A New Business Model for the Digital Age

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There is no question that traditional media is in disarray right now. Major news outlets from CBS (NYSE: CBS  ) to Gannett (NYSE: GCI  ) to The New York Times (NYSE: NYT  ) are being forced to transition to a different model because of the underlying economics of their mediums (in most cases, a digital model).

But transitions to digital by media and other types of companies have left many questioning what the magic formula for profits is. At a recent event sponsored by Hooks Books and The Motley Fool, Chris Anderson, editor of Wired magazine and author of the new book Free: The Future of a Radical Price, offered a solution to the conundrum.

It's called "freemium."

That term, first popularized by venture capitalist Fred Wilson, describes a business model that combines free with premium and is based on the underlying assumption that the most effective price is free. Anderson says that companies can use the powerful marketing tool of "free" to garner the largest possible audience, and then convert a portion to additional premium services for which companies would charge a fee, or "premium." From there, one figures out his optimal free-to-paid ratio. "You give away 75% to 90% of your goods and sell the rest," Anderson said.

Applying the freemium model to mobile phones, you would get the cell phone but pay for the minutes. For the music industry, you would give away your music for free, people would sample it, some would pay for the mp3, and some would attend the concert -- the premium part of the equation.

"We're learning that the freemium model is a much better model," Anderson said. Rather than taking the old business model with the media and applying it to everything digital (media and services), Anderson says, "freemium is the new business model for the 21st century." (What do you think? Can freemium succeed as a workable business model? Weigh in below in the comments section.)

Anderson's rationale for why the model will work
Anderson explains the reason this model will work is because people are psychologically drawn to free, and offering content or services over the Internet has no "real" costs associated with it.

According to Anderson, the Internet is the first deflationary industrial economy we've ever created. He says that digital is the first to progressively fall 50% every year -- and has been for 50 years. Once the Internet took the constrained processing from Moore's law, a rule stating that the number of transistors on a chip doubles every 24 months, and added storage and bandwidth -- both of which fall faster -- Anderson says we created a medium that basically says everything can be available in a free form.

As a result, Anderson says media companies have infinite competition, and the marginal cost of production and distribution is zero. "Whatever the cost is today, it's going to be 50% as much as a year from now, and fall 50% every year forever because of Moore's law."

Sooner or later, everyone will compete with free, Anderson says. "Free is not a choice," he said. "If you don't do it for free, someone else will. The question is, is yours worth paying for?

Fitting the model to today's businesses
During Anderson's visit to Fool HQ, we put him through our "win, place, and show" segment, wherein we presented him with a couple of sets of stocks and asked for his thoughts. Specifically, we asked him to identify which companies would create the most economic value over the next 10 years for their owners. Here are three companies he liked.

Craigslist, Twitter, or The Wall Street Journal?
Anderson says if Twitter plays its cards right, the micro-blogging website has the capacity to monetize brilliantly and turn its "reputation credits" into money very easily.

"The ratio of reputation to employee is probably unprecedented -- much higher than for Facebook," he said. "This is the way we measure things. We have a company called Reddit that we bought, which is like Digg. They have a 1 million-to-1 user-to-engineer ratio. Twitter isn't far off. That is a great way to create value."

In place position is The Wall Street Journal, which Anderson called "very smart." He says News Corp.'s (Nasdaq: NWS  ) Rupert Murdoch has mitigated the risk associated with pure ad revenue models by shrewdly blending ad dollars with premium subscription revenues. The Journal gives away its most popular stories, its exclusives, and charges for specialized analysis such as commodity trading. "They figure out how to give away the head and sell the tail," he said. "I would look to the WSJ to create a model that would work for newspapers -- but not all of them -- because few have the reputation and quality the WSJ has," he said.

YouTube, Netflix, or Hulu?
Anderson also thinks Netflix (Nasdaq: NFLX  ) will be a good one to watch as television and movie media undergo a transformation. "The same way that Apple (Nasdaq: AAPL  ) had the clout to reform the music industry, I think Netflix puts us closest to the clout to reform video," he said.

For more on free and "freemium," click here to listen to our brand-new Motley Fool Conversations podcast … with special guest Chris Anderson.

Jennifer Schonberger does not own shares of any of the companies mentioned in this article. Netflix and Apple are Motley Fool Stock Advisor recommendations. The Motley Fool has a disclosure policy.

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  • Report this Comment On July 30, 2009, at 2:08 PM, rfaramir wrote:

    "According to Anderson, the Internet is the first deflationary industrial economy we've ever created".

    Then he hasn't ever read Adam Smith. Division of Labor, the core key to the Industrial Revolution inherently implies deflation as the same goods (or better quality) are produced in prodigiously higher quantities, dropping the price to within easy reach of the masses. As more wealth is produced by the same effort, the purchasing price of the same income goes up, i.e., deflation. A very good thing.

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