How can YouTube survive?

It's wildly popular - and thought to be losing hundreds of millions of dollars a year. Now questions are being asked about the future of YouTube. Rhodri Marsden investigates a mystery of digital-age 'freeconomics'

It must surely rank as the most mundane business launch in history. Jawed Karim, one of the founders of YouTube, shuffles timidly in front of a video camera while standing in front of a group of elephants at San Diego zoo, with precious little idea of what he was starting. "The cool thing about these guys," he says, nervously gesturing behind him, "is that they have really long trunks. And that's pretty much all there is to say."

This 19-second video clip, uploaded to the brand-new website later later that day, 23 April 2005, may have been insubstantial, but it certainly wasn't inconsequential. Within 18 months, Karim and his partners Steve Chen and Chad Hurley had sold YouTube to Google for $1.76bn, and in doing so became one of a select band of online entrepreneurs who managed to grab our attention – and keep it.

Innumerable jaded web entrepreneurs will tell you how easy it is to get thousands of people to glance at a site, but how tortuous it is to get people to stick around or even come back again the following day. Not only do you have to fulfil a desire that people didn't even realise that they had, but it has to be done with such style and panache that your service becomes indispensable. While the internet may have dismantled many of the traditional barriers to reaching us, the general public, if your idea is anything less than sensational, we will flatly ignore it.

But YouTube was sensational. Prior to its launch, creating a videoclip for someone else to watch online was an arcane and deeply frustrating procedure of digitisation, encoding and embedding that was way more trouble than it was worth – not least because incompatible technologies meant that many people wouldn't be able to watch it. But from humble beginnings in a room above a pizzeria in San Mateo, California, Hurley, Chen and Karim made the process simple, they made it relatively quick, and above all else, they made it free.

By mid-2006, the site was fizzing with activity as we started using our YouTube channel as a jukebox, a blogging service, a promotional tool for our bands, a home video vault, a repository of famous film and television moments – sometimes with the blessing of the copyright owners, more often without it – and just occasionally, it provided an unexpected route to stardom. YouTube entered the lexicon and became synonymous with online video; the former Secretary of State for Local Government, Hazel Blears, dropped the phrase "YouTube if you want to" into an attack on Gordon Brown's style of Government.

Blears making a feeble joke about YouTube is just one small measure of its phenomenal success. But while its staggering popularity is without question – some 345 million visitors worldwide descend upon the website every month – it is haemorrhaging cash. The question of exactly how unprofitable it is continues to be the source of fierce debate online; back in April, analysts at Credit Suisse estimated that its operating losses for this year would reach $470m, while San Francisco-based IT consultants RampRate were more optimistic, but still put the figure at just over $174m. Google aren't rushing to put an end to speculation over the scale of the debt. One thing is abundantly clear from both studies: Google isn't making money by letting everyone and their aunt share videos with each other for free. And the news last week that founder Steve Chen was leaving YouTube to work on other projects at Google kicked off another flurry of rumours as to its possible fate.

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Music, television, sport, gaming: the flow of free entertainment to our computer screens seems almost the result of a magical process, and there's been little need for us to consider the costs that might have been incurred by those making it all happen. It's broadly accepted that YouTube will receive around $240m of revenue from advertising this year, but that sum doesn't even cover their general overheads and the cost of acquiring premium video content (such as TV shows) from copyright holders. In addition, there are the huge fixed costs from the supply side – data centres, hardware, software and bandwidth – that have to cope with the 20 hours of video clips that we upload to YouTube every minute of every day. Again, no-one knows the true total of these costs – the Credit Suisse and RampRate reports put it between $83m and $380m this year – but Google's Chief Financial Officer, Patrick Pichette, would only reveal one thing: "We know our cost position, but nobody else does." Or, in other words, we're not telling you.

