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Security & Privacy

What Tech Investors Get Wrong About Privacy

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Data breaches are now so commonplace that consumers have become conditioned to them. In 2018, personal information was compromised by airlines, mobile carriers, and of course social networks.

As today’s tech giants mature, they all need to evolve from ‘good enough’ products to those differentiated by useful and indispensable features.  With the smartphone boom coming to an end, a feature-rich product is all the more important. And the most differentiated feature to separate winners from losers in the next tech paradigm will be a commitment to privacy.

Even after all of Facebook’s privacy issues that have been exposed throughout the year, just last week, new information surfaced about a new breach that put the private photos of nearly 7 million people at risk. Facebook, of course, didn’t mean for it to happen, but then again Google didn’t intend it either, when more than 50 million Google+ accounts became vulnerable.

So what can be made of all this?  How does it change the calculus for investors?  How do data breaches and the importance of protecting data fit in when you are evaluating tech companies?

There are three tiers to the monetization funnel for online consumer companies: A) identifying a customer need; B) building a product to fit that customer need; and C) monetizing that relationship either directly with the customer or indirectly through companies that are seeking to reach them. The problem arises mostly at point C, because the tech giants seem to have lost sight of who the customer really is.

Perhaps the best way to understand how things with Facebook and Google have gone askew is to compare them to old media like television and radio. For those businesses, the priorities and incentives were always aligned with that of the customer, since the main objective was providing good content ― precisely what customers want ― while monetizing against that by selling to advertisers who sought access to the target demographic.  Easy enough.

Today’s digital age companies like Facebook and Google instead have incentives to slice and dice the consumer data, and to continue to accumulate more of it, rather than to augment the quality of product features customers experience every day. And it’s not hard to understand why, because the more precisely defined the advertising target is, the more it’s worth to an advertiser. This is why these companies can enjoy operating margins north of 40 percent.

The companies’ incentives increasingly align more with the interests of third-party advertisers than with the first-party customer who volunteered the information in the first place. Yet when these companies talk about their primary objectives, they always talk about the services they are providing for consumers.

Those misaligned incentives represent the biggest risk investors need to consider when thinking about the valuations of large cap tech companies.  The risk arises because these companies’ entire business model depends on the exploitation of customer information.  As a result, they turn “the customer into the product,” as is sometimes said. That redirects the incentives driving the entire business. Who do you think is really Facebook and Google’s true customer?

But for the larger industry, we are now in the final days of the smartphone boom, and with it the dawn of a new chapter defined and by features intended to grab market share (i.e. customer mindshare) on the smartphone itself. These features should include many tools for optimizing efficiency, or time, for individuals, while improving the quality of their experiences. And crucially, all of these changes will work best when they underscore the provider’s commitment to protecting the customer’s privacy and personal data.

Within tech investing right now, however, most of the concern around privacy focuses on the risks from breaches and less how privacy issues relate to the framework of the core product.

Meanwhile, as Apple critics obsess over unit sales, no tech company is as explicitly committed to privacy as Apple. Privacy as a feature should help facilitate a better consumer lock-in in each business ecosystem. Without it, competitive threats will be felt quickly.

Obviously, iPhone sales are slowing as the smartphone boom wanes. But when consumers face the largely binary decision of iOS versus Android, and which one is less likely to exploit personal information, the answer is not that difficult. The iPhone’s vertical integration helps protect data, while the fragmentation of Android across a multitude of manufacturers dilutes control.

Looking forward, privacy as a feature will prove increasingly critical to the evaluation of tech companies. When a company’s internal incentives are not aligned with its customers on this front, they are bound to underperform. Expect more privacy rhetoric as a marketing tactic, though at the end of the day nothing is more telling than real financial incentives. More on that in a future essay here at Techonomy.

James Cakmak was until recently a Wall Street security analyst for over 10 years covering the internet sector. He is also co-founder of Snailz, a nail salon booking app now operating in New York. Follow him on Twitter: @JamesCakmak. Ryan Guttridge, adjunct professor at Smith School of Business, University of Maryland, contributed to this article.

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