The Price of Free

Tuesday, 16 June 2015

Back in 2009, Chris Anderson, the Editor in Chief of Wired magazine published “Free: the Future of a Radical Price”. In it he argued that the Free and 'Freemium' models were the future of commerce in the digital world. With Freemium, the basic service is free, but there are chargeable additional services.

We have always had examples of free samples, free time-limited offers and the like, but it has been argued that the economics of the digital world are such that “free” is not just a market entry or market boost strategy, but a sustainable business model in its own right.

I first came across the odd nature of Free back in the 1970s. My late uncle was wrestling with a problem of bus fares. He couldn’t make sense of the figures he was given to work with. The aim was to increase use of public transport while cutting the bus subsidy. Remember this was an era before spreadsheets! At low prices usage went up but so did the subsidy. At higher prices, usage fell, but the subsidy rose!! He asked me to look at his numbers as he was sure the working must be wrong.

He worked out what the cost of a free bus service would be and it turned out to have the lowest subsidy. How come? At free, there was no need for ticket machines, the life cycle costs of cash management and the need for inspectors and legal enforcement went away. Even at 1p, all of the above was needed. Sadly, the chance to experiment with a city-wide free bus service never materialised. The key driver of the cost of the service was the cost of money!

Today, much of social media uses the Free and Freemium models. Facebook has over a billion users and Wikipedia, one of the most popular sites on the net delivers a multi-lingual online encyclopaedia for free. Much is riding on this assumption. The P/E ratio of Facebook is 60, LinkedIn is over 1600 and Twitter is -42.

So, are we in another bubble, or is it 'different this time'?

How do we evaluate a company who provides a service based on the Free/Freemium models? For instance is Facebook a B2C business or a B2B business? In the digital world, it is argued that there is such a thing as a “free lunch”. If you don’t pay for the product, then you are the product’. The value created it is argued comes from the data harvested about you and sold to advertisers, backed by complex terms of service.

One facet of the digital economy is that “network effects” tend to create big winners and losers, a “winner takes all economy”. Metcalfe’s law, starting in telecommunications networks argues that the “value” of a network increases with the square of the number of connected nodes, while the costs increase linearly.

This has been extended to the wider tech economy to explain the dominance of individual companies in different niches. This in turn supports the “go for growth and reach critical mass” and then the revenue will flow.

There are a number of approaches to challenging this assumption.

First, what do we mean by value? The next 100 million users on a tech platform will tend to be older, poorer, less well educated etc than the last 100 million. One approach is to replace n2 by nlogn to reflect diminishing returns as the number of users increase.

Given that the model is funded by advertising revenues, if we value social media companies as media, not tech, companies then looking at the valuations of the FT or the Guardian or the Economist, or the Daily Mail vs ITV shows that what matters is the value of the “audience” to the advertiser, not just the number of users. In this way, most social media is essentially an online version of the free newspaper.

These valuations also apply to the so-called sharing economy. Uber the taxi firm and Airbnb, the 'hotel' company have valuations that are reminiscent of the heights of the dotcom bubble.

The term 'unicorns' is widely used in Silicon Valley for start-ups with a valuation of $1bn not (yet) supported by revenue or margin. Unlike the creatures, they are not rare, with around 80 currently.

The evidence is that conversion rates from Free users to Freemium runs around 5% at best.

One good example from recent commercial success is to look at digital TV. Sky made the first generation of set top boxes free in exchange for a contract for use. Since achieving critical mass, subsequent developments in the set top box facilities have led to charges both for the box and the TV service.

So, do social media companies create sufficient value to charge the users to rebalance their revenue once critical mass has been achieved?

During the crash of 2007-8, the social media companies were relatively small and while advertising revenue overall fell, the switch to digital advertising allowed them to continue to grow.

However, now their size is such that a cyclical slowdown in advertising spend would impact on their growth prospects and valuations.

So, is this a bubble and when will it burst? My own experience of 1998-2001 was looking at the number of “experts” on the “new economy” who went into print arguing that “you just don’t understand”. As a leading indicator of market correction my own view is that this time that we are at the top of the market.

Even if I am wrong, the challenge to the business models of the dominant players by the EU for instance may well be a block on their expectations. Indeed it could be the needle that bursts the bubble.

The value of free is going to be an interesting voyage of discovery I suspect. “Man is born free, but everywhere wrapped up in Terms of Service.”

This article is part of a series on the Future of Price.