'Not for Free': Saul J. Berman on Creating New Revenue Models

The "phenomenon of free" has hit many businesses hard, particularly media businesses, argues Saul J. Berman, Global & Americas Leader for the IBM Strategy & Change Consulting Group within IBM Global Business Services (GBS). In Not for Free: Revenue Strategies for a New World, Berman offers lessons from businesses that have integrated successful business model innovations -- including Google, Amazon, Apple, Redbox and Hulu -- as well as from businesses that have failed to do so. Recently, Knowledge@Wharton and Jerry (Yoram) Wind sat down with Berman to discuss his thoughts on who pays for free content and why new models are essential for success.

The following is an edited version of that conversation.

Knowledge@Wharton: Saul, thank you so much for joining us today.

Saul J. Berman: Thank you for having me. I appreciate the opportunity.

Knowledge@Wharton: In 2008,Chris Anderson, the editor of Wired, wrote a very famous article that was titled, "Free: Why $0.00 Is the Future of Business." Based on the book that you have just written, was he right or wrong?

Berman: Well, it depends on how you want to interpret the question. He suggested that content would increasingly be free and that free was a much better price than near-free. I argue that somebody is paying for it somewhere. So, in some cases it may be free to the end consumer, but the point is that it is not really free. It is being paid for: maybe by an advertiser, maybe by a sponsor, maybe by somebody who wants access to a group of people for other purposes or somebody who is bundling it with other products or services they offer. But in one form or another, it is not free. Somebody is paying for it and somebody is seeing that the people who create the content will continue to create that content and be reimbursed for it.

In the case of the music industry, which was one of the first examples of disruption, we can see in our analysis that music is worth more than it ever was. It just doesn't go to the music companies anymore. The value of music goes to the people who make devices for you to listen to your music on. It goes to the cell phone companies that enable you to download music. It goes to the concert promoters. Since there is more sharing of music out there, people know more about the artists, which, in many cases, means the attendance for concerts has gone up. Overall, the amount of revenue has actually increased, and it is really not for free, though it may at times be free -- or perceived to be free, not that that's appropriate or legal -- to the end consumer. Though, again, there has always been advertising. Some of these models have always been out there, where you can get things without direct payment.

Knowledge@Wharton: Let me push back very gently on this issue.Let's take a company like Google that provides Gmail for free. It helps to build a massive audience. It does not directly charge the consumer, but at the same time, it is able to monetize the traffic through the advertising that it is able to sell alongside the emails. Is there anything wrong with that sort of a model?

Berman: Well, when you say "wrong," I am not sure we are into qualitative judgments, ethical judgments or economic arguments here. From an economic perspective, people are in business generally to make money, so somebody is making money out of the equation. The people who are creating the content are somehow making money, or they wouldn't be able to sustain their business in the long term.

So, again, back to my music company example. If the music companies themselves don't find a way to monetize the content they are involved with, either they won't be part of the equation or they will have to participate more so than they do today in some of these other revenue streams.

We argue not only about how much money is associated with content, but also who gets that money. In many cases, what we are seeing is the money shifting to other people because the business models are changing.

Knowledge@Wharton: But in Google's case, it is still Google that makes the money -- just not on the email, but on the advertising. That's where the question comes up. What's wrong with that?

Berman: I don't see anything wrong with that. That is a business model or business proposition. I use the example in the book of the Gillette razor blade model. Historically, Gillette gave you the razor for free -- or near free -- and you paid forever for the expensive blades, on which they made a very nice profit. Well, what Apple did when they created the first iToy, as I call it -- the iPod -- they gave you the music for free -- or near free -- 99 cents. That was the equivalent of the blades. They shared that money with the music companies very nicely -- 70% or 75%. But all of a sudden the razor -- or the device to listen to the music on -- became very expensive and they kept all the money on that. So they shifted the proposition. There's the opportunity in each of these innovations around different mechanisms for compensation, whether they be payer, pricing or a different model. There are going to be opportunities for the value to shift.

Knowledge@Wharton: Jerry, do you think that sometimes what is perceived to be free is actually paid for -- but in terms of information rather than cash? Is there any value to that?

Wind: The question is from whose point of view.

Berman: Right.

