There is a way to think about that. The model that I have in mind is a graph where the X-axis is the price and the Y-axis is the revenue. At a price point of zero, you make zero money. A ridiculous price or a very high price point, again you make zero money because no one buys your product. This curve starts from zero and then goes up and then comes down. There is a peak, the revenue maximizing price point. Theoretically it is there whether you know it or not. It depends on your product and your demographics, etc., but if everything else is fixed, there is a revenue-maximizing price point. If you actually know the revenue-maximizing price point, you can do say, okay, that’s the top of the peak. However, I prefer to make 10 percent less money but have 20 percent more customers. You want to stay a little bit to the left side of the peak. It is around 90 percent of the revenue maximization point. The way I think about it is a little bit different. I don’t look at it as a continuous thing. I would try to pinpoint the revenue-maximizing price point and then find the nearest round number right before. If my revenue maximizing price point is somewhere between $20 and $30, I would shoot for $19.95. I can tell you that there is at least 20 to 30 percent additional profit you can get by optimizing your product packaging and your product pricing. If you can figure it out, you can go from a company
Shah,Tarang; Shah,Sheetal (2011-11-16). Venture Capitalists at Work: How VCs Identify and Build Billion-Dollar Successes (p. 64). Apress. Kindle Edition.
A lot of people have asked me about how to determine optimal pricing for a product or service. This morning I read the following statement from Alex Mehr, the founder/CEO of Zoosk, and thought it was the best explanation I’d ever seen. It’s a great articulation of the theory behind the process I’ve used for years.
Alex Mehr, the founder/CEO of Zoosk on pricing: “There is a way to think about that. The model that I have in mind is a graph where the X-axis is the price and the Y-axis is the revenue. At a price point of zero, you make zero money. A ridiculous price or a very high price point, again you make zero money because no one buys your product. This curve starts from zero and then goes up and then comes down. There is a peak, the revenue maximizing price point. Theoretically it is there whether you know it or not. It depends on your product and your demographics, etc., but if everything else is fixed, there is a revenue-maximizing price point. If you actually know the revenue-maximizing price point, you can do say, okay, that’s the top of the peak.
However, I prefer to make 10 percent less money but have 20 percent more customers. You want to stay a little bit to the left side of the peak. It is around 90 percent of the revenue maximization point. The way I think about it is a little bit different. I don’t look at it as a continuous thing.
I would try to pinpoint the revenue-maximizing price point and then find the nearest round number right before. If my revenue maximizing price point is somewhere between $20 and $30, I would shoot for $19.95. I can tell you that there is at least 20 to 30 percent additional profit you can get by optimizing your product packaging and your product pricing. If you can figure it out, you can go from a company.”
Many of the most successful founders, CEOs and VCs in Silicon Valley belong to the cult of great product. They understand that a great product is critical to the success of a startup. News around the life of Steve Jobs has galvanized even more people to jump on the “great product” bandwagon. Generally this is a good thing, but there tends to be a lot of confusion about what makes a great product.
Great products aren’t anointed by product gurus. Only customers can decide if a product is great.
Customers will decide your product is great if you can map it to their motivation for changing to your solution. All customers change from something. Generally they either switch from a competitive solution or from just tolerating a problem without a solution. New products should decide on one of these markets. Trying to serve both markets generally leads to failure.
One way to decide which market to serve is to ask yourself: “when we are generating $100m in revenue, which type of customer do we think will contribute the majority of this revenue?” Your guess is usually the market you should serve.
Greenfield Customers
If you decide to target “greenfield” people (those without a current solution), then your product roadmap should be focused on simple, effective execution of their desired task. Simplicity is usually much more important for greenfield users than being feature rich. Dropbox is a great example of a product that has succeeded in a greenfield market with a dead simple solution. For some categories, features do eventually become important to users, but on a greenfield user’s first experience they should not be emphasized.
