Friday, April 4, 2008

Free is Killing Us. Blame The VCs

I believe it should be possible to start a small business and to have a small number of profitable customers, and to earn a living. From there, it should be possible to work hard, and to grow your business into something substantial. Until recently, this was the American way, and it applied to technology as much as to any other business. But no more.

In today’s “free” world, in most online business categories, it is inherently impossible to start a small self-sustaining business and to grow it. This is because in the digital world, advertising, the only real revenue stream, cannot support a small digital business. If businesses were based on the idea that people paid for services then small companies could succeed at a small scale and grow. But it is very hard to charge when your competition is free.

The economic problem with advertising businesses is that advertising businesses do not work without really significant scale. In the past, a good product or service could address a niche and succeed without being a home run. Today, a home run is required because if you do not reach a massive scale, advertisers are uninterested. And even if advertisers could be attracted, CPMs are so low that the revenue would be inconsequential. Small Internet businesses don’t work.

So how did we get here? In a word, VC.

Venture capital has totally distorted the market. VCs are investing billions of dollars in companies with instructions to get big fast and to worry about advertising revenue later. As a result the competition is for users and not paying customers.

Unfortunately, to fix this, many more companies need to die.

With less “free” floating around, a more regular supply and demand dynamic can take hold, customers will have to pay for the things that are important to them and non-quantized growth dynamics can return. In the meantime, why should consumers pay for products and services that VCs and their pension fund investors are willing to give away for free?

The good news is at some point VCs will indeed realize how dumb all of this is and stop giving away everything of value on the Internet. This will all stop when the average VC can’t get any of his/her companies to scale because there is just too much VC sponsored free stuff out there. Then and only then will this crazy eyeballs business model redux finally be put to bed.

I cant wait.

Update 1: this piece was cross posted on Silicon Alley Insider.
Update 2: I have written a follow-up piece to this here.


18 comments:

  1. I agree with a lot of this...

    But VCs aren't going to change (and it isn't really in their interest to do so). VCs ONLY win in two cases-- someone buys the company or the company IPOs. Sustained modest growth rarely gets you to that destination.

    It's not irrational for VCs to push for growth at the expense of revenue/profit. For their "business model" (the hits in their portfolio paying for all of the duds), it makes perfect sense.

    I suspect that if a VC tried a new model (focusing on sustainable growth and revenue/profit), they'd find that they'd have a healthier portfolio... That was largely illiquid.

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  2. I disagree, but young entrepreneurs are optimistic by nature. A recent BusinessWeek feature on SmugMug came to mind.

    "Competitors such as Ofoto, Snapfish, and Shutterfly (SFLY) were well-established, and free. The business that wasn't already taken by them was split among the likes of Canon (CAN), Nikon, and Sony (SNE), which offered photo sharing as a service to camera buyers. But today, SmugMug is the destination of choice for professionals and serious amateurs, with more than 450,000 customers, including nearly 120,000 subscribers who pay $40 to $150 a year for the service. Revenues doubled in 2007, as they have for the past three years, to $12 million. With only 29 employees (including seven MacAskills), it's profitable."

    source

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  3. Its funny but this article is cross posted over at alleyinsider.com and over there it seems like the repeated example is smugmug. The really funny thing is that seems like the *only* example. I am sure there are more, but if there were lots, one example wouldnt keep coming up.

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  4. This is an interesting topic and I frankly can see the value in both models. But I think there is a difference between B2C or B2B companies when you're talking about business models built around "free".

    Our company, Bluefolder, is definitely on the B2B side. We offer a hosted field service application to small and medium service companies. We do not offer a free version, although we've recently considered it. We have hundreds of small companies as customers and they are willing to pay anywhere from $25 to several thousand dollars per month for an ad-free, professional business app that is reliable and hassle-free.

    We see the possible addition of a free version as a way to build a base of *very* small companies who might then want a more feature-rich edition when their companies grow. This is certainly not a new business model, but I think it is evidence in favor of the fact that you CAN build a business without offering a free product.

    Several other similar examples off the top of my head include Freshbooks and 37signals.

