The end of the $0.00 FreeConomic model - again....

Silicon Alley Investor is the latest to report on the demise of the "Too cheap to charge for" way of thinking about online business models:

....startups are starting to return to a business concept many thought had faded into the past -- asking customers to pay for things. Namely: Pro accounts, plus accounts, premium features, enterprise editions, and white label versions.

This pleases us. Some of our favorite Web companies -- Flickr, TypePad, LinkedIn and Smugmug -- were born before Google launched AdSense -- and they turned to Pro accounts for revenues. They helped launch a wave of innovation on the Web that led some to -- at first cleverly, then obnoxiously -- say the Internet had iterated into version 2.0.

Indeed - I presented some of our thinking at the Web 2.0 Expo in Berlin, and I actually use Flickr as an example of a Freemium 2.0 model (you can see the Slideshare presentation and some commentary over here).

I'd like to just add a few thoughts which I've realised, from feedback at Berlin and after, is not clear to people about the economics of networked businesses.

1. Although the benefits follow Metcalfe' Law (ie value is added exponentially as links grow), so do the transaction costs - especially on social graph based services. And for most people, the Metcalfian value starts to come to an end at some number (the Dunbar limit of useful connections for them on that service). The transaction costs however, do not end - as the service grows, they grow with it and this is ultimately what kills "free". If the business is growing on an exponential S curve, and costs are rising exponentially to this exponential growth, and you cannot make money, then at some point the business is not sustainable from capital funding alone. And because costs, albeit small individually, are growing on an exponential of an exponential, that comes faster than you think..... I've graphed this effect above.

2. If you look at the game theory here, Free works well if you are the only player, or in early enough to get the positive return cycle going. If not, the game theory is merely a race to the bottom, typically with increases spending to try and bribe customers onto your service rather than the competitors'.

3. Its not the Crunch that is making these business unsustainable, they were always unsustainable - its just making them unsustainable earlier in their lifecycles. And that means they cannot be sold as easily (which is of course why people are less willing to fund the $0.00 revenue growth)

What is true is that $0.00 is a great way (probably the only way today) to start a business (a consumer facing one anyway), and that the burn rate of running it before it hits real traction is very low compared to the dotcom world. If you can get in early and / or be the only player who can afford to go free, (say going up against Old Industry players) then it can run for quite some time as t is clear that it will be bought or create sufficient value.

So for startups going forward, I'd argue that one needs to look for that sweet spot - in early, vs incumbents. In late, vs me-toos, is a death by a thousand razor & blade cuts.

Update - article today on TechCrunch saying that Facebook may need to make cash calls sooner than expected - I suspect its this very effect that is causing it:

The company is likely spending well over a $1 million per month on electricity alone, say experts we’ve spoken with. Bandwidth is likely another $500,000 or more per month on top of that. The company has earmarked $100 million to buy 50,000 servers this year and next. And sources say they’ve been buying one NetApp 3070 storage system per week just to keep up with all this user generated content. At up to $2 million each, that adds up quickly - we’ve heard estimates that they may have spent as much as $30 million this year alone with the company. And the icing on the cake - earmark another $15 million per year in office and datacenter rent payments.

And don’t forget those human assets. With 750 employees and growing, Facebook is spending at least another $10 million per month on payroll.

It costs a couple of hundred million dollars a year just to keep the lights on at Facebook. But the real problem is keeping up with growth, particularly storage needs.

Every new user makes many connections, the costs go up per connection, not per new user.......