Competitive Solution Customers
If you are targeting people who will be switching from another solution, then usually features are an important part of people’s decision to try it. In this case, you’ll want to make sure that you at least have parity on the key features. Of course they have no reason to switch if everything you do is the same, so you’ll need to understand their switching motivation. If you can differentiate on one of the key gripes of the competitive solution, there is a good chance you can be successful. Common gripes include price, reliability, poor customer service, lack of key features, etc. You’ll need to both message this differentiation and also deliver on the promise. A “false promise” will cause a high churn rate (people who stop using your product).
Reduce Conversion Hurdles
Either way, switching takes a lot of guts and effort. Most people are afraid and/or complacent about switching. Even for those who take the initiative to consider your solution, most will give up before actually trying it. So it’s also critical to reduce all hurdles that may cause them to abandon the conversion process.
You’ll know you have created a great product when users tell you they can’t live without it. Unfortunately the “cult of great product” occasionally forgets about these critical components of building an indispensible product.
The startup I founded last fall, CatchFree, officially launched at TechCrunch Disrupt on Tuesday of this week. Only a TechCrunch event could offer this: within 24 hour we were contacted by Corp Dev at two of the biggest Internet companies in the world. Of course it’s way too early to have any substantive conversations, but it’s a great early opportunity to build a relationship that could be meaningful down the line.
More importantly, TC Disrupt was very helpful in kick starting our UGC. Users submitted and reviewed hundreds of free apps and services on the first day. We had identified a critical mass of authentic, non-anonymous reviews as one of the biggest hurdles in the business. TechCrunch helped us clear this hurdle in a single day. It didn’t hurt that Dropbox, SpringPad, SurveyMonkey, LogMeIn, Wordpress.com, Xobni, KissInsights, Lookout, Webs, Mavenlink, and many others also recruited their passionate users to support them on CatchFree via Twitter.
The Key Challenge with Freemium
The vision for CatchFree is based on the frustration I faced trying to help grow 15 freemium startups. Customer acquisition is probably the number one challenge for a freemium company. You’d think it would be easy giving away free products. It’s not. To understand why, just try standing on a corner in any big city handing out free apples; you’ll find that people are pretty skeptical. That same skepticism applies when trying to give away free software, services and apps. Too many people have been burned in the past.
Compounding the issue is that freemium businesses can typically only afford to spend about 5-10% of their “premium only” counterparts acquiring a new user. This makes it very hard for a freemium company to buy growth in traditional channels, where inventory generally goes to the highest bidder. If the product is good enough, eventually organic growth kicks in, but many freemium companies give up or run out of money before they are able to achieve sufficient growth. Even when organic growth is reasonably strong, the inability to accelerate it can be frustrating for even the most successful companies.
Hub of the Freemium Ecosystem
CatchFree is solving this challenge by helping freemium businesses leverage their most important asset to grow – large passionate user bases. The CatchFree Network links together the best freemium apps and services, enabling each service to draw off the growth experienced by other leading freemium services. We will be offering referral credits for each person referred from a freemium business to the network and providing surplus referrals back to a freemium company at a profitable CPA. Collectively the best freemium businesses have nearly a billion users between them, so they will all benefit when traffic can circulate easily among them.
To be effective, CatchFree must adopt the culture and standards of the best freemium companies. So we have put it entirely within our community’s control to determine who can and can’t be accepted to the network. Unethical behavior by freemium businesses will quickly get them banned by the network. While this may seem anti-commercial, it turns out that a highly ethical approach is a key requirement for a freemium company to succeed anyway. Companies like Dropbox and Evernote are genuinely loved by their users and it’s their evangelism that propels them forward. I know some of you are thinking of some unethical companies that are succeeding with freemium, but I would argue that they were likely ethical in the early days and more recently lost their way because of greed. In those cases, freemium has become a tangential part of their model and is no longer their core.
The Wild Feedback Loop
There will be lots of learning and surprises along the way, but we are very excited to be out in the “wild”. As Paul Graham suggests: “tame” users can only take you so far. By working hard and acting on user feedback, we’re confident we’ll be able to give freemium the platform it needs to thrive and change the game in some of the most profitable categories of technology. As CatchFree gains traction it is going to be very hard to compete against a great freemium app or service.
