How Do You Select A Revenue Model For Your Startup?

One of the toughest decisions for a startup is how to price their product or service. The alternatives range from giving it away for free, to pricing based on costs, to charging what the market will bear (premium pricing). The implications of the decision you make are huge, defining your brand image, your funding requirements, and your long-term business viability.

The revenue model you select is basically the implementation of your business strategy, and the key to attaining your financial objectives. Obviously, it must be grounded by the characteristics of the market and customers you choose to serve, the pricing model of existing competitors, and a strategy you believe is consistent with your future products and direction.

So what are some of the most common revenue models being used by startups today? Here is a summary, with some of the pros and cons or special considerations for each:

1. Product or service is free, revenue from ads. This is the most common model touted by Internet startups today, the so-called Facebook model, where the service is free, and the revenue comes from click-through advertising. It’s great for customers, but not for startups, unless you have deep pockets.

2. Freemium model. In this variation on the free model, used by LinkedIn and many other Internet offerings, the basic services are free, but premium services are available for an additional fee. This also requires a huge investment to get to critical mass, and real work to differentiate and sell premium services to convert users to paying customers.

3. Cost-based model. In this more traditional product pricing model, the price is set at two to five times the product cost. If your product is a commodity, the margin may be as thin as ten percent. Use it when your new technology gives you a tremendous cost improvement. Skip it where there are many competitors.

4. Value model. If you can quantify a large value or cost savings to the customer, charge a price commensurate with the value delivered. This doesn’t work well with “nice to have” offerings, like social networks, but does work for new drugs and medical devices that solve critical health problems.

5. Subscription model. This is a very popular model today for Internet services, calling for monthly or yearly low payments, in lieu of one value or cost-based price. Startup advantages include a more stable revenue stream, easier customer retention, and increasing customer investment over time. The customer advantage is a lower entry cost.

6. Product is free, but you pay for services. In this model, the product is given away for free and the customers are charged for installation, customization, training or other services. This is a good model for getting your foot in the door, but be aware that this is basically a services business with the product as a marketing cost.

7. Product line pricing. This model is relevant only if you have multiple products and services, each with a different cost and utility. Here your objective is to make money with the portfolio, with high markup and low markup items, depending on competition, lock-in, value delivered, and loyal customers. This one takes expert management to work.

8. Tiered or volume pricing. In certain product environments, where a given enterprise product may have one user or hundreds of thousands, a common approach is to price by user group ranges, or volume usage ranges. Keep the number of tiers small for manageability. This approach doesn’t typically apply to consumer products and services.

9. Feature pricing. This approach works if your product can be sold “bare-bones” for a low price, and price increments added for additional features. It can be a very competitive approach, but the product must be designed and built to provide good utility at many levels. This is a very costly development, testing, documentation, and support challenge.

10. Razor blade model. In this model, like cheap printers with expensive ink cartridges, the base unit is often sold below cost, with the anticipation of ongoing revenue from expensive supplies. This is another model that requires deep pockets to start, so is normally not an option for startups.

If you have real guts, try the Twitter model of no revenue for several years, counting on the critical mass value from millions of customers to sustain your company. This model was popular back in the heyday of dot.coms, when investors were buying followers, but is not so common today. It definitely requires founders with deep pockets and investors willing to take a huge leap of faith.

Your business model interacts closely with your marketing model, but don’t get them confused. Marketing is initially required to get visibility and access to the opportunity, but pricing defines how you will actually make money over the long term. A key challenge for every entrepreneur seeking funding is to convince potential investors that the marketing model will substantiate your positive revenue model, customers will buy the offering, and you have a viable business model.

Overall, I’m a huge fan of the “keep it simple (KISS)” principle – customers are typically wary of complex or artificial pricing. Your challenge is to set the right price to match value perceived by the customer, with a fair return for you. It’s not a game show, so don’t guess - do your research early with real customers. Your startup’s life depends on it.