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  5. It's probably worth noting that SmugMug isn't venture funded.

    -- uber pig

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  6. There's another advertising model that may work for small companies. Here at Jackson Fish Market there are three of us. I think that counts as small. :) We also are a bootstrap.

    We make small beautiful web apps and offer sponsorships to brand advertisers. What we don't offer is an audience. Our apps are basically for rent to marketers who can get an audience elsewhere but need a place to send them to interact in a way that accrues value to their brand.

    We believe that this notion that advertising needs to be something that has value for the user (and not a distraction) is the wave of the future for brand marketers. These apps will need audiences, but there are literally hundreds of ad networks that can provide those. What those ad networks can't provide is useful destinations that are tuned to be complementary to a single sponsor.

    There is hope. At least, we think there is. :)

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  7. Just because things used to be one way doesn't mean they should be that way. Things are changing fast. Have you looked at the charts of the exponential increase in information technology? If you turn it upside down, you see the cost of information technology - it is going down just as fast. Things are heading towards free. This is good news, man. Really good news for all of us.

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  8. SmugMug is a great example to me. I'm a SMugMug paying customer as well and really satisfied about it. About the service and about customer care.

    It's not the exception. My company's B2B service Sitofono starts at € 499 / year... it's a customer engagement service with click to call. Do you want me to tell you how many FREE "click to call" services are there?

    BTW, Sitofono is a profitable division of my company.

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  9. VC's are not the only cause of this trend, IMO, Hank. So I think if you're waiting for it to go away, you'll be waiting a long time.

    Frankly I think "free" is a fundamental part of the digital economy, and is here to stay. So I think we need to learn to adapt to it.

    Is it a painful transition? No question. Just look at the music and newspaper industries.

    But a number of people have explained quite intelligently about "how to compete with free" (Mike Masnick from Techdirt, most eloquently, IMO - email me if you need a ref to some relevant posts). It can be done. And we all need to start learning how to do it.

    It's the nature of every major disruption that things that used to be slow and inefficient - and therefore cost a (comparatively) lot of money - get much cheaper after the disruption. It's no different with the digital economy. Perhaps it's more extreme this time (since it removes *so* much friction from the economy), but it's essentially the same process we've seen over and over through the centuries.

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  10. Forum software is a good example of this (although it's software rather than a service, so slightly different). Just look at Invision Power Board, vBulletin, Burning Board, they are all making a profit. I agree that a lot of things on the internet are moving toward "free", but there are even more things that you can still make money from.

    A lot of things that you and I (and probably the average person) would never pay for, someone else might. I don't undstand why someone would buy a forum when they can get something like phpBB for free, yet IPB is making tons of money. A typical person wouldn't pay for blog software, but a serious blogger might buy something advanced that meets his needs.

    Now, I do think that, in the direction we're going, more and more things are going to be free. That just means that if you want to sell a product or service, you're going to have to put a lot more work into it.

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  11. I recently made a similar observation. Free South Park episodes is just the first indication that even the entertainment industry is at least looking at the "free" model.
    Will it work? I believe it probably will for the big guys. But just as you, I don't know about the little guys. Youtube might pay publishers, there are independent initiatives like the animation show, etc. What will work and what won't? I don't know, maybe free turns out to be a dead end. Who knows. Interesting times.

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  12. I rather have companies that favors the users rather than the clients. This way the users (us) will get what we decide to have and not what the client (advertisers) wants us to have. Take TV for example. DO we really get to watch what we like, or do we get what advertisers decide what to air. Or the news, do we really get the news as they really are, or do we get the news based on the interest of the companies who sponsors the media?
    What I see here is a model where you get to work, get results and get paid. I don't any dishonesty in that.
    By the way, don't you pay for your internet service?

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  13. The VC situation that you describe reminds me of the Internet implosion of 2000-2001. The problem then, as now, cannot be placed solely at the feet of VCs however. The other shoe nicely fits the foot of the entrepeneour who chooses a business model that's doomed to fail. It seems to me that there are several open source business cases built around a free basic service. Why not just mimic what we know works?

