Roblox: Tweenage Mutant MMT-ers

Plus! The Gini Coefficient Bull Case for SaaS; Big Banks as Common Carriers; Yuan Bonds; In-House Chips; Understanding Consulting

In this issue:

Roblox: Tweenage Mutant MMT-ers

Roblox is one of the latest in a bumper crop of tech IPOs. (S-1 here.)  The product is a platform for building collaborative online games—think  of it as something akin to a modable video game whose usage consists  almost entirely of mods, most of whose audience is under 12 years old.  In Roblox, players control customized 3-dimensional avatars, which  interact in virtual environments—a small town, a school, a prison, a  pizza parlor, etc. Players pay to access specific locations, and pay to  customize their avatars and buy digital goods using an in-game currency  called Robux.

This is all thoroughly unsurprising to anyone who read Neal Stephenson’s 1992 novel Snow Crash. Snow Crash  imagines a future in which people interact in a 3-dimensional world  called the “Metaverse.” Roblox’s S-1 calls it a metaverse, too. Roblox  sells avatars; Snow Crash popularized the somewhat obscure  Sanskrit word “avatar” as a term for a digital representation of a  person. Here’s how Stephenson describes the social hierarchy of avatars:

Brandy and Clint are both popular, off-the-shelf models.  When white trash high school girls are going on a date in the Metaverse,  they invariably run down to the computer-games section of the local  Wal-Mart and buy a copy of Brandy… Her eyelashes are half an inch long,  and the software is so cheap that they are rendered as solid ebony  chips. When a Brandy flutters her eyelashes, you can almost feel the  breeze.

Of course, Snow Crash doesn’t predict everything. Roblox’s  model is to issue a digital currency, which users can spend by buying  experiences and avatars from each other. That model shows up in a later Stephenson novel, Reamde,  which centers around a video game whose revenue consists of  the FX spread between in-game gold and real-world currency.[1] That  model always struck me as a tad unrealistic; the game industry is  challenging enough when game publishers collect all the revenue from  selling digital goods. Could it really work if the gaming companies only  collected a rake on other players' sales of digital goods? It  implies a tricky Laffer Curve, where cutting taxes from their  traditional near-100% level creates an explosion of in-game activity.  That’s plausible in the real world, where there are plenty of real-world  activities that actually add value by satisfying human needs; in a  virtual world, the needs are entertainment and positional goods, both  notoriously challenging categories to get right. And it’s plausible that a tax cut would reduce the incentive to evade taxes, but catching tax evaders is easier in a game world where the tax collector is omnipotent and nearly omniscient.

And yet, Roblox gets it right. They reported revenue of $589m in the  first three quarters of the year, up 68% Y/Y. But their revenue  recognition materially understates just how much money customers are  paying. The company’s revenue recognition policy works like this:

  1. Accounting rules require them to report revenue only when a customer receives the goods in question. This is standard.
  2. Some of their digital goods can be consumed immediately (say, a  virtual pizza). Some can be used over long periods (a virtual hat). But  since every game on the platform has its own arcane rules, it’s actually  hard to tell which is which. What if the virtual pizza gives your  avatar virtual calories, and that particular pizza prevents your in-game  character from starving to death. Now the pizza is a long-lived asset!
  3. After what I can only assume were some very memorable discussions  between accountants and game designers, Roblox concluded that the only  appropriately conservative policy was to treat all of the in-game goods  as durables, and to recognize revenue over the expected time a player  would participate in Roblox, which currently averages 23 months.
  4. The net result of this is that Roblox gets money for its Robux  upfront, but only recognizes it as revenue over a two-year period  following each purchase of virtual goods.

This is insanely conservative. The real-world equivalent would be  Chipotle selling you a burrito, and recognizing 32.6 cents per month of  revenue from now until October 2022, starting only after you take the  first bite. It’s necessary, because digital goods are messy, but it  means Roblox’s GAAP revenue numbers are basically irrelevant. You want to look  at their bookings number, which was $1.24bn in the first three quarters  of 2020, up 171% from the same period last year. Bookings represent  actual money moving from players to Roblox; GAAP accounting, in all its  majesty, insists that this revenue should be recognized straight-line  ratably starting when the player exchanges Robux for a virtual dog or  something.

Robux are not just interesting from a revenue recognition perspective. They also make Roblox a unique economic actor.

