Why being a broker is a fool's errand

Mar 05, 2014

Table of contents:

1. How the internet is changing things
2. The disruption opportunity in commission based industries
3. The hubris of the incumbents
4. Examples of the destruction of commission based industries
5. How to disrupt a commission based industry
6. Conclusion

One of the most powerful characteristics of the Internet is that it is dramatically lowering the barriers to entry into thousands of incumbent industries. This is an amazing opportunity for a plucky upstart because they are many industries that enjoy massive profit margins for services, simply because they have been historically unchallenged.

By targeting the right opportunities, in the right industries with the right product and business model, you can very quickly disrupt incumbent companies that simply will not be able to compete at your much lower cost structure.

This is classic disruption theory 101, and it is happening all around us. In this post I’m going to be looking at this opportunity, exploring some industries and companies that have already seized this opportunity, and looking at how you can do it too.

How the internet is changing things

Unless you have been living under a rock for the last 10 years, you will already know that the Internet is killing or completely transforming entire industries.

Whilst many people argue that the Internet won’t disrupt their industry, it is clear to me that it will eventually contaminate all industries in one way or another. By this time, it will already be too late for the incumbents.

I believe that the Internet basically has four major impacts on traditional industries. Whilst there is of course more specific factors in each industry, and some things have a bigger impact than others, I think the following four signs show that an industry is being disrupted:

1. No gatekeepers

The first big thing is that there are no longer gatekeepers for talking to customers or the potential market. If you think of the Internet as broadly a system for communication flow, the distributed and decentralised nature of the Internet has destroyed any strangle hold incumbent companies had on talking to the market.

When there are no gatekeepers, all participants have an equal opportunity to talk to customers and make them aware of their products or services. Gatekeepers tightly control this flow of communication and so they protect their own self interests.

This is of course much better for the market because the customer has access to a much broader array of products and services to choose from.

2. Broadcast to two way dialogue

Before the Internet all media was broadcast. Television, newspapers, advertising and corporate to customer communication were all a series of one way messages with no feedback mechanism for the customer to raise their voices and be heard.

Of course, with the rise of Social Media, customers now have a platform for talking back to corporate entities, but also more importantly, engaging with other customers of a product.

Whilst this is threatening to incumbent companies, new companies who embrace two way dialogue are using it as a competitive advantage over their traditional rivals.

3. Customer acquisition

For the last hundred years, customer acquisition was centred around big advertising budgets, national marketing campaigns and very little in the way of actual quantifiable Return on Investment.

The Internet has of course completely changed that and so those techniques are becoming increasingly less relevant.

Marketing budgets can now be priced to the penny of the market demand and there is a constantly growing set of intuitive inventory that can be highly targeted to your chosen demographic.

Also, with very simple tools, all marketing campaigns can be tracked, analysed and optimised to increase performance.

Whilst big budget marketing, and national campaigns are still a long way from being dead. Surely it is only a matter of time before the transition tilts in the favour of the Internet.

4. Distribution

And finally, distribution is one of the most important characteristics of the internet. Whilst many see the Internet’s power in simply moving bits on the wire, the change is much bigger than that.

As more companies look to create additional value on top of existing industries as a differentiator, or mobile technology infiltrates and democratises the power of incumbents, I think distribution will finally be recognised as one the most influential changes that the Internet brought about.

If you are unfamiliar with the exact definition of disruption and how it actually plays out in real life, have a read of my post How to find disruptive opportunities before continuing with this post. Understanding exactly what disruption is and how to spot opportunities will be a valuable skill when you begin to start analysing the structure and opportunity of incumbent industries.

The disruption opportunity in commission based industries

Commission based industries are notorious for having extremely fat margins because they hold a level of power over the consumer without really providing a tangible benefit.

Commission based industries are where you have a broker who sits between the supplier and the customer. The customer can’t speak to the supplier directly because the broker withholds information in order to protect their position.

The broker will deal with customer enquiries and attract new leads and then pass them on to the supplier for a healthy commission.

Brokers are basically unchallenged for the most part because they have traditionally held a position of power over both the customer and the supplier. The broker’s position is to withhold information from both parties in order to maintain and strengthen both party’s dependency on them.