Marty Zwilling

Entrepreneurs Need To Keep Their Business Focused

One of the most common failures I see in startups is lack of focus. Unfocused entrepreneurs boast that their new technology will generate multiple disruptive products for consumers as well as enterprises around the world. Investors hear this as trying to do too many things with limited resources, meaning the startup will not shine at anything, and will not survive the competition.

For example, a while back I received a startup executive summary, requesting Angel investor funding, that touted technology for a line of new medical devices, also to be offered in a new military radar device. Even a company with unlimited money and people shouldn’t try to step into those two domains for the first time at the same time.

Other elements of startup focus are a bit fuzzier, so let me zoom-in on some key ones here:

1. Type of business model. Startups that try to mix a non-profit entity with a for-profit entity to share resources don’t work, and scare off investors. Providing shoes for the poor is a laudable goal, but quite a different business than Zappos, which sells clothes profitably, and provides free shoes for the needy due to social consciousness.

2. Solve one problem really well. Focus means starting with a problem that is painful, rather than a technology, and showing how you can solve that problem better than anyone else. Later in the pitch, you can show that you are not a one-trick pony by prioritizing related solutions in your long-term plan.

3. Limited goals and priorities. No organization can manage more than 3 to 5 goals and priorities without becoming unfocused and ineffective. Keep these balanced and aligned between people (customers, employees) and process (quality, service, revenue), and keep the scope realistic (eliminating world hunger is too broad).

4. Segment the opportunity. Targeting all the people in China as your opportunity gives you big numbers from a small penetration percentage, but will be seen as lack of focus by investors. Narrow the scope more realistically to people with specific age, income, and education demographics, that you can realistically reach with your marketing plan.

5. Keep your value chain consistent. Your value chain is your preferred business model, like premium quality, high service. If you mix that model with some commodity items, with no service, that will be seen as a lack of focus. Your team, customers, and investors will all be confused, leading to a lose-lose situation.

6. Simplify product scope. Your product will never have enough features to satisfy everyone, and it will never be perfect. Focus means creating a minimum viable product (MVP) first, and validating it in the marketplace. Feature-rich products take too much time and money to build, are hard to pivot, and will likely be slow and difficult to use.

7. Realistically frame the competition. If you really believe that IBM, Microsoft, and Oracle are your competition, you probably don’t have a business. It’s better to focus on a niche that none of them do well, and build your plan around that opportunity. Claiming you have no competition also implies lack of focus, or you don’t have a business.

8. Prioritize marketing channels. For a startup, it’s impossible to run an effective Facebook, Twitter, content marketing, and Google AdWords online campaign all at the same time. Focus on one channel at a time, measure results, and then move to the next. Offline, it’s not credible to talk about direct marketing, distributors, and integrators all in the same breath.

I certainly understand the pressure add more of everything to your plan, as you listen to more and more people, all with their own priorities and biases. But in the long run, you need a narrow and memorable focus to build a strong company. Even in the short term, customers and investors alike will help you carry a simple and clear focus all the way to the bank.

Marty Zwilling

5 Clues To Investor-Friendly Financial Estimates

Most entrepreneurs struggle with financial projections, not wanting to commit to numbers they can’t deliver, and having no clue what investors might consider reasonable. However, making no projections, or non-credible projections will get your startup marked as unfundable. I recommend a simple set of guidelines, which work for at least 80% of the business domains I see.

Equally important, you need to make these projections first as goals for your own use, to convince the team as well as investors that you have a business which is achievable. Projecting the financials should be the last step of your business plan preparation, since it assumes you already know the opportunity size, customer buying habits, pricing, costs, and competition.

Here are some basic “rules of thumb” that every Angel or venture capital equity investor uses, to help you anticipate their reactions. The rules are obviously not absolute, but you must be prepared to explain to potential investors why your startup is the exception to these guidelines:

1. Five-year financial projections are the norm. According to a recent Dow Jones VentureSource report, the average time to liquidity of an equity investment in a startup is now about five years. Thus most investors ask for 5-year projections, to get a sense of the opportunity and trajectory that you’re envisioning while their money is tied up.

