Why Online Ad Categories Are Won By New Entrants

In Silicon Valley, every startup fears than an established brand will one day acquire a rival or build a similar offering and instantly become the industry gorilla. When it comes to advertising, Google, which claims not only both the largest ad network and number of relationships with advertisers, but the most automated and profitable system on the Internet, is the most obvious example of this phenomenon. Ditto for Oracle and Cisco in the enterprise software space and eBay and Amazon in e-commerce.

Yet while fear of the 800-pound gorilla rightfully looms, upstart ad ventures can take heart in mounting evidence that suggests online ad categories are not cornered by deep-pocketed brands, but by new market entrants. This has held true across several different categories, including Google in search, DoubleClick in ad serving, Advertising.com in display, NexTag in CPA, RightMedia in exchanges and AdMob in mobile. Each of these companies emerged from humble beginnings to become billion-dollar businesses, and did so in the face of large, incumbent competitors. Additionally, a slew of other firms exited at valuations in the hundreds of millions of dollars, among them Overture (search), Atlas (ad serving), ValueClick (display) and Quattro (mobile), to name just a few.

So, what makes online ad categories so likely to be won by new entrants? History sheds some light:

First, on an economic front, online ad businesses exhibit clear network effects that ultimately preclude incumbents from contending in the category. When Advertising.com began to scale its network in the early 2000s, two trends emerged. As the company generated more leads for advertisers, the advertisers were willing to pay more per lead, and as it bought more inventory from publishers, they become more willing to accept lower per-impression CPMs. Per-impression ad-serving costs for DoubleClick and per-impression publisher onboarding costs for AdMob demonstrate similar network benefits. Each of these examples make clear that in online ad categories, new entrants grow so quickly that they effectively create a market dynamic in which slower-moving and less nimble incumbents simply can’t compete.

Second, on an innovation front, the classic innovator’s dilemma is unusually powerful in new ad categories because incumbents are hampered by legacy business models and technology infrastructure developed during a prior market development phase. When NexTag entered the education and finance lead-generation business, it brought with it a new model for buying traffic and valuing it on a per-impression basis based on advanced algorithms. Within a few years, NexTag’s internal media buying tools were so automated and accurate compared to the company’s predecessors that it was able to far out-pay for good inventory — and avoid paying for bad inventory at all. NexTag’s suite of media technologies put it at an advantage as the category grew and the cost of inventory rose, further enabling it to pull away from the pack and eventually exit for more than $1 billion. Incumbents often underestimate the importance of iterating early in a market, which means that as a category matures and the price of learning goes up, they find themselves falling behind.

Third, relationships with key inventory sources matter. On the Internet, there are millions of inventory sources, but only a few that can change the dynamics of the category. In search, it was the relationship that Google developed to monetize Yahoo search results. In display, it was Advertising.com’s entrenched relationship with the AIM client that enabled it to generate millions of dollars in profit from view-through conversions. And in exchanges it was the Yahoo partnership that solidified RightMedia as the No. 1 ad exchange. Incumbents seem more willing to give huge inventory opportunities to small, up-and-coming companies than they are to building out solutions internally. Such tight-knit relationships ensure the success of new entrants across the board.

The final lesson history has taught us is that focus leads to superior execution. Perhaps the least recognized but most valuable asset new entrants have is focus. In their respective times, Google was the best search engine, RightMedia was the best ad exchange and AdMob was the best mobile ad platform. Yes, incumbents often build a better product down the line (DoubleClick’s Ad Exchange is one example), but by that point the new entrant has already exited, as RightMedia did for $680 million. Incumbents know this fact implicitly, so it’s imperative that startups invest in and preserve their focus as they continue to grow.

The next generation of online ad categories is already repeating history. The key for investors and entrepreneurs is to identify which areas are going to be categories, not features, and get involved with them early.

Tod M. Sacerdoti is the CEO and co-founder of BrightRoll; follow him on Twitter at http://twitter.com/todsacerdoti. Disclosure: Brightroll is backed by True Ventures, a venture capital firm that is an investor in the parent company of this blog, Giga Omni Media. Om Malik, founder of Giga Omni Media, is also a venture partner at True.