Charles Hudson’s Weblog

Quick blog post as I continue to process a lot of things I thought about while I was away on vacation. These two things are unrelated but I have been thinking about them both quite a bit:

I have seen a lot of products in the social media space that bill themselves as utilities of some sort. I interact with a lot of utilities in the real world (power company, Comcast, etc) and they all have the same basic business model - an access fee and some form of consumption pricing. Why should utilities on the web be any different?

I played with two really cool netbook computers over the break and now I really want one. I think we are on the verge of seeing the “holy trinity of cheap” netbooks, cheap wireless access, and cheap (or free) software working together harmoniously a lot quicker than expected. I think this trinity of cheap is going to radically accelerate a lot of the trends we’ve been seeing, namely the mass adoption of web-based software.

I spend a lot of time thinking about what it means to offer products that are free or basically free to users on the web. I try not to get religious about free - there’s nothing inherently right or wrong about choosing a business model that incorporates a free component so long as you understand what you’re getting yourself into and have a plan for how to make up the revenue somewhere.

With so many social media companies rushing to discover and implement a business model that will work for their service and community, I think the discussion of free sometimes gets convoluted. I think there are some really important distinctions between a model that incorporates a perpetually free version with a premium upgrade and a model where there is one (or few) offerings that users can fully enjoy for some period of time before having to make the pay vs not pay decision.

I want to make the case for more companies tinkering around with the “free trial” approach as opposed to the model focused on a neutered version of the paid product being offered for free with the hope of eventual upgrades.

I can think of two sensible ways to offer a free web product whose ultimate aim is not to be ad-supported:

1. Perpetually Free with a Paid Upgrade Option - Under this model, you build a product that has a perpetually free version that is a degraded version of the paid product. The onus is on the company to properly delineate the free and paid offering such that the basic offering is sufficiently useful to the free audience and the premium offering is sufficiently valuable to those who choose to pay.

2. Free Trial with Pay or Quit Option - Under this model, you build a product where the user can consume the full version of the product but only for a limited period of time. At the end of the trial, the consumer must decide whether or not he/she likes the service enough to continue paying for it.

For now we will ignore a more nuanced approach that blends both of the generic strategies above.

There are a lot of social media people today who are trying to figure out a freemium model for their product or service. We’re already seeing models that combine a perpetually free offering with a paid upgrade option work pretty well in the free-to-play gaming space (you can see my earlier post on virtual goods in the United States as a reference). As a basic rule, I think freemium can work really well for products in which the free and paying users can peacefully coexist or where having more people engaged using the service actually makes it more useful for paying and free users. It’s still worth noting that the “free trial” approach in gaming still generates a lot of money (see World of Warcraft or any other successful subscription MMO).

There are a few things about the perpetually free with a paid upgrade approach that I think are worth considering before heading down this path:

It is very difficult to properly segment users and features such that you provide enough value to both paid and free audiences. For example, an email service that provided a 10 MB of storage for free and 1 GB for the paid version would have a hard time surviving - the basic offering isn’t sufficiently compelling to get people in the door. Conversely, a service that offered 2 GB for free and 10 GB for the premium service might be giving away too much value in the free product to expect a large audience of people to upgrade. And that’s just one product dimension. Adding more dimensions just makes it that much more difficult to figure out the features for which users would be willing to pay.

Going with a free trial can be much simpler. You offer one product that users can fully consume for some period of time before they have to decide whether or not they want to pay for the product. It’s more important to figure out how much time a user needs to experience your product before he / she is ready to make a purchase decision rather than which features should be exposed to paying users vs free users.

Offering a perpetually-free product is a framing event for your customers. Offering a product free with no prospect of a paid offering can be a sticky decision. Customers begin to think of your offering as free and attempts to introduce paid offerings can rile the community. It doesn’t match with what customers thought they were getting into when they signed up for the service.

Introducing any kind of monetization can generate backlash within a community. But the longer the ethos of free is allowed to become an expectation within your customers, the more difficult that conversation can be. I think it’s a much easier conversation to have with customers when you’re explicit up front with the fact that at some point they will have to make a decision as to whether or not the product is sufficiently valuable to warrant payment.

Price is a signal and there is value in sorting between customers who you can afford to keep and those who you cannot.For customers for whom your service is not sufficiently compelling at the price point you’ve offered, you have an opportunity to tweak the offering. If people aren’t biting at the price you’re charging, that’s a meaningful market signal. And that’s information that’s better learned sooner rather than later.

