That’s why he’s currently starting his own company in the medical field. I can’t tell you what it is about because he’s in “stealth mode“, a deplorable, old-fashioned way of starting a company quietly. Nobody should do this. As we know from all successful Internet companies, you should always immediately tell as many people as possible about your plans in order to build your “ecosystem”. Don’t worry about competition, let people give you feedback. So what if somebody steals your idea, there’s enough room for everybody, right? That’s something that non-Internet people don’t seem to understand. Just look at the guys Mark Zuckerberg stole his idea for Facebook from, they still did pretty well. I think.

Anyway, I was thinking about what kind of advice I could give him for his new medical company. I’m an entrepreneur in the Internet industry, so I’m very familiar with the latest and greatest thinking in how to start a company in our digital age.

This is what I would tell him:

First and most importantly, you need to get traction. People have to get to know you and use your service. The best way to do this is to give away your stuff for free for a couple of years. So just do anesthesia for free. You will be surprised how many people will want to use you as their anesthesiologist for their surgery. They will tell their friends, and that’s great free advertising for you.

Of course, since you do everything for free, you need to spend as little money as possible. As we say in the Internet business, you need to be capital-efficient. The best way to do this is to cut unnecessary expenses. Rent, don’t buy your equipment, and just get the cheapest type of medication. That’s good enough for a free service. Also, save on personnel costs. Don’t hire trained nurses, you don’t need that initially. Just get somebody who recently read a book about medicine or likes to watch “Grey’s Anatomy”. Most Internet startups don’t hire experienced engineers either, and that works just fine.

Due to these savings, it’s of course possible that things go wrong during a surgery (what we call a “Fail Whale”), but don’t worry. It’s a free service, so nobody will complain. Right?

At some point, you need to think about making money, or monetization. Don’t just start charging money, because that would break your momentum. You can either use the Freemium concept (“The basic anesthesia is free, but you also want pain killers later? That’ll be $$$$”). Or just use advertising. Show people ads while they’re preparing for surgery. Wake them up occasionally during the surgery to show some more ads, because that’s when they will pay attention, and this will give you high CPMs. You can also use “affiliate marketing” and have them sign up for freecreditreport.com while they’re still groggy. That’s a great way to get juicy affiliate fees.

It’s really important to leverage your service through your own ecosystem. Your patients are a valuable audience, so you should give partners access to these people. For instance, let insurance salespeople come to your OR. People will feel a need for security when they’re in bad health, so providing insurance offers adds value for everybody. And you will get a cut. Plus, the insurance guys will recommend you to their own customers. It’s a win-win-win proposition!

Any type of service today has to be social. People always make a fuss about privacy, but isn’t it much more fun when your patients’ friends can come to the OR and watch their surgery? There might be an increased risk of infection, but that’s a small price to pay for the feeling of community and friendship. Plus, you as the service provider might get somebody interested in having their own surgery. Great sales opportunity! Oh, and people will be interested in how the patient is doing afterwards. So make sure that any change is immediately published to their Twitter and Facebook accounts. Particularly the really personal, slightly embarrassing things (Incontinence? Like!) are fun for everybody.

Finally, the latest and greatest trend are “virtual goods“, which is basically money for made-up premium stuff that people irrationally put a value on. You can use this wonderful concept, too. For instance, why always use these boring old syringes? If your patient is a rap fan, just charge him $20 extra to get his injection with a limited edition Jay-Z syringe. He can’t keep it, obviously, for hygienic reasons, but it will still make him feel great! And your little patients will pester their parents to no end to rent this really cute Hannah Montana bed pan. Just imagine the profit opportunities!

You see, every type of startup can be made better and more dynamic with the latest strategic thinking from the Internet industry. Even boring, trivial stuff like medicine.

(Picture: OakleyOriginals, CC license)

But if the success of the iPod and iPhone are any indication, consumers actually seem to like this closed system that just works and removes complexity. I actually believe that Apple is just the most aggressive, but by no means only company that is pushing the trend towards simpler, consumer-friendly IT.

Consumer products have to be simple. Consumers buy products, not systems. But that also means that consumer products are typically not “open” in the way a Linux machine is. The way of the future in IT could be semi-closed systems that are tightly controlled by a vendor, but tap into open platforms for some key functionality.

There are many examples for this in the non-IT world. A BMW 7 series runs on the same fuel as a Toyota Prius and has a “user interface” that is largely similar, but apart from that, these two vehicles are completely different. Nobody would expect BMW spare parts to work in a Prius. So cars share a common, open infrastructure (the system of filling stations that sell standardized types of gas) and common user interface conventions (a steering wheel, accelerator pedal etc.), but the actual products are strongly proprietary. Another example: A Miele dishwasher runs on the same electricity and fits into the same standardized kitchen slot as a GE product, but otherwise, these two products are very different.

My favorite quote about technology is typically attributed to Antoine de St.Exupéry:
“Technology always develops from the primitive via the complicated to the simple.”

The early personal computers were clearly primitive. They were closed systems (forget about running C64 games on a TI 99/4a) and didn’t do much.

But then came the IBM PC, which more by accident than by design turned into an open platform. Suddenly people were able to run the same software on PCs made by many different manufacturers, and even peripherals and extension cards could be used on pretty much any “IBM-compatible” PC. This sounds and is great, but it led to a lot of complexity. Almost three decades after the introduction of the IBM PC, users still struggle with driver issues, compatibility problems and bloated systems because Windows has to support so many variations of hardware and software. Openness also turned out to be a bad business decision for the actual PC manufacturers, since it commoditized PC design. The winners were the two companies who were able to control the remaining proprietary elements, Microsoft and Intel.

