The Wall Street Journal issued an interesting article today on a topic that I’ve been pontificating about (here and on Yahoo Answers) for a while now: how are businesses going to switch from mindlessly burning up investors money to actually making money?

Last week I wrote about the 4 categories of business model that exist online. I’d like to take a quick look at a few of the successful (and not yet successful) examples (some from the WSJ’s article and its comments), and see if I can come up with a few specific ways in which websites can compete with “free”.

The issue at hand is fairly simple to describe: in each niche market online, there are many, many competitors. Most of them are giving away their services entirely for free. Some of them charge for specific premium services, but users are often willing to shop around to find some set of useful (to them) services that don’t cost them anything at all. This tends to result in a race to the bottom, where the only way (and it is indeed a dubious way) to make money for a website is through advertising.

Let’s look at a few of the most successful online businesses and see if we can learn anything from them:

Google

Google’s success is based on being able to deliver the largest number of ads, to the largest number of placements, at (in general) the lowest price. This business model depends entirely on having extremely high traffic, a highly viral method for spreading their system around, and excellent system for placing the right ad on the right website (it ain’t perfect, but it is good enough), and constantly doing interesting (but usually non-profitable) things to attract even more attention. At this point in time, it would be virtually impossible for anybody to launch a competing bid for that ad space – in order to do so, they would need to be able to charge advertisers less, while paying website owners more, which would likely make their margins uncompetitive. Google’s model – essentially a middleman model – has a large “moat” to use Warren Buffett’s terminology. Yes, they’re going to take a hit with cost per click going down a bit, but they have enough critical mass to ride out the storm and fend off competitors at the same time.

Craigslist

Craigslist is also a high traffic-dependant model. Basically it is a twist on the “freemium” business model – almost everything is free, except for a few types of ads in specific markets. As far as I can tell, they were the first ones to cotton onto the idea of giving away virtually everything, making yourself completely indispensible, and then charging for a few specific features that are very worthwhile for a small set of people to pay for. There are a great many competing websites – some who actually have quite a bit of traffic – that are giving away for free the specific set of things that Craigslist charges people for. However, they have sufficient traffic to make it worthwhile for advertisers to pay for things that need to attract attention. Basically their model boils down to being sufficiently indispensible that people will pay.

Meetup.com

A former employee of mine first alerted me to this website. When they started out, they offered a completely free service for people to organize groups to “meetup”. Their traffic grew exponentially until several years after launching, they switched to a fee-based model. Users of the site get in free. Owners of groups pay a monthly fee. When they switched, they lost about 80% of their groups. The ones that remained provided enough revenue to keep things profitable. Their methodology: lock-in. One people have a successful group with a large member-base, moving it somewhere else – even though feasible – is a pain in the neck. The amount that they charge isn’t high enough to drive away their customer base, although I have my doubts as to whether they’ll be able to grow much further. Basically they’re now a cash cow.

Salesforce.com

Salesforce.com gets away with charging a fee for an essentially simple system (there are lots of CRM packages around, some of them free) by providing a high-end feature set, in addition to a lower startup cost. Its easy to get going with Salesforce – you pay per seat, so the initial cost isn’t all that high, it is more convenient than installing and maintaining a system on your own, and then you are locked into a system as you grow to have more seats (which is where they really make their money). With a paid userbase that is apparently around 50,000 customers, they’ve probably grown to as large as their market will bear. Their key strategy: provide lots of features that aren’t available in the free/cheaper competitors; make the initial costs so low that they are painless; tie users in so that it is hard to leave; gradually ramp up the fees. This is essentially a “utility” model. Anyone hoping to compete with them is going to have to provide more features at a lower cost (and hence lower margins).

Wikipedia

Wikipedia has a much lower operating cost than a traditional encyclopedia: their content is basically free, they have things set up to run on a surprisingly small number of servers,  the crowd-sourcing model of producing quality (mostly) lends itself to a large amount of useful and accurate content, and people are willing to donate to keep something so useful alive. Like many of the other examples above, this is a business model that relies on being the highest trafficked website in its niche – and it is viral in the sense that the more content it has, the more useful it becomes. By keeping costs down, and basically guilt-tripping a subset of users into donating money, they can make a profit and keep things free. I’m not quite certain how Brittanica hopes to compete with them – yes, Wiki often has high-publicity editing faux-paux, but for the most part they are good enough. I’m not sure that providing a higher quality service (but charging for it) will be sufficient reason for people to switch to a different service.

I think that by now we can see a few specific trends:

• Be the first one in your niche
• Have the largest amount of traffic
• Provide a service that is good enough
• Make it difficult to switch
• Make it expensive to start a competing business
• Be willing to start charging and lose some traffic as a result
• Charge only for those things that you need to charge for; keep most things free
• Keep costs down

This isn’t all that different from any “brick and mortar” business model, is it?

Let’s take a look at a current favourite (of mine and many other people!): Twitter. What possible ways can they achieve their revenue goals, given that a) it isn’t necessary to login to their site in order to use it, and b) they provide a very small number of features, all of which are simple and easy to duplicate.

Their options (as I see it) are as follows:

1. Make it harder to access Twitter from elsewhere. Start charging to use the API. Lock it down with additional security features.
2. Place advertising on their site. This would rely on a larger percentage of users being forced to actually login to Twitter, as opposed to using tools like ping.fm.
3. Create additional features that are currently being served up by other websites in their “ecosystem” – all of the cool profile rating, desktop tool, website plugin, karma-inducing stuff. Yes, I know, they would irk a lot of people.
4. Sell products or services: branded versions of Twitter that are specifically for a particular company (i.e. for sales reps and customer service people, or for staff to tap into other staff’s knowledge). Services specifically for brands trying to tap into Twitter’s user base.
5. Create their own desktop tool, with advertising spaces on it.
6. Buy other websites with related features and tie them in.
7. Find some other product or service (My husband/wife/parents went on a Twitter vacation and all he got me was this lousy t-shirt) that they can sell. Hey check it out: the Twitter eBay account! I don’t know if that would work.

In all of the above cases, they would certainly lose a percentage of their users. I think that is why they’ve been holding off for as long as possible – once they are “big enough” they can set things in stone. They’ll lose some people, and the rest will stay, but it will be hard for them to grow afterwards. I’m also not sure whether or not they would be successful or not with this approach – users could potentially just gravitate to other similar sites. The point is that they do have options, even if they are going to be hard ones.

There are plenty of lessons to be learned from a recession like we’re currently in. I tend to view these times as performing a tough but useful purpose – like controlled fires in a managed forest. Nobody really likes having to deal with reduced source of income (never mind venture capital), but this is an excellent opportunity for businesses to fine-tune their business models so that they can be more profitable once the recession is over. If website owners can move away from “everything is free and I make money from ads” to “I have some set of products and services that I sell, and I also make some money on the side from ads”, the online economy is going to be stronger going forward.