
Free is Killing Us. Blame The VCs - llimllib
http://whydoeseverythingsuck.com/2008/04/free-is-killing-us-blame-vcs.html
======
hooande
I'm starting to understand that most websites, especially websites produced by
YC companies, are really media companies. From a business perspective, most of
our startups have more in common with MTV or the New York Times than we do
with Microsoft. We make money in the same way that any media company does - by
selling advertising.

I don't think there is anything wrong with that. It's certainly riskier and
subject to the whims of a fickle public. But there is also a bigger reward for
success.

Saying that a new media company should charge their customers before they
become popular seems counter intuitive. IIRC, this is how the Onion and many
other major media publications began...they gave their product away for free
until enough people read it that they could charge for ads.

It seems to me that most of the author's points could apply just as well to
starting a new magazine or newspaper. Yet, I don't think that many people
would agree that college newspapers are killing themselves by giving their
products away for free. I think that the expectations people have for web
startups would change if people looked at them as media entities and not
software companies.

~~~
mynameishere
The Onion predates the www. They were a subscription-based tabloid (and still
are). Generally, free media is bottom-of-the-barrel and advertisers prefer
paying audiences. The traditional broadcast networks are the biggest
exception, but that's probably a holdover from their predating cable. I've
mentioned the stats before, but the nytimes has 10 times the web traffic as
print, but 1/10th the ad revenue. (Those numbers are wrong, but it's something
like that.)

~~~
hooande
I was referring more to the print publication of The Onion and the New York
Times than to the websites. To clarify my point, starting a website with an
advertising based revenue model is similar to starting a new newspaper or
magazine. I used The Onion as an example because I remember it being freely
available in bars back when I was in college.

I don't have any marketing data on whether advertisers prefer paying audiences
or not, but I assume a lot of that would depend on the advertiser. I know that
the bigger players in web media (facebook, myspace, etc) are definitely
"bottom-of-the-barrel" when it comes to advertising rates because they reach
such scattered demographics.

With that being said, I don't fully understand your point about advertisers
preferring paying audiences. I think the problem is in the math. If I start
charging for content (turning my users into a paying audience) then I'm going
to most likely going to serve less page views. I don't know if the extra money
advertisers are willing to spend for my now paying audience would be enough to
offset the loss in page views.

The main example of a media website with a paying audience I can think of is
the NYT, and I think the only reason they can get away with charging for
content is because they've been established for so long. I think the rest of
us are going to have to decide between 1) charging up front 2) trying to build
a media property 3) trying to make money from premium subscriptions (which
usually just amount to being donations from dedicated users).

Thanks for the reply, I'll definitely be thinking about this.

~~~
mattmaroon
Advertisers in print media base their pricing on how many paying subscriptions
the magazine or newspaper has, not overall distribution.

Printed publications make far more per unit from advertising than they do from
the subscription fee. If advertisers didn't care about paid subscriptions, it
would be in their interest to give their magazine freely to anyone and
everyone who wanted it. But they don't because advertisers only care about
paid subscribers. That is why magazines seem to try as hard as possible to
give you nearly-free (but still paid) pricing on subscriptions.

I don't know why that is, but I know enough about the publishing industry to
know it is true.

------
edw519
Hey, Hank, the last time you flamebaited us with "Relational Databases are
Dead", we played along and had a nice little thread. But that was your only
free pass.

On to new business...

First of all, I still chuckle at "whydoeseverythingsuck.com" That thought is
the antithesis of everything we (should) believe here. I guess it's just your
little tongue in cheek thing. Cool.

You say, "it is inherently impossible to start a small self-sustaining
business and to grow it". I, along with 7 million of my compatriots beg to
disagree. If you don't want to play roulette, er I mean pursue VC, there are a
lot of other ways: bootstrapping, friends and family, angels, debt, etc.,
etc., etc.

I guess the thing that bothers me most about that remark is that someone may
come here, read that, actually believe it, and then become discouraged.

OTOH, maybe it's just another form of Darwinism. Anyone who pursues an
"advertising = only revenue" strategy should be prepared for the worst. More
prospects for those of us with sound business models.

