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, cons and special considerations for each:
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.
“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.
Cost-based model. In this more traditional product pricing model, the price is set at 2 to 5 times the product cost. If your product is a commodity, the margin may be as thin as 10 percent. Use it when your new technology gives you a tremendous cost improvement. Skip it where there are many competitors.
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.
Subscription model. This is a very popular model 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.
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 service business with the product as a marketing cost.
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.
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.
Feature pricing. This approach works if your product can be sold “bare-bones” for a low price, with 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.
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 it is normally not an option for startups.
If you have real guts, you can try the Twitter model of no revenue, 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 anything with a following, but is frowned on today. It definitely requires founders with deep pockets and investors willing to take a huge leap of faith.
In all cases, 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.
Image credit: CC by Thomas8047