Are we now entering an era of simplicity in IT that gives up some of this openness for other gains? That’s very well possible. And Apple is by no means the only example. Other successful products and services in the consumer market follow a similar approach:

• Facebook is by far the most successful web platform currently, but also very closed. It actively strives to extend its ecosystem to other parts of the web, for instance by promoting its Facebook Connect login service.
• The other rapidly growing smartphone platform next to the iPhone, RIM’s BlackBerry, is not any more open than Apple’s ecosystem.
• Game consoles by Sony, Nintendo and Microsoft have always been closed, tightly controlled systems.
• Google is an interesting special case. Although the company emphasizes openness in many of its activities, it is very closed when it comes to its central money making machine, Google Search. Both Yahoo and Bing offer relatively open APIs, while Google restricts very strongly what developers can do with its search results.

What these examples have in common: They all use open infrastructure (the Internet) and share some common approaches with their competitors, but apart from that, they’re all tightly controlled systems. And the interesting thing is that consumers seem to like it that way.

A well-designed, simple, reliable product trumps openness in the consumer market. There are plenty of social networks that are more open than Facebook, but guess who dominates social networking? You can buy a Linux-based smartphone that is completely open, but most people go for iPhones and BlackBerries. Most games are available on open PCs, but the closed consoles still dominate the gaming market.

So is this trend away from openness in IT a bad thing? Not necessarily.

The effectiveness of IT actually increases with more simplicity. People working in IT departments might not like it because it jeopardizes their job security, but a simpler computer is actually a better computer. Fewer technical problems mean that resources can be spent on something that actually creates value instead of just fixing shortcomings. That’s just economically efficient.

But doesn’t a lack of openness kill innovation? Again, not necessarily. The last few decades suggest that a focus on openness is actually bad for business. For instance, Sun Microsystems has always been one of the proponents of open systems. It opened its Java platform, but never turned it into a business. The result: Sun was just devoured by Oracle, which doesn’t win any awards for openness. Another example: Red Hat built a sizable business on open Linux technology and invests a lot into the open source community. That’s great, but it sells as much software in a year as Microsoft does in four days.

The point is: Innovation needs capital. Capital can only be obtained if there is a way to protect investments and turn them into a lucrative business. And full openness doesn’t really help with that. The open source movement has achieved many great things and creates a lot of value. But it has not come up with true break-through innovation yet. Openness is a strategy that makes things cheaper, not one that brings entirely new things into the world.

In the end, total openness vs. closed systems is a false dichotomy. As in the examples of cars and dishwashers, there will always be open standards and a public infrastructure that is needed to make products useful. And that’s exactly where consumer IT is going. The iPad is way more open than early home computers. It can access the entire web, using open standards. But at the same time, it restricts other things for the sake of simplicity and reliability (and commercial feasibility, such as the DRM unfortunately still required by movie studios and book publishers).

Very likely, that’s a blueprint for the future of IT. Technology should serve a purpose for its users, not follow some theoretical philosophy.

(Photo: dreamglow, CC license)

Or how about January of 2007? Another much hyped product caused quite a bit of frustration. Was this supposed to be all? Nice design, sure, but this lackluster feature list, the closed platform, all these technical restrictions — and this had been hyped as a revolutionary product?

Well, the iPod and the iPhone went on to become big successes anyway. To be more precise, they revolutionized their respective industries, even though many geeks and tech experts predicted their inevitable failure when these two products were originally announced.

Sounds familiar, right? The reactions to Apple’s iPad announcement were strikingly similar. Expectations had run so high previously that the actual product was almost certain to disappoint many. And as with Apple’s previous major new products, tech geeks and “experts” of all kinds were particularly critical.

But exactly as last time, these opinions will not really matter. Apple doesn’t play the same game as the rest of the gadget industry. To understand why, let’s have a look at how high-tech consumer products are typically marketed.

The definitive book on this topic is still Geoffrey Moore’s “Crossing the Chasm“. Moore explains how new products are gradually adopted in the market and which hurdles they have to clear.

New technologies are initially bought by “innovators”. These tech enthusiasts are ready to deal with immature, complex products and pay high prices, just as long as they can get their hands on the latest tech toys. In the next phase, the “early adopters” take over. These are people who want to see a certain degree of usefulness in a new product, but are still willing to pay substantial amounts of money and tolerate problems.

After that, according to Moore, new products have to overcome a “chasm”. The next segment of consumers, the “early majority”, is not really crazy about technology. These people first want to see that a Blu-ray player is really better than their old DVD machine, or that a wireless LAN at home is really useful. They want to pay a reasonable price, not spend all their disposable income on technology. Typically, they follow recommendations from their early adopter friends, but with a healthy degree of skepticism.

That’s why technology vendors target innovators and early adopters first when they want to sell new products. Once these early target groups adopt a new technology, vendors hope to reach the mainstream market. Early adopters are crucial as technology advocates. And since they pay high prices, they are important to refinance development costs, even if a product doesn’t turn out to be a mainstream hit.

There are many technologies that have crossed the chasm successfully: MP3, WiFi, smartphones, DVRs, IPTV, GPS systems. Others are still waiting for their big break: netbooks, internet appliances like the Chumby, or home servers. And many, many other products have failed to cross the chasm into the mainstream market: UMPCs, the Segway or the repeatedly failed video phone come to mind.

With the introduction of the iPod, Apple started to ignore this traditional marketing playbook, and the iPad is the latest and most dramatic example of an entirely different strategy. Steve Jobs’ company doesn’t make products for geeks, but targets the mainstream market from the very beginning.

The iPod obviously wasn’t the first MP3 player, and it didn’t offer anything that would have particularly interested the early adopter segment. On the contrary: Its closed architecture made it unattractive to serious MP3 fans. Instead, the iPod made strong technology available to normal users who didn’t have the patience to deal with the complicated players of the day. Same thing with the iPhone: No technical feature was outstanding, but the superior usability and simplicity of Apple’s phone targeted average consumers who were frustrated with overly complex smartphones.
Apple’s particular approach can’t be easily copied by its competitors. There are three preconditions for this to work. First of all, massive ad spending in mass media is essential. Apple spends a lot on TV ads, but very little on alternative new channels like social media marketing (which still mainly reaches early adopter target groups). Steve Jobs’ reputation as a gadget wizard and “CEO of the decade” helps a lot, since personified marketing works particularly well in mainstream markets.