~~~
attack
If you're going to call him out on the probability that any given person can
create a startup more successful than a day job then at least be more specific
as to what you think that probability is.

Him: It's impossible. You: It's so certain, it's basically guaranteed!

You can be a person who behaves very aggressively with what appears to be
extremely risky behavior but at the same time calculate risk very carefully
with as much data as possible. This is what I aim to be, a calculated risk
taker. Not a foolish man who dives head first without thinking.

Motivation is really great, but I don't see a lot of value in blind optimism.

------
pg
This reads like a pre-Ford car manufacturer complaining about the fact that
Ford was reducing the price of cars by an order of magnitude.

This is not a recent trend. In fact, it's practically the definition of
technological growth that it makes things dramatically cheaper. I don't think
this is a trend that will ever be "put to bed."

~~~
Hexstream
Well, he seemed to be saying the prices are made artificially low (ex: free)
because of VC's subsidizing the businesses.

~~~
pg
Sure, but since technological innovation tends to decrease prices, calling a
price "artificially low" is the same thing as calling it a future price.

When GMail launched, it offered artificially large amounts of free storage, in
the sense that they couldn't support many users at that size. That's why they
had to start with invites. But they knew that disk would keep getting cheaper,
so they just gave people a number that would make sense in the future.

~~~
attack
A very large percentage of sites/products start off free and without ads but
then start requiring subscriptions, reduce the value of their service and cram
it with advertising once they get big. In these numerous cases, "future price"
would not equal lower. Certainly, technology drives prices down but technology
is not the only factor that affects pricing. Unless you mean very long term?
But in very long term, everything is just going to go to zero so that frame of
reference is not very useful.

I agree that this elimination of competition is bad for the consumers, bad for
innovation, and bad for those more capable companies that didn't get the huge
funding. It's just making the rich richer.

------
nilobject
I don't know if it's true that free is killing us. I can point to several
counterexamples, such as 37Signals and FogBugz that charge for their
applications, and are apparently healthy. I think that no matter what, there
will be people who want quality service without the advertisements.

The author compares launching big and launching small, but really they're
apples and oranges. Yes, to launch big, you need to make a big splash and
either be free or very low priced. But the alternative is still there: get the
niche market, and launch slowly and by word of mouth of your users.

I don't think we're in a situation where you can't launch small and make a
living.

~~~
nostrademons
More counterexamples: LiveJournal, Flickr, HotOrNot.

~~~
nilobject
I forgot an obvious one that I pay for: SmugMug.

~~~
wallflower
From a talk by Jeff Barr, Amazon's Web Services Evangelist:

Smugmug is one of the biggest customers for Amazon.com web services (meaning
they could be invoiced if they wanted to be). However, they are billing
_everything_ on a American Express Platinum corporate credit card with the
highest credit limit ($100K). Jeff says every month they probably earn three
or four first-class tickets based on bonus points.

According to Jeff, their rate of growth is astonishing (Jeff said that they
are storing about 15TB (yes, Terabytes) a month in S3). What happens to images
in Smugmug ceases operations? Well, apparently the family has committed to a
multi-generational commitment.

------
davidw
He's wrong. We got there because of economics: the marginal costs of digital
products are essentially zero, and so tend towards free:

[http://www.squeezedbooks.com/book/show/7/information-
rules-a...](http://www.squeezedbooks.com/book/show/7/information-rules-a-
strategic-guide-to-the-network-economy)

~~~
hussong
They do, but only if they are commoditized. Once you get a sufficient amount
of differentiation, you can (and should) "price information according to its
value, not its cost".

~~~
davidw
Good point, but if it's big enough to interest VC's, it's big enough to
attract interest in an open source or free version (Linux, Wikipedia). I can't
think of VC's driving the price to zero in niches, as per his thesis that it's
VC's driving the price of things to zero.

I should add that there's also certainly space between a new product's entry
into the market, and when it becomes commoditized. If you're doing something
that's not easy to replicate, even if people do start trying, you might have a
number of years to make some money at it.

