Free 2.0: Don’t blame the VCs

by Mathew on April 4, 2008 · 24 comments

A New York-based entrepreneur named Hank Williams has a guest post over at Silicon Alley Insider about how the tech economy is being ruined by the “freetards” (although he doesn’t use that term). In a nutshell, Hank believes all the venture-backed startups that are littering the Web with their free apps are ruining it for hard-working guys like him, who just want to make an honest dollar by providing a quality service in return for actual money.

This is an appealing story — but is it true? There’s no question that a lot of Web-based services are going the free route, and there is a certain segment of the VC world that believes you need to build something up to a large enough scale first, and then find ways to monetize it. But is this really something that VC’s invented and have forced onto the tech startup market? Hardly. If anything, it is a phenomenon that has grown out of the reality of what it costs to run a Web business.

Why are so many things free? Henry Blodget suggests an answer in his comment on Hank’s post at SIA: because they can be. In other words, things — primarily services, information and so on — used to cost a lot because of the nature of those businesses, embedded costs, etc. Now, a large proportion of those costs have been removed. Does that mean everything can be free? No. But many things can come pretty darn close. And once the value of that service or content has been established, then it’s a lot easier to start either advertising around it or charging money for it.

This is the essence of the “freemium” approach. Give people some of what you have for nothing, and see if they like it. If they do, then offer them more for a fee. It works for SmugMug.com, it works for 37Signals.com and other companies. Did Craigslist choose to offer its services for free because its VC backers forced it to? No. It did so because Craig wanted to do it that way — and because he could do it that way. Only when it had become obvious how valuable it was did he start to charge for certain things, and then only in a limited way, and still the company makes close to $100-million a year with virtually no more effort than when it was free.

That is the power of the “free” model — it’s not some kind of snake-oil trick that VCs desperate for an exit have foisted on Web startups. While that may be happening, it certainly isn’t to blame for the entire Web-based freemium approach, and it has nothing to do with whether Hank Williams gets paid an honest wage for an honest day’s work.

Update: See Hank’s comment below. Don MacAskill of SmugMug also has a thoughtful response, in which he notes that lots of industries have a stratification between commodity (i.e. free) and premium brands — and also notes that SmugMug actually benefits from the free services that compete with it. For what it’s worth, I think Alan’s “Freetardis” offer at Broadstuff is hilarious.

  • http://www.atilus.com/blog Zach Katkin

    I'm a huge fan of 37signals (actively using basebamp). I don't know if Free ruins the economy, but I understand the point. Great post…

  • http://www.mathewingram.com/work mathewi

    Thanks for the comment, Zach.

  • http://www.livedigitally.com Jeremy Toeman

    I think the “messy area” is free services in clearly unsustainable industries. Services that host a tremendous amount of data – for now, are problematic in my opinion. I don't know if I'd go so far as to say “ruin” but they certainly cast a pall on “why should I pay for that?” services.

    One could make the argument that the radical quantities of free news and content on the Internet has caused as much hurt as gain… But then again, who doesn't love free? :)

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  • http://www.ramius.net Melany Gallant

    Providing a free service allows you to “test” what you've created and see if your target audience bites. It's a great way to get feedback and incorporate that feedback into your product development. You deliver something for free to gauge its value to the market. Then fine-tune it from there. As a consumer, it's unlikely I'll pay for something I haven't had a chance to try yet.

  • http://www.mathewingram.com/work mathewi

    Exactly right, Melany.

  • http://www.mathewingram.com/work mathewi

    That's kind of my point as well, Jeremy — it's not like VCs invented
    the idea of giving things away for free. That one has been around
    forever. Let's face it, people like getting things for free, and if
    you can afford to give it to them and get them hooked and then charge
    them later, then why not do that? I didn't mention it, but I'm pretty
    sure that was Facebook's model too, long before they got VC money.

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  • http://www.whydoeseverythingsuck.com Hank Williams

    I am the author of the original post. I just want to clarify a few things. The article is not sour grapes from some guy “looking to make an honest living”. I am actually developing a product that I firmly believe people will pay for, and so I do believe it is possible to build businesses that generate revenue from users. That said, on some level this is basic economics. VCs did not invent free. But VCs provide support for businesses that would otherwise be unsustainable. This taints the market because it messes up the basic market dynamic of “if it great people will pay for it and if it sucks they won't”. In the current market even well done, useful products have a hard time charging. This is the same issue we are facing in the music business. We are training a generation of kids to believe that nothing they get through their computer is worth paying for.

  • http://www.bijansabet.com bijan

    great post.

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  • http://www.mathewingram.com/work mathewi

    Thanks for the comment, Hank. I apologize if I gave the impression
    that your post was just sour grapes — but I still think you are
    wrong. Regardless of whether VCs support companies that are
    unsustainable, this does nothing to “taint” the market for quality
    content or services that people can't get elsewhere.

    Those businesses still have exactly the same chances they would
    otherwise — except that, as Henry pointed out in his comment, they
    can no longer charge higher prices than necessary because there is
    plenty of competition (and yes, some of that competition is free).

    Your music analogy is also incorrect, I would argue — no one has
    “trained” music consumers that music is free. If anything, many took
    to downloading because the industry continued charging far too much
    for CDs long after alternatives were available. That's the industry's
    fault, not consumers. Music costs less to distribute now than it did
    before, and the industry failed to adapt to that reality.