Secondly, there have to be clear differentiators that are important to the target group. And for mainstream electronics products, it’s not about the latest tech features, but things like beautiful design and ease of use — things that no other tech company does as well as Apple. Simplicity is essential, and that’s why Apple’s closed approach with iTunes is exactly right for the mainstream market. Early majority customers want to buy content as easily as possible. They don’t really care if the songs or movies bought on iTunes are protected by DRM, simply because they don’t know what DRM is and don’t care to learn about it.

Thirdly, mainstream distribution channels are important. Apple’s stores in malls and great downtown locations are exactly the right way to sell tech products to non-technical consumers. Most people want to touch a relatively expensive product before they buy it, and many will be influenced in their buying decision by the nicely designed store and the friendly staff, not so much by long feature lists.

With the iPad, Apple is driving this strategic approach to new extremes. All the elements of its proven formula are there, but one thing is really new: For the first time, Apple doesn’t simply try to sell a product category that is stuck in early adopter land to mainstream consumers. It’s trying to define a new category out of the fragments of several niche markets.

The iPad is a bit like a portable media player, a bit like a netbook, a bit like an e-book reader and a bit like a tablet PC. All these device types have found a niche market, but none of them have really crossed the chasm. Apple is now trying to enter the mainstream market with this recombination of existing, but not yet mainstream-compatible devices.

That’s a bold move that could easily go wrong. But Apple is one of the very few companies in the world that has the marketing power and unique capabilities to pull this off.

(This article originally appeared on netzwertig.com, the leading German tech blog)

This sounds like a fairly typical disruptive strategy (see Clayton Christensen’s books). A new entrant (Google) tries to disrupt the incumbents’ (Microsoft, Apple) business by offering a significantly cheaper and simpler product that will only appeal to the very low end of the market. Over time, as the new product category gets better, the incumbents’ products retreat more and more into the very high-end of the market, increasingly losing relevance.

The big question is of course if Google’s approach has a serious chance to disrupt the OS market. There’s more than enough reason for skepticism.

First of all, the OS is not a major cost point anymore at the low end of the PC spectrum. According to some sources, A Windows license only adds $15 to $20 to the price of a netbook. It’s unlikely that people will go with a very limited OS just to save a few bucks on a $300-$400 purchase. Disruptive price points have to make a 5x-10x difference to really move a market. Witness the fate of Linux-based netbooks. After a few months, the whole netbook market moved to Windows XP, because most buyers were willing to pay the difference for a more familiar OS.

Secondly, Google’s vision of a purely cloud-based computer (everything in Chrome OS is stored in the cloud, the local storage just serves as a cache) could turn out to be too cutting-edge for the low end of the market. In order for this to work, you need a pretty fast broadband connection and you have to understand and trust the concept of storing your digital stuff on somebody else’s servers. I’m not sure that most consumers are really comfortable with that just yet.

Finally, there’s little reason to believe that the incumbents couldn’t offer a stripped-down version of their OSes for low-end machines in order to defend their market. Microsoft has already been toying with the idea of a limited Windows 7 version for netbooks, but did not release it after complaints from its OEM partners. Apple is rumored to work on a tablet device that probably would run a stripped-down version of Mac OS X and could compete with web-centric netbooks.

It seems fair to say that Chrome OS will likely not succeed as a traditional, straightforward disruptive product in the PC OS space. But Google probably hopes for a much bigger, much more fundamental shift. Most people today have a primary computer that they spend most of their computing time on. The massive shift from desktops to laptops in the consumer market over the last few years shows that people want to take their primary machine everywhere, and that makes a lot of sense in the traditional model of personal computing. However, the increasing availability of cheap web-capable devices (like netbooks, smartphones, tablets, even game consoles) could potentially break this 1:1 relationship between user and PC. The more people get used to accessing the Internet from a variety of devices, the more they will want to seamlessly access their data from any of these channels. The consequence is that people will move more of their data into the cloud, and local storage and applications will lose much of their importance.

Chrome OS is probably a bet that prices for web-enabled devices will drop far beyond today’s $300-$400 netbook price point and that people will have not one, but several of these devices that they can use interchangeably for most (though not all) of their computing needs. Google is not trying to win Microsoft’s game. There will be no new PC OS war. Google is trying to start an entirely new game, where it could easily turn out to be the dominant player from the outset. Or to put it another way: Google is probably not interested in a short-term disruption of Microsoft’s dominance, but in winning the next game — which it hopes to be a fundamental shift in how people use computers.

The only problem is that nobody knows yet if and when this game will take place. Dominant designs in technology, like today’s PC, can be pretty hard to displace. Remember the Segway? Looked like a great idea, a fundamentally new way to provide transportation, much more efficient than the tired old car. But it didn’t go anywhere because people tend to be happy with a “good enough” solution that they already know, even if it’s more expensive and complicated. And that’s why Chrome OS could turn out to be the Segway of computing in the end. Maybe today’s PCs are just not flawed enough to open an opportunity for an entirely new approach. Time will tell, but Google is certainly not fighting an easy battle here.

According to some estimates, Facebook could make about $75M in revenue this year from virtual goods. Social game maker Zynga is even bigger in this space, with most of its estimated $250M in sales coming from the game add-ons it sells to its users. The total U.S. market for virtual goods could reach $1 billion this year. But that’s almost chump change compared to the Asian market, where one Chinese social network alone apparently sold $1B in virtual goods last year. Chinese authorities now even have to regulate this exploding sector.

So why would anybody in their right mind pay hard-earned money for something that is basically just a pile of pixels? Well, most probably for the same reason that makes people pay $450 for a regular pair of jeans just because it says “Gucci” on the label: To impress other people.

It’s no secret that people spend more and more time online, be it on social networking sites, playing online games or even in virtual worlds like Second Life (which is doing better than most people think) or teenage girl hangout IMVU. Online interactions with other people (under real names or nicknames) are an increasingly significant part of many people’s lives. And obviously, the natural need to define your social status carries over into the online world.