------
wmeredith
What about small software firms like Rogue Amoeba or Panic? They make fabulous
programs and sell them for reasonable prices. I think the biggest problem with
most of these web 2.0 startups is there is no product to sell.

~~~
jamongkad
Don't forget to toss in Delicious Monster in the mix too.

------
parker
I agree. 99% of Google's top-line revenues last fiscal year came from their
adwords/adsense empire... every single other web serivce they offer accounts
for 1% combined.

"Business" is about making money. Let's just agree that without revenue, you
have no "business". And this suggests that even Google is having problems with
monetizing products aside from their golden goose. This probably slightly
irritates Google, but it should really scare those of us who don't have a
golden goose yet.

We shouldn't be interested in creating products that are "built to flip", as
my ex-CEO liked to say. We should be interested in creating products that
create tangible, sustainable value... and that means making money.

Some startups can do that by offering products for free, and scaling up.
Others will have to charge for their offerings, commensurate with how targeted
and value-creating their offering is. It will be a combination of the two. The
idea that every internet startup can survive by giving away their service will
lead to one thing: disaster.

At some point the Googles and Yahoos of the world will not be able to explain
acquisitions to their shareholders, because they have a fiduciary
responsibility to create wealth. If the acquisitions do not create wealth,
they will stop making them. But that lesson will take years to learn, in my
opinion.

------
antirez
I can't agree more. And the result is that no one is willing to improve upon
something _good enough_ but that's free.

For example there are very wild problems affecting almost every internet user,
like email. I bet that there are many hacker teams around that are able to
come up with a better gmail, or simply a web based email system more biased
towards advanced users: but how can you compete with an alternative that is
good enough, is under this big name, and gives you all the space and free
access to POP, IMAP, ...?

Result: no enhancement over gmail, we just need to wait for them to release
the next feature.

Is this really better for users? Mostly not, the email or other core internet
services are such an important thing for users that to pay 30$/year is nothing
compared to the advantage of having a better internet experience.

------
malbiniak
man, you guys are a wordy bunch. chew on this.

"niche thyself."

don't believe me? may i present exhibit a, smug mug's article in business
week: "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."

sorry to interrupt, have fun.

------
dbreunig
I think there's another angle to this... And that's social.

Digital does have a lower overhead (less cost per user gained) than physical.
But Web 2.0 products are part product, part community. Their value is largely
derived from the bustling community that uses the product. FB would be worth
nothing with no subscribers, both from a consumer and investment perspective.
Remember how FriendFeed became suddenly awesome when the closed beta ended?
The value for myself (and others) is the relationships that form. If payment
is a barrier to usage, the growth stagnates and users don't get the best
experience.

~~~
davidw
Right - you're thinking of "network effects" or "positive network
externalities".

~~~
dbreunig
Why say friends when you can say "positive network externalities?"

~~~
davidw
Because it encompasses a broader meaning. eBay isn't about friends at all,
really, but has strong network effects: buyers go there because there are lots
of sellers, and sellers go there because there are lots of buyers.

I'd highly recommend the 'Information Rules' book I linked to elsewhere (via
my site:-) to anyone interested in this stuff. Most of it is pretty intuitive,
but it's nice to have it all grouped together and explained.

~~~
dbreunig
That was a joke. :)

~~~
davidw
Ah... well, truth be told, I think that economics does tend to weighty jargon
for concepts that are, if not completely obvious, not exactly earth
shattering. Still, they are useful to give labels to those concepts.

~~~
dbreunig
I think we're on the same page, but... They're useful labels until you have to
explain them to someone else. If you need to explain the words you're using to
explain a concept or idea, it's probably a detriment to your argument.

Using jargon to explain new concepts is taking the easy way out. Figuring out
how to communicate complex ideas with plain, straight-forward language? That's
the name of the game.

------
hillel
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. :)

------
dpapathanasiou
You can't blame the VCs as long as companies like Google, Yahoo, etc. can make
money offering free services.