2. Aggressive revenue projections and growth rate. The first filter applied by most investors is to identify high-growth investable startups from ones that may be a good family business with organic growth, but could never generate a 10x return. Revenue in the fifth year should be at least $20 million, with a growth rate average of 100% per year.

   But don’t go crazy with this number. If your fifth year projection exceeds $100 million, that puts you in the rare category of the next Google, and probably won’t be credible with investors, unless you have a track record in this range. In other words, revenue projections are not the place to be too conservative or wildly optimistic.

3. Gross margins greater than 50%. Most entrepreneurs, with no experience, believe that they can make good money with lower margins than competitors. The reality is that even if you eat Raman noodles and do survive with low margins, your growth rate will be stunted, yielding a low return for investors.

   Financial projections for investors should always show an annual cost of goods sold and gross margins line, as well as revenue. Low gross margins in the first couple of years are expected, but they better climb to the 60% range by year five.

4. Show red ink to match your funding request. Financial projections shown to investors should always be pre-funding projections, to illustrate what revenues and expenses you think are possible, and how much your current funding falls short. Don’t ask for funding if your projections imply you don’t need it. Investors don’t like their money used frivolously.

   If you show a negative cash flow of $800 thousand before the business turns cashflow positive, it is fair to buffer that amount by 20% and ask for a $1 million investment, since we all know that there will be un-anticipated additional costs.

5. Build a path to 10x return. The only path to any return for equity investments is a liquidity event, like a merger or acquisition (M&A), or IPO. That’s why investors want to hear about your exit strategy. If you don’t have one, or intend to buy out investors with their own money, you probably won’t get much interest.

   What investors want to hear is that your company will demonstrate that high rate of growth to get you to $50 million in revenue in 5 years, making you a premium acquisition alternative to one of your partners, selling for 5 times revenue, for a total of $250 million. That makes their $1 million investment for 10% equity worth $25 million, or 25x.

Be aware that investors will be testing your financial projections in real time against your opportunity numbers, volume projections, pricing model, and performance to date. If you have no data in one of these areas, be prepared for the “come back when you have more traction” message. Investors don’t want to antagonize a potential winner, but you are not fundable yet.

Of course, the quality of your management team, or demonstrated performance in prior similar ventures, can override any or all of these rules of thumb. On the other hand, you must remember that only about one percent of Angel investor funding requests get satisfied, according to the Angel Capital Association. Venture capital requests that get satisfied are even lower.

Overall, financial projections that make sense in your business domain, and cross-foot with available data from independent market analysts are no guarantee that you can deliver. They do show you already stand out from the crowd of talk-only entrepreneurs, understand financial realities, and are willing to commit. What more could an investor ask, since he is really investing in you, not the numbers?

Marty Zwilling

Every Small Business Founder Needs An Advisor

Sponsored by VISA Business

Friends tell you what you want to hear. Advisors tell you what you need to hear. When the message is the same from both, you don’t need the advisor anymore. In that sense, you should think of an advisor more like your mentor who has done all he can. You always need the friend.

Also don’t confuse a business advisor with a business coach. An advisor’s aim is to teach you what to do and how, in specific situations, unlike a coach who helps you develop your generic skills for deciding what to do and how. The advisor helps the entrepreneur fill an experience gap, and a coach helps fill a skill gap. Both may be required.

Before you are ready for an advisor, you must know yourself. Have you assessed your strengths and weaknesses? What are your goals? Where are you heading? Unless you know these things, no one can help you. Also, you need to be prepared to take advice and criticism if it is honest, helpful, and given in a friendly way.

Once you are ready, what are some attributes of a good advisor that you should look for? You need someone who:

1. Applies pragmatics to your ideas. Most entrepreneurs have lots of ideas. Some can be put into practice easily, but others will be off-the-wall and need refinement to implement. A good mentor will have some knowledge and some perspective on almost every business subject, which compounds their effectiveness.

2. Challenges your accountability. Entrepreneurs tend to be driven by the crisis of the moment. As such, it is easy to neglect the real priorities of growing the business. Sharing your goals with your advisor means that if you don't complete them, you have a credible voice to remind you and help get you back on the right track.

