Distribution Is King

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Let me tell you about the smartest quote I’ve heard in the last year: “Content innovation grows audiences, and distribution innovation creates enterprise value.”

What does that mean? It’s tempting to think that the stuff we make, the products and content we spend our days delivering, is what makes a company valuable. There’s a reason that "content is king" has been a defining mantra of the past decade. Surely, if you make the coolest product, you’ll produce the most valuable company. But this isn’t as true as you might think. Long-term enterprise value—that is, building a big-ass business—is only possible by having a differentiated way of getting that great product to a customer. The channel through which users receive and access content matters most.

This argument comes from investor and former Benchmark Capital partner Mitch Lasky, and it’s been ping-ponging through my mind for months. Every financial document I read, every analysis I write, Lasky is in my head reminding me about why a company becomes valuable. It’s distribution, stupid.

Lasky is one of the greatest consumer investors of all time with a portfolio that includes Discord, Riot Games, and Snap. Much of his career was focused on video games, a submarket of the tech industry that I’ve found often precipitates broader trends. Nearly every consumer innovation you come in contact with, in one way or another, owes its lineage to some video game company’s innovation in content, pricing, or go-to-market strategy. Nvidia built graphics chips for video game rendering, Slack started as a video game chat system, and that 30 percent fee that Apple takes from developers partially stems from mid-1980s agreements between Nintendo and Pac-Man creator Namco. 

Lasky teamed up with fellow investor Blake Robbins to host a podcast called GameCraft, which takes distribution innovation as its core idea and shows its efficacy at driving the last 40 years of gaming. This piece mostly draws from episode 14, “Distribution.”

His thesis was good enough that I think it can be applied to all bits companies: software, content, marketplaces—all of them mirror video games. If you want to know how to make your startup valuable, you should learn and apply the lessons of the video game industry.

Mind the toll

Lasky argues that distribution means “the totality of costs that exist in between getting the finished product in the hands of the developer and the playable product in the hands of the consumer.” Distribution is not just a marketing cost; it is a series of choices around pricing, packaging, and a myriad of other things that interconnect on how you get your product in the hands of customers.

He uses a metaphor of a network of roads connecting developers and consumers:

“As content moves along a particular pathway through that network, that movement has an associated cost. There may not be an explicit toll, like, for example, distributing through the iOS App Store, where you know going in that you're going to pay 30 percent. But, regardless of what pathway you take, there's always going to be a cost.“

For founders, it is tempting to assign distribution as the purview of a company’s “growth” department. After all, sales and marketing generate the demand—that’s their job! It is especially tempting because that is how financial documents are designed. Marketing costs are legible, platform fees are obvious. A CFO prepares a spreadsheet each month where you can see how much you spent on ads. But this bucketed thinking is a disease.

To make matters worse, investors are super-spreaders of this ideology. They also perpetuate this fallacy by simplifying your business into ratios like LTV/CAC. Metrics are important and useful signals. However, by assuming that the payback period for acquisition costs are all you have to account for to grow a company, you forget the whole point of a startup, which is to make something people want.

There’s a better way to think about distribution. Novel product usage patterns? That’s distribution. New pricing models? Also distribution. Building social sharing into the core workflow loop of your app? Distribution. Expanding the capabilities you put into the distribution capability bucket allows for founders to be more innovative.

This is also true for costs. Distribution isn’t simply what you pay Meta for ads; it is the opportunity cost that comes from picking a certain channel:

“It's not only the value in monetary terms for cost. Sure, it’s the 30 percent of revenue that you have to pay to Apple. But when you go on [the video game platform] Steam, you're making a choice about your control over the customer, your access to certain kinds of information, and your ability to communicate directly with the customer.”

Digital media companies have been learning this ugly lesson for the past four years. Firms like BuzzFeed chose to build distribution mediated through social media platforms. It worked for a while, giving it access to enormous scale quickly. However, its choice to rely on platforms like Facebook also took away crucial forms of customer engagement. In reality, the audience was borrowed from those platforms with relatively little demographic information (hurting its advertising effectiveness), and the company captured few direct lines to its readers, such as email addresses. While BuzzFeed once had a $1.5 billion private valuation, it went public, shut down its news division entirely, and is worth a measly $55 million today.

As go video games, so goes software

In the 1980s and nineties, video games were physical cartridges and disks distributed through retailers. A kid might beg his parents to go to Best Buy, buy the latest Mario game, and go home to play.

The margins looked something like this:

• A retailer would sell a game for about $50.
• Of that, the game’s publisher might receive $40. 
• Distributors like Ingram Micro would take a cut of about $15 from the publisher to ship the game to a retailer.

Assuming no additional marketing costs, every time a video game was sold, a publisher would end up with roughly 50 percent of the advertised price, or in this case, $25.

To make it even worse, that was just the publisher's cut! If you were a developer studio partnered with a publisher, then a developer may end up with as little as 10 percent of the listed price. The actual labor that creates the game walks away with basically nothing.