Wind: If you look at it from the consumer point of view, I would suspect most consumers will perceive the products that they get for free as free because they don't see the advertisement as a payment. From a consumer point of view, free may be a great component of the value proposition of deferring. But I think the key point that Saul is making -- and which I really like in the book -- is the idea that [it is important to] start paying attention to the business model and the revenue model, and to ask, how are you going to make money eventually?

Google is a great example. The overall Google proposition -- or the business model -- is still very valid. They make money off of this. Can they make more money if they start charging for Gmail or for some of the other components? That is a different question. But there is real value in focusing the attention of management on what your revenue model is. How are you going to make money? Look at this in the broader context.

Berman: You have to look at, as Jerry is saying, the broader consumer experience. That experience is the combination of content, hardware and software. It is the integration of those pieces and the creation of the experience that often gets the value. The challenge is who is going to control that value in these different mechanisms for monetizing. Is it going to be the hardware company? Is it going to be the software company? Is it going to be the content company? Is it going to be a fourth party that puts all those propositions together? That is where the interesting challenge is and the opportunity to make more money even if, as you say, it may be free to the end consumer in terms of the direct pricing model. There may be indirect payment by somebody else or otherwise to monetize.

Knowledge@Wharton: I know you focus a lot on workable business models in your book. When it comes to business models for information goods, do you think that free could be one price point along a continuum of prices for information goods?

Berman: Well, yes. There can be a free-to-the-consumer model for the basic service, and then you try to get everybody to trade up to what Chris calls a "Freemium" model, where you charge more for additional services. Take an automobile, which we talk about in the book as well. The value-add in an automobile includes the sensors, actuators and intelligent information that comes from them.

So we can now provide help with navigation. We can provide entertainment services. We can provide concierge or restaurant reference services in the car now. Increasingly, just like the car companies may have made money in the past for selling you after-market service on your vehicle, now they have improved the quality of the vehicle, and they may make more money from these subscription-based entertainment or other types of concierge and information services. That may be where they make a lot of their money in the future.

Now who gets the money out of that is still an open question. But the adoption of the information sensors, actuators and connectivity -- those devices can now control the refrigerator or the washing machine or the heat or the security system in your house at the same time. So there is a world of possibility opening up and the question is, how will that work as every product becomes more information-based?

Knowledge@Wharton: One industry that has been hugely disrupted by free content is, of course, the publishing industry. What are your thoughts on survival strategies?

Berman: I would like to hear what Jerry has to say on this one.

Wind: First of all, let's link it back to the previous question in terms of digital product or information product in a single price or continuum. I don't see really any distinction between information products -- or digital products, in general -- and regular products in terms of product line when you have to start thinking about a product line offering. The product line can be from free to whatever price it is. The key is going back to what Saul was describing before -- the move from product to service to integrated offering, a tall solution, and, most importantly, the customer experience. Each one of these is a value of social business and, therefore, the willingness of a given segment to pay for this.

The same thing is true in the publishing area. People still want to hear, read and find out about the news. They just don't want to read it in the traditional form. There is also a segment that may be lagging behind -- a segment like me. I still like to read The New York Times on paper and for the feel, but I am part of a shrinking segment. What you have to realize is that the market is heterogeneous. That's one of the key things we know about marketing. Therefore, you want to offer the news in a variety of ways. Furthermore, it is a re-definition of news. What is a newspaper? Is it only news? Is it entertainment? What is the nature of the offering? I think the publishing industry is now in a situation where they see an opportunity to re-invent themselves, to ask, what is the value proposition? What are we trying to offer consumers and how do we integrate news with entertainment?

From some data we have seen, my understanding is that younger people get most of their news from Jon Stewart. What is the competition of the newspaper to a Jon Stewart--type show and delivery? It is a great opportunity to innovate -- a great opportunity to rethink what publishing is and what it is we are trying to do.

In general, I think that Saul's book offers a great opportunity for companies to reinvent themselves and to rethink how they can come out with a more innovative solution. You will not be able to innovate if you just stay within the boundaries of your old industry definition. By rethinking business models and revenue models, there is a great opportunity for innovation.

Berman: Let me give you one of my favorite examples, which is the music industry example again. The industry was under all this pressure. Albums sold from $9.99 typically online. Songs sold for 99 cents until the industry got Steve Jobs to let them raise that price a little. But a ring tone, which is a 10-second clip of a 99-cent song, people were paying $2, $3, $4 or $5 for. Now bits of your overall content are worth more than the whole. That is a pretty good business model if you can make it work.

