Dropbox: Novel Innovation or Economic Genius?
A Comprehensive Analysis on Electronic Storage.
University of California, Los Angeles Engineering 110, Fall 2012

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Introduction to the File Sharing Industry and Dropbox In an era in which the large majority of information is stored electronically, companies that specialize in online file sharing and cloud storage services feast upon massive consumer demand for remote data storage. By 2011, many of the largest technology companies had already created storage services: Amazon Cloud Drive by Amazon, iCloud by Apple, and Google Drive by Google. Other companies providing similar consumer and enterprise services include Scribd, Mozy, Box, and Carbonite. However, none of these services could have hoped to mirror the success of Dropbox. Founded by Drew Houston (an MIT computer science graduate) in 2007 as a Y Combinator startup, Dropbox was considered “a late entrant to the fiercely competitive online backup and storage services space.” (Eisenmann et al., 2012, p. 2) Y Combinator, a California LLC that financially seeds promising startups in exchange for a small amount of the company’s equity, provided $15,000 to Dropbox. Houston’s endeavor soon grew at an astonishing rate. As of 2011, according to a Dropbox engineer, the company backed up 1 million files every 15 minutes, much more than what storage services created before could achieve. From the outset, Dropbox has been immensely successful. In fact, Dropbox was so promising that Apple’s Steve Jobs offered to acquire the company in December 2009. However, Houston turned him down, saying that he intended to build a large standalone company and was not willing to sell no matter the price. So far, Dropbox’s primary advantages over similar services has been its ease of use, simplicity, reliability, and performance. For example, Dropbox backs up users’ files and documents on both a third party cloud storage platform (Amazon S3) and synchronizes the files locally to all designated devices. This approach allows users to access their files locally without logging onto the service’s website while still maintaining the availability of the files to other devices. Further, many of Dropbox’s competitors often have poor performance when dealing with firewalls or a large amount of data. Indeed, Houston’s hard work and programming abilities have led Dropbox to achieve his ideal of a service that works flawlessly and smoothly, embodied by its starting motto: “It Just Works.” “‘We engineered Dropbox so it just worked, all of the time,’ Drew explained, ‘We handle all kinds of obstacles, from flaky wireless connections to corporate firewalls, which is not an easy task.’” (Eisenmann et al., 2012, p. 3) Another aspect of Dropbox is that so far, unlike many of its competitors, there is only one version of Dropbox that does not differentiate between business users and consumers. Although this has been criticized, Dropbox has responded that such segregation of customers would violate its commitment to simplicity and ease of use. Houston also commented that Dropbox “would rather do a few things well rather than present [itself] in a confusing way.” (Eisenmann et al., 2012, p. 7) In short, Dropbox provides an elegant and superior solution to the modern problem of being able to work with and share your electronic data wherever you are.

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Basic Business Strategies Due to the competitive nature of and the number of firms within the file sharing industry, this market is best classified as a monopolistically competitive environment. Therefore, it is crucial that Dropbox not only remain technologically superior, but that it also makes the right business decisions at every step and in every direction, from expansion to adding new features to advertising. Like many file sharing services, Dropbox utilizes a “freemium” business approach. Users can use up to 2 GB of storage for free; a premium subscription of 50 GB or 100 GB costs $10 or $20, respectively. Underlying the freemium strategy is a simple idea: it allows customers to try Dropbox for free, potentially bringing in more premium customers. As Houston said, “‘It’s hard to master freemium products unless you can build an organic customer acquisition engine. If you think of your free user costs as your marketing budget, then things begin to make more sense.’” (Eisenmann et al., 2012, p. 8) Clearly, Dropbox’s profits depend entirely on its premium users, which constitute only 4% of Dropbox’s total customers as of 2011. Despite this fact, Drew Houston claims that Dropbox is already a very profitable business, as will be discussed in more detail below. Also, Dropbox utilizes a simple form of viral marketing by offering additional free memory to customers that refer new users (250 MB per new user referred). These techniques have proved themselves to be quite successful, since most of Dropbox’s users came from such viral marketing efforts and word-of-mouth referrals from loyal customers as opposed to paid advertising. Let us now briefly dissect Dropbox’s profit components. On the cost side, both costs for storage and bandwidth have been declining rapidly in recent years. “The per gigabyte cost for enterprise-grade storage equipment had fallen from $5.35 in 2005 to $1.23 in 2010, and would decline further to $0.36 in 2014.” And, “the average monthly wholesale cost for high-bandwidth Internet data delivery... had fallen from $75 in 2005 to $5 in 2010, and would decline further to $0.94 in 2014.” (Eisenmann et al., 2012, p. 9) This is akin to Moore’s Law, which describes how the number of transistors on an integrated circuit increases exponentially over the years. On the revenue side, once rational customers that use Dropbox for free reach their 2 GB storage limit, it is reasonable to assume that instead of trying to cumbersomely transfer all their data to another site or keep their data below 2 GB, a good number of them will start subscribing for additional memory. This implies that Dropbox’s revenues will continually increase. Declining costs and increasing revenues indicate that Dropbox’s profits will steadily rise. Dropbox has also been finding numerous other methods to expand its business and bring in more capital. Early marketing and advertising efforts were too costly and not sustainable. Initial attempts at forming partnerships with other software providers also proved fruitless; as Houston said: “‘I’ve realized that no significant tech company has been built solely through distribution deals without having a strong brand of its own.’” (Eisenmann et al., 2012, p. 7) However, now that Dropbox has been well established, it has been getting many lucrative offers to package its software with other products. For example, Dropbox has partnered with HTC to have some of their new phones pre-installed with Dropbox, and for users of these new phones to have 5 GB of free storage. When it comes to raising cash, most of Dropbox’s working capital has come from venture capital funding. In 2008, Dropbox raised $7.2 million. In contrast, in fall of

