For those of you not fans of South Park, the Underpants Gnomes featured in an early episode.  They would sneak into peoples houses and raid their underwear drawers.  When questioned they reveled the great business plan.

Step 1: collect underpants

Step 2: ?????

Step 3: Profit

I would not be the first person to suggest a similarity between this and many Internet business plans.  Thankfully I don’t believe any companies actually tried to build an underwear theft based empire, still

Step 1: attract lots of users

Step 2: ????

Step 3: Profit

has an eerie similarity.  This model was always based loosely around the theory of network effects.  Network effects are well illustrated by the phone system.  If you own the only phone it is of little use to you.  The more of the people you know that own a phone the more useful it is.  This is a network effect, where the value to you of the product depends on how many other people have one.

If you look at companies like Facebook or Twitter it is obvious that they need a base level of other people in the system before it offers you any real value.  You certainly wouldn’t be tempted to pay for the service if it only had a thousand or so users.  This is the main reasoning behind the “everything for free” model many Internet companies start out with.  They are trying to get the network effect kick started.  The problems occur when they try to then monetise the users they have.

As I have discussed before, advertising models are often flawed, particularly in a market so oversaturated with a consumer base so jaded.  Turning free services into paid services generally loses you a lot of users.  And whatever way you want to introduce charged services, your product needs to be sticky enough that people will stay with you, or pick up the charged content.  In general, if you do not have a viable method for generating revenue from day one you have an Underpants Gnome strategy which can only dream of future profits.

Early on in the piece Skype looked different from this.  While it offered an attractive proposition for free Internet calls, it very early on had a revenue model for calls to non-skype phones.  And while it probably will never be able to charge for all calls, it could also easily have added a premium service where conference calls, calls with QoS, or assurances you would not be used as a node attracted a reasonable charge.

And then when Ebay took them over it still all looked rosy.  Ebay were themselves an Internet company that started with a viable revenue model so they at least appeared to have some idea of how to profit online.  The promise has never seemed to pay out under this combination though.  While Skype is still generating a reported $550M per year, this is still clearly not enough to pay for their costs.  So while Skype is generating about $10 per user each year some analysis has estimated it costs them up to $45 to acquire each user.

So was Skype actually out there collecting underwear?  A collection of private equity, and venture firms obviously believe that this is an issue of bad management enough to pony up $2B for theor controlling stake.  That is generally the sort of situation that drives these companies to buy.  At the same time Skype is fighting a legal battle over its technology and inking big ad deals to help acquire more users.  The latter is arguably a bad move when it is still losing money on the users it has.  As with most things time will tell, in the meantime my underwear drawer will remain closed when I am using Skype, just in case.