We also announced our $5.5m Series A funding by Polaris Ventures, True Ventures, Index Ventures, First Round Capital and 500Startups.
Lessons Learned
I’ll try to share lessons learned for taking a network effect startup to market over the coming months. It is significantly more difficult to get traction in a network effect business, but post traction they are much easier to grow. This is part of the reason we raised so much up front.
Here’s our launch demo and a bit more on the vision:
Most founders following a lean startup approach understand the importance of documenting and validating assumptions. My team and I have been doing it since day one.
But recently I began to realize that validating assumptions can also be a waste of time. In a startup your most precious resource is time and focus. If you waste too much time on things that don’t directly impact your ability to succeed, you will almost certainly fail. And if you do succeed, it will be based mostly on luck.
Prioritization is Everything in a Startup
The best way to avoid wasting time is by prioritizing how it is used. Since so much of the focus in an early stage startup should be spent validating assumptions, an essential task is to prioritize the assumptions that need to be validated. While more information about your market is always helpful, certain market assumptions probably aren’t that critical to your success. As with any data, “actionable” is a key word here. If validating or disproving an assumption is not going to change your actions, then it may be interesting, but isn’t actionable.
Crystallize Your Vision of The Successful Business
So how do you determine critical, actionable assumptions in your business? You should start by crystallizing your vision. This is an important part of success anyway. In fact a classic book that studied many of the most successful entrepreneurs in history highlights this exercise as the single most important thing they did.
Visualize every detail of your business when it’s successful. You should be able to answer questions like:
How will customers discover us?
What will be their first experience?
When will they realize they’ve found something great (what specifically will they be doing)?
Why will they think it’s great/important?
Why will they think it’s better than the old way?
How will they describe us to other people?
How will their experience evolve with our business?
When and how will we generate revenue?
How will we reinvest that money to accelerate the business?
Why will the whole model be repeatable and scalable?
Document every detail you can possibly imagine that describes your successful business. The more you visualize it, the more you will really begin to believe it. This will help you generate the authentic passion needed to raise money, attract talent and partners… It will help you connect to the emotions that are so critical to getting people to take a leap of faith on your vision.
Time for a Reality Check
Now stop drinking your own cool aid! Document everything that will need to go right for this vision to be a reality. What are the core assumptions that if proven wrong will make it completely non-viable? These are the assumptions that will be critical to validate. These are the things that will cause you to need to course correct. The earlier you can see the realities that affect your assumptions, the sooner you can get on the right track.
Of course broader market assumptions will also be important over time. They can help you develop a strategy to pursue bigger market opportunities. However, startups are too resource constrained to spend time on these assumption until fully vetting the base assumptions that support your original business premise.
Expect some debate about the order in which assumptions need to be validated. It won’t always be clear which assumptions are critical to success and which are just nice to know. But some level of prioritization will ensure that you maximize time spent validating the most important assumptions.
Below is an answer I recently put on Quora… Since I haven’t posted on my blog for so long, I figured some people not on Quora might find it useful.
Your marketing spend should be very minimal until you validate that you have created a product that people want or need (an important exception is for network effect products, which I’ll cover later). I would suggest 95/5 ratio between product and marketing. You don’t necessarily need a marketing person on the team to do this early validation.
Once you’ve validated that people want or need the product, you should spend as much as you possibly can on customer acquisition as long as the value of each user exceeds the cost of acquiring them. Often this requires raising additional funding, but if you can present proof of profitable, scalable marketing channels then it should be easy to raise the additional funding. Of course you should complement this paid customer acquisition with free sources if possible (and you can start these early in the validation process). If your product really does a good job solving an important need, you should also have strong organic growth. At this point the spend ratio generally tips toward marketing. I’ve seen it as high as 80% to marketing and 20% to product.
