because these had been made plentiful by the mainstream industry, there was no way to build a big business in corporate film-making. Something similar will happen in VR.
Augmented reality is completely different. Because uses of AR will be more varied, content creation will be less expensive (because there will be no “arms race” to create the single work that everyone sees.) No single part of the value chain will dominate. I expect AR to be more similar to the internet in its evolution. Content may explode in popularity overnight and then fade, but there will be no winner-take-all in AR content. Because content will need to be less expensive to make, content tool companies will be needed. Because this will lead to more varied types of content, hardware makers will do well: the hardware will be tuned to specific customer needs and content will address more specific customer problems, so AR will be more valuable to a customer than VR. This will allow both hardware makers and content makers to have higher margins. Distribution and monetization may end up consolidating, but not necessarily through existing players.
If my reasoning is correct, VC investments in VR will end up doing poorly as startups are outcompeted by incumbents. The AR market, on the other hand, is wide open.
There’s an arguable point here about distinguishing between content creation and content discovery on the internet, and normally I would write several pages defending my choice but, luckily for you, no time. ↩