Give away the diagnostic, sell the remedy

Companies that employ the “freemium” business model give away a product or service for free and then charge for additional features. The freemium model has gotten more popular as the cost to deliver free services has dropped but the cost of employing sales and marketing people hasn’t. One of the hardest questions around freemium models is deciding how to divide free from paid features.

One particularly effective version of freemium is: “give away the diagnostic, sell the remedy.” The best known example of this is anti-virus companies that give away free virus scans but charge for virus removers. In fact, this tactic works so well for anti-virus that it almost seems coercive (and has indeed been abused, for example, by “anti-spyware” software that deliberately conflates cookies and viruses). But, in general, giving away a diagnostic seems like a reasonable way to demonstrate the effectiveness of a product while still being able to sell valuable additional features.

Selling the remedy has become increasingly popular with B2B companies. For example, a friend recently wanted to ensure that his company’s (non-spam) e-mails weren’t getting blocked by spam filters, so he contacted an “email delivery optimization” company. They ran a free test and reported that his emails weren’t getting filtered. Two months later they called back and said “uh oh, your emails are getting filtered.” Sure enough his open rates had dropped and his anecdotal tests confirmed that his emails were being inaccurately labelled as spam. Because of the free diagnostic, he had confidence in the company’s technology, and was willing to pay them to fix his problem. And the email optimization company had spent almost nothing to acquire a new customer.

 

Revenue vs margin

Three years ago, Fred Wilson wrote a great blog post called When Talking About Business Models, Remember that Profits Equal Revenues Minus Costs. The point he made was both simple and profound. The simple part is summed up in the post’s title[1]. The profound part is that high growth, early-stage tech companies often have a choice about how to become exceptionally valuable businesses: they can focus on growing revenues at the expense of margins, or margins at the expense of revenues.

Most recent successful tech companies seem to have chosen the former: growing revenues at the expense of margins. Again and again, we see S-1 filings with revenues growing rapidly but profit margins that are low to negative. The same is true for the rumored financials of private companies. I think I understand why they made this choice, but wonder if it was a mistake.

To understand why these companies made this choice, you need to look at their formative stages. Many of them raised money from VC’s at multi-hundred-million to multi-billion dollar valuations, often before the companies were profitable or had even settled on a business model. In most cases, the companies and investors were acting reasonably[2]. But the end results might have been to unwittingly commit themselves to revenue over margin growth.

Why? Money has its own inertia and somehow always seems to get spent. Some of this spending is reasonable and even necessary (infrastructure, defensive expansion to international markets). But then there are harder choices. For example, do you invest heavily in sales and marketing to grow your revenue faster? Do you stay open and try to become a platform and therefore force yourself to experiment with new business models? Or do you become closed to “own the user” and therefore benefit from existing business models like advertising? Fast revenue growth seems to be the best way to justify your valuation. But the next thing you know you have a high cost structure that requires you to raise even more money and grow revenue even faster.

The root cause here is a deeply held belief throughout the business world that exceptional revenue growth is more likely than exceptional margins. For example, if you talk to professional public market investors and analysts you’ll often hear statements like “that’s a low margin industry” – implying that every industry has “natural” profit margins which companies can only defy for short periods of time. This belief is also reflected in public market valuations for recent tech IPOs: companies like Groupon that put revenue over margins command very healthy valuations.

The problem is that this deeply held belief in “revenue exceptionalism” over “margin exceptionalism” is a hangover from the industrial era. Unlike industrial era companies, information businesses tend to be deflationary, shrinking the overall revenue of an industry. They also tend to have network effects (and complementary network effects), making them more defensible and therefore higher margin than non tech businesses. Given this, why do companies continue seeking revenue at the expense of margins? Fred made this same point in his original post, but people didn’t seem to listen.

 

[1] Companies (like all cash generating assets) are ultimately valued at a multiple of present and projected future profits. The historical average P/E ratio of the DJIA is about 15, meaning that (on average) if a company is generating $100M in profit, it is valued at $1.5B (Fred prefers to use a 10 multiple, perhaps to be conservative?). One way to understand this is to imagine that companies dividend out all their profits every year. If you bought something for $1.5B and it dividended out $100M every year, that would be a 6.6% annual return.

