Lately, I’ve met with a lot of young software entrepreneurs that want my advice about their new product or business idea. When I ask them what their sustainable advantage is over the competition, they invariably point to their innovative technology, their first-to-market status and their decision to build out a consumer network via a free software or service. But they don’t all dwell on how and when they intend to monetize their business.
Many even assume that they will figure out the monetization part of their plan in the future. Clearly this approach worked out spectacularly for WhatsApp when it sold out to Facebook recently for $19 billion! But not all startups have such happy endings. So it’s helpful to get some perspective on how the role of software has evolved over time and how much your startup’s success with a free software strategy depends on your target market, your business model and the prevailing investment climate.
Early IBM software was free
Computer history buffs will recognize that the approach of giving away free software is neither new nor recent. IBM existed in an era when most corporations paid handsomely for their computer hardware, but they insisted that the software be free. Since its founding in the early part of the previous century, IBM sold expensive “business machines” and employed an army of technicians to help its customers make use of these very complex and finicky early computational systems.
Those early IBM technicians kept the hardware running (the job of IT operations today), and most of the programming was done by other technicians using archaic “machine language” instructions (what we could call “software development” today). While the hardware and software were all proprietary to IBM, the company’s entire business model was based on charging high prices for hardware bundled with free software and customer service. The reason for giving away software was not to create a consumer network but, in fact, to offset the cost of running the expensive hardware.
The U.S. government got involved
But a seminal event in the late 1960s caused a change in this preferred business model. An antitrust lawsuit against IBM brought by the U.S. Department of Justice forced the company to unbundle its software from its hardware and to stop giving it away free. This shift to unbundled software favored small startups that previously just could not compete against IBM and its free software.
Enter Microsoft and Oracle
Microsoft started selling a microcomputer operating system called MS-DOS by mail order for less than $1,000 to power early Intel-based personal computers. Oracle started selling a relational database package for as little as tens of thousands of dollars to run on low-cost minicomputers and workstations. The selling was extremely geek to geek, and the support provided didn’t need to be anything like what IBM provided. There was no reason for Oracle to give software or services away free since prices for the new hardware systems were already so low compared to those from IBM.
For the next 20 years, this software-license business model prevailed in the independent software industry, which grew phenomenally. As the fortunes of software companies like Microsoft and Oracle rose, IBM’s star dimmed along with a host of other hardware companies.
By the turn of the century, Microsoft had become a monopoly in its own right by controlling more than 90 percent of the desktop PC operating system market. Like IBM before, it too started to try to cement its monopoly by “bundling” free products with its operating system in order to thwart the competition. Perhaps the most egregious example of this was the bundling of Internet Explorer with Microsoft Windows in order to blunt the spread of Netscape, the first commercial Internet browser. Pretty soon, the government stepped in, took Microsoft to court and forced it to unbundle the browser.
While it was too late to save Netscape, this legal development along with the spread of the World Wide Web made it possible for young companies to experiment with innovative new business models without fear of being killed off while they were still young.
During the last decade, free software has been used as a formidable competitive business weapon not only by Google against Microsoft but also by Apple, Amazon and Netflix to rapidly increase the size of their consumer networks against traditional brick-and-mortar industry incumbents.
But while each of these new upstarts gave away free software, they all started charging quite early for the digital equivalents of the things that they were truly selling (ads, music, books and movies).
Google sold search advertising
Google was not the first company in Internet search, but it won out decisively over earlier entrants with its uniquely different pricing model for Internet advertising. All Internet search companies figured out early that they had to give away free search capability within a browser in order to attract consumers to whom they could show paid Web advertisements.
In the early days of the Internet, everyone before Google essentially treated Web pages like a printed page or a TV screen to be interspersed with banner ads. Advertisers paid for the number of impressions shown to consumers — the same way they did for print pages or TV, with no guarantee of effectiveness.
Google’s genius lay in its early decision to monetize its billions of daily search transactions via pay-for-click pricing instead of “banner ad” pricing. Because Google only charged the advertiser if consumers clicked through, Google’s customers were willing to pay more per ad. As a result, it grew fast in revenues and became profitable quite early in its history (at least compared to today’s startups). Today Google has built a virtual monopoly with its pay-for-click search advertising network, and it enjoys more than 80 percent market share in that lucrative space.
