Seven years ago, First Round Partner Josh Kopelman wrote a seminal blog post on the importance of free services in consumer-facing business models. He argued that most entrepreneurs misunderstand how subscription pricing works and assume that as price goes down demand goes up in equal measure. Instead, he suggested that price affects demand to a point, but the relationship is far from linear — there is a gap between free and any other price. This gap is known as “The Penny Gap.”
Years after the post was written, WhatsApp used a novel approach to solving the Penny Gap while creating one of the fastest growing mobile networks on the planet. And while WhatsApp built an incredible product that solved a real need, their understanding of the Penny Gap may have been their shrewdest product move of all. In this article, we explain why, and how this knowledge can help your company and apps succeed.
Minding The Penny Gap
Kopelman pointed out that while lower prices generally create higher demand, there is a unique phenomenon that occurs between free ($0.00) and paid ($0.01). Most entrepreneurs assume that the cheaper a service is, the more people there will be who are willing to pay for it. But that doesn’t account for the massive gap between unpaid and paid products, or the power that dynamic holds for growing a consumer business.
The Penny Gap, according to Kopelman, can be understood as follows:
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To support this claim, Kopelman pointed to breakout hits of the time. When compared to their legal, paid competitors, free music sharing services Napster and Kazaa weren’t just incrementally better — they were exponentially bigger, suggesting that the relationship between price and demand is more complicated.
He went on to assert that sometimes offering your product or service for free is actually cheaper for consumer businesses. Acquiring customers for a paid product with a low conversion rate can be expensive, while monetizing free users through ads is relatively easy. In the world of mobile, this lesson may be more important than ever.
The Mobile Penny Gap
In the years since Kopelman coined the Penny Gap, this reality has been compounded and magnified in the mobile space thanks to App Store distribution and the massive number of users on platforms like iOS and Android.
A quick look at revenue for top grossing iOS games highlights the effect of the Penny Gap. On Think Gaming’s list of the highest grossing games, out of the top 50 games, only one — Minecraft — is a pay upfront app. The rest? Free with in-app purchases. Out of the 100 highest grossing, only five use pay upfront models. The numbers are similar for Android apps, with just two pay upfront games out of the 120 highest grossing games on the Google Play store.
In what he refers to as An App Store Experiment, Stuart K. Hall observed the power of free when he built a very basic 7 Minute Workout App. After letting the app run as paid for a few weeks (he sent out press releases with promo codes and added iPad support, with minimal effect on downloads), Hall decided to make the app free to see what would happen. Within three days, the app’s downloads had grown to an average of 72,000 per day, or around 2,500 times what they had been for the paid app. It became the #1 fitness iPad app in 68 countries and the #1 fitness iPhone app in 49 countries.
The app’s revenue was also impacted by the shift from paid to free. When Hall switched the app to free, he added in-app purchases by way of a “pro” upgrade that provided workout tracking and customization. The switch led to a 300% increase in overall revenue, even though 97% of users didn’t pay anything to use the app. Hall’s experiment highlights the real power of the Penny Gap.
Free in Winner-Takes-All Markets
The examples Kopelman used in his original post weren’t just any old consumer businesses. Both Napster and Kazaa were driven by the network effect. And when it comes to businesses built on network effects — such as LinkedIn, Twitter, and Yelp — their value is only as great as the size and quality of the network. Any business fighting the early challenges of Metcalfe’s Law knows how important it is to quickly build out their network to create value.
Notably, making things free removes some of the friction that comes with establishing the value of a network. Network businesses are fighting for a ‘winner takes all’ end game where the dominant network is so valuable that users don’t want to leave because other alternatives don’t offer the same value.
Sean Ellis is CEO of Qualaroo andGrowthHackers.com. He's also an angel investor and prominent marketing advisor for a range of startups.
The network that gets the most users early on becomes the most valuable, locking in users and locking out competitors. Big networks carry heavy switching costs.
