[UPDATE: See two update posts: “The Value in in the Experience” and “Music Operates Directly on Your Abstract Syntax Tree“]

The “Free” Firestorm

Hank Williams, my recent blogging buddy, lit the internet on fire recently with a series of posts where he accuses venture capitalists of collapsing the market for software entrepreneurship by funding so many companies that give products away for free. He says:

In today\’s “free” world, in most online business categories, it is inherently impossible to start a small self-sustaining business and to grow it. This is because in the digital world, advertising, the only real revenue stream, cannot support a small digital business. If businesses were based on the idea that people paid for services then small companies could succeed at a small scale and grow. But it is very hard to charge when your competition is free.

…Venture capital has totally distorted the market. VCs are investing billions of dollars in companies with instructions to get big fast and to worry about advertising revenue later. As a result the competition is for users and not paying customers.

Then at Startup School 2008, DHH took Hank’s fire and poured a 500,000 DWT oil tanker on it with his talk “The Secret to Making Money Online“. And what was the secret? Charge people for your product! Breathtaking, isn’t it? We’re living a world where feathers get seriously ruffled when you insinuate that people should have to pay money for stuff.

This recent “free” debate needed to happen, and some good points were raised. Anything that can be digitized can be copied and distributed for (essentially) free on the Internet, so anyone whose business is digital or digitizable needs to understand free. It can either be an advantage (if you’re starting from nothing and building up) or a disadvantage (if you used to rely on high copying costs to protect your profits – I’m looking at you, music and movie industries).

Breaking Free From Free

What does this mean for software entrepreneurs? Right now the market for people wanting to make money off the Internet (supply of entrepreneurs) is growing, the demand for free software is growing, but what about the demand for non-free software?. Reg Braithwaite aka Raganwald asked a great question:

What does this mean for startups and business models? Is this effect stronger in some niches (programmer tools, for example) but weaker in others (enterprise integration applications)? Does SAAS change the game? Does pricing a product so that it is credit-card-ware change things?

Rather than answer those specific questions (which I don’t have any particular insight or experience into), let’s look at some guidelines for anyone trying to grow a profitable, Ben and Jerry-style software company. Hank gave his advice on the subject in “Seven Dos and Three Dont’s for Creating New Web Products” post (definitely go read the whole post for details and examples). Here’s my list of 5 principles to evaluate an idea to see if people will pay for a product that:

1. Supports serious, expensive hobbies
2. Is so outstanding it redefines its category
3. Helps businesses spend less money
4. Helps businesses make more money
5. Can be bought easily and instinctively

1) Consumers with serious, expensive hobbies will pay for high quality tools and services. Look at what people DO spend money on, and figure out what benefit they get out of it. Then provide a similar or better benefit. For example, photo buffs like SmugMug because it’s better, more attractive, and has better tools to make showcasing pictures easier. Millions of people pay for XBox live because it’s the best console-based Internet gaming platform. Audio and video buffs buy expensive software to give them the effects, speed, and ease of use that they need. People throw money around all the time – if we’re afraid to charge money, have we really created something that people value?

Heck, I paid over $150 just for my scuba fins and that’s not even the part that keeps me alive! Not only that, I was ogling the $250 pair that made me swim faster for less effort. And I pay $50-70 every single time I get on a boat. Looking around my house at my hobbies, I have about $1,200 of scuba gear, about $1,000 of camera gear, a $600 camcorder, over 100 DVDs, a gajillion dollars worth of kids’ toys and books, etc. I even have about $500 worth of lawn tools and I hate working on my lawn! Now try to tell me it’s hard to get people to pay for stuff.

Just take go through every expensive hobby that people have and find some aspect of it that could be digitized and delivered through software. Again, back to scuba diving – if you mapped and created 3D models of the world’s most popular dive sites, I guarantee people would pay to preview them (the trick would be to do it cost effectively, but that’s the sort of technological problem that we’re supposed to be good at, right?). If you’re paying $5K for a one week diving trip to Hawai’i, what’s another $99 to scope out the territory before you get there? Piggyback off where people are already spending tons of money.

People throw money around for experiences all the time – if we’re afraid to charge money, have we really created an experience that people value? If you can’t get people to pay you what they pay for a cup of coffee, a magazine, or one adult beverage, then how much are you really enriching their life?

2) Don’t be second best. People that are paying for hobbies pay for excellence. Excellence is your opportunity to build a moat around yourself. Two things happen if you build something that’s the best in class: you become easier to choose and you become harder to leave.

When you’re the best and you exceed expectations, people talk about you, the press covers you, and your sales and marketing job just got a whole lot easier. The hype before the release of the iPhone was estimated to be valued at $400 million in marketing value. If a satisfied customer raves to his friends about your product, your cost to sell to his friends is lower. They know about you and someone they trust has already recommended you. They’re now much more likely to choose you than Joe Schmo who hasn’t heard of you.

Not only that, once they’re in your fold, you get to raise the bar for their expectations as high as you want. While it might be hard for you to clear that bar, it will be sooooo much harder for your competitors. No one likes to backslide when they feel they’ve made progress – I get claustrophobic just thinking of some of the apartments I lived in when I was in college. Do I ever whip out my old cassette Walkman because I get so sick of having thousands of songs on my iPod? No. Have I ever copied the address from a company’s MapQuest page and entered it into Google Maps? Yes. Once I started using MSN Maps, I never used MapQuest again. Once I started using Google Maps, I never used MSN Maps again. I think iTunes/iPod music syncing falls into this category – people who would never dream of dragging and dropping music files to a mapped drive have no problem plugging in an iPod and waiting a couple minutes. Most people never looked back on tenements, horses, or farming once houses, cars, and grocery stores were available.

