• by Jeffrey Tinsley , March 9, 2009

The quickly cooling online advertising climate threatens scores of startups that have monetized free content with ads as their sole source of revenue. It's especially sensitive because most Internet users have come to enjoy -- if not depend on -- free sites for news, information, analytics, and more. A fascinating symbiosis has emerged: Since free is good, publishers have amassed big audiences and delivered them to advertisers. Increased advertising allows the publisher to deliver cooler services, attracting more audience.

But all of that is slowing in the recession.The Interactive Advertising Bureau reported recently that third-quarter online ad revenues reached $5.9 billion, up just 2% from the second quarter, signaling sluggish market growth at best. AdAge reported that display advertising, which represents 20% of online advertising, is slowing faster than search, which represents 40% of online ads.

Without this mother's milk of advertising, Web startups are reassessing how to monetize their content and reset expectations of a generation of people who've grown accustomed to finding whatever they need for free. During tough times, the interactive realm is expected to take a disproportionate share of marketing budget cuts. That's because it's a relatively new form of advertising, and much of it, though growing fast in terms of reach, is unproven.

But even if we weren't in a recession, I'd argue that the expansion of the online advertising model could slow. Content is ubiquitous, and the audience is easily distracted. It seems that each Web niche has at least a handful of sites offering similar services, all for free, and site loyalty is fleeting.

Publishers are forced to race on the hamster wheel of content creation to deliver ad impressions. Big-brand advertisers at the same time are looking for reach -- television-like numbers in the tens of millions of eyeballs. Finally, online display ads get little click through, and their demise is increasingly predicted.

Doomsayers believe the recession will force massive consolidation among ad-supported startups. There will be some streamlining to be sure, but I'm more optimistic. I predict that sites will quickly begin to revalue their content and embrace a hybrid subscription/advertising model in which a layer of their services will be free and the most valuable paid. It's come to be known as the "freemium" model.

We're seeing some of it already, and I have consulted with several early-stage companies reconsidering their business models to improve their revenue for each user and page view. A good example of a shift recently occurred in publishing. Rupert Murdoch bought Dow Jones and The Wall Street Journal and suggested shortly after the deal closed that the online subscription model would end. He changed his mind after a month of careful analysis. His European competition, Financial Times, has a similar online subscription model. I analyzed those sites (below). Even before the financial crisis became headline news in September, their traffic was growing steadily and attention (total time on the domain as a percent of time on the Web) was rising. It's impossible to tell whether the "free" or the "freemium" is driving this, but suffice it to say that subscription sites are not hurt by their model.

Our site now has approximately 1 million active paying subscribers, and others are doing very well with similar models that many forecasters said would die in the era of free. But when advertising dollars shrink, business models have to change. Services such as people search, data mining, and tracking -- robust and unique information that would ordinarily take days to track down through public records or a number of different sites -- can be monetized through paid transactions and subscriptions that deliver ongoing service. Users may protest at first and lament the end of free, but they will realize quickly that the time savings and value-added service benefits through such online experiences is enormous.

How does this work? "The Long Tail" author Chris Anderson, who's written about the economics of free, notes that giving away 99% of your product to sell 1% works well. "Where the marginal cost is close to zero, the 99% costs you little and allows you to reach a huge market. So the 1% you convert is 1% of a big number," he writes.

He points out that 5% -10% of free Flickr users (roughly 25 million people) convert to paid Flickr Pro, and 3% of Ning's 500,000 social network creators pay for the premium version. A New York Times article pointed out that LinkedIn gets only a quarter of its projected $100 million in revenue from ads. The rest comes from premium subscriptions and revenue from companies using recruitment tools to find prospects.

So, the much-maligned quip "content is king" shouldn't be maligned at all. Sites that deliver value-added information or services that are demonstrably different and more robust than those of competitors will be able to move into this new business model comfortably.

The current economic crisis will serve as a forcing mechanism for Web site business models. While we all love free sites and services, there just won't be as much of it around as advertising shrinks, and a multitude of businesses fail. The successful sites will be those that add value to their products and services and move away from crowded niches to areas where content can be monetized through subscription-only or freemium models. That transition is not an easy one, but once it's done, the model is not as vulnerable to economic fluctuations as the pure advertising model. For many companies that have adopted the model, it has already proven more stable and predictable.

In the long term, this is good news not only for businesses but consumers. The approach will continue to drive healthy new crops of Web startups for years to come. And consumers will be assured that their favorite sites, which might be struggling with their current model in this economy, will not vanish because they can't sustain themselves.

The free lunch may end, but the food will still be plentiful and delicious.