Most of these online platforms have managed to establish something like a social hierarchy that strongly depends on virtual status symbols. If you want to be cool in Second Life, you need to own a fancy island and have a nicely equipped avatar, which will cost you a bunch of “Linden dollars” (you can get that virtual currency for real U.S. dollars, of course). If you want to avoid being humiliated by a monster in an online role playing game in front of your virtual friends, you’ll need good weapons, which are available for cash. Oh, and all these annoying “Mafia Wars” and “Farmville” updates that you get on Facebook? Just shows you how many of your friends are already trapped in one of these games. And yes, they’re probably spending money on that stuff.

It’s easy to see why platform owners like virtual goods: Margins on this stuff are amazing. Once the software is written, the costs are minimal. And for that reason, the idea of virtual goods spreads to more and more platforms. For instance, Apple now allows iPhone developers to sell virtual “things” right inside an app.

Probably nobody will claim that virtual goods will make the world a better place, but people get what they want, and sellers make a killing. So everybody should be happy about this rapidly growing new market, right?

Well, there is a dark side to the virtual goods market. First of all, some game vendors don’t make their users pay directly for all goods. Instead, people can sign up for “offers” (e.g. a Netflix trial subscription) and get some in-game currency in return. The problem is that many of these offers are scams or at least use unscrupulous business practices like hidden subscription sign-ups. After getting a wrist slap from TechCrunch, Zynga and other game makers just announced that they will police their vendors more strictly and weed out questionable offers.

The other problem is that almost all virtual goods just work inside a particular game or platform. That’s a restriction that is even more extreme than the hated DRM of digital music which allows you to only play your (legally purchased) music on compatible devices. What happens if you get fed up with a game? In some cases, you can sell you virtual goods, but that’s not always possible. Even worse, if the game company goes bankrupt, you probably lose your “investment”. But the most significant problem is that platform owners can suddenly change the rules. Second Life maker Linden Labs for instance banned virtual banks in its system a while ago, costing several people very significant amounts of money. It’s therefore not surprising that some governments are already considering to regulate virtual currencies and virtual goods markets.

We will probably see quite a bit of growth in virtual goods over the next few years. But the real danger for this market is probably none of the issues mentioned above, but the possibility that people simply could lose interest after a while. To some extent, most forms of virtual goods have the typical characteristics of a fad. It’s a frequent cultural phenomenon that large groups of people spend a lot of money on a seemingly pointless (or at least not particularly remarkable) product or activity, just to lose interest after a few months. Not surprisingly, virtual goods are most popular with very young people, a target group that is particularly susceptible to fads of all kinds. Remember Tamagotchis? Virtual pets looked like THE next big thing at the time. Now they’re just embarrassing.

The economic problem with a fad-driven business is of course that fads are entirely unpredictable. There are entire industries (like the toy industry) that try to produce fad after fad, but it’s very difficult to consistently come up with something that will take off in the mass market. It’s therefore really hard to build a sustainable business on this foundation. That’s bad news for investors and startups in this sector.

So there are good reasons not to believe the hype, even if some industry analysts already provide the usual hockey-stick growth curves. For instance, Piper Jaffray predicts that the global market for virtual goods will grow from $2.2B this year to $6B in 2013. Maybe so, but almost all analysts overestimated the growth of social networking revenues a few years ago. And just to put things in perspective: $6 billion is a big number, but for Google, this would just be a nice single quarter of ad sales. And for Microsoft, it’s less than half a year of net profits.

(Picture: Ivan Walsh, CC license)

Why can Google do this? It now owns all the necessary map data thanks to its Street View project, and reusing this wealth of data for another application is very cheap. Giving away the navigation software probably won’t cost Google much in incremental costs, since it’s already giving away the entire smartphone OS anyway. Of course Google hopes to make money in the only way it really excels at: Through advertising, in this case built-in ads in the GPS application.

Tough luck for TomTom, Garmin, Navigon and all the other vendors of GPS products, right? They will just need to adapt and match Google’s business model. Well, unfortunately, they will have a hard time doing that. Only TomTom owns a maker of map data, but probably can’t easily afford to just give this data away, because it doesn’t have an unrelated source of profits the way Google does. Things look really bad for the other vendors, because they have to buy their map data from external providers. The only company that could match Google’s free offer is Nokia, which bought map data provider Navteq a couple of years ago. But Nokia has no experience selling advertising, and it’s increasingly losing momentum in the smartphone market.

This case shows very nicely how whole industries can be turned upside down without warning by a new player who leverages the Internet to completely change the economics of a market.

Let’s recap: Google takes advantage of

• free distribution of its software (the app will simply come pre-installed on smartphones or can be downloaded)
• free marketing (no need to convince people to use a free, pre-installed app)
• free support and maintenance infrastructure (software and data updates will be distributed through the wireless data plans that smartphone users already pay for — at no cost to Google)

The missing link that prevented anybody from offering a free GPS app so far was the map data. And Google is in the unique position to have collected the necessary data (at least for the United States) for its Google Maps service. This huge effort has probably already been paid for by the local ads that Google shows in Maps.

Of course there are still years of life left in the traditional GPS device market, since not everybody owns a smartphone and Google still has to overcome obstacles with data availability. But the writing is on the wall: Another fundamentally disrupted market, with incumbent players that soon will fight for survival.

History shows that no business is ever really safe from disruption. But the Internet with its particular economic characteristics speeds up disruptive processes and makes them much more dramatic. The classic case studies of disruption show how disruptive competitors enter a market with products that are less sophisticated than the “state of the art”, at much lower price points. This over time forces the incumbents to offer simpler, cheaper products (if it’s not too late by then). But having somebody come into your market who simply gives away a sophisticated, in some aspects even superior product for free is an entirely different matter.

Sure, Google cross-subsidizes its new GPS service heavily from its traditional business. It will probably not make money from this product for years, if ever. It’s a long-term bet and an investment into a whole ecosystem. The fundamentally important point is that this kind of extreme strategic move is only possible in the digital world, and only thanks to the ubiquity of the Internet, which provides nearly free distribution. The marginal costs of digital goods are very close to zero, and this enables an entirely new set of deeply disruptive strategies that most managers (and academics) have probably not even begun to understand.

