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February 21, 2007

It's The Contract, Stupid

There's a great old story about Bob Metcalfe - the inventor of Ethernet, founder of 3Com, and former employee of Xerox PARC. It goes like this.

One day, Metcalfe invited a bunch of young, college-age electrical-engineering types (young Bobs, basically) over to his palatial Valley estate, which is all Roman columns and high ceilings and Sub-Zero freezers and Koi ponds. The geeks, of course, are doing what normal people do in these situations - they're standing, slack-jawed, staring around at the opulence and trying not to remember that their beat-up '86 Hondas need a new fuel pump sometime soon. One of them, sufficiently awed, says, "Wow. So this is what you get when you invent Ethernet."

Metcalfe, standing nearby, says, gently, "No. This is what you get when you sell Ethernet."

I love this story for a lot of reasons, but mostly because it's a great reminder that, at the end of the day, technology is a business, and businesses must sell. Successfully bringing a product to market is as much about the product attributes/engineering as it is about how the product is brought to market - the customer segmentation, the message, the distribution channels, the partners, the pricing, the deal.

And at the core of every deal is a very, very good contract.

Bob Metcalfe understood this, and worked his tail off to ensure that Ethernet became the standard in the industry. His house (and his yacht, and his New York apartment, and his jet, and his small island in the Bahamas, yadda yadda) was the prize for making "the deal" happen by hook, crook, or skin of teeth.

Most big fortunes in the tech industry have been made because of superior dealmaking, rather than superior technology. The classic example, of course, is the deal Microsoft cut with IBM in the early '80s that licensed their (arguably technically inferior) MS-DOS to Big Blue for inclusion on the IBM-PC. The popularity of the PC ensured a nice chunk of direct revenue for Microsoft, but the fortune was made on one particular quirk of the deal - namely, that Microsoft would retain the rights to DOS, and was allowed to sell it to other firms. So when the PC clones arrived courtesy Compaq, et. al., well, Microsoft sold to them, too, and thus became the industry standard for the next 20 years.

To repeat: it was the deal, not the technology, that provided that first fortune. And in contracts, knowing what to ask for, and why, is huge. It's the ball game. It's knowing what you can give up, and what you have to hold fast on.

Flash forward to 2003. Apple unveils the iTunes Music Store, bearing (a whopping) 200,000 songs for purchase and download. While other online music stores existed before iTunes, none of them had serious traction in the marketplace, largely due to the bizarre/capricious pricing and licensing terms their purchased songs came with. Some songs might cost $0.79 per, but only be playable on a single PC, and not permit CD burning, other songs might cost more, and have more rights - e.g., burning but no portable music on one, portable music and sharing on another (but no burning). Consumers were, therefore forced to become very informed as a prerequisite to purchasing music, and, unsurprisingly, many chose not to buy in the new medium.

The iTunes Store, conversely, benefitted from a simple, direct value proposition to its customers: all songs $0.99, all songs playable on several computers, all songs burnable to CD a certain number of times, all songs playable on the iPod. This was not a technical innovation, but a contractual one - Apple deftly navigated the record industry, secured what they needed to make the iTunes Store successful, and drove that value deep into the market. Today, the iTunes Store is the undisputed heavyweight champion of the online music marketplace, aided, in no small part, by the fumbling of its rivals as they sought to get similar contractual terms for their own customers.

Again: the deal, not the technology, provided the fortune. And again, Apple knew what they needed to stand firm on - and where they could give - to write a very, very good contract.

I mention all of this as a preamble to the larger point of this post, which is about the contract Apple and Cingular struck to bring the iPhone to market. Back when the iPhone was announced, I commented in my post ("The Sound Of The Starting Gun"):

The Apple/Cingular contract is pretty interesting to me. Apple agreed to give Cingular exclusive carriage of its phones in exchange for design freedom. This, too, is huge. Historically, phone makers like Motorola and Nokia have designed cool features into their phones (WiFi, Bluetooth, PC syncing), only to have them stripped out or crippled by mid-level managers at Verizon, T-Mobile, et. al. because those features were perceived to be competing with some ridiculous service that the carrier wanted to sell to the consumer.

As details of the contract have come to light, it's clear that Apple has done something rather unprecedented (in a contractual sense): They have wedded themselves to the Cingular network in exchange for the unfettered right to make the phones they want to.

I predict that, for as cool as the iPhone is (and it is very, very cool indeed), the real home run for Apple will be in this contract. Apple has, with the stroke of the pen, given itself the kind of competitive advantage that no handset maker had been able to secure before now. Apple now has an enormous amount of flexibility and control over its fledgling handset business, and is free to make and sell the kinds of phones it wants to, without needing to go through traditional gates and channels. This will speed innovation in the market (barriers to innovation have been removed), but it will also give Apple a rather remarkable head start in designing - and selling directly - iPhone v2, v3, and so on.

Nokia, Motorola and others will surely be demanding deals from the carriers similar to "the one Apple got" but it's unclear what their leverage is to obtain it. And without such leverage, it's hard to see why Cingular, T-Mobile, Verizon, et. al. will feel the least bit inclined to change their relationships with other handset makers. If the iPhone is a hit, then, yes, Verizon will feel the need to respond by loosening up the reins a bit ... but by then, the iPhone brand will be established, the phones themselves will be popular, and the other phone makers will have an enormous burden to explain to consumers why they ought to be purchased in lieu of an iPhone. In many ways, it's the music space all over again.

It's fascinating to watch an organization learn from its past mistakes (namely, the failure to protect the Mac GUI) so visibly, and so vibrantly.

As Metcalfe might say: "it's the contract, stupid." And the cell phone business never felt so exciting.

Posted by Gavin Shearer at February 21, 2007 10:06 PM. Posted to Apple.

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