The brokerage business has been around for a long time. This is because communication between a customer and a supplier was difficult. Customers did not have unlimited information at their finger tips and suppliers did not have a frictionless way to communicate directly with their target customers.

In many ways the Internet is the first direct threat to the incumbent brokers and their fat unnecessary margins.

The hubris of the incumbents

The idea that the Internet is killing commission based industries is certainly not a new one. For a long time the Internet has slowly been eating away at brokerages as they are forced to transition online.

Many traditional brokerages have indeed moved a lot of their customer facing services online. It’s now very easy to get a quote online without having to talk to a sales person.

However, the underlying problem of the unnecessarily high cost structure has not gone away. The brokerages are able to lower their costs by moving online, but they are reaping the rewards, not the consumer.

Many brokerages feel like they are ahead of the game by moving online. By having a website that can generate quotes or a mobile application for consumers they feel that they are embracing technology.

However that is not what this is all about. The real change is the destruction of the cost structure, not what type of website you have. The fact of the matter is, it is not the technology that is important, it is the business model.

Examples of the destruction of commission based industries

There are many exciting Internet first companies that are embracing the idea of the destruction of the incumbent commission based industries.

These companies have many of the same attributes.

1. They open the communication between both sides of the market
2. They reduce or remove commission
3. They provide better services for the consumer

Robinhood

Robinhood is a 0% commission stock trading platform that is built to be mobile first.

Stock trading is a classic example of the power of a brokerage over the customer. Trading stocks is something that is not exactly consumer friendly and so for a long time brokerages have held a position of power.

Stock trading brokerages make money when you make a trade. This commission can often be upwards of $10 per trade. This makes trading stocks economically unviable for consumers who want to get their feet wet without having to invest large sums of money.

Robinhood is destroying this incumbent industry by allowing anyone with an iPhone to set up an account and start trading straight away. With 0% commission, consumers are free to start trading small volumes of stocks without having to pay a hefty toll to the gatekeeper.

Robinhood is an example of how to build a software first product and forget about the high cost structure of sales people, offices and expensive marketing campaigns.

Makersrow

Makersrow is a directory of factories across America that can be used to allow new businesses to create their products without having to go through the expensive brokerage system.

Traditionally, if you had an idea for a product and you wanted to work with a factory to have that product created you would need to speak to a broker who would put you in contact with a factory who could meet your needs. This would add a big commission to your overheads and would often mean that you couldn’t get your product manufactured domestically.

Makersrow is changing all of that by providing an online directory of factories and reducing the cost and friction of connecting makers with factories to close to zero.

This has totally destroyed the back room deals of brokerage firms who would charge a significant commission just for connecting both sides of the market.

Makersrow is an example of how the Internet has brought the cost of communication to zero. By removing the friction and opening up the communication to the world you can massively reduce the cost to the consumer.

Wealthfront

Wealthfront is an internet first investment company that allows to you invest your money without the high management fees or the huge account minimum required amount.

This is made possible by utilising software and the Internet to remove the need for account managers or high fixed costs.

Wealthfront is bringing the opportunity to invest in a better future for the 99% of people who are unable to be apart of the traditional investment industry. Investment companies can make significant commission from high net worth individuals purely from that fact that their industry is shrouded in secrecy.

Wealthfront does not charge commission and can manage an investment of $100,000 for less than $20 per month. If you invest less than $100,000 the cost also dramatically falls. If you invest $5,000 you will pay nothing at all.

Wealthfront is an example of a company that can take a commission based industry and completely change the economics of how it operates.

The Resumator

The Resumator is attacking the incredibly high margin incumbent industry of recruitment.

A recruitment company will basically act as a gatekeeper to source and recommend applicants for a company. However both the applicant and the company are forced to be kept in the dark so that the recruitment company can protect it’s position in the middle.

This is a negative for both sides of the market. The applicant does not find out important information about the company they are applying to until after they have invested their time into applying. The recruiting company does not know where the recruiter is sourcing the applicants from and what they are doing to find people to apply.

The job of the recruiter is to source candidates and organise the communication and filtering process for the recruiting company. The recruiter will usually take a 10% commission of the first year salary of the chosen applicant.