3. Able to extrapolate the business. A successful business never stands still. You need a constant stream of ideas for scaling and expanding, with a realistic understanding of the costs and resources required. Then, there is the exit strategy which needs planning, connections, and forethought.

4. Has the contacts you need. When you need contacts for investors, equipment, and legal or accounting advice, your mentor has the contacts and knows where to find the information. More importantly, the advisor tells you what you need to do to build and maintain your own list of contacts.

5. Provides perspective as someone from the outside, looking in. An advisor knows what to look for, and sees what your customers see. It’s natural to become so immersed in your business that you forget to step back and look in from the outside. Like living next to the railroad tracks; after a while you don't hear the trains.

How do you find a person who meets these criteria? Sometimes an advisor just appears naturally, but continues to network among friends and colleagues. Look for a person who could be a good role model, someone who has the skills and personality that match your chemistry.

This person could be a professional who does this for a living, or a role model in a related business who is willing to help you. An ideal candidate is someone from the Boomer generation, who is semi-retired, but still active in local organizations or the investment community.

I don’t mean to imply that an entrepreneur needs an advisor more than a friend, just that friends are not normally positioned for double-duty as mentors. You need at least one of each, and the ability to tell the difference.

Marty Zwilling

Disclosure: This blog entry sponsored by Visa Business and I received compensation for my time from Visa for sharing my views in this post, but the views expressed here are solely mine, not Visa's. Visit http://facebook.com/visasmallbiz to take a look at the reinvented Facebook Page: Well Sourced by Visa Business.

The Page serves as a space where small business owners can access educational resources, read success stories from other business owners, engage with peers, and find tips to help businesses run more efficiently.

Every month, the Page will introduce a new theme that will focus on a topic important to a small business owner's success. For additional tips and advice, and information about Visa's small business solutions, follow @VisaSmallBiz and visit http://visa.com/business.

Inventor Entrepreneurs May Be The Rare Exception

In my experience, inventors and technologists aren’t interested or aren’t very good at building a business, and entrepreneurs aren’t usually good scientists. These people need to find each other, and can jointly make a great team for a new startup. Without the synergy, companies like Apple might never have gotten off the ground.

Historically, it’s also not often that a good inventor was also a good entrepreneur. There are some old arguments that even our entrepreneur heroes, like Thomas Edison, really cheated on the invention side. Most of the great entrepreneurs of recent times, like the young Steve Jobs, had a great technologist, Steve Wozniak, who could implement his dreams.

I’m convinced that this is because the personal characteristics required for these two jobs are quite different. For example, here are a few of the attributes that come to mind for a good technologist:

• One idea, one focus. They have perseverance, based on strong personal conviction that something is possible. An inventor has to know precisely how things work. Inventors build solutions to a problem, and they relish in the success of having solved the problem.

• Good with details. If you have ever written a patent application, you know it’s all about details, linkages, and causes vs. effects. Good inventors love to diagram out all the details, algorithms, and get their reward from finding new ways of getting things done.

• Creative and artistic. You have to give the creator some resources, time, and throw in some food once in a while, and a “completed design” will appear in due time. Then they are done. They hate sales, and don’t understand what making a profit even means.

• Realistic if not pessimistic. Every inventor, programmer, musician, and artist will tell you that you can’t schedule invention. They won’t commit to a completion date, and always dream of an unlimited budget. They expect many attempts will be required.

Entrepreneurs, on the other hand, have a complementary but different set of strengths and weaknesses:

• Lots of ideas, can’t focus. Most good entrepreneurs are idea people, and can flood you with ideas. The reason they can't focus is that they haven't yet flushed out all of the half-baked ones. When teamed with someone who can focus, things work, and a lot of wasted effort is avoided.

• Likes the big picture, not good with details. An entrepreneur always has a “vision” of a bright future. But many fail, or have lots of stress because they don’t like to deal with the details. They tend to leave the details to others, who don’t have the vision or the skill, so the business suffers.

