Hank Williams managed to stir up quite the controversy with his recent post lamenting the rise of free and blaming the VCs. His assertion is that the venture capitalists have made free, ad-supported businesses the norm and effectively "ruined it for everyone else" (my words).

I believe it should be possible to start a small business and to have a small number of profitable customers, and to earn a living. From there, it should be possible to work hard, and to grow your business into something substantial. Until recently, this was the American way, and it applied to technology as much as to any other business. But no more.

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.

Hank blames the VCs for this trend, but as Charlie points out, this model has been around for a while. "Giving away the blades and selling the razors" certainly predates the Internet and this epidemic that Hank thinks we're experiencing. As Charlie said,

Noticing a trend here?   Ford went out of his way to get these cars as cheap as possible.  It's not a stretch to think that if Ford would have thought of a way to make money giving cars away for free to get scale (maybe make money just on replacement parts or gas or something) he would have done it--and he would have tried doing it on the backs of his investors, too.

Hank blames VCs for essentially breaking this tried and true apple pie model of business.  The reality is that, for years and years, outside investment has enabled businesses to fill the gaps between overhead and incremental revenue until scale has been reached. 

What Hank fails to realize is that profit and revenues aren't the same thing...so, just because you make revenues doesn't necessarily make you a better business nor does it preclude the need for outside capital. Amazon didn't turn a profit for years... and now they're making lots of money.  Without not only venture capital, but public market investment, that business would have never existed... and they were making revenues, just not at a profit.

Mike Masnick rebuts Hank's assertion that advertising is the only option.

Advertising certainly is one revenue stream -- and an important one at that -- but there are many business models where you can make money by leveraging "free" to make scarce goods more valuable. Advertising is one such business model (using "free" content to make someone's scarce attention more valuable), but it's hardly the only one.

But, really, there's a bigger dynamic at play here that I think Hank is missing. Obviously, venture capitalists invest in companies that have huge upside potential. They're not interested in cash cows or companies that grow "responsibly". Part of the reason they invest that kind of money is to get to scale quickly, establish or disrupt the market, and then figure out how to make money.

Business Models Happen

There are plenty of business models we know about today, but ultimately the lesson is that business models "happen". Many of the more interesting startups today don't have advertising today - Twitter comes to mind - and though I haven't seen their strategic plan I highly doubt if advertising is a core element in how they plan on making money. Personally, I think these emerging business models are the most interesting and potentially disruptive.

Hank argues that the supply of free is "ruining the dynamics of supply and demand", but Mike suggests that this is in fact the "natural natural economic state of the market". Mike concludes:

It's been shown that people naturally have trouble understanding the concept of zero. We may think we do, but as soon as a zero enters an equation, people tend to freak out and assume a model is broken. Yet, if we trust the model and realize it's not broken -- good things start to happen. Many businesses have learned that they can embrace "free" not because of a bunch of VC funding, but because that's the natural economic state of the market, and it allows them to make many, many other things more valuable. The real business trick is in making sure those things that are made valuable are what you're selling.

Indeed, much of this discussion was probably spawned from Chris Anderson's article arguing that free is the future of business. I think Ed Sim summed up the article best, saying "all services eventually get priced at their marginal cost [...] and that price is quickly going to zero in a world of technology." But, as Ed added, "at some point in time dollars do have to come from somewhere". This is where attention and those new business models come in. Or, to quote Chris' article:

There is, presumably, a limited supply of reputation and attention in the world at any point in time. These are the new scarcities — and the world of free exists mostly to acquire these valuable assets for the sake of a business model to be identified later. Free shifts the economy from a focus on only that which can be quantified in dollars and cents to a more realistic accounting of all the things we truly value today.

This does not mean, as Hank asserted, that you can't start a small business, be profitable, earn a living, and grow steadily. As Guy Kawasaki's recent experiment proved, you can build a site on the cheap. To wit, Corey and I are consulting with a friend helping him to build his site, and we got a quote from an ASP.NET developer near NYC (not usually the cheapest combination) for less than $10k. When you invest so little initially, it's relatively easy to grow slowly over time. With so much free and open source software out there, it's even easier.

A great example of this steady growth is a content-based site like TechCrunch - there was relatively little capital investment needed to make it into the powerful brand it is today. Rather, it was Mike Arrington's sweat equity. It was profitable early, and now has certainly grown into "something substantial".  

Or take the example of Digg, which Kevin Rose built with a $2,000 investment - $1,200 of which went to purchasing the digg.com domain. There is little doubt in my mind that Kevin could have just run it as a successful business making money off the ads, but they decided to raise two significant rounds afterwards because of an obvious opportunity to scale it into what is now being rumored at a $200-300M business. It's a lot easier to make profit when your overhead is low, but the point here is that the initial idea and plan did not stem from what Hank would call the VC's "perverted economics" (again, my words).

But perhaps the greatest example of all is Craigslist - you know, the site that never took VC money and has steadily grown over the years into a $5 billion business expected to do $80 million in revenue in 2008.

Disruption, Innovation and Commoditization

Here's where I'm struggling to sympathize (or empathize, for that matter) with Hank. VCs invest in potentially disruptive businesses, and disruptive businesses usually need to achieve scale before they can do so. And, more often than not, disruptive businesses do not grow steadily and "earn a living" - they are high risk, high reward and that's precisely what attracts that kind of money.

The Innovator's Dilemna from WikipediaBut if they are truly disrupting the existing economics, they are doing exactly what they set out to do.

In many ways, I see this as the the corporate version of the dynamic we saw in outsourcing. As I discussed in the past, being a commodity is not a good thing. The lesson there was that we get comfortable with what we know, use this as an excuse to stop learning, and then act surprised when our skills - which are no longer rare commodities - don't command a premium price. I think the same dynamic holds true here.

Look, for example, at RSS aggregators. In the past, Newsgator was able to command a premium price - I was among their paying customers for several years. Now, the NewsGator client applications are free and it's precisely because of the rise of a different commodity. Unlike the music industry, Jeff and NewsGator was tuned in enough to realize they were working with a dying business model - that is, the act of selling what was quickly becoming a commodity.

If you look at all the stalwart top firms across all industries, you'll recognize a very similar pattern emerging: they milk something while the milking is good, but are always looking at continuing to innovate. My former employer, Goldman Sachs, was famously good at this. They would create a new financial instrument or market, make huge margins while everyone else was catching up, and then move on to the next big thing. If you look closely, mainstays in the tech world like Apple, Google and, yes, Microsoft all do this well.

In the end, whether it's driven by VC investment, angel investment, or self-funded, there are always going to be companies that come along and disrupt the status quo. They do so precisely by changing what we see as the "normal" economic model.

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