~~~
marrone
Google and Yahoo can do it because they can take advantage of their scale to
monetize ads, as well as their diversity of products (profitable products can
help pay for the unprofitable ones).

Which is exactly the author's point. He says that small companies are forced
to swing for the fences in terms of user-base because a) that is all
advertisers are interested in and b) the competitors (such as Yahoo! and
Google) offer free alternatives.

I dont think it reasonable to set Yahoo or Google as the measuring stick of
success as those companies are clearly way out ahead of anyone

~~~
dpapathanasiou
Forget advertising for a moment.

Suppose you start a company to compete in an industry (any industry) where
your rivals are profitable despite offering free services.

The fact they're able to do that is going to force your hand in that
direction, too.

So it's _the market_ which dictates those conditions, not your investors.

~~~
parker
So then by this logic, it's the market that's going to tend internet revenus
to zero?

You're right. And this will lead to a massive market correction at some point.
Companies that had the balls to listen to reason (a la 37signals), will be the
ones that weather the storm. They'll end up being the Berkshire-Hathaway of
the internet industry because they a)focus on the long-term, b) concentrate on
what they know and do best, and c) fiercely execute on value, and not trends.

There's a reason Warren Buffet came through the dot-com crash unscathed. And
it's the exact same reason why companies like 37signals will as well.

~~~
dpapathanasiou
If ad-subsidized businesses turn out to be infeasible over the long term, then
yes, you'll see companies go out of business and/or start charging for their
services.

Either way, though, it's not the fault of the VCs.

------
jrockway
What about 37signals? They make money from charging for their products.

I think it's possible to do, but not as easy as "hack some website together
and hope for the best". Some things are going to be easier to market than
others. 37signals products (while I think they're useless) appeal to a lot of
business-type people (who have money so spend), so they do well.

If you look at startups like Reddit, they set themselves up for advertising-
only revenue. There is nothing worth paying for there, so of course nobody is
going to pay them. (Yes, I know that reddit sells the reddit engine. But the
most public part of reddit is reddit.com.)

------
webwright
Here's that I posted on his blog:

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.

~~~
nostrademons
Something I'm curious about: what if VCs worked like Berkshire Hathaway,
reinvesting the cash thrown off by portfolio businesses but never selling
their shares? Profitable businesses all generate return-on-capital; that cash
can be reinvested to get new businesses off the ground.

It seems like this would be a good model for seed-funding businesses like YC
to try, because they've got many more at-bats than big VCs. It might be hard
for a big VC firm to generate enough cash for this: if the average investment
is $5M, they take 50% of the company, and 90% of their investments fail, then
their "hit" needs to churn off $100M in profits to sustain the next round of
startups. But if you target hundreds of niche businesses, your investment is
$20K, you take 10% of the company, and 50% of the companies survive, then they
only need to spin off $400K/year in profits to fund the next round. That seems
a lot more achievable.

Then again, one of the reasons Berkshire is successful is that Buffett refuses
to invest in businesses that don't have predictable streams of cashflow.
Startups are anything but predictable, so maybe the model's fundamentally
flawed when it comes to startups.

~~~
webwright
"Something I'm curious about: what if VCs worked like Berkshire Hathaway,
reinvesting the cash thrown off by portfolio businesses but never selling
their shares?"

How does cash get thrown off? Are you suggesting a "dividends off of profits"
type of thing for growth companies? Aren't growth companies supposed to be
reinvesting profits in their own growth?

The problem with dividends is that they are really only good one the initial
investment is liquid. So if Berkshire invests in a value company that throws
off 3% dividends per quarter, that's great. But it's only great because they
can get their cash out at any time.

If a VC invests in a startup (say $1mm), how exciting is the prospect of 50%
chance of failure, but a possible 3% quarterly dividend IF the company
succeeds? With no actual market to sell their initial investment of $1mm?

I can't make these numbers look attractive in my head.

~~~
nostrademons
"Are you suggesting a "dividends off of profits" type of thing for growth
companies? Aren't growth companies supposed to be reinvesting profits in their
own growth?"