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2011, Dropbox raised a whopping $250 million from Silicon Valley venture capitalists, which it plans to use for partnerships, expansion, and acquisitions of other software companies. Despite Dropbox’s immense success and rapidly growing business outlook, it has maintained a small number of employees, almost all of which are programmers and engineers. For example, as the number of Dropbox users increased from 200,000 to 2 million, Dropbox only increased its number of employees from 9 to 14. By the end of 2011, Dropbox had reached 100 million users but had only hired 70 employees. Houston has also been skeptical about hiring too many business or management oriented personnel, since he does not want too many different ideas to get injected into Dropbox’s current simple and successful principles. All in all, Dropbox’s characteristics and its business strategy have proven themselves to be effective and profitable: the company is rapidly expanding, its financial outlook is good, and it has won many battles against big competitors. Dropbox has not published its financial results, but estimates indicated that Dropbox grossed $240 million in revenue in 2011. Also, Dropbox is currently valued by some investors at over $5 billion. Clearly, Dropbox is a worthwhile investment for venture capitalists to pursue. Below, some of the more specific aspects of Dropbox’s business and economics will be analyzed. Macroeconomic Environment Dropbox was funded by the Y Combinator in the summer of 2007, and took off afterward to grow into one of the largest remote data storage companies in the world. While bright economic decisions and legitimate innovation may have been partially responsible for Dropbox’s success, much of this success would have been diminished had Dropbox not been funded and founded in April of 2007.

Figure 1: The federal discount rate decreased heavily almost immediately after Dropbox's formation. First and foremost is the issue of investment. When Dropbox was founded in April of 2007, federal interest rates were as they had been for a few years: relatively high yet constant. At 5.5% since early 2006, investors would be hard-pressed to find an investment earning more than

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the discount rate; quantity of loans demanded decreases considerably when interest rates increase. In order to make it out ahead of their competitors, investors such as those in the Y Combinator would have to invest in a relatively high-risk investment. That investment, as it turns out, was in one Drew Houston and his idea for a remote file system called Dropbox. A cut of the company’s profits for the rest of its lifetime was a fair trade for the $15,000 price tag, at least at the interest rate of 5.5%, so both parties were relatively happy. All things held equal, both could have made a reasonable profit at or slightly above this 5.5% interest rate. Only a few months later, however, a huge collapse in interest rates helped to place both Dropbox and its investors far ahead of the competition.

Figure 2: “Internet Services and Retailing” was one of the fastest growing industries in 2007. In August 2007, 3 months after the founding of Dropbox, interest rates began to quickly descend from 5.5% to nearly 0% over the course of a year. No doubt Y Combinator felt as though they had dodged a bullet; has Dropbox been founded when such low interest rates were prevalent, Dropbox could have easily funded itself and turned a profit without the Combinator’s help. Now, more than ever, the Combinator’s investors largest profit lie in the success of Dropbox and its other ventures, and it would no doubt do everything in its power to keep these ventures successful. Other investment firms, too, found it lucrative to invest in Dropbox, given the massive growth in the internet services industry; in 2008, online products and services were the fourth most quickly growing industry in the world. Furthermore, with monetary capital so cheap with the new interest rates, Dropbox was now almost guaranteed to be a more lucrative investment than T-bills or standard loans, whose interest rates almost directly correlate to the discount rate. Even the more risky investments saw a drop in interest, as borrowers could now get money for far cheaper directly from banks. Because of this, investors piled huge sums of money from 2008 to 2011 into Dropbox, with most recent number totaling up to more than $255 million dollars in investment. Such massive investment has brought immense returns: Dropbox is currently valued at over $1 billion dollars, and most recent annual revenues have totaled $240 million.