As a result, products in winner-takes-all markets can also afford to (and should) spend more for early users than for later ones because these users help to secure their network’s dominance and establish lock-in. It’s definitely worth overpaying for them, even if it means giving the software away for free.
The Year Long Trial and the Penny Gap
Most networks use an ad-supported model to keep the service free while driving revenue to keep growth going. WhatsApp certainly understood the critical nature of network growth and the winner-takes-all implications of building a business on top of a massive user base, but they also knew they didn’t want an ad-supported product.
WhatsApp's “free for the first year” model allowed them to solve for both business requirements — it got users over the dreaded Penny Gap and onto the platform, contributing to its rapid growth and creating lock-in. The eventual revenue meant that WhatsApp didn't have to worry about monetization through advertising — something the founders are still against. In addition to solving this challenge, the year trial gives users enough time to try and get hooked on the product, but still sets the precedent from the beginning that WhatsApp will not be free forever.
Paying for Early Users
When network effect is at play, it's well worth it for startups to overpay for early users in order to establish dominance. Those early users create value by bringing in and creating new connections.
You can overpay for these users in two ways: By overspending on pay-per-install above your anticipated lifetime value, or by absorbing the cost of giving away the product for free. In WhatsApp’s case, they chose the latter.
While they look like equivalent choices (after all, its paying one way or another), the reality is that paid installs can often be inferior to and more expensive than giving your product away. For WhatsApp, paid acquisition would’ve been slower, the network effect would’ve struggled to take hold, and the user experience would’ve been much more cumbersome, resulting in less word-of-mouth marketing and stifling adoption.
Morgan Brown is Head of Growth at both Qualaroo and TrueVault. Previously, he co-founded Full Stack Marketing. He's directed marketing at several startups and is the author of books on the subject of digital marketing and growth.
Had WhatsApp not pivoted to free upfront, we probably wouldn't be talking about it today.
Letting the Trial Ride in Growing Countries
WhatsApp gets the Penny Gap. In some fast-growing countries where they’re trying to establish dominance they’re letting the $0.99 year one charge slide, continuing to pay upfront for early users in markets where the company is trying to establish itself as the clear winner.
But WhatsApp is not the only company paying a premium for new users in emerging markets. In places like India, Malaysia, and Brazil, the potential audience is huge, yet customers often can't afford costly data plans that come with regular mobile internet use. In a bid to establish network lock-in in these new markets, social networks are arranging deals with mobile carriers, paying all or some of customer data costs. They’re trying to prevent payment friction from slowing down network adoption.
This process is no doubt expensive for the companies in question, with the cost of subsidizing data likely exceeding resulting early revenue. Yet these types of strategies are becoming necessary as more apps fight for growth and try to stave off in-country competitors. They all know the value of Metcalfe’s Law.
The Takeaway
While WhatsApp’s success is no doubt due in large part to the fact that they solved a major problem for a large number of users — exorbitant SMS charges and restrictions of local carriers — their savvy pricing decision is equally noteworthy. It not only helped them overcome the Penny Gap, but also allowed them to avoid advertising on the platform while creating the network value needed to lock in users.
It's this strategy that crowned WhatsApp as the early victor, capturing enough of the mobile messaging market to be worth $19 billion to Facebook. For any company also looking to expand in emerging markets, the value of this move is clear.
The challenge now is that the mobile market has grown so big that there is no longer one true winner. Apps like Line are growing even faster and winning in countries where WhatsApp has been unable to make a dent. As this trend continues, it will be interesting to see if WhatsApp rises to the occasion or loses its user lock-in, becoming the mobile messaging version of Friendster in the process.
If you’d like to read more case studies like this on fast-growing tech companies, check out our book Startup Growth Engines. It’s a collection of deep dives into how the smartest companies in the world are growing today, including LinkedIn, Snapchat, Square, Evernote and more. You can also find more tips on GrowthHackers.