Under the free trial model, it seems to me that testing alternative hypotheses is easier. You have the features you have and all users get to use them. You can increase the length of the trial, decrease the price, or do both. But what you don’t have to do is to go back through your segmentation of features and figure out if you sorted properly.

At the end of the day, I think it’s good to figure out whether the business model you have in mind works. The sooner you find it out, the smaller the stakes and the more time you have to fix it.

I was reading Justin Smith’s good post on Faecbook’s delayed payment system and I thought I’d share a slightly longer version of what I left in the comments on his blog:

I do think most of the major social networks have looked at payments and decided it’s a tricky business for them to tackle for the following reasons:

Payments generally don’t work as a side business - It’s pretty hard to run payments as a side business. Most people who have tried to do it have met with some real challenges. There is a lot of management overhead, regulatory requirements, and domain-specific knowledge required to run a payments business. Most companies don’t have the expertise to be good at what they’re doing as their core business and bootstrap an in-house payments initiative at the same time.

Facebook Connect can and should reduce friction for developers looking to accept payments- I do think there’s potential for Facebook Connect to reduce the friction associated with taking payments on social networks by allowing user to use their social network IDs to authenticate themselves when using payment mechanisms. I expect that most of the major monetization engines on social networks today (incentivized offers, micropayments, PayPal, PayByCash, etc.) are all looking at whether Facebook Connect can lead to a more seamless payment experience on social networks.

Developers are already cracking the payments nut without help from the platforms - Developers are actively experimenting with payments products today. Most of the top social games on social networks are already using some combination of MyOfferPal, SuperRewards, PayPal, SpareChange, Zong, Mobillcash, and other alternative payment technologies to enable their users to pay them directly. Unless there is some strong incentive to adopt a solution provided directly by the platform provider (Facebook, MySpace, hi5, etc), I’m not sure that most developers would adopt it.

In spite of all of that, I do think there are some real benefits to seeing a payments offering blessed and endorsed by the social networks themselves:

The current methods of payment on social networking applications are not well integrated into the flow of user behavior. Topping up a wallet, buying something, or otherwise transacting in many games is an out-of-band experience that often times takes the user out of whatever he or she was doing in order to transact. Presumably the payments offerings from platform providers would enable developers to tighter integrations into application flows. Make transactions more integrated into the flow of the game / app has been shown to improve conversion in more classic web e-commerce and gaming applications - why should it be any different on social networks?

Having a wallet or payment system offered and promoted by one of the major social networking providers would help lift the boat of any app developer who chose to integrate with it. Presumably Facebook / MySpace would provide meaningful promotion for whatever payment product they endorsed. Having an official payments solution being promoted by the social network itself should increase the number of payment-enabled customers on social networks. I have to assume that there are some users who are not transacting with app developers today but would transact if there were a blessed, trusted solution for payments provided by the social network itself.

We shall see how this all turns out in 2009.

I’m really excited to announce that I’m now an Advisor for Echovox, the company behind the very popular mobile payments service called Zong. I’m really looking forward to working with David Marcus and the rest of the team on their growth strategy.

I think mobile payments are a really big deal for virtual goods companies and I’ll have more to say on payments in general in a subsequent post.

I decided not to do a predictions post this year. My predictions for 2008 were reasonably good in my opinion, but review them here and make your own judgment.

I grew up in Michigan and just got back from vacation over the weekend. My home state is in a difficult place right now, so I figured I would focus more on talking about things that I think are positives for the tech industry next year instead of contributing to the pervasive sense of doom that’s out there (not that it isn’t warranted - 2009 will probably be tough). So here are my four “silver lining” guesses about good things that could happen in web technology for 2009.

The tenuous economy means technology that is “good enough” will get much more serious consideration from both enterprises and consumers and prove its mettle - It’s pretty clear that big businesses, even the likes of GE, are considering some very meaningful deployments of web-based office suites. I use Google Docs all of the time and while it’s not perfect, it works great and takes care of most of the things I need from a word processor. Even better, because these tools are built to be collaborative from day one, there’s no need to layer on collaborative capabilities after the fact. Given the cost pressures facing enterprises today, I think a lot of them are going to look at these systems and decide that they are good enough. I believe the same is true for consumers, especially given the growing robustness of netbook sales. Cheap computers need cheap software and you can’t beat the prices offered by most web-based software suites. The same will be true of other classes of web-based software applications beyond office tools.

