Social Website Dysphoria

Around Europe, raising funds through venture capital is not as widespread as in the US, and this shows quite well the huge difference in innovation between the Old World and the New World. While the US have just 12% or so of the Internet population, they have created over 90% of the most popular websites — or probably more (again, these numbers vary a lot and depend on the sources you look up). In fact, the concept that anyone without any contacts, but with just an idea, and the ability to sell that idea on an “elevator pitch” to a business angel will get them millions on their account, usually even without needing a business plan or any kind of collateral — that’s an American concept, and one that is quite successful. At least in the sense that out of all those bad ideas, a few good ones will emerge: so long as you can generate many. And gosh, by the late 1990s, there were quite enough ideas around. Too many ideas, as we found out after the bubble burst — but, of course, it’s so easy to judge history from our end. Back then, people simply had no idea what would work out and what wouldn’t.

But that didn’t mean that they wouldn’t get funding — rather the contrary. America financed dreams. Most of the projects were, in fact, as insubstantial as dreams. But a lot got financed. And, although we can be very critical today, the truth is that this model usually works.

The bubble didn’t burst because too much money was invested — rather the contrary. Even if investing in a silly idea that would utterly fail after 3 years, the money would circulate. It would allow the failing company to buy servers and bandwidth, thus, well, providing more revenue for ISPs and making them push for higher bandwidth from the carriers, and demanding better chips from Intel and less expensive routers from Cisco. All this happened incredibly fast: since a lot of money was spread around, a whole industry started from virtually nothing, and not everybody lost.

There are a lot of ironies after the bubble, of course. Web-based ads, which was deemed one of the worst ideas during the last days of the bubble, survived. The giant Google only gets revenue from ads — they lose money on everything else (specially on YouTube). They’re excellent survivors of the dot-com days — they seemed to be one of the many stupid ideas around (how do you finance the huge running costs of a free search engine?) but in fact they had a totally different business model. Giants like Amazon.com and eBay/PayPal also survived well, and we’ll shortly see why.

But a lot of companies failed. Hundreds of thousands of them. Why?

The answer, surprisingly, is very easy: They did not have a solid business model.

And this is the hardest thing to understand. During the wild days of the dot-com bubble, most companies were looking for valid business models, a way to generate revenue based on their ideas, and prove to their investors that the model worked. They looked good on paper. Almost everything was either subscription-based (like, well, web-based email…) or traffic (VoIP…) or something like that. The idea was to tie the costs of running the service to the growth of the paying user base: if you attracted enough paying users, you’d be out of the red.

What accelerated the process, in my not-so-humble opinion, was the sudden inspiration that a lot of companies had. They weren’t generating enough users to pay for the costs of running the service; so, well, before all venture capital was burned, they opened up the service for free, expecting a huge influx of new users, and hoping against hope that some of those would stay and pay.

These were the very first days of the “free Internet”, when suddenly even Internet Service Providers started providing service for free — burying the small companies, of course, and almost collapsing themselves in the process.

But on the Web side of things, “free basic accounts” started to pop up everywhere. And this has a dramatic effect. Every good sales manager learns the Rule #1: Once you drop the price for a customer, you’ll never be able to charge more again. So, dropping the price to zero meant that they would never be able to charge for the service. Ever.

To make things worse… more users, and an explosive growth of users, naturally means more costs. Here is where the very few companies with realistic business plans were placing their bets: twice the infrastructure does not mean twice the cost, but usually an increase of, say, 50%. There was your margin. So, all you needed to do is to reach that point where suddenly your costs would be growing at a much smaller rate than your user population. Once you reached that point, you’d be safe — even losing here and there a few million users on free accounts wouldn’t make a difference at all.

Unfortunately, for hundreds of thousands of companies, the bubble bursted too soon: way before they reached that point. And, of course, this meant that Plan B wouldn’t work, either.

Plan B was also simple enough. If you never reached that wonderful point of diminishing costs, but had a large subscription base, you’d become a valuable asset for any huge megacorp interested in investing on the exponentially-growing Internet business. Back in the late 1990s, this meant becoming attractive to, say, AOL or Microsoft (but there were more). As you might imagine, the number of those companies that actually managed to reach that ultimate goal was quite small — hundreds or thousands, but definitely not hundreds of thousands!

The bubble simply burst when it was clear that the vast majority would never reach the point where they would actually become interesting — either as a self-sufficient company or as a valuable asset for a megacorp. And so, bye-bye Web 1.0.

The legacy of those wild years was simple: people don’t want to pay for Internet-based services. So the only things that interested a majority of users was for free. And if you don’t have a revenue model, you’re out of business after you burn out all your venture capital. It’s a simple and harsh fact of reality, and completely unavoidable. It should have been easily foreseen. I’d be too arrogant to claim otherwise, but even in my naive days, as soon as I understood that everybody was going to go for free accounts in despair of attracting new users, my partners and myself immediately dumped out company and sold out — because we were financially unable to survive in a world where everything was for free. It seemed obvious to us in 1999, but I’m not happy to say today “told you so” and waggle fingers at the ones who lost millions thinking otherwise. We never thought the collapse would come so quickly.

Not surprisingly, the new generation of companies that appeared after the bubble burst were quite different: they assumed that their services would mostly have to be for free, and started announcing free subscription models, right from the very start. Web 2.0 is the free web of free profiles, free uploads, free contacts, free email, free messaging. Everything we use has a free subscription model.

So how do these companies make any money?

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