This typifies the slightly secretive but ultimately sanguine position of Google even as phrases like "financial folly" are bandied about to describe the YouTube business model. With Google's overall profits reaching some $1.42bn for the first quarter of this year alone, the king of online search is certainly a position to support a loss-making venture that also happens to be the third-most-popular website on the internet. (Google, naturally, is the first.) But Keith McMahon, senior analyst for the Telco 2.0 Initiative, a research group that studies business models in the digital economy, believes that YouTube is not the albatross around Google's neck that it's widely imagined to be. He sees the search company as deriving massive indirect benefits from operating YouTube and believes that estimates of its losses obscure the true picture.

"There are many urban myths surrounding the way that companies extract value from the internet," he says. "Google's spin-off benefits from owning YouTube include the accumulation of our data and strengthening of their network design – and the more time people spend watching online video, the more advertisers will pour into marketing on the internet as a whole. There's no doubt that Google can afford YouTube."

McMahon also believes that by keeping quiet about YouTube's hidden benefits and by allowing the misconception of it as a deeply unprofitable business to circulate, things work very nicely in Google's favour when it comes to negotiating with copyright holders in the world of TV, movies and music. Copyright holders can't demand money that isn't there, and it would certainly take no more than a hint of profitability at YouTube for lawyers to descend, threatening court cases and demanding higher royalties. In the new, topsy-turvy world of online economics, it seems astonishing that losses on paper have actually made YouTube a more powerful online force.

But while Google's pockets may be deep enough to operate a phenomenally popular online service at no cost to its users, what about the countless other internet startups whose operations scarcely extend across a dingy office, let alone several continents? With the free model slowly establishing itself, how can businesses sustain their activities? Sadly, the most common answer is: they can't. The traditional way to generate revenue and offset losses has been to sell some form of advertising space on the website. But an increasing number of industry commentators believe that the internet advertising model is broken – and what better proof than YouTube itself, whose advertising revenues don't even cover their overheads, and who might be dead in the water if it wasn't for their multinational sugar daddy?

In a piece this year for the insider's technology blog, TechCrunch, entitled "Why Advertising Is Failing On The Internet", Eric Clemons, Professor of Operations and Information Management at the University of Pennsylvania, argued that the way that we're using the internet has shattered the whole concept of advertising. We need no encouragement to share our opinions online regarding products and services and offer them star ratings; as a result, we're much more likely to look for personal recommendations from other customers than wait for a gaudy advert to beckon us wildly in the direction of a company website or online store. He claims we don't trust online advertising, we don't need online advertising, but above all we don't want online advertising.

There's certainly a huge weight of evidence to support the latter theory; extensions for web browsers that block advertisements from displaying on the screen have proved to be incredibly popular, and we seem increasingly resentful of attempts by companies to compromise our free online experience by pushing marketing messages in our direction. Spotify, the online jukebox launched this year, has won countless plaudits for its innovative, free and legal approach to online music, but you don't need to look far online before finding users who bitterly complain about the brief audio adverts that play every 20 minutes, interrupting the flow of the new Kasabian album. One comment on a story about the possible expansion of YouTube's advertising is typical: "If advertising is made one iota more intrusive, I shall use other video sites instead."

Small wonder that YouTube only dare feature advertising in less than 5 per cent of the videos on the website, along with a few subtle ads in the sidebar of their search results. But while Google continues to finesse its YouTube model, with click-to-buy links and sponsored competitions, it's contended by Professor Clemons that no matter how innovative the advertising industry might become, "commercial messages, pushed through whatever medium, in order to reach a potential customer who is in the middle of doing something else, will fail".

If this is true, it obviously has implications for Google, even though they're sitting very pretty at the moment as the overwhelmingly dominant force in online advertising. But other companies dependent on ad revenue aren't so fortunate. Joost, another ad-funded online video service, announced last week that it would be reinventing itself as a provider of white-label – generic – video for other businesses, and would be cutting jobs in the process.

"In these tough economic times," said its chairman Mike Volpi, "it's been increasingly challenging to operate as an independent, ad-supported online video platform."

