Free is not a business model

The usual blast of hot air is wafting around the Internet in a renewed discussion of how to make money from giving content and services away for free. This has been prompted by the publication of Wired editor Chris Anderson's new book, Free: The Future of a Radical Price. A lot of people seem to like the idea of being able to make money without having to charge for what they do, presumably because the idea of asking people for money makes them uncomfortable, or because they haven't the vaguest notion of how to go about building a charging mechanism into their website (vide Twitter, Facebook, etc).

The unfortunate side-effect of this kind of wishful thinking is that otherwise sensible people write utter tosh about this topic. I've just read a blog post by Mark Cuban, in which he asserts that Google "lives and dies by free." I don't think so. Maybe Cuban is privy to a Google scheme that I'm not aware of, but I've not heard of Google giving away advertising, unless you count the $50 introductory vouchers it uses to get people hooked on AdWords. Google's business model is selling ads, and it has so little effective competition that it gets away with charging a fat premium for those ads. Sure, those ads run on content that's free at the point of use, but none of that content is owned by Google. Google's genius is to have built a business that allows it to make money by piggy-backing on other people's free content. The rest of the Web absorbs the risk, Google gets the profit. Nice one, guys.

Not even Anderson believes that people can make money without charging someone for something. In a revealing blog debate hosted by John Gapper of the Financial Times, he spells out that his book is not about free so much as freemium — the notion of giving away some things for free as a means of luring potential paying customers. In a statement that will intrigue the many readers of this blog from the SaaS industry, Anderson elaborates:

"... this is actually the core of the book. When I refer to a 'new economic model', I'm not referring to slapping advertising against stuff, which dates back centuries. Instead, I'm talking about the underlying economics that allow Freemium to work. Freemium is the inversion of the traditional free sample. Rather than giving out few percent of your product away for free as marketing, hoping to sell the rest, you give away most of your product for free as marketing, hoping to sell to a minority. This is only possible in the online realm, where the marginal costs of production and distribution are close enough to zero to 'round down'.

"Freemium is now the main business model of the booming 'software as a service' industry online, the online games industry and the fast-growing iPhone applications market. I think that creating business models around Freemium — what to charge for and what not to, a question determined as much by psychology as economics — will be the most interesting, and lucrative, efforts of this online era. And the book, both in its chapters and its tactical advice at the back, is intended to help guide that."

Anderson clearly understands this model all too well, for you can read the debate for free in John Gapper's blog, in blog posts by VCs Fred Wilson and Brad Feld, and in a critical book review by Malcolm Gladwell in the New Yorker. But if you want to settle down in your snug to read the hardcover book itself, it'll set you back up to $27 (currently Amazon is offering a third off that price). Though UK readers prepared to compromise with alternatives can get a special sponsored abridged version or an audio book version for free.

I suspect most practitioners in the SaaS industry will be surprised to learn that freemium is now their main business model, as Anderson asserts. That may be true for productivity software vendors — Zoho, Google Apps and Adobe all practice a freemium model — but I'd find it hard to identify any freemium in the business models of leading SaaS application vendors such as Salesforce.com, NetSuite and SuccessFactors. Freemium won't work for everyone. But there are a couple of important trends described in Anderson's book that we should all be conscious of.

1. The cost of distributing content and software online has fallen close to zero. This is highly disruptive for companies whose business model was designed for a prior era when distribution was more costly, such as print media, entertainment and software publishing. Software with mass market appeal — so long as it's easy to develop, operate, support and maintain — now costs virtually nothing to deliver to customers, which means the high prices and comfortable margins vendors used to charge are now being wiped out.
2. Certain classes of software, delivered as SaaS, will become free at the point of use. The virtual elimination of distribution costs will allow new vendors to enter markets with business models that rely on one or more of three alternative revenue sources to cover the cost of their free offering. The most disruptive of these competitors will be the ones that identify alternative revenue sources with high value and/or high margins, because this substitute revenue will fund low-to-free software pricing in markets where conventional vendors have traditionally charged high prices.

The three alternative revenue sources are:

• Advertising. As we've seen from Google Apps, non-intrusive advertising does seem to be accepted even for business use when it's perceived as funding free use of the application. SaaS vendors should be cautious, however, as we have no confirmed evidence even that Google (let alone anyone else offering ad-funded apps) makes enough from advertising to cover its costs.
• Freemium. Distributing a free version in order to reach a wider market, among which some customers will decide to pay for premium services, is well established. It's worked for some open source vendors and for SaaS vendors with mass-market appeal as 37signals and Box.net. As I've discussed previously, the trick is to target the right free users to yield a sufficiently lucrative conversion rate. I don't agree with Anderson that this is the default business model for SaaS, but I do agree that we haven't yet explored all the potential it holds.
• Syndication. I'm not sure about the name — it may end up being called something else — it's the least developed of the three, but I think it holds the greatest potential. What I mean by syndication is delivering third-party services within an application and taking a commission on the sale. I've previously called it promotion, as opposed to advertising — it's also akin to what the retail industry calls merchandising. Some examples include SlideRocket, which sells media objects, such as images, music and cartoons, for use in slideshows created on its platform, or SmartRecruiters.com, which is a free online recruitment application for small businesses, funded by reselling a portfolio of ancillary services within the application, such as job board placements and reference checking. I recently recorded a podcast with the vendor's CEO about this model. Last month, at the OnDemand Europe conference in Amsterdam, he took part in a very interesting panel discussion I moderated on the topic of SaaS monetization. A video of that discussion is now online.

I believe we're at an interesting juncture, when new models are being tested out that will be game-changing for certain applications. But no one should be under any illusions here. The rules of arithmetic have not been subverted. Giving away stuff for free is not a business model, it's either an act of benevolence or it's a marketing ploy. If it's the latter, then you'd better make sure you've planned a sustainable means of making money once your marketing starts to bring in customers — either that or find yourself some extremely benevolent financial backers (if you believe such a thing exists).