The Resumator allows a company to set up their own recruitment channel to source applicants. Those applicants are then managed through the funnel from first contact, through the interview and to the job offer. Through the process the recruiting company can manage and organise their own recruitment without having to consult with a third party.

Recruiters hold a position of power because hiring companies feel that they do not have the reach or processes for sourcing and hiring new employees. The Resumator has taken the activities of recruiters and productised them into a low cost product. Instead of paying a 10% commission, The Resumator allows you to handle the entire process using very simple tools and software.

By removing the recruiter, applicant’s benefit by knowing more about the company they are applying for and companies benefit by being able to remove the high cost dependency of another company.

The Resumator is an example of a company that has productised the activities of a broker to remove them from the equation altogether.

Homepolish

Homepolish is a company that is connecting interior designers with consumers who want to decorate their home.

Hiring an interior designer has traditionally been out of reach for the majority of home or small business owners. Homepolish is looking to expand the number of accessible interior designers and increase the number of people who hire one by removing the friction and high cost structure and processes that have traditionally plagued the industry.

Homepolish has switched the commission based industry to a pay by the hour business model. This removes the incentive for interior designs to only go after big budget projects and has dramatically opened the market for people with smaller budgets.

Homepolish is an example of a company that has moved a commission based industry to a different business model to incentivise the supply side and make it more accessible to the consumer side.

How to disrupt a commission based industry

So what can we learn from the examples that I have given above? I think there are basically 5 common characteristics that we can take from the companies I’ve highlighted in this post that are important for disrupting a commission based industry.

Software not people

As I mentioned at the top of this post, the really big change that the Internet is enabling is a dramatically reduced cost structure. In order to slash the cost of an industry you need to replace the traditional employees of a company with software. This mean you remove layers of unnecessary management, fixed costs and inefficient processes with software that runs in the cloud and enables ubiquitous access on any Internet enabled device.

Communication should be free

A big part of commission based industries is that the broker stands in the middle of the flow of communication. This allows the broker to justify their commission by being a roadblock in connecting both sides of the market.

The Internet makes communication free, instant and easy. You should remove all roadblocks between both sides of the market so that they can communicate between each other easily. You should be the connector, not the method of communication.

Remove commission

The traditional cost structure of brokerages revolves around taking a big commission for each transaction. When you remove the high cost structure of traditional offline business and you remove the cost of communication you can dramatically cut the cost of commission or remove it altogether and still be in a much stronger position than any of the traditional incumbents.

Productise a service

Inefficient processes and services should be productised into reusable software and tools that can be given to the consumer to further cut the cost structure. Running software in the cloud is essentially free whereas employing someone to do that same job manually is a very high fixed overhead.

Remove friction

By moving a business online you can remove a lot of the friction of purchasing or using their products and services. Websites offer the convenience of usage in your own home 24 hours a day and mobile applications can simplify and allow that same experience to be taken with you at all times.

Dealing with paper forms, telephone calls and costly in-person meetings are relics of the old world.

Conclusion

Being a broker in 2014 is not a very good business to be in. The period of withholding information from your suppliers and your customers is well and truly over.

The Internet has had some dramatic effects on a number of different industries over the last couple of years. One of the greatest impacts of the Internet has been the dramatic reduction in the cost of communication and the huge new wealth of information that we now have at our finger tips.

Brokers can no longer be the gatekeeper between the customer and the supplier. The tyranny of this relationship has now ended.

Many existing brokers will attempt to transition their high cost structure to the Internet. The ones that do will enjoy a brief period of calm as they believe that they are ahead of the curve.

However the existing high cost structure of these businesses are simply unmaintainable in the new world. Whilst many will think they have survived the transition, one day they will wake up to their new competitors.

The beautiful thing about this movement is that we do not have to compete toe-to-toe with the existing incumbents. We do not have to challenge them on their ground. The new victors will be the ones that reimagine an industry and forever rewrite the rules of how the system works.

The great beneficiaries of this movement is the consumer. No longer will they be forced into the unknown or kept in the dark about the underbelly of an industry. Consumers will have ubiquitous and frictionless access in the palm of their hands. Products and services that were once only available to the privileged will become available to the masses.

The broker is dead. Long live the Internet.