Web Hosting – An Illustration of the Dangers of No Entry Barriers

Web Hosting – An Illustration of the Dangers of No Entry Barriers

The internet continues to grow at a rapid pace, not only in terms of the amount of websites online, but also internet use and business done online. A very natural and good thing has happened as a result – the cost of "space" on the internet has gone down. Virtually everyone wins in this situation, with the exception of those attempting to make money in the web hosting business.

Having operated websites long enough to be complaining about web hosting costs in 1999, and also having headed a web hosting business that is alive 3 years later and now part of my Tilted Pixel venture, I’m going to take you on a tour of the web hosting industry and show you what happens when you choose to start a business that is snowballing towards commoditization. If you know what web hosting is skip the next two paragraphs and jump right in, otherwise I have a little intro to help you along.

In case you aren’t completely familiar with how internet services
work, the internet is literally run by a whole bunch of computers. Some
computers at the very top of the hierarchy hold the whole thing
together, but beyond that anyone with a computer and internet
connection can not only go online, but they can also make their
computer a part of the internet by providing services such as a
website. By providing services your computer is now deemed a server.
This architectural quality of the internet is great because it allows
anyone to contribute and makes it very difficult for any single entity
to assert control of what the internet contains.

If you are running a website you typically don’t want to run it on your machine due to the administration involved, high bandwidth requirements (a cable modem doesn’t stand a chance), and increased hacker risk, so you purchase a set amount of space on a machine run by a hosting company. Reputable hosting companies have special equipment operating in data centers – large facilities with incredibly high speed connections, redundant power systems, and 24/7 technical staff.

The Business and Economics Behind Web Hosting

Renting space on a hosting company’s server 10 years ago was far more expensive than it is now. This is primarily a result of the fantastically decreasing costs of computer equipment powerful enough to operate a website server and the shocking price cuts in bandwidth itself – the cost of actually being hooked up to the internet pipes capable of handling web server traffic. Alongside this a host of web server administration products was released and evolved, making it far easier than before to operate a web server.

So prices fell and hosting became cheaper. Why the hell are you boring me with this Matt? Well these price cuts and user-friendly software eliminated the barriers to entry, an economics and business concept defining the obstacles to entering a certain market. These obstacles include everything from government regulations, cost of start-up equipment, patents held by competitors, special expertise, etc.

The brunt of this occurred several years ago when the cost of renting a web server suddenly plummeted drastically. At the heart of this was Server Matrix, a new venture by capital-heavy Texas company The Planet. Leveraging economies of scale and an aggressive growth strategy, Server Matrix pulled a Walmart and started renting web servers at insanely low prices. The rest of the major providers quickly fell in line behind them and began providing the same. The funny thing is that by this time computer technology was advanced enough that these new cheap servers were more powerful than far more expensive web server equipment bought two years ago.

Suddenly entering the web hosting market required an outlay of $300, a credit card, and a Linux reference manual. That was enough capital to operate for 3 months and more than enough time for a good salesperson to attract enough customers to recoup the costs and then some. Web hosting companies sprung up overnight, each offering more features, making crazy promises, and slashing prices insanely. Most of these were basement operations with horrifically flawed business plans (or more realistically, no business plans), but there were of course legitimate companies as well. Unfortunately anyone with an extra $68 lying around could purchase a graphically impressive website template too, so it became difficult for the customer to distinguish professionals from amateurs.

This situation created some interesting consequences:

1) Finding a Quality Web Host Became Very Difficult

Finding a good web host wasn’t easy to begin with, but this new situation created a nightmare. I personally went through quite a few hosting companies and unlike many customers I did some research and consulted previous customers beforehand. Nevertheless the following pattern emerged:

  1. I’m impressed with speed, quality, and support.
  2. Service begins to degrade. Slow periods and outages occur.
  3. Collapse
  4. I find a new host with better features and lower prices.
  5. Rinse, repeat.

Of course at the root of the problem was a lack of infrastructure and foresight. These companies were all riding the line, providing the lowest possible price to continue to gain customers. Market prices plummeted, server resources were drastically oversold, and margins thinned. This was all sustainable until heavy-use customers, spammers, hackers, and rising support costs body checked the operation into a budget low-quality service or into bankruptcy.

2) Web Hosting Became a "Make Money at Home Opportunity"

To make all this worst some terribly inexperienced people looking to make a quick buck jumped into this "lucrative" industry. Such basement operations didn’t look at where the market was really headed, had no experience in actually securing and maintaing a server, thought they could make money selling $2.99 accounts on their "$100/month" (see the cost analysis flaw here?) box, and lasted for as little as weeks.

You know those ads promising you lucrative income for doing as little as an hour of work a day? Well the marketers employing this strategy started selling "start your own home business" kits for hosting. People with very little experience bought these kits, jumped into a commodity market, and lost a bunch of money while burning their customers (who it’s hard to feel sorry for since they price shopped to the point of paying half the cost of a Starbucks drink per month to operate their site).

3) It Became Quite Profitable to Sell Tools to These Hosts

While web hosting companies were acting out the cycle of life left and right, some enterprising people did a very smart thing and sold web hosting software such as control panels, value addons, and billing systems. They tapped into a hugely growing market and got the sale regardless of whether the hosting company ultimately succeeded or not. Now there’s a sweet business, particularly for the likes of CPanel, Fantastico , and ModernBill, which became the standards of the industry.

The Lesson In All This

The hosting companies that are making it in this industry are falling into two categories. First is the relatively small company with a solid business plan, careful attention to margins, and a unique price-insenstive customer source. Second is the large company that can employ economies of scale to provide a functional service with the insane resource amounts and low prices that are being pushed throughout the industry.

What starts as a lucrative opportunity becomes a margin game very quickly if everyone else can jump on the same opportunity. The laws of supply and demand are in force. The primary mistake most of these failed hosting companies made is a failure to look to the future. They had no plan on how to stay competitive when prices were slashed, and nowhere close to the capital required to compete on price. Jumping into a commoditizing industry is difficult and I personally discourage it. There are just better opportunities out there. Look for situations where you can apply unique ideas, products, and skills to rapidly grow a business. Competing on price isn’t fun.

Where Did I Fit Into All This?

I started in the business just as Server Matrix launched. I had a lot of right reasons for it and a lot of wrong ones. Ultimately I was lucky enough to have the sense to pay attention to the bottom line while providing the most absolultely fantastic support I possibly could. I was careful with security and put that above and beyond features that I knew were high-risk. I also set a standard for my pricing and didn’t attempt to gain more clients through price cutting (not only would this have destroyed margins, but they would have left as soon as a lower priced company came along). Through all this I carved out my own niche.

At the moment I don’t generally provide hosting outside of referals and people I know through personal or business means. The core of my hosting business comes from clients of my website development venture, and I make use of the resulting revenue to continue building a better and better infrastructure. At the end of the year I am for hosting to be as close to $0 profit as possible so that clients that utilize my website development services don’t need to worry about whether their site is up.

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