If you are a book publisher or a newspaper publisher, increasingly you are able to take the archive, and you are able to monetize content from [it], in some cases, for more than the original newspaper or the original magazine would have cost you -- or a chapter in a book for more than what the Amazon price on that book might have been.

Knowledge@Wharton: I would love to get your thoughts on one other area. If you look at what has been happening recently among young people in the Middle East, the vast majority of them have been getting their information not from newspapers, magazines or even radio or television. They have been getting it from Facebook and Twitter, especially because of the curbs that the government put on the Internet. Both of those happen also to be free services. How, then, should people think about revenue-generating models in publishing?

Berman: First of all, they are not, in my terms, totally free. Facebook makes a lot of money from advertising, though many people don't realize it is even there. But they are making a lot of money on it. So, again, it is being monetized. The other point is as you get more of that information and use it, it is creating stars. It is creating new vehicles around the people who become famous for sharing content over these services. Those people are finding other ways to monetize the celebrity or the status that they have created by being an authoritative source who contributed to something. So both the provider and the individual are increasingly going to find ways to monetize, or they are going to have to find something else to do with their time.

Knowledge@Wharton: Do you think that, in publishing, content creators are being eclipsed by what are called "content curators"? And what are the implications?

Berman: Interesting question. We do think there is a big role for curation as a value-added service. We think there is a big role for analytics. Companies like Bloomberg have long created value around the analytics. We have told people in the information publishing space, beginning five years ago, that they have to do more than just, if you will, provide the information. They have to provide people the tools and capabilities to do different things with that information and they have to provide analysis and insight.

Increasingly, it gets back to the point we make about the experience. There are lots of different ways to monetize, which we outline in the book. You can monetize with different audiences in different ways.

Knowledge@Wharton: Just one last question: You have examples in your book about innovative business models involving Progressive, Redbox and so forth. Could you give us some more examples?

Berman: Sure. Obviously we are all familiar with some of the ones in the music space where now you can buy singles. You can buy ring tones. You can buy à-la-carte individual tracks. But companies, like Netflix, came along and turned what was a pay-per-view or buy media experience into a rental media experience. Redbox came along and provided a less service-oriented, go-to-a-vending-machine, lower-price way to get that content. So we talk about the idea of variable pricing. You can sell different things to different people at different times.

The airlines go further with dynamic pricing. They will sell not only different things to different people at different times, but the price will change at different days or times of the day. So there are lots of different ways. What is new is that you take them to another industry in many cases. We talk about Zipcar in the book. Instead of buying a car or leasing a car, you can subscribe and rent it by the hour, by the day, or whatever you want. You get charged for your usage of that vehicle, and the vehicles are staggered all over and you can go use them.

There are examples of advertising in spaces where they have never been used before, such as the phone business. Instead of paying for information services, you can listen to an ad and get free information services. Even in industries such as medical, now we are seeing people experiment with pricing based on results. In some cases, where drugs have not been approved by insurance companies, some of the medical drug companies are experimenting with, "You pay us if it gets results for you." If it is in the experimental stage and hasn't been approved and your insurance company won't pay it, take the drug. If it lowers your whatever and improves your medical condition, then pay us for it.

So some of these models -- or most of them -- have always been around some place. The challenge is now applying them in different ways to different businesses. In the book, we categorize them into three categories.

The first category is pricing, where you change the direct price and the way you price to the end consumer. This applies in a B-to-B world as well, where we used to invest in assets and build capabilities in companies. Today, we might outsource them and pay somebody over time. We are still paying, but we are paying in a different way.

Payer innovation is the second category, where someone other than yourself pays. We are seeing many more ways to do advertising, sponsorship or performance-based types of payment that are indirect and from other people.

And, finally, package innovation, where you package it with something else or sell the parts as we suggested in the cell phone or the publishing case. What we think is the real challenge for most companies is they are going to have to have multiple ways of monetizing for different consumer segments who will want to pay in different ways. Some will say, in effect, "I want it to be free to me. I will pay in some other form." Others will pay directly: "I don't want the advertising. I don't want anybody having my name." Even there, there are going to be different ways of doing it. As I say, the challenge is how do you do this in a way that makes sense to the different segments and then be able to manage that complexity in your business?