If you sell a product or service that can be replaced by an entirely digital product or service, all that is needed for a fundamental disruption is somebody who is willing to invest some money into the initial development of such a product. The money can come from an existing profit pool (as in the case of Google) or from investors who believe that there could be profits in the future. The barriers to entry are extremely low in almost all digital markets, and the speed of disruption can be breathtaking. Just ask a newspaper executive.

The characteristics of digital markets attract competitors who behave irrationally in the short term (by putting money into a free, profitless product) in the hope of somehow winning control of a market in the long run. The low barriers to entry (thanks largely to free digital distribution) make many digital markets look very disruptible and hence attractive to potential disruptors.

Unfortunately, once a player gains significant market share and starts to make profits, it will attract other competitors with similarly aggressive strategies. The result is almost constant disruption, which makes it hard to ever build a consistently profitable business. Commoditization is of course nothing new and happens in the physical world too. But the clock-speed of Internet-based disruption is much, much higher. Remember, just two years ago, MySpace looked like the unassailable king of social networks. Then it got replaced by Facebook, which burned through $716 million in capital to build its current position and is still not profitable. It’s safe to assume that somebody with even deeper pockets and/or better ideas could eat Facebook’s lunch in the near future.

This increasingly frequent pattern will have pretty profound consequences. For instance, the traditional venture capital model is built on the assumption that a tech startup can achieve a strong market position and profitability within 4-7 years and is then ready for a major exit, preferably an IPO. The attractive past returns of venture funds were fully based on this model, not the profitless “Please, Google, buy us” model of most Web 2.0 startups. But when even very well capitalized, market-leading startups have trouble reaching profitability before yet another disruptor attacks them, the whole system of tech investments as we know it breaks down.

Are there any strategies that protect a company against this kind of disruption? There are probably only two: One is to have extremely strong platform-based lock-in effects, as in the case of Microsoft Windows. For most businesses, switching from Windows to even a free OS like Linux would be so costly that it’s almost impossible to justify. However, this is not the same as having just some superficial network effects, which are often weaker than expected. Facebook is not safe from disruption just because a lot of people have built their friend lists on it. Yes, that is a network effect, but the decline of MySpace shows that it’s not a very strong protection against a better competitor. Building a deep lock-in is very difficult. Apple and Amazon are trying to do this for digital media, but their lock-in doesn’t look nearly as strong as Microsoft’s.

The other strategy is to consistently be at least as good as all competitors and invest heavily into a protective ecosystem. Google is of course the poster child for this strategy. No company so far has come up with a search engine that is really significantly better than Google’s. And through services like Maps, Gmail, Google Docs, Wave etc., Google is slowly building a network of small lock-in effects that collectively can build a pretty strong wall against attackers. The free GPS app is of course part of this plan, because Google wants to play in most parts of the mobile Internet market in order to defend its core business against competitors.

But it is clear from many recent examples that the Internet will change how we think about competition, strategy and business plans. And this change will probably be more fundamental than we think.

(Picture: Erik Charlton, CC license)

Brad Burnham pointed out in a recent blog post that both sides probably lack a deep understanding of the fundamental economic shift that is going on here. He mentioned the work of pioneers like Herbert Simon and Michael Goldhaber on the economics of attention as a framework for better insights.

I think it’s correct to say that we are currently experiencing the rise of something like a parallel economy, driven not (like our currently suffering traditional economy) by money and scarce physical goods, but by information and scarce attention. However, probably nobody really understands yet what this economy will look like as it matures and how its interaction with the “real world” will work. Obviously, the two will have to coexist, because last time I checked, my local supermarket didn’t accept hyperlinks as payment for groceries.

We are all so deeply rooted in the principles of the traditional physical economy that it is easy to forget the basics. The good old economy as we know it revolves around scarce physical goods and (more recently) around scarce services. The goods are scarce because considerable work has to be invested into their production, starting from the (often scarce) raw materials that we find in nature. Services are scarce because most of them require some kind of skill, and acquiring these qualifications needs time, which is limited and therefore valuable. Humans trade these scarce goods and services amongst each other because of course not everybody can produce every type of good or service. And then there’s of course money, which provides a more efficient way to trade stuff by separating value from a lumpy physical item or perishable service. Money is basically condensed value, which stems from physical scarcity.

So far so good. But how is the digital economy different?

Most importantly, value in the Internet economy is detached from the physical world and its limitations. For instance, a digital text can be valuable without having a physical manifestation. Sure, all these bits have to be stored somewhere, but the storage medium is a reusable commodity, not bound to this particular piece of information. Digital information can of course be copied without loss of quality (this doesn’t exist in the physical world) and distributed over a network, instantly reaching every corner of the world. And all of this is remarkably cheap nowadays.

The result is a huge abundance of information. And this changes what is scarce: Not the actual product (information), but the capacity for consumption — attention. Every day more free information is made available to the world than a human being could consume in a lifetime. Obviously, human attention is finite, and therefore it’s the scarce factor in the digital world.

That’s why many Internet users can’t understand that media companies want to charge for their online content. Aren’t they already getting the most valuable thing that an Internet user has to offer, his or her attention? And obviously, attention can be converted into real money through advertising, so what’s the problem?

At this point the discussion typically breaks down, because media companies, and newspapers in particular, have a very hard time financing their costly content production just from online advertising. There are probably two main reasons for this problem:

First, on the cost side, newspapers still apply the old principles from the physical world to their content production process. In the old media world, news has to be distributed physically (or through scarce airwaves), and therefore it is most efficient to produce local newspapers that cover all the important news in one single information product. This results in probably dozens or even hundreds of editors slightly rewriting the very same news agency report, adding almost no value. In a digital world of ubiquitous information, that’s completely unnecessary.