The “platform as company” model is one that I’ve used before. Facebook operates like a government,  more specifically a giant city, with zoning complaints and local  interest groups. (Although it can collect much higher taxes than most  cities.) Google, Twitter, and Netflix have similar platform tradeoffs.  But reading the Roblox S-1, I’m struck by another political category: if  all of these companies are like countries, they’re all like emerging  markets, who have to use somebody else’s currency to purchase their  imports. Roblox is not the only company that offers a virtual currency,  but it is one of the few with key suppliers who accept that currency and then spend it directly on consumption. Here’s the crucial line from the S-1:

Developers and creators do not always cash out their  Robux to real-world currency. Some choose to reinvest their Robux into  developer tools, promote their experiences through our internal ad  network, or spend the Robux as any other user would.

This makes Roblox one of a tiny number of institutions globally that  can think in Modern Monetary Theory terms: it has a significant share of  its expenses denominated in a currency that it can print.[2]

Roblox is building something much more interesting than a gaming  platform aimed at kids: they’re building a genuine virtual economy.  Other online businesses are closer to a currency entrepôt, where money  flows in and out but doesn’t stick around. For Roblox, this means that  there are two high-level drivers of their long-term cash economics: how  much people spend on the game, and how much of that spending stays in  the game. This is a very interesting S-curve to ride: one thing online  games do is create a new status ladder; you can be a loser in real life  and a celebrity to a few hundred people online. And since Roblox is a  platform, not a game itself, it’s a way to manufacture those status games,  at scale. As the games get better, players get more invested in Roblox  relative to real life, and more of their Veblen-type spending happens  within the game.

This makes one of their strategic choices especially promising. As  they note in their risk factors, Roblox’s audience is extremely young  now, but they’re targeting an older audience over time.[3] This is not a  way to grow the TAM, but to keep up the existing Roblox userbase. An  app whose average user is 12 years old is an app whose userbase gets 8%  older on a like-for-like basis every year. In general, social networks have an easier time making  their userbase older than younger. In fact, almost every  medium seems to age over time (the median age of a TV viewer is 56; the  median age of a Facebook user is a little over 40; Snapchat’s seems to  be in the twenties, and TikTok is younger than that). New products tend  to have younger users, and as a company matures, its growth shifts from  active user counts and time spent to dollars spent per user.

Since Roblox’s developers are often users, and vice-versa, the  company has a built-in hedge. Older developers will make experiences  that appeal to people their own age, so the average target age of  Roblox’s offering rises right along with the users themselves.

Many software businesses get described at a high level as if they run  themselves. Facebook sets up a login page, and gives users some forms  to fill out, and suddenly there’s a Facebook. The sad record of Facebook  clones and social-for-X startups shows that this is much harder than it  looks; there’s a lot of execution and many product decisions between a  good concept and good execution. Roblox, to a greater extent than any  technology company other than perhaps TSMC (to be the subject of a  future Diff writeup), outsources the product question and  focuses entirely on making execution as seamless as possible for  external designers. This is a very hard system to bootstrap, but it  creates a company that pivots by default. The product as experienced by users is constantly changing; as long as Roblox can keep its servers running, it can keep collecting its cut.

[1] I have enjoyed every Stephenson novel I’ve read, and his books often address themes that overlap with The Diff. Cryptonomicon is probably the best of them, but Snow Crash and Diamond Age are a smaller time investment.

[2] Technically, loyalty programs also have this feature. They can  sell loyalty points for cash, and devalue them. What they can’t do, that  Roblox can, is pay suppliers in points that suppliers go on to spend at  zero marginal cost to them.

[3] The most interest risk they cite in the risk factors has nothing  to do with the external state of the business: it’s that their  programming language of choice, Lua, might get less cool over time.


The Gini Coefficient Bull Case for SaaS

Jason Lemkin points out that it’s hard to make money in SaaS at a price point under $10/month. As he puts it:

Yes, 1m users paying x $1 a month = a $12m ARR business.  But it is so, so hard to get 1,000,000 (!) paying customers in SaaS. And  it’s very hard to support them with any customer support or salespeople  at that price point. At $12 a year, how much can you spend on live  support? Or sales commissions? Or even hosting?

But it’s possible to reverse this argument: every product that lowers  the cost of sales, support, or hosting expands the universe of  potential SaaS companies. Some of these costs are close to fixed: it’s  hard to scale sales, for example, which sets a floor on some kinds of  products. But customer support can be scaled; some fraction of  it is inevitable, but some fraction is the entirely evitable result of  poor UI, bugs, or incomplete documentation. A hypothetical $1/month SaaS  product is not all that exciting as a business, even if it does scale  to millions of customers, but it does get more possible over time. And  the large rewards earned by a relatively small number of SaaS companies  at high price points implies that there’s a larger set of hypothetically  possible ones at lower prices.

