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On The House

Sometimes, the best way to make millions is to provide something free of charge.
June 1, 2000
URL: http://www.entrepreneur.com/article/28220

Justin Kitch has raised millions of dollars by giving things away. Homestead.com Inc., the 120-person Menlo Park, California, business he co-founded in 1997, provides free Web sites for the asking. Anyone who wishes can get 16MB of free disk space on the company's Web servers, along with the use of free site design tools that rival costly commercial versions.

Huge numbers of people have signed up to create their own "homesteads" on the Web for free. "Last year, we started with 100,000 homesteads and ended up with four million," says Kitch, 27. "And we're currently growing at more than 15,000 new sites per day." Granted, it's not too surprising that customers like Homestead's offer. But how do you explain the more than $50 million Homestead has raised from investors over the past two years?

The fact is, Kitch has figured out how to generate revenues by giving things away. It works like this: Homestead collects fees from more than 75 online brokerages, electronic publishers, search engines and others for distributing their services to customers who are building free Web sites. "I don't believe in charging upfront for it," Kitch says of his company's site-building service. "And you can actually make a lot more money off the enormous volume of visitors you generate."

Kitch isn't the only one attempting to give his way to the top. Many well-known companies hand out products and services without charging anything for them. Adobe Systems has distributed millions of free copies of Acrobat Reader software for displaying electronic documents. Id Software has given away fully functional versions of the popular computer games Doom and Quake. And Microsoft claimed ownership of Web browsing software by doling out its Internet Explorer for free--after Netscape Communications, since acquired by AOL for more than $4 billion, created the browser market by gratuitously dispensing the Mosaic browser in the early 90s.

As Homestead does, other businesses can generate revenues from giveaways by selling others the opportunity to present their messages. TV broadcasters and free community newspapers do this, too. Businesses can also generate revenues by selling additional products and services, such as add-ons, upgrades, manuals, consulting and training, to people who are using the freebie. Adobe, for instance, charges $250 for the Acrobat software used to create the documents its free reader can display.

The power behind giving away products and services for free is in the way doing so can quickly create dominant market share, says Philip Evans, a senior vice president at Boston Consulting Group in Boston and co-author of Blown to Bits: How the New Economics of Information Transforms Strategy (Harvard Business School Press). "The strategy works," he says, "because once you have dominance, you can extract enormous value from it."



Mark Henricks is an Austin, Texas, writer who specializes in business topics and has written for Entrepreneur for 10 years.

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."

Do The Math

Giveaways can be considered a simple expansion of pricing policy all the way down to zero. But charging nothing for something can build your market so powerfully that sales actually multiply. Assume, for instance, you get 40 percent of your revenues from selling a product. The other 60 percent comes from selling upgrades, add-ons, service, training, manuals, consulting and the like. If giving away your product results in twice as many users, who then purchase twice as much of your related offerings, sales will grow 20 percent.

Of course, this isn't going to work for every business. If product sales generate half your revenues, then revenues may stay the same even if users double. If 60 percent come from product sales, then this model predicts revenues will decline. And if your number of users grows by less than 100 percent, revenues may shrink drastically.

Just because you start giving away products and services for free doesn't guarantee you'll gain users, either. You must have a good product that meets a definite need. Plus, you have to be able to market it well and provide competitive customer service. Ideally, this will allow you to establish a brand and build a powerful market share from which you can then derive substantial profits.

But giveaways remain an exceptionally aggressive and risky strategy-one that, as more companies attempt it, becomes riskier all the time. If a giveaway doesn't capture market share, the strategy fails and likely destroys the company. Giveaways can also obliterate a market's pricing structure, resulting in lower total sales for everyone. When several competitors offer giveaways, usually only one survives. Says Evans, "It's a bet-the-company kind of gamble."

No one expects giveaways to become the most important means of competition, but the lure of becoming the next Microsoft, which has a stock market valuation of half a trillion dollars, keeps the competitors coming. "The logic is that there's a huge [pot] of gold at the end the rainbow," Evans says. "People think, 'If we do this right, we can be the next Microsoft.' "


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