Furthermore, a key value proposition of newspapers is the context that they create by selecting the most newsworthy content. Again, this process is duplicated for every single newspaper. In the online world, there are far more efficient and sophisticated ways to provide this value, even though most can’t exist without at least some human intervention. But frankly, semi-automated aggregators like Memeorandum often provide a better view of what is going on in the world than most newspaper homepages.

About 50% of the total cost of a newspaper goes into physical production and distribution, the rest into actual content production. But if you subtract the obsolete and redundant editorial work that most newspapers are still doing, what would be left? Maybe 5%, maybe 10% of the cost base? Most probably, it’s even less. The percentage of truly original reporting in most traditional media is surprisingly low. But in the digital world, there’s no mechanism to finance the unneeded redundant production of information, because there’s already so much information out there.

Secondly, on the revenue side, advertising is a very unsophisticated and inefficient way to convert attention into money. Today’s advertising models are still built on the scarcity models of the past — the type where ad space is scarce, not attention. If you wanted to reach people in a certain local market with your commercial message, your only option was to advertise in the local newspaper or on local TV and radio stations. Even in big markets, there were only a handful of channels available, with very limited and therefore expensive ad space. Targeting was only very basic, because reaching many people with a lot of wastage through mass media was still more efficient than other methods.

That’s of course fundamentally different in the online world, but ad agencies and publishers are still stuck in old thinking. Most online publishers complain about the low rates that they’re getting for display ads. But that’s not surprising, since online ad inventory is almost unlimited. The trick is to reach the right audience at the right time. But ad agencies still think in big demographic clusters, not in the situation-specific micro-segmentation that the Internet could provide. It’s therefore not surprising that paid search is by far the most lucrative form of online advertising, since Google and its competitors can convert very specific attention (somebody searching for a certain topic right now) into commercially relevant results.

So what needs to happen to make the attention-driven online media economy viable?

• Clearly, media companies have to become leaner and more focused. They need to concentrate on original content that really adds value and therefore is worthy of people’s attention. That’s frankly only a fraction of the current media production. All the other fluff, as well as the fat corporate structures on top of the actual content production, will simply not be viable online.
• Also, media companies need to recognize that unique context, filtering and editorial selection are more essential than ever in dealing with people’s limited attention. This will be a great way for media brands to get competitive differentiation. But today’s typical news homepage is still built on an old, generic one-size-fits-all model that is neither cost-effective nor customer-friendly.
• Publishers and advertisers have to experiment with new ways of converting attention into commercial value, i.e. building the bridge from the attention economy to the monetary economy. I think we currently stand at the very beginning of this process. Traditional advertising is becoming increasingly ineffective. But new ways to channel people’s attention in order to sell them something are still embryonic. Almost certainly, there will be many ways to do this, but no silver bullets.
• Media companies have to recognize and deeply understand that attention is the scarce commodity in the digital economy and therefore is a currency in itself. The current conflicts between Google and newspaper publishers show that old media executives are starting to get this, although most of their actions go into the completely wrong direction.

But at the end of the day, attention has to be convertible into money somehow, since people still live in the physical world, where scarcity is a reality and money is needed. Companies and their executives will continue to be measured by their financial success, not by the attention they accumulate. Determining the monetary value of intangibles like attention, intellectual property, brand assets and customer loyalty is a thorny problem, and it’s unlikely that there will be a commonly accepted solution anytime soon.

However, people working outside of the traditional corporate framework might be willing to forgo at least some of this conversion. Under some circumstances, people tend to value attention more than money. Let’s be honest: Most people in the Western world already have more material things than they need. Particularly the richest European countries are increasingly turning into post-material societies that don’t necessarily try to optimize their GDP, but instead the general well-being of their population. And getting attention is something of fundamental importance for humans.

So it wouldn’t be surprising if more and more people would add value to the digital economy without getting paid for it in monetary terms. The open source ecosystem is of course a great example of how this can work. And most bloggers blog (and Twitterers tweet) because they like the attention and the good things that can result from it, not because they get paid.

Another example: Craigslist provides fundamentally the same value as the many classified sections in newspapers that it basically killed, but it captures only a fraction of the monetary value. Does that make any sense at all? Yes, because Craigslist created a top 20 website that commands a lot of attention with minimal resources. It provides a valuable service and gets paid with huge amounts of attention and loyalty, as well as with quite a bit of money. It is wildly profitable in monetary terms, but obscenely profitable in attention terms. That’s bad news for the people who used to make a living selling classified ads, but good news for Craig Newmark.

Welcome to creative destruction, attention economy edition.

(Picture: Josh Sommers, CC license)

But does freemium really work that well in practice? There are early signs of a backlash against this model. Google recently strongly de-emphasized (i.e. practically killed) the previously offered free version of its Google Apps suite, which used to be free for companies up to 25 users. Potential customers are now encouraged to try the product for free for 30 days and then start to pay $50 per user per year. A similar change can be seen at 37signals, once the poster child for freemium, who now hides the permanently free versions of its products pretty well. Startups like photo sharing site Phanfare and the recently demised LucidEra (a vendor of SaaS business intelligence) tried freemium models, but weren’t successful. And many other startups that use freemium are still far away from profitability.

So the question is: Under what conditions does freemium really work for software vendors? Obviously, customers like freemium, but how can software companies use this model to build a really sustainable business?

It think there are probably six conditions:

1. Your marginal costs have to be extremely close to zero.
Freemium only works if the distribution and support of an additional copy of your product (i.e. the marginal costs) costs you almost nothing. Thanks to the Internet, the digital distribution of software is now nearly free, both for downloadable applications and online apps.

That sounds obvious enough, but I think many companies underestimate how close to zero the costs really need to be. Web-based applications for instance need to provide enough server capacity and storage for all these freebie users. This can quickly add up to substantial amounts, even if the capacity for one single user is cheap.

2. The target market has to be big enough.
There doesn’t seem to be any reliable data about how many users of a free product end up buying a paid edition. Obviously, this will strongly differ from product to product. But from anecdotal evidence, it’s probably safe to assume that typically less than 10% of users convert to the paid version.

