A couple of weeks ago, TechCrunch, a blog that hit it big by chronicling the rising fortunes of Web startups, launched a decidedly downbeat new feature: a layoff tracker. Silicon Valley insiders have long wondered how deeply an economic downturn might hurt tech firms; after all, companies here in the Bay Area weathered the worst of the last recession, and since then, they've all adopted leaner, less profligate business practices. (E.g., there are no more Super Bowl ads featuring sock puppets.) But hard times are here again. Venture capital firms are telling their clients to batten down the hatches because free money is gone. Share prices for the biggest tech companies have plummeted over the past year. Per TechCrunch, dozens of companies have announced plans to let go of more than 24,000 workers, and no one doubts more cuts are coming soon. Even Google's fabled free-food privileges are being cut back.
The worst-hit companies are the smallest—the startups that are the star players in the Valley's recurring tragedy of flameout and rebirth. With the market down and the financial sector in distress, startups that launched with only the haziest plans for making money now have nowhere to go. Young entrepreneurs flock to Silicon Valley to win billion-dollar IPOs or to sell out to Google or Microsoft for huge sums, but neither option is feasible anymore. Now startups have to think of other ways to make money. The bad news is that the Web economy is dominated by advertising dollars, and advertising often suffers during a recession. So what to do? In the absence of ads, an IPO market, venture capital funding, and guaranteed acquisition, how can startups make any money?
Allow me to propose something crazy. Tech companies should start charging people to use their services. No, seriously. Let's take the biggest example of a Web site that has no clear path to profitability: Facebook. The social network attracts more than 100 million "active users" around the world, but as of now—as even its founder Mark Zuckerberg admits—it's still looking for a "business model" (that is, a way to make tons more money than it spends).
But let me say that again: 100 million people use Facebook regularly. Judging from some of the folks in my social network, a sizable minority of Facebook users have hundreds of "friends" and check in to the site multiple times a day—call them superactive users. Let's imagine that Facebook became a tiered service. A free plan would limit you to 200 friends, one status update per day, or some other non-Draconian combination of restrictions. But for $5 a month, the limits would be lifted. Certainly, many users would balk; tens of thousands would join Facebook groups to protest the new pay model. Let's assume that 95 percent of users will refuse to pay a dime. That still leaves 5 percent, or 5 million people, to pay $60 a year. That's $300 million in the bank.
I confess that I didn't come up with the idea for this radical business model on my own. I stole it from David Heinemeier Hansson, a developer at the innovative Web software company 37signals, a firm that has long proselytized the advantages of asking people to pay for stuff. The firm makes a tidy sum by charging small businesses—companies in what it calls the Fortune 5 Million—$50 or $100 a month to use its suite of excellent project-management and collaboration apps.
"We've found out that having a price is really cool for making profits," Hansson pointed out last spring in an entertaining presentation called "The Secret to Making Money Online." "You have customers, they pay you money for the product or service, and you get profits! It's almost too simple to work." Of course, 37signals didn't come up with this idea on its own, either: "I've heard that over time—hundreds of years actually—this has been how most businesses have made their money. But somehow that notion got lost in the Web world."
But wait a minute, you might be thinking. That can't really work—perhaps Facebook can make a few hundred million dollars a year by charging people to use its site, but Facebook's investors have valued the company at $15 billion. Facebook harbors Google-like aspirations of changing every facet of society—by mapping our social relationships, it aims to alter how we make friends, how we do business, how we understand the world around us. That sounds like a very grand plan, a plan that deserves to make billions—not just a few hundred million.
But does it? What exactly is so bad about making a few hundred million a year? Is that anything to scoff at? A strange delusion overtakes the tech industry in good times. When entrepreneurs see a few startups selling for billions—in 2006, Google snapped up money-losing YouTube for $1.6 billion—they believe that they, too, can realize billion-dollar dreams, and in the process they overlook million-dollar opportunities. "People tend not to look closely at the odds," Hansson told me. "There will always be people winning the lottery, but that doesn't mean a good financial strategy is to go out and buy lots of lottery tickets."
Instead of taking a heap of venture capital money—lottery tickets—in the hope of one day getting a huge payout, Hansson says that Web entrepreneurs would be better off starting their businesses in the way most offline entrepreneurs do: Use a small amount of seed capital to make a good product that appeals to a client base that is willing to pay you for it. Then, over time, use the money you make from your customers to improve the product or to create more products—allowing you to attract more paying customers, which then lets you invest more into the business, and so on. It's a cycle that has proved quite successful over the millenniums that humans have engaged in economic activity.
Hansson calls this the neighborhood Italian restaurant model of Web commerce: It's a lot easier to start a nice neighborhood restaurant than it is to start the best Italian restaurant in the world (the Google of restaurants). But just like their bigger brothers, neighborhood Italian restaurants make money. Sure, they don't make as much as the best restaurants in the world, but they do well enough—and it's not nearly as much of a headache to run a neighborhood restaurant as it is to run a place where investors, critics, and the world's press are breathing down your neck.
Indeed, launching a small business online is much easier than starting one offline. Startup costs have plummeted over the last few years; using application-hosting services from Google or Amazon, one or two smart developers can cobble together a Web app with just a few thousand dollars. And the Web offers numerous ways to charge for your wares. Like 37signals, you can levy a subscription fee. But Hansson points to other firms that have seen success with different strategies. Freshview, a software company based in Australia, runs a service called Campaign Monitor that manages e-mail newsletters. There's no subscription fee; you just pay per use—a flat fee of $5 plus $.01 for every recipient. (E.g., sending a newsletter to 4,500 subscribers would cost you $50.) The Web also lets businesses offer tiered pricing. FaxIt Nice, a clever startup that lets you send faxes from your computer, charges $4.99 to send a single fax or $.18 per page if you buy in bulk.
The beauty of such small Web businesses is that they are well-positioned to survive downturns. Software from 37signals replaces collaboration tools that cost thousands of dollars; as IT departments around the country shrink, Hansson predicts that his software will increase its market share. Contrast that to the fate of Web firms that rely on advertising to make money: When the economy turns sour, large clients will stop buying ads, and suddenly the Web firms are sunk.
Hansson told me that many aspiring Web entrepreneurs thanked him for the presentation he gave last spring. "Many felt that being in San Francisco, they were being pushed to start the next billion-dollar social-viral-whatever thing, and if they were not doing that—if they were just trying to think about a business that makes money—they got the feeling that they were doing it wrong," he says.
Since then, however, Hansson has seen some evidence that rationality is coming back to the startup world. Consider the nascent microblogging sector. The much-ballyhooed startup Twitter now has more than a million users, but it still has no way to earn a single penny from them. But in September, a new microblogging service hit the Web. Yammer is pretty much identical to Twitter except in one major way—it charges businesses a fee to manage employees' Yammering. It's unclear whether this is the right model, but at least it's a model—something Twitter might have thought of, Hansson notes, if it hadn't been given a free ride by investors. Incidentally, Twitter seems to have heeded the message; the company says it'll reveal its business model next year. Hopefully that won't be too late.