Business Strategy: The Razor's Edge

Baldwin Louie — Mon, 06 Aug 2001 15:00:00 -0700

This fall marks the centenary of Gillette, the company that invented not only the safety razor, but also the business model that has fueled much of the high-tech boom over the past two decades.

Born in 1855, King Camp Gillette was a 40-year-old salesman for Crown Cork & Seal, the author of an anti-capitalist tract called The Human Drift and a failed inventor when he had the epiphany that would re-write economy textbooks worldwide. He was standing before his mirror, ready to shave, when he realized that the Star razor in his hand was useless. "It was not only dull," Gillette would write later, according to his biographer Tim Dowling, "but it was beyond the point of successful stropping and it needed honing. As I stood there with the razor in my hand, my eyes resting on it as lightly as a bird settling down on its nest, the Gillette razor was born."

The stubble-chinned utopian had just dreamed up the world's first disposable razor blade. It took him five years to find someone who could provide a machine that would automatically hone thin sheets of steel to the required sharpness, and at first the blades sold for less than they cost to make. Undaunted, Gillette forged ahead and eventually had a second epiphany: He would give away a razor and sell the blades. By 1910 Gillette dominated the razor business, and its founder was a millionaire.

Certain types of companies, of course, have always given away or subsidized one product in order to sell another. This magazine is one of them: The Industry Standard, like most consumer magazines, sells subscriptions at a loss in order to make money on advertising. Radio stations and traditional TV networks operate on a similar principle.

Adobe Systems' John Warnock was one of the first to realize that this model made sense in the digital world. Founded in 1982, Adobe gave away its basic Acrobat Reader software to better sell its high-margin creative tools, such as Acrobat Distiller. Adobe is now the second-largest U.S. PC-software company, with annual revenues exceeding $1.2 billion. Other companies quickly followed suit, including Oracle, which gives away its development tools to promote sales of its database software, and Sun Microsystems, which supplies Java for free and sells workstations and the Sun operating system. Even IBM, once the quintessential hardware company, has made a successful transition to a service organization while watching the margins on many of its computers decline steadily. (Microsoft, which gives away its Internet Explorer to retain customers for Windows, is a different case, to which I'll return shortly.)

In the wake of the dot-com meltdown, though, contrary examples abound: Webvan, for instance, tried to give away home delivery (for orders over a certain amount) to sell more groceries. It burned through more than $1 billion in less than two years and shut down last month. Likewise free Internet service providers, which gave away access in order to sell advertising - that category is essentially dead. Free online media outlets such as Salon and Inside.com have suffered the same fate. In fact, the failure of the giveaway model in many categories can plausibly be blamed for the bursting of the dot-com bubble.

Senior executives at five wireless telecommunications carriers on Wednesday sent an open letter to FCC Commissioner Michael Powell and U.S. Attorney General John Ashcroft, proposing a means of settling a dispute over the allocation of coveted radio spectrum.

NextWave Telecom originally won the spectrum for $4.74 billion dollars in a 1996 auction held by the Federal Communications Commission. The government later repossessed the licenses, after NextWave filed for bankruptcy protection, and re-auctioned them to carriers such as Verizon Wireless and VoiceStream for over $15 billion. In June, a court of appeals ruled that the FCC had violated bankruptcy laws by seizing the spectrum licenses and re-auctioning them, a decision that effectively handed the licenses back to NextWave. The FCC is expected to appeal the ruling.

In the letter, the executives urge the government to pay NextWave Telecom between $4 billion and $5 billion, in exchange for which NextWave would renounce all claims to a set of disputed wireless spectrum licenses.

"We are at a fork in the road. The government can continue to litigate this case, possibly for several years more. Or, you can negotiate a resolution now," reads the open letter. "This litigation, however, is tying up substantial blocks of precious spectrum, in markets across the country, forcing it to lie wasted and unused. The public is gaining no benefits – either in auction revenues or wireless services – from this spectrum."