Freemium will be misapplied by many in the web 2.0 arena, but we’ll learn a lot in the process - If the first 9 months of 2008 were about growth, the last 3 months were most surely about finding a revenue model and cutting costs in advance of 2009. There are a lot of companies out there who appear to be considering various freemium business models. I continue to believe that freemium is much harder to apply after you’ve achieved scale (more on that in a post that I should have done later this week) than it is from the beginning. Retrofitting any business model to a site with scale, let alone a freemium model that introduces a paid version of the service, is fraught with risk. While a lot of people will misapply the freemium model in the desire to put a revenue model in place, we will learn that there are some segments of the market where consumers are willing to pay and where the model does make sense. Moving from a model where ad-supported free offerings to a world where there’s more diversity in how services are priced to consumers will help create an umbrella where new entrants can be experimental. I don’t believe that everything in the consumer web space should be ad supported and I don’t believe everything on the web has a freemium play - it’s about time we start sorting out which services fall into which category.

Acid test for large, established social media companies - There are a lot companies in the tech space that fascinate us (Facebook, Digg, Twitter, etc) where the amount of time we spend noodling on them is largely out of whack with the current business opportunity for those services. I think 2009 will be the year where we really get a sense for how successful some of our tech darlings are as businesses. If they don’t work out, I think we’ll all have to rethink how big the near-term business opportunity is around these things.

Lots of small companies will “aim small” and do some impressive things - I think there are going to be a lot of small companies (small in terms of number of employees and capital at their disposal) that are going to build some very solid businesses in 2009. I’m not talking IPO-scale businesses, but businesses that generate millions of dollars a year, allow the team to cover burn, and leave enough left over to continue to invest sensibly in R&D. These companies are going to come out of the downturn in good shape because they’ll have had to figure out how to make the business work as they grow, as opposed to growing first and finding a business model after the fact. And some of these companies that start off trying to do one or two things really well at small scale will learn that they’re really good at doing that one thing and that what they thought was a small market is a lot bigger than they thought. Looking for some examples of what I mean? Facebook application developers who have apps that are working fall into this category. Ditto on iPhone application developers. I’ll even toss in a handful of web app developers who are building services that monetize without using ads. It’s happening already and I think these kinds of success stories will attract a lot more attention next year.

There you have it. There are enough negative things to dwell on so let’s not do that -feel free to leave a comment if you have other ideas about silver linings for the tech space.

I’m fully consumed with a number of projects at the moment, but I continue to be absolutely fascinated by iPhone games. I’m in the very preliminary stages of thinking through what a half-day conference focused on iPhone games might cover and I’m looking for input from folks as to what you’d like to see covered. Because URLs are cheap, I already have a skeleton site up here. If you have thoughts about what you’d like to see covered, who you’d like to see participate, or other feedback (positive or negative), just leave a comment here or on the skeleton page. The wheels are already in motion but it’s not too late to turn back if you all think it’s a terrible idea.

I read this article on All Facebook summarizing the basic arguments put forth in a slide deck called “Portable Social Graphs - Imagining the Potential” from Avenue A | Razorfish. I flipped through the deck and didn’t actually find the argument terribly compelling. I’m pasting thoughts below (I left them as a comment on AllFacebook but wanted to post them here too).

I read this slide deck and didn’t get why it’s such a big deal.

1. Amazon already offers collaborative filtering based on the feedback from a lot of other people. In the off chance that my friend and I bought the same product, why is that information more useful to me than information from someone else who’s a qualified / experienced product reviewer on Amazon? Most of my real friends have never reviewed the places I go on Yelp but I still get lots of utility from it.

2. When it comes to music, we already have some pretty good music solutions for sharing content with friends and the community at large. I’m not sure why the iTunes piece was more important or interesting than what can already be done using a broad, crowd-based filtering approach.

The one benefit to Amazon would be the same benefit that Beacon offered - the ability to broadcast activity to the News Feed to drive more commerce activity.

Over the past week or so, a number of people have asked me if there is any good data that one could use to estimate the size of the virtual goods market in the United States for 2008. I haven’t seen too many published estimates that make sense to me, so I thought I would start working through the exercise of coming up with an estimate of my own. For those of you who are short on time, I’ll save you the need to read the entire post - my guess is that the virtual goods economy in the United States is at least $200 million and possibly more. But please do read on and help me refine my estimates by providing some additional information.