[2] Why are these high-priced financings reasonable? From the company’s perspective: your traffic is growing so fast you need to invest millions of dollars in infrastructure. Meanwhile copycats are popping up in other countries. You don’t know if the financial markets will suddenly dry up. Someone offers you, say, $50M for minimal dilution. Seems like a reasonable hedge. From the investor’s perspective: the history of venture capital shows that almost all the returns are generated from big hits like Amazon, eBay, Facebook and Google. (As Paul Graham once put it: “The difference between a bad VC fund and a great VC fund is one big hit”).

Twitter and third-party Twitter developers

I can’t remember the last time the tech world was so interesting. First, innovation is at an all time high.  Apple, Google, Facebook, Twitter and even Microsoft (in the non-monopoly divisions) are making truly exciting products. Second, since the battles are between platforms, the strategic issues are complex, involving complementary network effects.

Twitter’s moves this week were particular interesting.  A lot of third-party developers were unhappy. I think this is mainly a result of Twitter having sent mixed signals over the past few years. Twitter’s move into complementary areas was entirely predictable – it happens with every platform provider. The real problem is that somehow Twitter had convinced the world they were going to “let a thousand flowers bloom” – as if they were a non-profit out to save the world, or that they would invent some fantastic new business model that didn’t encroach on third-party developers. This week Twitter finally started acting like what it is: a well-financed company run by smart capitalists.

This mixed signaling has been exacerbated by the fact that Twitter has yet to figure out a business model (they sold data to Microsoft & Google but this is likely just one-time R&D purchases). Maybe Twitter thinks they know what their business model is and maybe they’ll even announce it soon. But whatever they think or announce will only truly be their business model when and if it delivers on their multi-billion dollar aspirations. It will likely be at least a year or two before that happens.

Normally, when third parties try to predict whether their products will be subsumed by a platform, the question boils down to whether their products will be strategic to the platform. When the platform has an established business model, this analysis is fairly straightforward (for example, here is my strategic analysis of Google’s platform).  If you make games for the iPhone, you are pretty certain Apple will take their 30% cut and leave you alone. Similarly, if you are a content website relying on SEO and Google Adsense you can be pretty confident Google will leave you alone. Until Twitter has a successful business model, they can’t have a consistent strategy and third parties should expect erratic behavior and even complete and sudden shifts in strategy.

So what might Twitter’s business model eventually be?  I expect that Twitter search will monetize poorly because most searches on Twitter don’t have purchasing intent.  Twitter’s move into mobile clients and hints about a more engaging website suggest they may be trying to mimic Facebook’s display ad model. (Facebook’s ad growth is being driven largely by companies like Zynga who are in turn monetizing users with social games and virtual goods.  Hence it’s no surprise that a Twitter investor is suggesting that developers create social games instead of “filling holes” with URL shorteners etc.) Facebook’s model depends on owning “eyeballs,” which is entirely contradictory to the pure API model Twitter has promoted thus far.  So if Twitter continues in this direction expect a lot of angst among third-party developers.

Hopefully Twitter “fills holes” through acquisitions instead of internal development. Twitter was a hugely clever invention and has grown its user base at a staggering rate, but on the product development front has been underwhelming.  Buying Tweetie seemed to be a tacit acknowledgement of this weakness and an attempt to rectify it. Acquisitions also have the benefit of sending a positive signal to developers since least some of them are embraced and not just replaced.

What’s Facebook doing during all of this?  Last year, Facebook seemed to be frantically copying Twitter – defaulting a lot of information to public, creating a canonical namespace, etc. Now that Twitter seems to be mimicing Facebook, Facebook’s best move is probably just to sit back and watch the Twitter ecosystem fight amongst itself.  As Facebooker Ivan Kirigin tweeted yesterday: “I suppose when your competition is making huge mistakes, you should just stfu.”

Disclosure: As with everything I write, I have a ton of conflicts of interest, some of which are listed here.