The execs who signed the letter are Dennis Strigl, president and CEO of Verizon Wireless, the country's largest wireless carrier; John Stanton, CEO of VoiceStream; Conrad Bagne, identified as a managing member of Alaskan Native Wireless, which is affiliated with AT&T Wireless; George Crowley Jr., president and CEO of Salmon PCS, which is affiliated with Cingular Wireless; and Everett Dobson, CEO of Dobson Communications.

The carriers argue that the radio spectrum in question is desperately needed in order to satiate the nation's growing demand for wireless services. According to the Cellular Telecommunications Industry Association, the number of Americans with cell phones has grown from 33,000,000 in 1995 to more than 118,000,000 today.

But Nextwave rejected the latest offer from the carriers. "Consumers are waiting for this spectrum to be put into use to deliver them the next generation of wireless services," says Nextwave deputy general counsel Michael Wack. "It's time to stop litigating and start building out. Competition should be carried out in the marketplace, not in the courts or through inappropriate use of the regulatory process."

So what types of businesses can profit by giving away stuff? It turns out that this question has recently been explored by a couple of obscure but dedicated economists (is there any other kind?): Marshall van Alstyne of the University of Michigan School of Information and Geoffrey Park of Tulane University. In a paper published last year entitled "Information Complements, Substitutes and Strategic Product Design," the pair presented a theoretical model that explained the razor-and-blades strategy and provided a road map for companies that might pursue it. Their work is full of complex equations and terms like "free strategic complements" and "cross-market externalities," but I think I've managed to glean a few core principles.

No. 1 is that the company must have a compound product, one that can be split into pieces, some of which are given away and some of which are sold at a large profit. Cell phones are a good example: As the cost of the handset has dropped, companies have found it more profitable to essentially give away the device and charge for the calling plan. But, as van Alstyne points out, the paired products must have "strong complementarity" - that is, the one must be unusable without the other. A cell phone without service is no more useful than a razor without blades. Red Hat gives away its Linux-based operating system so it can sell consulting and maintenance contracts, but many customers - particularly the techno-geeks who tend to favor Linux - don't need the services that Red Hat provides. There may not be enough complementarity in that model, which helps explain why Red Hat's share price lost about 86 percent of its value in the past year.

The second condition is that the free goods must have negligible marginal costs: Once you've made one, it should cost next to nothing to make the second and each one after that. That explains why the giveaway model works so well for information technology: Creating the first copy of Acrobat Reader took years and cost millions; knocking off copy after copy entails only the cost of running the server from which customers download them, for free.

The third requirement is to have a product, like razor blades, with inelastic demand: In other words, people will keep buying it, over and over, in perpetuity. That's why Bill Gates is so enthusiastically touting Microsoft's .Net initiative; it's a way to shift the company's business model from selling razors (that is, the Windows operating system) to selling blades (Internet-based software applications). As PC sales have flattened, Microsoft has had trouble convincing people to keep shelling out for "upgrades" that they regard as little more than bug fixes. In the future, if Gates has his way, the software platform will be a one-time purchase, while the applications that run on top of it will be sold by subscription and delivered over the Web. That's a self-perpetuating razor-and-blades model, except for one thing: Gates still wants to make money off both the razor and the blades. Here's a wild-eyed suggestion, Mr. Gates: Give Windows away.

Another sector that could profit from Gillette's insight is telephony. For years, the cost of providing long-distance calls has dropped toward zero. But companies like AT&T and WorldCom continue to milk the dying market for every cent they can, plaguing consumers with confusing bills and phantom charges. Meanwhile, the demand for more valuable services, particularly high-speed Internet access, piles up. The phone companies would be better off giving away long-distance calls and charging for the cool stuff.

But then, telco executives have never been known for their vision. Before he died in 1932, King Gillette lost his fortune in the stock market crash and in patent lawsuits. His company has also struggled of late: Its share price is on a two-year slide, and in the quarter that ended July 20, the company's profits from razors and blades dropped 14 percent. Nevertheless, Gillette has $9.1 billion in annual revenue, and you can buy its blades from Dubuque to Djibouti. And King Gillette's essential insight has not lost any of its force or clarity. The phone company executives could learn something from Gillette's eccentric life: One way to make money in this world is to let something go.

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Business Strategy: The Razor's Edge