If freemium is your main sales channel, this obviously means that your target market needs to be large enough so that you still can build a sizable business just from getting paid by a few percent of the total potential user base. Furthermore, the free marketing benefits (and maybe even positive network effects) of freemium can only kick in if there are enough people to spread the word about your product, and for that they first have to be interested in what you have to sell. In other words, niche products that only appeal to relatively few users are probably not ideal for freemium. Some more targeted form of sales might be the way to go there.

3. Your product has to be very simple.
It’s great that users can self-educate about your product while using it for free. Hopefully, they will soon reach the limits of the free version and feel the desire to upgrade to the paid edition.

But for this to work, your product has to be very, very simple. People don’t read manuals and rarely follow online tutorials. The product just has to be easy to use and has to provide obvious value almost instantly, so that users will have enough motivation to dig deeper. Some of the better iPhone games are a good example.

4. If your product is not simple, you need competent customers.
Not all software products can be and should be simple. This has nothing to do with a lack of usability, but with the scope of features that a product offers. Photoshop is not simple. Database systems and application servers are not simple. Content management systems (the decent ones) are not simple. They’re powerful tools for skilled professionals. Products that satisfy the needs of professional users are almost certainly not as easy to use as consumer software, because you need a certain skill set to make sense of what the product does. That’s a problem for freemium.

LucidEra’s founder tells the story of his company’s failed attempts at selling through the freemium model. Many trial customers were simply not able to figure out what the product was good for. They never really used the more advanced features and therefore never really saw a lot of value in the product.

So if you want to sell a complex, powerful product using freemium pricing, make sure that you address a well-defined, skilled audience. Your users need to already understand what they want to do with your product, and they have to be motivated and skilled enough to invest considerable time into working with it. Only then will they discover enough value to upgrade. If you offer a complex product to a user base that has not previously used this type of software (like in LucidEra’s case, selling BI to mid-market customers), freemium will be tough.

5. There has to be a minimum useful feature set, but plenty of additional functionality.
We’ve probably all used freemium software for which we didn’t see a need to upgrade. There are probably two cases where that happens: When the free version of a product doesn’t offer enough functionality, you don’t recognize that this is a useful product that is worth paying for. On the other hand, some free versions offer so much functionality that it will only make sense for relatively few users to upgrade to the paid version.

Google Apps prior to the recent strategy change was an example of the latter case: Small companies got almost all the functionality for free. If you had less than 25 users (and most small companies are way smaller than that), there was simply no good reason to upgrade.

Most successful freemium vendors now use a carefully designed combination of feature restrictions and a limit on the amount of data you can store or the number of users you can sign up. It’s clearly not easy to strike the right balance. Setting the right restrictions is probably the single most difficult thing in the freemium model.

6. You need to really understand the demand curve.

A demand curve in economics describes how many people are willing to buy a product at a certain price. If you can have only one price for your product, you lose a lot of potential customers (who don’t want to pay that price) and you lose a lot of potential profit (by undercharging the customers that would have been willing to pay more).

The solution for this dilemma is price differentiation. Why does Microsoft offer eight different versions of Windows Vista at different price points? Because it wants to ride the demand curve and extract as much money as possible from different customer groups. If Microsoft would offer only one version at a low price, it would leave a lot of money on the table (but maybe have happier customers).

Freemium is of course a form of price differentiation. The assumption is that there are many people who have a very low willingness to pay, but still find a certain product useful enough to spend some time with it and maybe tell their friends about it, some of whom will be willing to pay something. Most freemium products offer several different paid product levels with different feature sets — price differentiation at work.

The problem is that it’s really difficult to find out the shape of the demand curve and match it with your cost curve. One question is what the price point for your cheapest paid edition should be. Will many people pay $9.99 a month? Or is it better to start at $99/month and hope that you get so much free marketing out of your free version that many people will sign up who are willing to pay that price?

A key consideration is your cost curve and the usage pattern that users at different levels have. In some businesses, the most active users who use the most resources are also the most profitable ones, because they have a high willingness to pay. In that case, it makes sense to have a relatively high minimum price. But there are also cases where the low-intensity users are the most profitable. Then it makes sense to extract money from as many people as possible, even if it’s a far lower amount per user.

Conclusion: More an art than a science. And watch out for pitfalls.
There are obviously many variables that go into effective software pricing. Freemium can be a great model, particularly for smaller companies. But it is hard to get it right, and it can also be dangerous on several levels. If you get the demand structure wrong, you might leave a lot of money on the table. If you underestimate the costs caused by your free users, it will reduce your profits dramatically (and it’s not easy to get rid of these users without risking a hit to your reputation). Oh, and how about liability? If you lose a freebie user’s data, can he sue you? Better make sure that your terms of service are watertight.

Freemium is not a panacea for the software industry, it’s just another tool for the hard task of getting software pricing right. It’s great for certain market segments, but software companies should avoid to go freemium just because it’s convenient and reduces sales costs. Sure, a freemium model can get you more users relatively quickly, but in the long term, it might hurt your bottom line and growth prospects dramatically.

Finally, what would Google do? There’s probably a good reason why Google basically got rid of the free edition of Apps and now does pretty conventional software marketing with billboards and the like. They now even do competitive upgrades, as well as channel sales through resellers. Sounds more like traditional software industry tactics than the wonderful world of free Internet-based software.

(Picture: Timothy Lloyd, CC license)

If true, that would be a pretty bold move. The history of tablet computing — flat devices that use a touch screen or pen for interaction — is a long sequence of failures and disappointments. Microsoft had at least three shots at this market, starting in 1993. Windows XP Tablet PC edition in 2002 was a flop, and the entertainment-focused Ultra-mobile PC, released in 2006, didn’t fare much better. Now tablet-oriented features can be found in every copy of Windows Vista, but very few PC models use them. Many other vendors tried their luck with tablet form factors, but the only moderate success were probably the PDA devices of the late 90s.

So what does Apple need to do differently in order to be successful in this market?

