The Illusion of Prosperity: How Free Models in Internet Startups Are Fueling a False Boom

In the business world, offering free services and products is neither a phenomenon that emerged only after the development of information technology nor an exclusive feature of the internet era. Models such as “try before you buy” to encourage purchases of genuine products, providing equipment for free while charging for services, and distributing free newspapers and journals supported by advertising revenue have long been established. However, amidst the current surge in internet-based startups, the free model has become increasingly prevalent. Implementing free offerings without considering prerequisites or consequences can easily become a self-inflicted trap, from which it may be difficult to extricate oneself.

“Free” Sparks the Imagination

Why Is the Free Model So Popular in Today’s Internet Startups? From online news and information data to various online services, software features, and even hardware products, free offerings are ubiquitous. Although many overseas observers enthusiastically endorse free culture and sharing culture from a sociological perspective, the scope of value transfer they envision is not confined to the commercial realm but extends to the entire social environment. In other words, even if the free model does not generate commercial profits through other means, it still holds positive social value and thus deserves encouragement. However, entrepreneurs driven by commercial interests do not plan their implementation of the free model with such considerations in mind.

Compared with low prices, “free” implies zero cost and no sacrifice. Consumers no longer need to spend time weighing costs against benefits, thereby eliminating this step from the entire consumption decision-making process and making decisions significantly easier and faster. This is the free effect from the perspective of consumer psychology.

So, why do entrepreneurs, whose fundamental goal is to generate commercial profit, offer free products and services? Consumers tend to focus more on the “cost” they incur, which includes not only monetary expenditure but also the time and energy spent weighing pros and cons to make purchasing decisions. In contrast, business entrepreneurs overwhelmingly focus on “returns.” All entrepreneurs who provide free products are anticipating a return that exceeds the intrinsic value of the products they offer. The exact magnitude of this return is often difficult to calculate precisely at the time, leaving entrepreneurs to indulge in lofty expectations. Faced with a choice between a relatively realistic but limited space and an immense space fueled by infinite imagination, which would you choose?

This “uncertainty” has also sparked the imagination of venture capitalists backing entrepreneurs. All investors are talking about “room for imagination” and “future possibilities.” This prevailing investment philosophy has greatly boosted entrepreneurs’ adoption of free business models. It is as if presenting investors with a tangible, already delicious cake is less effective at capturing their attention than showing them a much larger cake drawn on paper. Whether the cake on paper can actually be baked has become less important; what matters more is the ability to keep drawing it bigger.

The Inevitable Path to Becoming a Disruptor?

Predatory pricing aimed at squeezing out competitors carries legal consequences, both in China and in developed Western countries. Selling products below cost to quickly drive competitors out of the market with the intent of achieving a monopoly is considered an unfair business practice that disrupts normal production and operational order, thereby subjecting violators to legal liability.

Yet there is no legislation to curb the market-disrupting practices of the free-to-user business model. Why? Because historical regulatory frameworks have primarily aimed at restraining large corporations and safeguarding the survival space for new entrants and small businesses. Today, however, it is often startups that employ free models to capture market share. In the vast majority of cases, when these startups initially launch free products to acquire customers, they are in a weak position within the competitive landscape and are far from achieving a monopolistic status. Nevertheless, while offering free services temporarily may be harmless, the widespread claim of “permanent free” access clearly disrupts the market. Yet nowadays, such behavior is not regarded as market disruption but rather celebrated as “disruptive innovation.”

It is undeniable that many internet companies have created a series of disruptive effects, and it is precisely because of these risen business heroes that more entrepreneurs are stepping forward one after another. However, the "Internet Plus" free model does not necessarily guarantee disruption. In fact, there is an essential difference between disruptive innovation with a positive connotation and market disruption with a negative connotation. It is actually not difficult to determine whether something is truly disruptive innovation. We can simply compare it through three dimensions: cost, efficiency, and sustainability.

With the backing of substantial capital, offering free services has become increasingly easy. However, do not mistake “free” for innovation or assume it guarantees disruption. First, ask yourself these three questions: Have costs truly been significantly reduced compared to traditional models? Has operational efficiency genuinely improved? Is the business model truly sustainable? If the answer to any one of these three questions is no, the venture is highly unlikely to end well.

Many entrepreneurs mistakenly believe that adopting a free model is the inevitable path to becoming disruptors. In reality, “free” is merely the surface; what underpins a successful free model is sustainable low cost and high efficiency. The true prerequisite for disruption is precisely this sustainable combination of low cost and high efficiency that surpasses legacy models. Without these foundational conditions, burning cash to offer free services amounts to nothing more than chasing fleeting trends.

Competition Driven by Product Homogenization

Another reason why internet startups are trapped in the free model is product homogenization competition.

In fact, numerous strategic management studies have sought to identify ways to escape vicious price wars, which frequently arise in industries characterized by severe product homogenization. Because the products launched by various brands exhibit minimal differentiation, companies are often compelled to rely on low prices to attract customers and gain a competitive edge.