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Figure 3: Amazon’s “Simple Monthly Calculator” shows the estimate for Dropbox’s 2011 costs. Just how large are these returns? Considering that Dropbox uses Amazon as a backend, that Dropbox stores 10 petabytes of data, and that Dropbox receives 325 million new files on a daily basis at 100 kilobytes per file, Amazon would charge approximately $826 thousand per month, or $9.9 million a year. Considering that Dropbox has 90 employees, and the average software startup employee is paid around $100 thousand per year, this adds on another $9 million dollars in costs, to reach a total of $18.9 million in costs. In light of these costs, we can estimate that Dropbox has had a profit margin of anywhere from $180 million to $220 million dollars in the past year, almost the same amount that was invested in it to begin with, meaning that an investment in Dropbox in 2010 had an equivalent interest rate of approximately 60% APR. Comparing this to the .18% attainable via investment in T-Bills, the choice to invest in Dropbox was an easy one. Dropbox Outside the United States The international outlook today for Dropbox is a meeting of high potential with great vision and management. The main reason Dropbox is used so much internationally as well as domestically is because everyone who has a computer and working internet connections can use this product. This is why it is not surprising when we look at the statistics from 2010 which show the percentage of Dropbox users from each country. Although The United States is leading this list, it only accounts for a little bit more than thirty percent of all Dropbox users. Dropbox also boasts that around fifty percent of its paying customers are actually international users. The numbers don’t lie and clearly Dropbox is playing a good international game. The Statistics: Below we can see the percentage of Dropbox users internationally,

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Figure 4: Dropbox user percentage by country. The statistics provided above are from the year 2010. When we look at the increase in Dropbox users from 2010 below we will see that there has been an exponential increase in the number of users. As of today, the total number of Dropbox users stands at 100 million a fourfold increase from when the previous figure was released. Recently Dropbox also announced that it had users in 200 countries (including 10 users in Antarctica!) in 2012. We can correlate the increase in the number of users to the increase number of different countries Dropbox.

Figure 5: Number of Dropbox users over 2 years. International Support: As more and more customers are using Dropbox, Dropbox is realizing the necessity to adapt to these new customer bases. As such they co-founder emphasized native language support, he said “Native languages are a really important part of our growth going forward, We have a lot of adoption in Germany, but when you want to share a photo with a grandmother that doesn't know English you need native language support.” (Dignan, 2011) Clearly the company believes that international growth and support for international customers in very important. In a globalized society this sort of adaptation and thinking can be seen as something which is essential for any company vying for significant growth. German is also not the only language that Dropbox is giving native support to; it also launched Spanish, German, French, Japanese, as well as several other languages for native support. Now anyone can share their files and folders

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to their loved ones who do not necessarily speak English. The expanded support for native languages in mid 2011 can be attributed as one of the causes for the increase in member subscription during this time period. Dropbox also realizes the necessity of having good partners in different countries. It has partnered with local companies who are technological leaders in their region of the world. For example, in 2011, Dropbox contracted with Japan companies Softbank (a mobile carrier) and Sony Mobile Communications (a handset maker) to have Dropbox preloaded on smartphones and devices marketed and sold by these two companies. This will make it easier for previous Dropbox users to look at documents and photos from their phone and also bring in a significant amount of new users. Clearly Dropbox knows how to fulfill its potential in these international markets. With future partnerships Dropbox hopes to expand its services to more customers worldwide. Management: With increasing demand from international users Dropbox recognizes the need to establish bases in foreign countries so that any region specific needs can be met quickly and efficiently. Thus it came as no surprise when earlier this year Dropbox established a local base in Dublin, Ireland. In 2010, the United Kingdom had the second highest percentage users of Dropbox and Dropbox recognized the need to have a base in this country. The CEO of Dropbox agreed with this reasoning as well when he described this international headquarters “By opening our international headquarters in Dublin and tapping into the large talent pool that exists there, we’re better positioned to serve even more people locally while we continue to grow.” (Business Wire, 2012) For a company that has already over a one hundred million users this office should just be the beginning and since they cited the Dublin location as an “International Headquarters” we can safely assume Dropbox plans on opening more smaller offices throughout the world. Having a clear management goal and plenty of local support when establishing an international brand in important. Dropbox realizes the importance of these elements and has slowly started expanding its base of operations. A good management structure helps alleviate growing pains while expanding an operation internationally and Dropbox has certainly done this in establishing their European base. Clearly we can see that Dropbox is going into the International market with a solid game plan and the results are self evident. Externalities in the File Sharing Industry In economics, we must analyze the unintended costs or benefits that may arise from a product having an effect on unsuspecting people. Negative externalities can arise from unintended costs like pollution, or unintended benefits such as a consumer receiving a vaccine on the people that they come in contact with. In an example where a company is not directly paying for everything that society gives up, the current supply curve does not represent the true ratio between price and quantity as there are costs that have been unaccounted for. As depicted by the figure below, the more accurate supply curve and equilibrium point has been raised.

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