Back to the 3D scuba site model example (hint, hint to anyone that wants to collect some money from me): if your models are slow, wireframe models with little detail and no fish, then adios. If you’re offering full screen, full color, interactive environments with lots of detail, realistic fish, day/night cycles, tides, etc, then I have no choice but to take you. How good could you make it? Could you compare with Finding Nemo? Could you make it into a video game? Could scuba simulators be as popular as flight simulators? Don’t think small.

Make the product that is so good it forces your customers to raise their expectations.

3) Businesses buy things that help them spend less money. After all, if you shrink the top line, the bottom line grows. After all, businesses are just organizations whose expensive hobby is making money?. One way to do this is to build something comparable to an existing product and sell it for a lower price. This is very tempting because it’s easy to measure, but competing on price in a world with no distribution costs leads you to…free. Nuff said.

This isn’t a good idea for any industry and it’s especially bad for software. The price of physical goods is partly based on reproduction and distribution costs, while software is almost entirely priced according to willingness to pay (maybe that’s why there is more free software than free products). So if you have a worse physical product with better distribution or lower cost, you have more ways to swing the balance in your favor (think McDonalds vs Five Guys). With software, the only two variables are design (how well you solve the problem) and marketing (how aware are customers of your product).

A better approach is to shrink a market or disrupt your competitors. You build a worse solution to a known problem that happens to be a better solution to an unknown problem. This opens up new markets that you conveniently become a dominant player in – look at 37signals in simple web-based project management software. Basecamp is terrible compared to MS Project, unless you’re part of the (much larger) group of businesses that doesn’t find the power of Project to be worth the effort of dealing with it. This lets you nail the most important subset of features and since you have a different business model, you can charge a premium for your product while still undercutting competitors on price.

4) A close corollary of #3 is to help businesses make more money. The other way for businesses to make more money is to earn more money. They would love to buy a product that helps them make more money, but why should they trust you when you’re telling them exactly what they want to hear? They only want to buy things that works, not just what the vendor says will work. The Pragmatics and the Conservatives need to see other successful examples in order to trust you and to take the uncertainty out of your promised ROI numbers. The uncertainty of a new product is fine for the entrepreneur that created it, but not for most customers.

That’s why you need bold initial customers who will take the risk and are willing to share their experiences. Having predictable results is often more important for a client than good results (“No one ever got fired for choosing IBM’s $400/hr consultants”). This is fine, because once you have this baseline level of market confidence, your name and reputation sells itself and you get exponential growth through client case studies and testimonials.

Why else is this hard? You have to know a business or industry well enough to know how to improve it. You don’t have to be the guru of that industry; you can often make a huge difference by bringing a computational perspective to the domain. I bet everyone of you reading this has cringed at a horribly inefficient business practice that could be done cheaper, faster, and more reliably with a little bit of computing added to the mix. If you or someone you know has access to a non-computer business, dive in and look for ways it could be improved. Find out what they have to do but hate doing and find a way to simplify or automate it. A dentist would rather clean teeth than fight with insurance companies, a band would rather write songs than try to book gigs, an architect would rather design buildings than wrestle with permitting, etc. If they can invest some money in software that would help them do more of what they love and are good at, they’ll buy it. And what if they don’t? Their aggressive competitor will :).

Those previous examples were ways to save time, which was then used on the primary business to earn more money. Another way would be to augment the primary business to make it run better. For instance, video editing software makes video production faster and easier while improving the quality. Digital cameras let you spend more time taking pictures and less time developing, while also letting you take more pictures and get instant feedback. A CRM lets you keep better track of your customers so you have more information to help your interaction with them. Project management software helps you write better software with fewer bugs. A Mercedes helps a real estate agent impress his clients while chauffeuring them from showing to showing. Know the business, make it better.

5) Make buying your product easy and instinctive. I can grocery shop very fast because I buy the exact same things every time – bananas, apples, milk, yogurt, Marshmallow Mateys, Tennessee Pride sausage biscuits, 5lb bag of rice, frozen veggies, ground beef, chicken breasts, etc. I don’t comparison shop anymore because I’ve already done that and now I know what I should buy. The companies I buy from literally don’t have to do any more work to sell to me! This is the appeal of subscription based software – continue to meet expectations and you continue to receive payments. Make something that becomes part of everyday life, and you’ve got a recurring revenue stream. Just ask Amazon how nice that tastes.

And please, please, PLEASE, make it easy for people to give you money! If you only accept Google Checkout, expect to miss out on PayPal users. If you don’t take checks, you’ll probably lose business. Do you customers really need to register to buy your product? If not, don’t make them! The exact amount of lost business because of payment restrictions is unknowable, but you can be pretty confident it’s not $0.

Conclusion

If you’re now thinking “So what happened? I thought this was supposed to be the easy answer to all of my entrepreneurial woes! All this guy did was increase the amount of work I have to do before I can cash out and go kiteboarding all day!”, then my work here is done. The simple lesson of economics (that I could have saved myself 2,500 words if I wasn’t busy trying to blow your cache) is that people pay for things that they value and that are scarce. Fix your eye on that principle, and while you’re walking down the road towards it, you’ll find what they value (expensive hobbies, making money) and what’s scarce (original, non-commoditized products, experiences, services that create value).

Now quit reading blogs and get to work!

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UPDATE: Here’s a good article with a similar idea: 13 Tips for creating a successful new online product

Follow the discussion on reddit and Hacker News