On The House

The Rules

Not just any business can prosper by giving away valuables. If you want to do it well, you have to understand your business thoroughly. It's especially important to ask whether you have strong economies of scale-do your costs go down sharply as your volume increases? "If you can't make money at low volume," warns Evans, "you can't make money at high volume."

You must also understand your market. So, the key here is to ask and determine whether there are signs of network effects or virtuous circles. These terms describe the way popular products tend to become more popular. Examples include the VHS video standard, which trounced the competing Sony Betamax technology once it had a lead in the marketplace. If using your product fails to encourage others to use it, there isn't likely to be any beneficial network effect.

However, if the answer to either of these questions is strongly positive, then you may have a business where a giveaway strategy makes sense. The software business is probably the best example, because it costs next to nothing to make an additional copy of a program, and users want to use the same technology so they can share files. That's why software giveaway strategies work so well.

Distribution is another issue. Internet businesses can distribute services and products inexpensively, widely and rapidly, so giveaways let them grow extremely fast. In its speediest spurt, Homestead grew from two million users to more than four million in just three months.

Giveaways can also help businesses where innovation is valuable. When software companies give away their source code, which allows others to tinker with their programs, they may effectively gain thousands of volunteer programmers who fix bugs and add features, says Michael Tiemann, chief technology officer of Red Hat Inc., a 600-employee Raleigh, North Carolina-based company that's built its business around charging for beefed-up versions of Linux, which is distributed free using this open source model.

Today, the Linux operating system rivals Microsoft's Windows NT operating system in reliability and other important aspects, largely due to the efforts of more than 10,000 volunteer programmers who have contributed patches and bug fixes since its creation a decade ago. "The open source model not only reduces the barriers to distribution," says Tiemann, "but also reduces the barriers to innovation."

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This article was originally published in the June 2000 print edition of Entrepreneur with the headline: On The House.

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