The companies that got big back then, like Activision and Electronic Arts, had great games, but they won because of distribution innovation. They “built their own distribution system so that they didn't have to rely on the expensive services that Ingram Micro would provide,” Lasky said. “Instead, they would do it themselves.” Activision hired an army of package packers and salesmen. Even with all the overhead, this distribution system lowered the cost from the 14-or-so percent a distributor would take down to single digits. Calling back to the invisible costs that permeate distribution choices: It turned out that building their own distribution arms also allowed them to bundle games at retailers. If Best Buy wanted to stock the latest FIFA game, it would have to also leave shelf space for Electronic Arts’s newest experimental franchise.

A similar story played out with enterprise software. Microsoft built impressive software, but it won because it found cheaper ways to get its software directly into the hands of users. Microsoft initially convinced IBM to subsidize its building an operating system, MS-DOS, and as part of that agreement, the former were allowed to sell the operating system to other computer manufacturers. Microsoft then struck pre-installation agreements with most personal computer manufacturers, allowing it to skip retail distribution entirely.

When video games went from physical disks to digital platform publishing, a nearly identical evolution occurred. In comparison to the 10 percent margin a video game developer might get by teaming up with a publisher, working directly with the platforms seems like a relatively good deal. Most app developers only have to give 30 percent of their revenue to Apple or Google or Steam (an online game store founded in 2003), and they can cut out all of those middlemen. The cycle goes something like this:

• A new platform has a highly qualified audience with high price tolerance and a propensity to pay.
• There is relatively little competition.
• Developers and users flood the platform, ascribing more value to the discovery portion of distribution.

The original 30 percent fee—whose value once included the totality of distribution—now only covers the end transaction point, not the discovery along the way. Marketing costs creep back in, and search ads replace shelving fees (i.e., paying retailers for placement in the most visible parts of shelves). It’s still a better deal for some content creators, but it isn’t a long-term way to build enterprise value. Saying your distribution strategy is to list something in the App Store is the equivalent of, in the nineties, walking through the Mall of America shouting out the name of your video game.

Once a platform shifts from the role of curator to distributor, the take rate will stay the same, but the value offered to suppliers on the platform will be ever-less.

The race is on for network effects

Disrupting digital giants is incredibly challenging. The clearest example is the struggles of Epic Games against Steam. Steam is like a games-focused App Store. Gamers can build friend lists and purchase video games, and the platform charges a 30 percent fee to video game publishers hoping to sell through its marketplace.

In 2018, Epic, which makes Fortnite, decided to launch a direct challenger to Steam. Remarkably, it only had a 12 percent take rate—60 percent lower than Steam’s 30 percent. For developers who built their games using Epic’s Unreal Engine, a video game creation system, Epic Games Store also dropped its additional 5 percent revenue take rate from that software, resulting in gob-stopping levels of savings for a video game developer willing to leave Steam for it. To further juice the store, Epic subsidized the demand side with free games. 

Still, that wasn’t enough. Despite the savings for suppliers, both developers and users still overwhelmingly prefer Steam. Steam has roughly 50,000 games on its platform, while Epic’s store only has about 2,000 as of 2022. Epic has yet to turn on a profit on the platform while Steam is making hundreds of millions per year.

Two-sided network effects, where the greater the supply, the more demand-side benefits there are—and vice versa—are so powerful that all of that isn’t enough to take Steam down. Just like how social media platforms are more valuable to users and advertisers alike when more people and developers use it, the same is true for video game platforms.

Distribution innovation is about taking advantage of market arbitrages—places where you can profitability acquire customers—and building network effects as quickly as possible.

In 2004, soon after Steam launched, its parent company Valve made an enormously popular series of games called Half-Life, available exclusively on Steam. Even if you bought a disk of the game at Best Buy, you still had to download Steam. While the company wasn’t the first to pioneer exclusive originals as a growth strategy, it was among the first to do it in order to build an online store. That original seed in 2003, coupled with 15 years of compounding network effects, forced Epic to sacrifice hundreds of millions of dollars to try to compete.

This is why platform shifts are the most important moments in tech. The transition from physical distribution to internet distribution set Steam up for decades of profit. Similar dynamics occurred in enterprise software, where the companies that owned the cloud transition (like Adobe and Microsoft) thrived, while others were unable to make the jump (Cisco, IBM, etc.). 

Distribution is all you need

We sit on the precipice of multiple platform shifts. In hardware, there are new AI-driven devices like Humane. Elsewhere, the Apple Vision Pro mixed-reality headset represents a remarkably different capability. In software, I believe that large language models and generative AI may be one of our most significant inventions ever.

It is the most exciting, dynamic time in my entire career. The world is changing fast. Think of a technology paradigm shift like a massive volcano erupting. The landscape changes, and new mountain peaks appear. Sometimes the giants of the old world can neatly transition, sometimes they can’t.

But in this new world, the temptation is to get overly focused on building something cool with flashy tech. Mostly, because that’s the most fun! Very few people get their jollies debating the efficacies of pricing strategy. Lasky taught me that while great product and great content grows audiences, the companies that ultimately conquer industries are those that know that distribution is king.