I’m actually a fan of the tablet form factor. I experimented with the first “Windows for Pen Computing PCs” back in 1993 (which were really, really bad) and still own four different Tablet-PC and UMPC devices plus various PDAs and smartphones. From my experience, Apple needs to avoid the usual pitfalls and do the following:

1. Make sure it’s really mobile.
Tablet devices are supposed to be extremely mobile. But that’s pretty pointless if their battery life makes you carry around a power brick and various accessories anyway. My worst device in that respect was a UMPC built by the now defunct OQO. Its battery lasted less than two hours, and the power brick was bigger than the computer itself. So Apple needs to make sure that battery life is adequate and that the product doesn’t need any accessories (such as easily lost digital pens or external keyboards) to work — as in: Really work for the things people want to do with it, not just for a quick demo.

2. Do one or a few things really well.
The most successful tablet device in history, the Palm PDA, had a very clear focus: It was a digital replacement for your appointment book, not more and not less. Microsoft’s tablet PC on the other hand suffered from ambition overload. It tried to be a full-blown PC, but also a digital notepad, a highly portable information capture device for professionals, and oh yeah, also a great entertainment gadget. Unfortunately, it did none of these things particularly well. So Apple needs to decide what its tablet device should be for and provide a great user experience for that purpose. It looks like it will have a clear entertainment focus, which is probably a good idea.

3. Have a truly simple UI, don’t try to solve the hard problems.
Most tablet devices contained some kind of handwriting recognition. This seems to make sense for a tablet form form factor, but the sad truth is that computers are still pretty bad at reading handwritten text. A success rate of 95% (which is what most vendors claim) sounds good, but is almost unusable in practice. Most tablet devices have relatively slow CPUs and are therefore not able to get much better results. That’s why Apple should concentrate on an extremely simple touch UI without fancy input methods. But judging from the iPhone, Apple already knows that.

4. Make really, really good hardware.
Tablets need to be light, and that’s why many vendors compromise on hardware stability. Most of my tablet devices have one or several mechanical defects, since highly mobile use tends to be strenuous for hardware and the flimsy build quality of many of these devices is simply not good enough. An Apple tablet device at the rumored price of around $800 needs to be much more robust than the iPhone. People will expect these things to last for several years, not just until the next model comes out.

Apple already has the other necessary ingredients for a success: It knows how to generate that “wow” factor that is necessary to make people consider a new product category. It has retail shops that will provide a hands-on experience for consumers — something that the Windows-based Tablet PC market always lacked. And it has the developer ecosystem and licensing agreements to provide interesting content for the new device.

Now the only question is if and when Apple will come out with such a new device. If somebody can crack the code in tablet computing, it’s clearly Apple.

Maybe. But the seemingly huge user numbers of these services could turn out to be far less impressive (and commercially relevant) in practice. Sure, both platforms have tons of registered users, but are these users really active? That’s probably something advertisers would like to know before they spend money on these channels.

Several new reports (e.g. here and here) indicate that Twitter’s user activity patterns follow a typical “long tail” distribution.

There are a few heavy users that are extremely active, tweet a lot, have thousands of followers etc. But beyond this small group, usage drops rapidly. 50% of Twitter’s registered users are basically inactive. Since Facebook is far less transparent than Twitter, there are no similarly precise studies about usage of the leading social network. But a quick survey of the activity level of my 358 Facebook friends showed similar patterns. Only 71 (=19.8%) of my friends showed any activity in the past 72 hours, with only a handful clearly dominating. Admittedly, that’s anecdotal, but I’ve not seen any studies that show a different pattern.

Now, it’s not surprising that this kind of service has a long tail usage pattern. You can find very similar patterns in other types of communication networks like the phone system, e-mail, instant messaging, etc. The problem lies in how to best monetize these services. Both Facebook and Twitter don’t charge users. They want to monetize their services indirectly. Facebook mainly sells ads and virtual goods, Twitter still has not come up with a business model, but probably will go a similar route.

The problem is: these monetization approaches depend heavily on actual usage. Nobody pays much for ads that not many people see or click on. Virtual goods are profitable, but you can only reach a decent revenue size if many people buy them. So if it’s true that only 20% of users on both Facebook and Twitter are really active, that’s a big problem for both services, since their opportunity to sell ads and premium services is much smaller than their raw user numbers suggest. Granted, both platforms are very big even then, but maybe it’s not quite enough for total world domination…

So what would be a better way? Think about it: How does your phone company charge you? Your cable company? They charge flat fees because they want to extract a lot of money from low-volume users. Sure, they have different price levels for different user types, and they offer premium services, but the lowest levels are not cheap at all.

For instance, I’m a very low volume user of phone services. AT&T charges me for a 550 minutes per month package for my iPhone plan, of which I typically use 100 minutes or less. There’s no smaller package — tough luck for me. Do you want high-speed Internet at home, but use it only a couple of hours per week? You’ll still pay the full price. You need Microsoft Office for your business (because people send you fancy PPTX and DOCX files), but only use it every couple of weeks? That’ll be $399 for the “Standard Edition”…

These flat-price plans are simply a very profitable way to make money from services that have strong network effects plus a long-tail usage pattern. Charging based on usage (and online advertising is economically speaking an indirect way to do that) is fine as long as you sell to a heavy user, early adopter customer base, but as soon as you reach the mainstream, flat-fee models are way more profitable.

So the problem for Facebook (and, supposedly, Twitter at some point) is that the current business model will not really scale well with further growth in the mainstream, low-usage market. Online ads are measurable, and advertisers will only pay for audiences that are really active, i.e. generate page views or click on ads. I think Facebook and Twitter can only scale financially if they find a way to charge people even if they don’t use the service frequently.

By the way: Google recently killed strongly de-emphasized the free version of their “Google Apps” suite of messaging and productivity apps. Their model until recently was that small companies with less than 50 users could get the product for free, financed through advertising. Looks like that didn’t work out so well. The costs for accommodating a lot of mainstream users probably grew more quickly than the revenue from heavy users and ads.

And I’m convinced that Facebook and Twitter will face similar challenges in the near future.