• Good at starting a business and selling. Every entrepreneur reads everything they can find on running a business, maps out all the steps in their head, or explicitly on paper (business plan). They love talking about their business and their product, and dream of having millions of customers.

• They exaggerate and are too optimistic. Exaggeration, pipe dreaming and denial are the tools and comforts of the trade of entrepreneurism. The psychological source of this "always at the edge" may be an addiction to adrenaline, the pleasure/high of "pulling it off" at the last minute, or the high that victory brings.

For a successful business, it takes the discipline and creativity of a technologist, as well as the vision, planning, and optimism of an entrepreneur to create customer value. So if you’re an entrepreneur, find yourself a frustrated technologist and likely both of you can find more success and happiness.

Marty Zwilling

5 Entrepreneur Ideas That Investors See Too Often

People are always asking me for an inside tip on Internet sites that will be “the next big thing.” Those are hard, since someone has to invent something innovative, but I do have some views on other ideas whose time has come and gone.

In some cases, these are concepts that have already been done too many times, and the space is crowded. In others, the concept has been tried too many times, or no one has yet succeeded in making any money. Or both. Here are my favorites:

1. Social and business networking sites. Just for starters, Wikipedia now lists about 200 sites by name (once over 300), which they claim is just some of the more notable social networking sites. I still get about one business “idea” per week for a new networking site, which will combine the “best of all the sites” into a new one. If you must do one of these, skip the “me too” and focus on a niche, if you can find an unoccupied one.

2. Online dating sites. Feedback from my old diatribe on this subject tells me that there are over 8,000 existing ones world-wide, including two or three new ones per day. Most of these will fail, or never turn a profit. I hope you have a better idea than Women Behind Bars, or Herpes-Date.com. But then, this is an emotional need every single seems willing to spend money on (not to mention the 40% more who are already married).

3. Search engines. You can find web sites like the Comprehensive List of Search Engines, which is nothing but a list of 250+ available search engines. Remember the three “big gorillas” in this space, Google, Microsoft Bing, and Yahoo. There may be room here for something really innovative, but just a better user interface, people prioritized results, or one millisecond faster will probably not do it. If you have more money than the incumbents, try it, but don’t look for investors.

4. Micro payments, micro loans, micro investments. Micro “everything” has had lots of entrants over the years, but most are gone, or not making any money. Paying for your ice cream on your cell phone through Twitter is more trouble than cash, and getting a $10,000 loan accumulated from 50,000 people is hard to manage. The latest is “crowd funding” your startup with thousands of tiny investments. It’s already a crowded space, with over 450 sites already out there at last count, making it tough for new entrants.

5. Portals and single sign-on sites. A portal is a “home page” which you can partition to be the entry to a dozen others, with a single login to minimize the “yellow stickies” on your computer. The trouble is there are thousands of portal sites, like My AOL and My Yahoo, so you need a portal for the portals. Single sign-on is a technical dream that requires world-wide standards be set before it can be implemented.

Somewhere below this list is another tier of questionable potential startups, including more calendar sites, blog aggregators, Craigslists, photo sharing sites, music sharing sites, or more instant messaging sites. Web site generators have made it cheap and easy to launch a site, but that doesn’t mean it’s easy to succeed.

In my view, the single biggest reason for startup failures on the Internet is a lack of real innovation. Changing the user interface, and adding a couple of features doesn’t compensate for not being there first (“me too”). The second biggest reason is lack of focus. Combining the features of several successful products will not assure success (“something for everyone”).

For other ideas, the wave has simply passed. Rather than trying to extrapolate linearly from solutions already popular, be the first to solve one of the myriad of current and future problems causing real “pain” in our society. Problems like health care and diseases, or alternative energy solutions, offer a wealth of possibilities, with huge potential paybacks for everyone.

These also have the potential of satisfying a higher purpose (socially conscious), as well as making money. The rewards are greater and longer lasting, and it’s a lot more fun. What’s your idea?

Marty Zwilling