Knowledge@Wharton: Saul, thank you so much for speaking with us.

Berman: It has been a pleasure. I appreciate the opportunity. Please send me a note if you have any questions at Saul.Berman@us.ibm.com, and please let me know what you think of Not For Free.

http://knowledge.wharton.upenn.edu/article.cfm?articleid=2817

Groupon: All About Unredeemed Coupons

An analysis of the Groupon S-1 filed last week for their upcoming IPO highlights some interesting trends. A single table illustrates how the Groupon business model is entirely based upon the concept of float. The payments the company owes to merchants are growing at much faster rates than actual revenue rates. In fact, the balance sheet shows that the company owes more to merchants than total current assets, an unusual situation.

The Revenue Curve

There is no question that Groupon's revenue curve is amazing.
From sales of just $30 million in 2009 to sales of $713 million in 2010, Groupon has shown incredible growth rates.
As if that were not enough, sales in the first quarter of 2011 were $644 million.
Assuming trailing twelve-month revenue of approximately $1.2 billion, this would give Groupon a price/sales ratio of about 160. This is an extremely high valuation metric for a company with revenues of over $1 billion. (The S-1 does not provide quarterly revenue data for 2010, so assumptions must be made; we assumed $550 million for the last three quarters of 2010.)
This type of growth rate is astonishing, frankly, but focusing on only the revenue growth is superficial with Groupon's business model.

Groupon's Business Model

Groupon sells coupons to customers on behalf of merchants who sign an agreement with Groupon. To the merchant, Groupon serves as outsourced marketing, with the hope that Groupon's incentive to customers increases business. The merchant sells their services at a steep discount through a Groupon coupon.
Why are merchants willing to sell their services at discounts as much as 50% below the retail cost?
Part of the value offered to the merchant is the potential that coupons will either be unredeemed or not redeemed at all. In the U.S., an unredeemed coupon means that the merchant is effectively paid for nothing.
If the coupon is not redeemed for a long time, the merchant has accrued a future liability, but has increased cash flow. Since many small retail businesses survive on cash flow, rather than accrual-based accounting, any increase in current cash flow is a positive factor.
If the merchant views the unredeemed coupon as cash and views the lower revenue for services from redeemed coupons as marketing costs, the Groupon value proposition can be attractive.
The delay of time between the sale of a coupon and its redemption is where Groupon has built nearly all of its value.

Accrued Merchant Payable

On the balance sheet, amounts that are owed, but as yet unpaid to merchants, is recorded as a current liability called "accrued merchant payable." This metric is in addition to the standard balance sheet lines of "accounts payable" and "accrued expenses."
A very interesting picture emerges when the trend of this metric, the accrued merchant payable line, is measured against revenue, gross profit, and current assets trends.
The following table illustrates the trends in revenue, cost-of-goods sold, and gross profit, as given in the Groupon S-1.

Metric, $K	2009	2010	Q1 2011
Revenue	$30,471	$713,365	$644,728
Cost of Revenue	$19,542	$433,411	$374,728
Gross Profit	$10,929	$279,954	$270,000
Total Current Assets	$14,207	$173,855	$208,688

Source: Groupon S-1 Filing
When the trend of "accrued merchants payable" is compared to the trends in revenue, gross profit, and current assets, a curious development is seen, as illustrated in the table below.

Accrued Merchants Metric, $K	2009	2010	Q1 2011
Accrued Merchants Payable	$4,324	$162,409	$290,700
Percentage of revenue	14.2%	22.8%	45.1%
Percentage of cost of revenue	22.1%	37.5%	77.6%
Percentage of gross profits	39.6%	58.0%	107.7%
Percentage of current assets	30.4%	93.4%	139.3%