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  14. This is a very interesting post. Thanks, Hank. It brings so many interesting issues to the surface, it's hard to know what to pick.

    Is "free" a pricing question? It's interesting what a total "state change" takes place between charging some nominal amount, such as $4, for a service, and charging nothing at all. Paying for something brings up all kinds of concerns, most notably the risk of identity theft/credit card fraud that every payment online brings with it. We're 10 years into the "Internet revolution" and we still haven't found a micropayments solution. If we did have such a solution, there there would be a more gradual commitment gradient between free and $4. Imagine, for example, if instead of paying $99 a year to access the Wall Street Journal, you could read a single edition for $1, or subscribe for a week for $5. It seems likely to me that part of the success of iTunes Music Store is that they tackled the micropayment problem with their music cards.

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  15. Kevin Kelly from Wired has been thinking about the same subject a lot lately, but he came to a different conclusion.

    http://www.kk.org/thetechnium/archives/2008/01/better_than_fre.php

    http://www.kk.org/thetechnium/archives/2007/11/technology_want.php

    I was surprised that no one mentioned this already. Boing Boing covered the Kevin Kelly essay.

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  16. Well, it's a free market economy.

    VCs have the right to fund or not fund.

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  17. Free.... it says 'FREE' but there is always a cost. It may not be directly link to your wallet at the time of the 'FREE' purchase, but the hidden cost are always lurking.
    Hmmmm.... I go on the web for 'FREE' stuff. I download it. I use it and and tell my friends how much I like it....wait hold on... I just did 'FREE' advertising for that company. Traditional Advertising is VERY, VERY expensive. This is a cheaper means to reach a larger audience. Cigarettes companies do it to new markets (Countries) they enter. The government has to pass the law to allow the sale of Cigarettes within their country. Some countries governments try to keep Cigarettes out. Soooo….. cigarettes companies sell Cigarettes on the ‘black market’ within that country. Cigarettes are sold cheap and the ‘black market’ buys. In time the government sees how much money they are loosing out on, because the people are NOT buying smokes at local stores or paying Tax on the Cigarettes. The government now see’s the sale of Cigarettes in their country as a wrecking ball they can’t stop, so they might as well tax it for money.
    Cigarettes can be compared to ‘FREE’ internet stuff. Cheap available and NOT censored. ‘FREE’ porn for my 4 year old….no cost?? I beg to differ. ‘FREE’ TV sitcom download. Hey why can’t I watch my local News Channel, what going on in my area? I know what War is current, but what about my local issues I’m not aware of any more because EVERYONE is now supporting ‘Main Stream’ channels. Hummm… I just got today’s latest and greatest software for accounting…for ‘FREE’! Why is my support in a foreign language? Why is it so easy for people to hack my latest software? Why am I stuck paying more every year and it very hard to transfer to a different program. Why are there few options for different ‘Main Stream’ programs? What happened to variety? Why does this software SUCK!
    Things may seem ‘FREE’ but consumers have to look at the big picture and not just their wallet at the time of purchase. Variety is a good thing. It makes the market more completive, creative and level. Pretty soon well regress back to 1920 when Ford invented cars…. And all you got was a Black car. No options. Pretty soon the big guys will be so big and their ‘bottom line’ will be the only thing that matters. They will be forced to squish all the little guys to get their market share, because if the ‘Big Guy’ doesn’t meet the budget…heads will rolls, shareholders will pull out and that will be the end of the corporate lifestyle to the few controlling the ‘Big Guy’ company. Like Rome the ‘Big Guy’ will eventually fall but to the expense of how many ‘Little Guys’ that have new fresh ideas that would be better for the market.
    I’m not against ‘FREE’ stuff, but I am against unfair advantages. When companies get too big they can directly influence the rules on the business playing field. They make it a Monopoly to suit their profits. I’m a ‘little guy’ that used ‘FREE’ stuff to learn what is available. So, I guess I’m also a hypocrite. I watched the internet evolve and know how to ‘surf’ through all the ‘FREE’ garbage to find what I want. There are definite advantages but the regular Joe will get caught up in the ‘FREE’ garbage and drown in in a sea of porno!... what was I looking for??????

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