But even taking the effects of the recession into account, Keith McMahon is unsurprised. "All those startups have burned through their initial venture capital money, and they've seen that the business model that they were originally planning for – this landgrab for advertising – just isn't there any more." As a leader in The Economist entitled "The end of the free lunch" put it earlier this year, "Reality is asserting itself once more ... Silicon Valley seems to be entering another 'nuclear winter'."

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We are uninterested, verging on contemptuous, of the marketing strategies that were supposed to pay for us to enjoy online services for free. We've become totally unwilling to pay for them directly, either; we simply figure that someone, somehow, will pick up the tab. Rupert Murdoch recently announced plans to "fix" the current newspaper business model by charging for access to News Corporation's newspaper web sites, stating that "the current days of the internet will soon be over", but Chris Anderson, the editor of Wired magazine, spends 288 pages in his new book "Free: The Future Of A Radical Price" explaining why this is ultimately impossible. He contends that information wants to be free, and that there's an unstoppable downward pressure on the price of anything "made of ideas", adding that the most worrying long-term problem for internet businesses is that the Google Generation are now growing up simply assuming that everything digital is free. They've internalised the economics of the free model "in the same way that we internalise Newtonian mechanics when we learn to catch a ball".

In other words, the fact that most people over the age of 30 doubt that online businesses can survive by offering free services is irrelevant, because most people under the age of 30 are demanding them. On messageboards and forums across the internet you can see them calling for record companies, film studios, newspapers and television channels to come up with a solution that will extend their entertainment utopia, and quick; if they don't, well, they'll find a way around it. And while many see this as a selfish, unrealistic attitude, the onus is on businesses to get themselves out of this mess because the digital medium exercises unstoppable power. However much Rupert Murdoch and others may wish to control it, it's Anderson's contention that the beast is way, way too slippery.

Anderson, along with other digital visionaries, tends to display a sunny optimism that new business models will inevitably step into the breach, while leaving speculation about what those models might actually be to others. But while Anderson says it's "head spinning – and exhilarating – to watch an industry reinvent itself in the face of a new medium", those working in the online economy aren't quite so thrilled. The news regarding YouTube's losses have caused such consternation because people simply can't believe that the third-most-popular website on the web is unable to stand alone and turn a profit. And suddenly, the magical web, whose supposed capacity to revolutionise business has attracted and continues to attract waves of ambitious entrepreneurs, may slowly be revealing itself as an arena in which only a few large companies can survive.

This was illustrated by a tale recounted by the publisher of the Dallas Morning News, James Moroney, who recently told the US Congress about Amazon's proposal for licensing his newspaper's content to be read on Amazon's e-reading device, the Kindle: he was informed that 70 per cent of revenue would go to Amazon, with only 30 per cent to the Morning News for providing the content. It seems both unhealthy and deeply disappointing that Amazon, Microsoft, Google and the like are beginning to wield so much power; it's even something over which even Google CEO Eric Schmidt has expressed concern.

But Keith McMahon says that we shouldn't be surprised. "Remember in the 1980s when the home computer boom started? The country was full of young kids coding games and selling them on cassette," he says. "But from that rose a gaming industry that's controlled by a small number of very wealthy organisations. Cottage industries that can't survive on their own will either fail, or get swallowed up."

McMahon's message to online businesses is essentially one that's remained the same ever since humans first started making transactions: business is business. For all the cries of foul by entrepreneurs or copyright holders in the face of "unfair" behaviour by multinational corporations or websites such as The Pirate Bay, if you can't find the money to make your business work, that's the end of your business. Because ultimately, the market can't be fought.

YouTube's lack of profitability other than as part of a colossal global multinational may signal the end of a dream that has somehow managed to extend past the bursting of the dotcom bubble back in 2001, and the options for new online ventures seem to be as follows: either produce something that people are willing to pay for, or come up with an idea for a free service that's so ingenious that a benevolent multinational is willing to take it off your hands. But remember: that trick of making a home video of yourself in front of a few elephants has already been done.