I have recently been reading the book “Free: The Future of a Radical Price” by Chris Anderson.  Well I am not actually reading it as I find I do not have time for reading books any more.  These days I do all of my “book reading” using audio books from Audible.com.  I find that by making a conscious effort to listen to a book every time I am driving a car, on a plane, in a cab, in a restaurant by myself on a business trip, etc, I can actually get about 45-60 hours per month of audio book covered using time that I cannot otherwise use all that productively.  This amounts to about 1200-1500 pages of book equivalent per month which is a lot.  Anyhow, I digress.  So I am “reading” Chris’s book and while I tend to agree with Chris on a lot of the trends and use cases cited in the book, the Financial Economist in me is screaming that there is a potential train wreck coming for the technology sector and consumer oriented Internet startups in particular.

For those who have not read the book, let me boil it down for you enough to understand where this article is coming from.

In a nut shell, Chris’s premise is that since the marginal cost of a computer program, web site, etc is close to $0 and given the expectations of Gen X and Gen Y that all things are available free on the Internet, that most software or web offerings will be forced in the future to have some form of Free version in order to get traction.  Furthermore the book is filled with examples and cases of how people have made a viable business by offering something for free and making money through an upsell, advertising, etc.

If you are in any way thinking of starting a technology company or bringing any product to market (particularly if its aimed at consumers under 35) then this book is a must read, as it makes some important points about the behaviors and mentality of today’s consumers.

Anyhow, what concerns me, particularly for consumer Internet apps is that it basically implies there will be only 2 viable business models going forward.

1. The core product is offered for free and is subsidized by advertising
2. The Freemium model, where you offer a scaled down free product and hope to convert a small percentage of users to a paid premium version

Now I do realize this is an over simplification but it’s sufficient for the purposes of this discussion.

What worries me about all of this can be broken down to the following few points:

Scale
Both of these models require huge scale in order to be viable as a serious business (by that I mean supporting more than a handful of employees in the business).  While I understand that its certainly possible to achieve huge scale with consumer Internet based apps, it’s very difficult.  What portion of applications on the web get to 1 million users never mind 10 million or more?  The bottom line is that if you cannot achieve this kind of scale,  then it will be very difficult for a business which relies on advertising revenue or converting 2-5% of users to a paid product to support more than a part time income or at best a handful of employees.

Reliance on Advertising
In the case of a business that relies on advertising from others to subsidize its product, I question the long term viability of this model for any one company, unless you are one of the few big success stories such as Google, and lets face it, although everyone wants to be, not all startups can be a Google.  Again, without huge scale It won’t be possible to generate enough advertising revenue to support more than few employees.  In addition,  lets do a small thought experiment (albeit one that is hopefully not too realistic or we are all in big trouble).  Imaging that all consumer oriented internet based apps eventually end up being free and that they are subsidized by advertising revenue. Who buys those ads?  If no one is making money directly through the sale of end product, then I argue that no one has money to pay for ads and the whole model fails.  The only way this model can work for more than just select point businesses within an ecosystem where at least some businesses make good money from direct sales of products, is if there is tons of external capital being pumped in to subsidize these business and to pay for those ads.  In this case its just a matter of time before that external capital dries up as its absolutely impossible for this system as a whole to make a sufficient return on investment at a systemic level.  That’s not to say some business won’t reap very good profits, My point is that as an economic sector overall using just this model,  its not possible to be profitable.  Therefore there must be at least some products for which the consumer is willing to pay for the product directly in order for this to succeed.  When you consider the average Gen Y doesn’t feel they should ever pay for anything computer software related, this is a big potential problem for the information economy in the future and the companies who hope to be successful selling to them.

The Freemium Model
I actually think this model is more viable but it has its own challenges.  Firstly,  you still need huge scale to support more than a handful of employees.  Lets assume we can achieve that scale for the sake of argument.  What I think is difficult here is determining what your Free product should be such that it attracts a large number of users, but still leaves them wanting more.  If the product is feature light, you will not attract a large enough user base.  If the free product has too many features, then people will feel no need to upgrade to the paid premium version.  This is a very fine line in my opinion and one which is very hard to discern.  To make matters worse I suspect that over time as more and more gets offered in free versions, the level of features that will need to be in the Free versions will constantly increase making it harder and harder to get people to convert to the premium product.  If this turns out to be the case this business model will also collapse in time as conversion rates will constantly be in decline and will eventually approach zero.

I guess the bottom line here is that if you are planning to build a consumer oriented internet application,  you need to think long and hard about your business model.  Are you doing this as a hobby, in which case you may not care if it makes money or are you hoping to make a living off of this effort, in which case you need to think about this long and hard before you begin or you will fail to be successful.

Anyhow, as always, comments are welcome both here and on Twitter (@TechMusings)