This issue appears to be even more severe in the internet startup sector. Many internet startups do not possess core technologies or capabilities with significant barriers to entry; instead, they are primarily focused on constructing new business models. Early entrants find it difficult to withstand imitation by later competitors, and survival ultimately depends on capturing market share at all costs. To seize market dominance, every possible marketing tactic is employed, with no hesitation to spend heavily. Under such circumstances, how could these companies possibly charge users?

Why have valuations for many internet startups been pushed higher and higher, with funding amounts also climbing steadily? Because in a market saturated with homogeneous products, burning cash to buy market share seems to be the only way to win out. To burn cash, more capital must be raised; to raise more capital, higher valuations are required. Early-stage investors become the driving force behind ever-rising subsequent financing rounds. It does not matter whether the valuation is justified, as long as there are buyers willing to take over. Are such stories rare in the investment world? Nevertheless, the market will eventually return to rationality.

China has long been associated with an image of “low price, low quality” in traditional manufacturing. In the realm of internet startups, how many entrepreneurs are willing to think rationally and break free from the vortex of homogeneous product competition? In fact, many successful internet startup projects overseas do not rely solely on business models. Everyone knows that Uber is a paradigmatic example in the O2O (Online-to-Offline) sector and is well aware of its aggressive cash burn. But how many people realize that Uber abandoned Google’s API for route algorithms and instead recruited a top-tier team of scientists to optimize its estimated time of arrival (ETA) algorithm? As a result, Uber’s ETA accuracy surpassed Google’s by 42.5%. Fortunately for China’s internet industry, many foreign companies have struggled to adapt to the local market, failing to grasp its nuances.

Reality is cruel; I would rather die in my dreams.

Once a company starts with a free model, many internet startups are likely to become increasingly hesitant to charge fees. Once you begin charging and establish a more defined revenue model, the “future possibilities” that were once purely hypothetical become easier to quantify. In reality, however, the calculated outcomes often differ significantly from initial expectations.

Indeed, a startup that initially entered the market with a free model faces significant psychological hurdles when transitioning to a paid model. Will users pay for my product? What if they don’t? How do I justify this shift to investors? What if sales volume is too low? What if the sales growth rate is sluggish? Will the current sales figures negatively impact my company’s valuation? Will investors question my profitability? Will competitors poach my users?

The number of users in internet startups is the core metric underpinning future growth potential. Whether these are users reflecting genuine demand, those driven by pseudo-demand, or artificially inflated figures achieved through ranking manipulation and subsidy-driven acquisition, this volume can obviously be many times larger under a free-to-use model. However, once fees are introduced, the true situation is likely to be exposed immediately. In the end, many entrepreneurs, fearing an premature awakening from their dreams, choose to continue offering services for free. They believe it does not matter if they cannot make money now, as long as they can secure funding; profitability can be addressed later. But is this really the case?

1. Not being profitable and lacking a business model are two different things.
2. Insufficient cash flow and unprofitability are two different matters.
3. Spending your own earned money is a different matter from spending investors’ money.
4. Painting a rosy picture for investors during the angel round is a far cry from continuing to sell them on your vision after the Series B round.
5. Having a sufficiently large potential user base is entirely different from targeting users within a specific niche vertical.

In fact, many startups that entered the market with a free-of-charge business model are now struggling to figure out a viable path to profitability after completing their Series B financing. The grand visions previously promised may well prove unattainable, yet valuations have already been driven up significantly, accompanied by substantial capital infusion. How can these companies construct a sustainable profit model that prevents valuation declines, secures sufficient funding to support their established high-burn-rate spending habits, and convinces stakeholders of the feasibility of reaching break-even and ultimately achieving profitability? The anticipated profit model continues to oscillate between lofty promises and practical implementation. As prior investment costs keep rising, the pressure mounts to continuously expand future revenue potential. Over time, this challenge becomes increasingly difficult to resolve. Reality is harsh; eventually, one must wake up and confront it, yet many prefer to dream until the end.

Beware of the Pitfalls of the “Free” Model

It is undeniable that the free model is highly effective in rapidly acquiring users. However, crafting a successful free model is no easy feat, and transitioning from a free model to sustainable profitability is not necessarily a smoother path. It is essential to understand the adverse effects of the free model, as several pitfalls may lie ahead.

1. Implementing a free-of-charge model from start to finish may cause you to forfeit the optimal revenue model. In fact, in the vast majority of cases, it is uncertain whether generating revenue through other indirect channels is necessarily superior to direct product sales.

2. The free model may cause you to overlook user experience. “It’s free, so what more can we expect?” Free users are less likely to be highly critical of your product, making it harder for you to obtain this valuable feedback.

3. The free model may create an illusion of prosperity, obscuring users' true needs and hindering your ability to identify your core user base.

4. It is more difficult to educate users who are accustomed to free services to develop a habit of paying than to charge them from the outset.

5. The free model may also cause you to forgo the opportunity to establish healthy cash flow at an early stage, significantly increasing your reliance on capital and ultimately leaving you vulnerable to being held hostage by investors.

To read more articles by this author, please viewGu Beini Column