    In any case, as someone once said, your competition isn't the product
    or service that is better than yours — it's the one that is good
    enough. If someone can get away with providing that for free, then you
    have your work cut out for you. If they are just a bunch of losers
    being propped up by VCs then they will eventually fail.

  • http://www.mathewingram.com/work mathewi

    Thanks, Bijan.

  • http://www.bijansabet.com bijan

    I just linked to your post on my blog response as well.

    http://bijansabet.com/post/30782384

  • http://www.whydoeseverythingsuck.com Hank Williams

    No apologies necessary. I just wanted to clarify. On the main point I think
    we can agree to disagree. In any case I only post occasionally on SAI. If
    you want to read more of my “controversial” opinions you can check me out at
    whydoeseverythingsuck.com. I am sure you will find lots more to disagree
    with:) This conversation has been fun, but I do seem to have ruffled some
    feathers elsewhere!

  • http://www.mathewingram.com/work mathewi

    Thanks, Hank — welcome to the disagree-o-sphere :-)

  • http://www.5o9inc.com Peter Cranstone

    One of the problems of funding free models is what happens to the cap table e.g. dilution of the entrepreneurs. By the time you've pumped in $30m plus at high valuations the number of shares goes up tremendously. Now the exit (if there every is one) is predicated on a) the value in the company – earnings and b) the number of shares outstanding. By the time you hit 30 million shares outstanding the exit is in the hundreds of millions and because currently there is no IPO market for companies without real earnings all you are left with is M&A and with a free model, no earnings it's tough to justify anything north of $75m which makes the exit price per share about $2.50 well north of what the last investor paid for his/her shares.

    Cheers,

    Peter

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  • http://pop-pr.blogspot.com Jeremy Pepper

    I think the basic thing that's being ignored is that you get what you pay for. Some things are free because they really aren't worth more than free.

    Some things are given away as free as a loss-leader – think photo sites of the dot-com boom, where the storage was free, and the prints cost money.

    There are plenty of examples, of course, but there does seem to be some of the same ideology from the dot-com era to Web 2.0: don't worry too much about a business model beyond free and advertising, and we'll just have an exit strategy.

  • http://javajosh.blogspot.com Josh Rehman

    Interesting take on the freetardation of software. I think there is common ground between you and Hank, though. VCs are drawn to “free” because they want to hit the lotter; if they hit the lottery, the economics are enormously in favor of the VC. Google, who won the lottery, gets *far* more money from advertisers than it spends to attract and keep users. The market is flooded with short-term plays where VCs spend *far* more money to attract and keep users than it gets from advertisers. Obviously it's not sustainable, but VCs expect low success rates.

    The net result is that consumers may end up skitting from one free offer to the next (much like some saavy consumers have done with credit card borrowing). Consumers will learn to mistrust companies and software, and treat them as, at best, temporary tools to be used and discarded.

    I presonally believe this is unhealthy, for the simple reason that relationships never form, knowledge never deepens, and efficiencies are never realized.

    OTOH, many of these services probably won't make sense in 10 or even 5 years. And, it's probably a good lesson for the public to learn – that you really shouldn't trust corporations anyway. Last but not least, 90% of internet software is unnecessary and frivolous, trying to “carve out a niche” where no need previously existed. The problem is we don't know which 90%, and the market is doing this R&D relatively efficiently.

    http://javajosh.blogspot.com

  • http://500hats.typepad.com dave mcclure

    oh please.

    hank: your arguments & logic are just absolutely wrong, and they aren't even accurate if you were describing the market ten years ago (when perhaps a FEW of your observations were true, and not just patently false).

    VCs aren't funding the majority of companies out there, small business or otherwise. and those that are VC-funded aren't only offering free services, and aren't only advertising driven. and those that are free and based on advertising aren't killing you.

    see my comment for 3 specific point-by-point examples that rebut your assertions:
    http://www.alleyinsider.com/2008/4/_free_is_kil

    get over yourself, deal with the market, and get to work building a product of value.

    whether or not it's based on advertising, if it's useful & provides value, and if you're not a complete idiot, then it will survive. if it doesn't, or you are, then it won't.

    period, end stop.

  • http://www.joiningdots.net/blog Joining Dots

    I think where Hank may have a point is start-ups that appear almost to be over-funded by VCs. For example, Seesmic has $6m to create some kind of video-blogging service. That gives it a lot more options, e.g. free by default regardless, over similar alternatives that choose to bootstrap. But I also think such examples are the minority, they just get more news coverage. VCs didn't cause 'free' to happen, they are perhaps now funding 'free' in untested areas in the hope of striking gold. That's a problem if you're in the same playground. But that's the way it goes. No different to sports, where some athletes are backed by big sponsors, even before they win anything of note, and others are working nights to pay for their kit and training.

  • http://www.joiningdots.net/blog Joining Dots

    I think where Hank may have a point is start-ups that appear almost to be over-funded by VCs. For example, Seesmic has $6m to create some kind of video-blogging service. That gives it a lot more options, e.g. free by default regardless, over similar alternatives that choose to bootstrap. But I also think such examples are the minority, they just get more news coverage. VCs didn't cause 'free' to happen, they are perhaps now funding 'free' in untested areas in the hope of striking gold. That's a problem if you're in the same playground. But that's the way it goes. No different to sports, where some athletes are backed by big sponsors, even before they win anything of note, and others are working nights to pay for their kit and training.

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