Yeah, dividends-off-profits. The growth-company thing is an issue for the
initial ramp-up phase: it'd probably be 10 years or so before the fund would
start having additional capital to invest. But in the steady-state, older non-
growing businesses throw off cash that can be reinvested in small growth
businesses.

"So if Berkshire invests in a value company that throws off 3% dividends per
quarter, that's great. But it's only great because they can get their cash out
at any time."

Berkshire _can't_ cash out of their value companies at any time. Their typical
modus operandi is to buy 80% of a successful privately-held business, leaving
the other 20% to the founders. The companies remain privately held, and their
stock is not sold on the open market. The only way Berkshire can cash out is
if they find another buyer, like a private equity firm or large conglomerate,
to take the whole business off their hands at once.

Also, dividends thrown off by private companies are often a lot more than 3%
(public companies have such lousy dividends largely because shareholders lack
bargaining power). Take See's Candy, one of Berkshire's early acquisitions
([http://valueinvestingresource.blogspot.com/2008/03/sees-
cand...](http://valueinvestingresource.blogspot.com/2008/03/sees-candy-magic-
formula-stock-from.html)). They bought it in 1972 for $25M on earnings of $5M.
Since then, See's has required capital infusions of $32M and spun off
dividends of $1.35B. That's a dividend-to-profit ratio of 98%, in comparison
to the normal Wall Street averages of 30-50%.

Of course, few startup entrepreneurs would be willing to sell 80% of the
company from the outset. Berkshire functions in reverse to VC firms, providing
liquidity and multi-million-$ payouts to firms that have already gotten
successful. But what if you reversed the terms? 10-20% of the equity for the
chance to be your own boss? With the investor's dividend payouts protected by
a legal clause in the investment documents, guaranteeing that after certain
profitability and cash reserve milestones are met and growth has fallen below
a certain amount, X% of the profits are distributed as dividends?

This is all idle speculation, since I don't have money to put where my mouth
is. But if I had a billion dollars or so, I'd definitely want to try it.
Because if these assumptions are true:

1.) Startups are the most productive part of the economy

2.) A small initial investment would let many more people quit their day jobs
and found startups

3.) Getting bought destroys most of the efficiency advantages of being a
startup

Then a logical consequence is that a firm that buys-and-holds small profit-
oriented startups should do better than one that invests in large public
companies.

Besides, it'd be a cool financial hack.

------
thenotself
The free model can work if it leads to a secondary revenue model, such as B2B
services, or secondary products that actually do make money. Launching a
business blindly for free hoping to "fake it until you make it" is not a
recipe for a successful business model.

I wrote about how to properly use the FREE software model today at
[http://www.onlineepiphany.com/2008/04/04/how-do-they-give-
th...](http://www.onlineepiphany.com/2008/04/04/how-do-they-give-that-away-
for-free/)

------
GavinB
"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."

Markets don't disappear because they're too crowded. When they're too crowded,
some people are forced out and it moves down to a more reasonable equilibrium.
That's like saying that a theme park will fail because it gets too crowded --
when something is too crowded to be worthwhile, people stop going and it then
becomes not too crowded anymore.

------
antirez
> 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 is unfortunately not the case since VCs know that for companies like
Google and Yahoo is valuable to buy a startup that is not able to be
profitable from itself, but added to a core of other free services it will be
worth the money.

------
adityakothadiya
I read this on 37signal's blog once - charge only for those products which
enable people make more money, or save time, or be productive, or gain
something in general. The rest should be Free - like Facebook, Twitter, or so.
Facebook and Twitter do provide value, but they dont enable me to make money
or help my business per say.

------
noodle
his assertion that online ad revenue is the only real revenue stream is false.

the rest of the article fails because it was built on a faulty premise.

its true that there are lots of sites built on ad revenue, but it is
definitely not the only revenue model.

------
gscott
Free is a very powerful marketing tool you will get more sign ups and then can
convert those up rather then having nothing free and try to convert people
with limited trials.

------
sabat
Social, economic, and technological changes are bad because they force me have
to think and work.