Source: Groupon S-1 Filing, Briefing.com calculations
It is the accrued merchants payable line that is astonishing, particularly as a percentage of current assets.  The accrued merchants payable line simply gets larger and larger as an overall percentage the more Groupon grows.
In fact, the accrued merchants payable line is greater than gross profits, which means that if Groupon had to pay their merchants immediately, the payment would consume all of the gross profit for that quarter.
What this means is that Groupon is essentially staying just one step ahead of having to pay the piper. Instead of having accrued liabilities go down as the company grows, the accrued liabilities expand. Such a model is somewhat equivalent to paying your rent with your credit card, prior to receiving your salary check, but the rent is larger than your salary each and every month.
The revenue trend at Groupon is the first metric that the public has focused on, particularly the media. It is certainly the incredible metric curve that the very high valuation is based upon.
However, if there was any lesson from the internet bubble era of ten years ago, it is that valuations based upon revenue alone are extremely risky. The minute an incredible revenue trend stops, the valuation the market is willing to place upon a stock drops dramatically.
Such a stock is somewhat comparable to the game of hot potato, where the goal is to acquire the stock and then pass it on as quickly as possible before the potato explodes.
We think that such a scenario is likely with Groupon, eventually, although it is difficult to predict when. Nothing keeps growing forever. The ticking time-bomb, however, is the money owed to merchants, and it's an ever increasing trend.

Unredeemed Coupons Are Key to Groupon's Financials 

Imagine, for instance, what the balance sheet would look like if Groupon paid all merchants their entire amount due at the time of the sale of a coupon, on a per-coupon basis, instead of waiting until the sale of coupons reaches a pre-arranged, negotiated level.
There would be no accrued merchants payable line on the balance sheet, except for the single day when the sheet is generated and issued checks are uncashed.
In such a scenario, the balance sheet would show negative current assets, meaning that there is no buffer of cash with which the company can operate on a daily basis. The situation is roughly equivalent to a company operating without any checking account at all.
What this all means is that the faster Groupon grows, the more of its accumulated cash is owed to the merchants, as a percentage of revenues, profits, and assets. However, Groupon needs the cash from unredeemed coupons to finance its daily operations. It is somewhat similar to a restaurant charging its customers in advance for a meal a week from now, and then using the payment to go out and buy ingredients and hire a chef.
With the Q1 2011 accrued merchant payable line at 45% of total revenue and 78% of cost-of-goods sold, it simply begs the question of why the merchants aren't being paid.
We think the accrued merchant payment line is going to become the critical metric to watch as Groupon grows.

Unredeemed Coupons Are Groupon's Working Capital

Groupon is funding its entire working capital needs with the money that is owed to its merchants.
This type of situation is fine as long as the company never stops growing at fantastic rates, and customers take months or years to redeem their coupons.
However, both of these trends are likely to recede at some point as Groupon gets larger.
Merchants that have sold coupons that haven't been redeemed, and therefore, haven't been paid by Groupon, are likely to eventually either demand their share of the cash, or withdraw from using Groupon as a marketing tool. After all, they haven't gained anything in such a situation.
Customers that fail to redeem coupons are not likely to continue buying coupons in the future. The initial thrill of Groupon occurs when services are bought for half the retail price. That thrill fades, however, as time goes on and the coupon is not used.
How many Groupon customers that have yet to redeem their coupon are likely to buy another one? At some point, purchasers of coupons that are unredeemed will change their view of Groupon from one of "a real bargain" to one of "an unnecessary impulsive purchase."
At the moment, the thrill of "getting a deal" is the driver behind the Groupon explosion of revenue. Someday, however, that thrill has to be backed up by the merchants increasing their business and receiving revenue and the customers returning to buy more coupons.

Conclusions

Groupon's entire business model depends on the time frame between the sale of a coupon and the time it is redeemed.
Certainly, they have sold a lot of coupons. But the scale of the unredeemed coupons is immense, and without it, the Groupon financial statements would look horrible, even with the incredible revenue trends.
How large is the market for persons who buy coupons and never redeem them? With a business model so dependent on customers being slow to redeem coupons, combined with delayed payments to merchants, Groupon's long-term investors have to make such an analysis for themselves. 
Your guess is as good as ours, but we do think that eventually, people who do not redeem the coupons they purchase are not a long-term viable customer base. At some point, the game collapses upon itself.
In the final analysis, customers need to receive actual value for their payments, not a perceived future value that is never delivered. We think the tone of the S-1 indicates that Groupon itself understands this issue.
You might notice, for instance, that Groupon is not selling any coupons for a 50% discount in their own stock offering.
Comments may be emailed to the author, Robert V. Green, at aheadofthecurve@briefing.com

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