The exception for network effect businesses mentioned earlier is for the following reason… The user experience for a network effect product improves with each additional user. You may need to reach a critical mass of users before you can validate that the product is important for users.
In the age of the lean startup, we often forget about the importance of vision. A big audacious vision is critical for attracting venture capital and for getting the early team to “take the leap.” It also stimulates the emotion/passion needed to fuel your team’s persistence to blast through inevitable hurdles.
Vision Needs Traction
Achieving your vision requires first getting traction. The most realistic way to get traction is to break down your vision to something very relevant now for the sweet spot of your target market. This MVP (minimum viable product) is a bridge between concrete customer needs today and your big audacious vision.
Customer development teaches us that elements of the MVP are often based on flawed assumptions. As we validate and refine our assumptions, we need to make sure that the MVP is tracking to these new facts.
Vision Synching/Expanding
It’s also important to revisit your vision when new customer facts emerge. This often provides inspiration for extending the original vision but you should not be exclusively tied to your original vision. Always seek more interesting directions to be able to take the business once traction is established.
At FREEjit we’ve mapped out a primary vision but we continue to explore other huge opportunities we could pursue once we have some traction to leverage. Each new fact adds credence to some potential pivots and reduces the viability of others. Eventually we’ll need to focus on one vision, but the right vision will crystallize over time. Even while we explore these opportunities, our current execution is very focused on the MVP needed to get traction. And the MVP maps well to each of the big opportunities we’re considering.
While vision synching seems like a distraction from gaining traction, I find that it reinvigorates the team and makes the pursuit of traction even more exciting.
Freemium is a difficult business model to execute but can create a valuable, sustainable company when things go well. I helped to conceive of and execute the freemium business model at LogMeIn, which is now valued at over $800m. Since then I’ve helped optimize the model at another 14 startups including Dropbox, Xobni, Eventbrite, Lookout, Webs, Wordpress.com, etc.
Through these roles I’ve discovered the following three elements always seem to be present with successful freemium businesses:
1) A free version that provides users with a lot of value and at least one premium version that also offers users a lot of value but is clearly differentiated from your free version
3) Deep understanding of customer perceived value and use cases
There are times when freemium doesn’t make sense. For example, it rarely works with products exclusively targeting enterprises (open source has done well with enterprises, but that’s probably more a function of product flexibility than price). Also, freemium requires that the marginal user cost for the free product is zero or low. Finally, freemium shrinks the potential revenue of the total addressable market for the category, so the overall market needs to be big enough to still be interesting after a successful freemium company shrinks it. Of course incumbent players serving the category are unlikely to want to shrink the market, so freemium generally comes from disruptive startups with nothing to lose.
If these startups are able to gain traction and meet the three requirements above, they generally gain strong organic growth and are very defensible businesses.
As startups get better at executing the freemium business model I think we will see a lot more of it in both existing and emerging categories. Why? Users have always loved free and the freemium business model makes it viable to offer something of value for free. Already the model extends well beyond software to dating, identity protection, music, video, phone service…
In case you missed my Tweet on Aug 13th “Burn the boats – I’ve reached the point of no return and finally admitting I’m founding a new startup. Details soon.”
I didn’t really intend to become a founder, but was hit with an epiphany of a huge opportunity that I was perfectly suited to execute. I actually tried to push it out of my find for several days (my consulting practice has been fun/lucrative) but I kept having a nagging feeling that it had to be done. I shared the vision with a few venture capitalist friends and they quickly offered to fund it. I then received strong need validation from potential customers, which wasn’t surprising since the original epiphany had been based on engaging many potential customers. Momentum has been strong ever since (though surely there will be course corrections along the way).
I’ll be on a blogging vacation for the foreseeable future…
Below are my slides from Lean Startup LA, where I introduced recommendations for bringing a network effect startup to market. There is still plenty to figure out, so I appreciate any feedback (positive and negative). The presentation was also recorded on video here.
I completely agree with everything Paul Graham says in this short interview… I’d want to invest in this type of team if they were using a lean startup approach.