Big Banks as Common Carriers

For a subset of controversial industries, including firearms,  cannabis, and some kinds of media, one of the major risks is losing  access to banks. Bank of America, for example, stopped doing business with some gun companies, and more recently some banks have pulled away from fracking. (That particular moral judgment is much easier to make with WTI at $43.)

A proposed rule from the OCC  would require large banks to have quantifiable rules for which  customers they work with and which they turn down. Large companies, I’ve  noted before, suffer from superlinear PR risk: the bigger they are, the  more likely they are to do something unpopular, and the more likely it  is that any given unpopular thing they do will be newsworthy. A rule  like this would set a new schelling point. It’s a rule with some serious  negative side effects—there are valid qualitative reasons for a bank to  work with some customers and not others, and it’s not as if their  entire business should be replaced with a series of Boolean statements.  But such a rule would allow some peripheral industries to access more  capital (and be a pain for Silvergate Capital, a bank that trades at  almost 2x book value because it specializes in working with the digital  currency startups other banks are reluctant to take risks on).

Yuan Bonds

Saudi Aramco is considering issuing yuan-denominated bonds ($, Nikkei).  I’ve written before that dollarization is contagious: a company that  sells its product for dollars (such as almost any commodity producer)  wants to denominate costs in dollars, too. Otherwise it has currency  risk. So the suppliers to commodity producers price in dollars, and they  deal with their suppliers in dollars, and so on. When margins  are thin, more risks are existential. Saudi Aramco does not have thin  margins, though. In 2019, the company’s revenue was $330bn, and reported  net income was $88bn. However, they paid $49bn in royalties and $90bn  in income taxes, mostly to their controlling shareholder, which is also  the entity that sets those taxes. So Saudi Aramco’s real pretax  income is more like $227bn, giving them a 69% pretax margin. That’s a  big enough buffer that they can afford some volatility.

Saudi Aramco is unusually willing to accept the currency risk of yuan  bonds, and has unique incentives, but that’s how such shifts work: at  first, they require a unique set of circumstances, but every time those  circumstances obtain, the next company to consider non-dollar financing  has slightly more reason to.

In-House Chips

Mule of Mule’s Musings has a great piece on big tech companies' chip efforts.  Apple, for example, has been ramping up R&D spending in absolute  dollars and relative to revenue (2011: ~$2b/2.5%; 2020: ~$18bn, almost  7%). One way to read this is that advances in hardware are increasingly  driven by specific demand, which can only accurately be measured by  companies that sell tightly-integrated products directly to end users.  At the height of Moore’s Law, chip companies could be indefinite  optimists, who knew that the next generation of hardware would coincide  with the next generation of software that required it. Now, Amazon is  designing chips for cloud computing, Google for machine learning, and  Apple is offering (giddiness-inducing) chips for its own laptops.

Understanding Consulting

Last week, I wrote about how lower business travel will affect consulting companies,  and a few readers with experience in the field reached out. One  particularly interesting bit of feedback was from Aaron Renn, who sent  me his tyranny of the org chart piece on the real function of consultants:

When you occupy a box on an org chart – in a company, a  government, etc – or a known position inside a social structure,  everything you say or do is seen through the lens of that box. If you  are a middle manager say, what are the odds that you can even get access  to the CEO, much less have the CEO act on your ideas? It doesn’t seem  likely.

Consultants, by contrast, exist outside the org chart. To steal a  phrase, they stand behind a “veil of ignorance” about their status in  the hierarchy. Consultants take great pains to maintain this, which is  one reason why consultants have such nebulous, generic titles. It’s to  disguise the fact that the “partner” consultant is actually middle  management in his own firm. This enables even top level executives in  large corporations to engage with the consultants in a totally different  type of way.

Large organizations have powerful economies of scale, but the  hierarchy that makes those organizations possible also makes it hard to  transmit information to where it’s most needed. (The companies that are  famous for having a flat org structure tend to be relatively small, and  they also tend to have a very high bar for hiring.) In this view,  consultants exist to subvert the status system long enough to share  information, but not to overturn it completely. In other words, they’re  not just paid to show up. They’re also paid to leave.