Meanwhile, banner advertising continues to suffer from excess inventories and declining prices and has caused companies ranging from Yahoo to Facebook to seek other additional ways to monetize their user base beyond just Internet banner ads.
Apple’s impact on how we consume music
Around the same time as Google was emerging as a force in the Internet software industry, a resurgent Apple under Steve Jobs applied the free software model to reduce prices in the consumer music industry. Jobs’ first insight was in recognizing that older style consumer music products like the Sony Walkman were ripe to be taken out by a low-cost but stylish and purpose-built mobile computer technology called the iPod based on the MP3 standard.
But this in itself was not entirely new. At that time, there were a lot of MP3 players available on the market. Apple’s genius was in making the iPod a part of an entirely new iTunes proprietary software ecosystem for purchasing music “by the song” instead of requiring consumers to purchase an entire album. Consumers have paid from the very beginning for the hardware and the music they bought.
Enterprises move from perpetual licenses to SaaS
But what of the enterprise computer technology market pioneered by companies like IBM, Cisco, Microsoft and Oracle? The business models there do not involve selling to consumers, yet that sector has evolved too, albeit not at such a rapid pace. During the early days of the Internet, many enterprise software entrepreneurs (this author among them) branched out to build “software as a service” (SaaS) companies.
At first the SaaS model worked best for Internet-centric services such as Web hosting and e-commerce deployment, but eventually all kinds of enterprise software solutions ranging from business process management to systems management adopted this model. These companies succeeded because they reduced purchasing complexity for their corporate customers by offering pay-as-you-go subscription pricing and on-demand usage-based models instead of increasingly complex software under a perpetual software license.
Freemium to premium
We’re all familiar with the freemium model. This usually involves giving away some software free in order to be able to charge for a premium version later. Essentially, the free software is like a lead-generation tool, and it makes it easy for a software company to upsell its product to people that have tried the free version and want more features.
More enterprise software startups use this approach today, but these companies usually need to be assured of converting enough free customers to paid customers to build a viable business. It’s unlikely that simply building out a large network of corporate customers that use a free trial/sample product will result in meaningful valuations for an enterprise software company.
What’s up with WhatsApp
In the case of WhatsApp, there is a presumption by Facebook that it is buying a consumer network that it will eventually monetize over time. But whether and how Facebook will actually do so, and at what magnitude, is anybody’s guess.
Unlike the core Facebook business, which is dependent on advertising (hence the number of eyeballs could be one proxy for future revenues), the WhatsApp market was for communications services, which may or may not have as much advertising value as implied by the Facebook purchase price. In fact, Facebook has indicated it will not necessarily pursue an advertising model for WhatsApp. But if not advertising, then what?
Some people have pointed to communications services as a possible new source of revenues for Facebook. But just because WhatsApp obliterated (by some industry estimates) $38 billion of text messaging revenues from traditional telecommunications industry players by giving away its own such services free does not mean that it will now be able to replace these with an equivalent amount of its own revenues.
In this, the example of Skype is instructive. Skype also built up a massive consumer network based on free voice calls and subsequently sold out to eBay at a valuation that was equally stratospheric for its day. But eBay was not able to monetize this business and subsequently sold Skype back to its founders at a substantially lower price, which then turned around and updated Skype’s technology a bit and sold it again – this time to Microsoft, albeit not at the same high price as that which eBay originally paid.
Skype still does not make enough money for Microsoft to justify its initial or even subsequent valuations. Whether Facebook’s big bet in WhatsApp will pay off better is a stretch to imagine.
Mark Twain said that history may not repeat itself, but it sure rhymes! The role of software has continued to evolve in different ways through various industries in our economy, and business models have oscillated between giving away free software vs. charging for it vs. giving it away conditionally.
The occasional spectacular valuation notwithstanding, it is better to know early what to charge for vs. what to give away free and whether a customer network is an eventual revenue-generating asset vs. a costly lead-generating tool.
In a world where software is no longer the domain of a few geeky Silicon Valley engineers but is the stuff that billion-dollar companies are made of, it still pays to have a viable business model.
Umang Gupta is a well-known Silicon Valley technology visionary, entrepreneur, company founder and public company CEO. After having spent more than 40 years helping to build the enterprise software industry and, among other things being credited with writing the first business plan for Oracle in 1981, Umang now devotes his time exclusively to the fledgling online education industry as an investor, board member and advisor. He can be reached at email@example.com.