It’s the End of the Road for Freemium Cloud Services

September 23, 2014

“The first goal of a startup is not to go bust. And going bust is very easy to do if you are a freemium company, if you don’t choose the features right.” Professor Vineet Kumar, who researches the freemium business model, couldn’t have better summed up the situation in cloud storage today.

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After five years of betting on growth from the consumer upwards, cloud storage startups are finally waking up to the bottom line. Macroeconomic trends have rendered “land and expand” obsolete. The “Big Four” cloud players — Google, Amazon, Microsoft and Apple — are offering terabytes of data storage for less than the cost of a glass of cabernet.

Especially in the enterprise realm, outside players face two choices. Carve a niche, or plan for an exit, but quickly, before the tech bubble bursts. Those still betting on the freemium strategy will face annihilation.

Still, despite all obvious indications, cloud providers keep trying. Why is that?

Aspiring to be like Salesforce

Around 2008, it became normal for tech startups, particularly in the Bay Area, to pour one-third or more of their revenue into a sales and marketing army at the expense of profit and a sustainable business model. The origin of this top-line fever comes from trying to duplicate the success of this model for early players such as Amazon and Salesforce. Today’s cloud players have forgotten that such successes are outliers and cannot be imitated in today’s market conditions.

Salesforce, the poster child for most B2B players, took advantage of an uncompetitive ecosystem to generate traction first with small and mid-sized businesses, then mid-market enterprises. A strong sales team drummed up enthusiasm, then cast its net around the marketplace to acquire customers. Salesforce still prioritizes generating brand interest through company-driven events like Dreamforce. Top-line revenue has grown by 35% annually during the past five years. Salesforce hasn’t turned a profit in two years, but that’s not a major concern, as the profit has always followed the top line.

The same model isn’t working for cloud providers. The Salesforce formula only works when your marketplace offers a clear, unobstructed glide path. When the market dictates that you navigate around “The Big Four” — Google, Amazon, Microsoft and Apple — in a commoditized market, you must adopt a radically different approach.

Group think

Yes, Salesforce dominated its niche. Yes, the Twitter IPO made 1,600 millionaires, and Splunk succeeded too, all without a bottom line. Such successful IPOs validated the top-line model as the top method for startup success in the 2010s and beyond.

During the past two years, every venture capitalist has been made to look like a brilliant money manager. Private equity firms from Camden Partners to Tiger Global Management have even gotten into the VC business, a sure sign of unprecedented exuberance. The S&P 500 recently closed below a new record again. Alight with optimism, investors pumped up the stock of CYNK, a tech company that doesn’t actually exist, by 30,000%.

Few cloud startups are willing to admit that the top-line ship has already sailed. In a race to develop a sticky user base, everyone is giving away growing amounts of free storage. That’s not a vote of confidence for “land and expand.” It’s quite the opposite: a sign that the “Big Four” providers are in acommodity bidding war to store users’ data and, as a corollary, gain their loyalty.

Where does that leave the cloud providers who have a large user base of unpaid consumers but want to penetrate the mid-market enterprise? In the dust, unless they can partner with a larger player ordevelop/acquire their way into a more complete enterprise solution. The consumer cloud isn’t currently secure, flexible, or capable enough to handle the needs of the enterprise. No matter how much free storage you give away, you must prove to your discerning enterprise prospects that you’re worth the monthly payments.

The old new definition of startup success

One of the definitions of sustainability is that something is “able to be used without being completely used up or destroyed.” A sustainable startup does not burn through its entire venture investment with the idea that more will be available in the future. It doesn’t base its business model on volume of unpaid users. Rather, it justifies its value through a core market of paying users, those who find enough value in its services to justify paying real money to use it again and again.

We’re already seeing signs of the top-line bubble ripening. Venture investment is at similar levels as the year 2000, just before that first .com bubble burst. Valuations for players such as Snapchat and Whisper are way out of line with fundamentals. It all points to the same destination, namely, a market correction.

Companies with unsustainable business models will eventually be forced into an acquisition because their IPOs will be infinitely delayed. Valuations will eventually ease back to normal. Measuring the real value of a company, stalled in favor of number of eyeballs during the bubble, will come back.

*The original post appeared in VentureBeat.