Before I get too deep into my analysis and assumptions, I wanted to suggest a few important questions to consider when trying to come up with a sensible estimate:

Subscription vs virtual goods revenue - There are a number of companies, both in the free-to-play and subscription gaming space, that blend both virtual goods powered by microtransactions or macrotransactions and subscription revenue. So how should we treat this subscription revenue? For my own purposes, I’m going to exclude what I estimate to be revenue driven primarily by subscription fees unless those subscription / recurring fees are used as a way to provide premium access to special features not available to the general public. So, for free-to-play games these subscription / premium services are included in the total revenue estimate whereas I am going to exclude them for games or services where a subscription is required to access the service.

Primary vs Secondary markets
One of the biggest challenges in estimating the overall size of the virtual goods market is understanding the breakdown between transactions that take place in primary and secondary markets. There are lots of games with thriving secondary markets, some of which operate for cash and some of which operate for virtual currency, some of which are sanctioned and some of which are not, some which operate openly and some of which that don’t. Adding in various forms of currency farming, which are just secondary markets on their own, it becomes really difficult to quantify the scale of secondary market activity. So instead of speculating, I’m just going to exclude it.

One thing worth considering - in many (but not all) cases, secondary market transactions reflect revenue that flows between players and the revenue does not accrue to the publisher. So I don’t think excluding this revenue has a major impact on rough market estimates.

U.S. vs Global Estimates
I would have really liked to make a global estimate, but I think that’s really difficult. The reason why it’s so hard to estimate is that there are a lot of players in various countries that are large players in their own geographies but not major players on a global scale. So making a global estimate would require a deeper understanding of what’s happening in some specific key countries such as Korea, China, Germany, and some of the other emerging gaming markets.

One other reason I don’t think it’s that a global estimate is as useful is that relatively few companies have shown an ability to succeed in multiple countries. There are a few exceptions (Habbo, Runescape, Nexon) and a few others that prove the rule (CyWorld).

Casual MMOs and Virtual Worlds: $50 million to $75 million
Gaia Online has stated publicly that they do more than $1 million per month in virtual goods. In the spirit of disclosure, I used to work at Gaia and I know that this figure is both accurate and not an anomaly reported based one month’s performance. And, believe it or not, Gaia’s traffic skews heavily toward the US. IMVU has also stated that they do roughly $1 million per month in virtual goods sales as well, but I have less visibility into the geographic split of their traffic and how firm that $1 million has been over time. Habbo does somewhere in the range of $60 to $70 million annually worldwide, but a relatively small chunk of that activity (my guess is 10-15% by revenue volume) takes place in the United States. Based on what I’ve observed from other players in the space, including Stardoll, Meez, Neopets, and others, I have a rough idea for how much they’re making. Rather than try to estimate each of their revenues, I’ll lump all of them into the “other casual MMO and virtual worlds” bucket and call that $20 million per year. The last company I want to specifically call out is Second Life. They make a very healthy topline revenue based largely on real estate and a bit on the premium accounts a well. Second Life, however, has a very international user base so I’m not going to attribute a ton of revenue in this total to their activity.

You’ll notice that there are a lot of familiar names missing here. No Club Penguin. No FlowPlay. And I’m excluding most of the kid-focused virtual worlds and communities here as those are driven primarily, if not exclusively, by subscription revenue. To my knowledge they’re less focused on a microtransaction-based business model than they are the classic subscription model. I don’t find that too surprising as kid-focused virtual worlds have the opportunity to have a parent in the loop (and hence make selling subscriptions to young people more lucrative).

Social Networks and Social Networking Applications: $50 to $75 million
Of all of the places where virtual goods are making hay, the one place where I think it’s being underestimated is on social networks. Estimates, including this one by Jeremy Liew, place Facebook’s virtual gifts revenue at somewhere in the neighborhood of $35 million on an annualized basis. If you add in the revenue streams that top application developers are generating by selling virtual goods and services on social networks (both MySpace and Facebook), I think there is another $20-30 million at a minimum. Top applications can do anywhere from $100,000 to $1 million per month in virtual goods, with the high end of that range being more anomalous than average. I would add an addition $20 to $30 million in revenue from app developers on social networks to the Facebook total, bring the category total to around $75 million (if each of the top 10-15 social networking application developers were to generate $100K per month on average in virtual goods revenue, you start getting in the $15-20 million range very quickly).

Let me pause for a moment here and say that I feel pretty good about the order of magnitude of the calculations above. Those are two spaces where I feel like I have a pretty firm grasp on the . The next two or three categories are far more speculative and I’ll need your help to better fill in the gaps.

