As an American living in Europe and, more importantly, as a resident of Second Life since 2006, I have become increasingly concerned by the apparent lack of strategic vision on the part of Linden Lab. At the beginning of 2008, I wrote ‘An Assessment of Second Life’ in which I said:
“Philip Rosedale and the Board of Directors are highly skilled engineers with little or no knowledge of economics, economic history, strategic planning or customer relations. As Second Life grows from a technological startup to a mature business, they are out of their depth. They are making serious mistakes. They are destroying the wealth and confidence of the entrepreneurial class who risked enormous time and money to build Second Life in the first place.”
In May, Mark Kingdon replaced Philip Rosedale as CEO. In July, he gave us his second-month ‘State of the Union Address’. His first major policy review concerns VAT. This is an important issue because it not only affects European entrepreneurs (landowners and content creators), but LL’s solution to this problem will tell us much about the new executive team and the future of SL’s social, economic and commercial environment.
Let me put VAT in context. Linden Lab is no longer a software startup or even a service provider. Linden Lab’s product, Second Life, is more akin to a national economy than a game or social network. The closest historical parallel would be the Virginia Companies of London and Plymouth (1606) whereby the success of the Virginia Company of London depended on the success of Jamestown (1607). Yet this description too is limited. Linden Lab has created the world’s largest realtime, transnational, free-market community.
VAT is a sales tax levied by the European Union on goods and services, passing through the value chain like a bad penny to the final consumer. To the best of my knowledge, Linden Lab got itself into this mess by opening an office in Brighton, England, thereby gaining a physical presence in the EU, thereby acquiring a legal presence in the EU. The most efficient solution to the VAT problem, therefore, would be to close the Brighton office.
Presuming that LL cannot now extricate itself from the EU Tar Baby - even by closing the Brighton office - how should the VAT problem be resolved? Here is what Zee Linden has to say, “Our business in Europe has quadrupled each year since 2004 and already it has more than quadrupled in 2007 through September. As a result, we can no longer afford to absorb these costs for European Residents.”
Yet the conclusion does not follow from the premise. In terms of propositional logic, Zee’s argument is incomplete. In fact, I could draw the opposite conclusion: that as a result of its enormous success in the European market, Linden Lab can afford to absorb VAT - and do so without detriment to non-EU residents. Let’s take a closer look.
COGS (Cost of Goods Sold) is a cost that varies with sales. The simplest way to think of it is the cost of hiring more salesmen or designers when your business grows. Alternatively, think of the cost of electricity for a restaurant. The more customers you have, the more food you cook, the more electricity you use, the higher your electricity bill. Needless to say, it would be stupid to turn away customers in order to save on electricity. You need to measure costs against revenues.
Gross Margin = Gross Revenue - COGS.By absorbing VAT, Linden Lab would face an increase in COGS. In addition, Linden Lab would face a surcharge on existing European revenues. At the same time, passing VAT onto European entrepreneurs reduces Gross Revenue because 1) existing European entrepreneurs withdraw their financial and human capital from SL, 2) potential European entrepreneurs decide against investing in SL and 3) the reduction of European participation undermines the Network Effect (a term used by economists to describe increasing marginal returns).
In other words, passing VAT onto European residents is not ‘free’. While absorbing VAT reduces Gross Margin, passing it on reduces Gross Revenue. I maintain that absorbing VAT is the lesser cost - especially in the long term. I believe that by passing it on, Linden Lab is turning away customers to save on electricity.
Imparting VAT is akin to charging European customers higher fees based on higher European electricity costs. Such ‘discriminatory pricing’ would make sense if customers and commodities were encapsulated in geographic areas (cars or restaurants in Tokyo versus Paris), but it does not make sense in a realtime, transnational market such as Second Life.
Here is the problem. For a player in Arkansas, the price of a new island is $1000 + $295 per month tier; for a player in Aberdeen, the cost is $1175 + $347 per month. Multiply the difference by 50 sims and it is obvious that no European will create a continent such as Dreamland, Caledon or Paradise dAlliez. Yet, it isn’t just the big players who get hurt. I watched a neighbor’s half-sim mainland store go to the wall the day VAT appeared on her bill.
There is more to it than just money. The once-harmonious relationship between Americans and Europeans has come under tremendous stress as a result of Linden Lab’s current practice of discriminatory pricing. The issue has run like an open sore for months as European entrepreneurs bled out of the game to the catcalls of their American brethren. If SL is to be an American game, no problem, but unless LL reverses its policy of discriminatory pricing, it’s nonsense to pretend Second Life will become a ‘global village’ in the face of massive regional disincentives.
Discriminatory pricing balkanizes the SL community and distorts the transnational market. It creates a set of inworld social and economic conditions that undermine the current and future revenue stream of the company. The result is not the healthy competition of the free market or Olympic Games, but the pernicious business of economic nationalism. A restaurant that turns away customers to save electricity is bad enough, but one that does so by setting higher menu prices for Europeans is unlikely to remain convivial.