Free-to-play Flash and downloadable games: at least $50 million
Nexon has stated in the press that they have done revenues of almost $30 million in 2007. There are other games, such as Puzzle Pirates and Runescape (in the range of $60 million globally on an annual basis) that are generating millions of dollars in revenue in the United States.There are also a number of other free-to-play games, some of which are Korean / Chinese IP repackaged for the US environment and some of which are net new IP developed here, for which I have no idea how much revenue the generate. Nexon appears to be the clear leader in making this model work. Gameforge is a very large company in the FTP space, but I don’t have much sense for how much revenue they do in the United States. There are also many other large regional or country specific publishers who do huge revenue outside of the United States. I have to say that I’m at a loss at estimating the market size here.

I am curious to hear more about people who are succeeding in this market today. If you have data or want to chat, you can leave a comment or just message me directly.

Subscription MMOs: unsure, but my hunch is that it’s large
Okay, this is probably the trickiest sub-segment to target. This one definitely deserves its own post as I continue to get data. There are two things that make this really difficult to gauge. First, there are just a ton of subscription-based MMOs whose financial performance is difficult to track. It’s hard enough to figure out what their actual subscriber numbers are and the breakdown between subscription revenues and virtual goods. Second, many of the most popular MMOs have thriving secondary markets, some of which are sanctioned by publishers and some of which are not.

Console Games with Online Components
I have even less insight here as there are new generations of games coming to market that will have a major microtransactions components. I’ve heard some really large numbers tossed about in this space, some of which are so large as to defy reason (specifically around the music games like RockBand and Guitar Hero). If you have thoughts on this one, let me know.

This is just a thinking out loud exercise. Please contribute your thoughts to make this a better estimate.

I was reading a post on AllThingsD about the Twitter+Facebook tie-up that wasn’t. I have been scratching my head since reading that post - it’s good reporting but I still can’t figure out why Facebook would want to buy Twitter.

Twitter is building a very interesting community of users with very different norms from Facebook. As an active user of both services, I think there are three basic things that really differentiate the Twitter audience from that of Facebook:

-Self-promotion is much more acceptable on Twitter - Promoting one’s own products, brands, services or general wares is much more widely-accepted on Twitter. Whether it’s sharing links to blog posts, talking about new product announcements, or whatever, twitterers seem less bothered and generally more tolerant of such behavior.
-Twitter has a laserlike focus on simple content sharing - it’s a communications utility, not a social utility. It makes the value proposition for Twitter much simpler to understand and allows users to interact with people on a simple level without having to know everything else that’s going on in that person’s life (wall posts, photos, virtual gifts, new friendships, relationships, etc).
-More appropriate relationship with brands / non-human entities - I don’t actually know that I want to fan or become friends with brands on Facebook. For the few brands I do follow, I don’t really get much for it - I don’t hear from them or get any communications of value from them. The same is not true on Twitter. There are a number of brands that I follow on Twitter and I find that to be a much more satisfying experience - I hear from them from time to time and it’s usually interesting or useful information. I also follow a few entities on Twitter (Caltrain and BART) and find the experience to be a useful way to stay up to date on commute-related delays. I can’t imagine that I’d want to be a fan / friend of either of these entities - follower is the right relationship given the way in which I interact with them.

When I look at why Twitter is interesting and why it might be interesting to Facebook, the only answer I can come up with is that Twitter might be another tool to help Facebook improve its somewhat awkward relationship with advertisers and brands. Brands and users seem to get along much better on Twitter than they do on Facebook - the follower / followee relationship between brands and users makes a lot more sense to me than the “let’s be friends” or “fan” model that other social networks are testing. Also, the open nature of most Twitter conversations makes it much easier for brands to get a sense for what users are saying about their products and services.

Despite the better fit in terms of the relationship between users and brands that Twitter offers, I’m not sure that they will be able to a) turn that into a business model and b) turn it into a model that justifies a multi hundred million dollar pricetag.

As is the case for all companies that achieve scale, there comes a point where competitors will beat you on point features or experiences. In reading between the lines, it seems to me that Facebook might be grappling with the onset of this reality and how they want to address it. In the event that there is a modicum of envy over the level of success that Twitter has achieved with status updates, it certainly won’t be the last time that a smaller company develops a feature around an activity that Facebook feels it ought to own.

Videos for the Virtual Goods Summit 2008 are now available online - you can check them out here. Thanks again to all of the speakers, sponsors, and attendees who made the event a success.