Startup Marketing Blog – By Sean Ellis

User Growth Vs Revenue (Why “Free Only” May Limit Growth)

Last week I wrote about finding the right business model for your startup.  But many startups aren’t convinced they should even have a business model (yet).  They claim “our current priority is growth.”

In my experience, the right business model not only supports sustainable growth in the long run, it can drive faster growth today.  I’ve found three primary reasons for this:

1. “Free only” offering freezes prospective users  Site visitors often face a “what’s the catch?” moment when downloading free software  that doesn’t have a visible business model.  This is particularly the case when users respond impulsively to an advertisement – without the assurance of press or a trusted referral from a friend.  I discovered this dynamic a few years ago when I sent visitors to a landing page that made no mention of our premium product. I had no idea why these users were dropping out of the acquisition funnel at such alarmingly high rates.  Bigger download buttons and snappier headlines didn’t solve the problem.  It wasn’t until we surveyed users from impulse sources that we realized the primary problem was that people didn’t trust our claim of having a free product.  Once we knew the cause, solving this problem was easy.  By simply giving these users the alternative to download a trial of the premium product we were able to triple the download rate of our free product.  This experience demonstrates the risks of a startup that makes no mention of a premium product anywhere on their site.
2. Business customers looking for sustainable solutions It takes time for a business to implement a new IT product or service throughout an organization.  This implementation cost often exceeds the direct financial cost of buying the product.  So when a business sees that you have free offering, they will be hesitant to standardize on your offering if they worry you don’t have a sustainable business.  Even worse, they may fear that you are generating revenue through more nefarious ways such as selling their information.   Business buyers are usually more concerned with eliminating risks than saving the company a few dollars on a free offering. 
3. Hard to get aggressive on unproven assumptions Committing to aggressive acceleration is difficult when your business is loaded with unproven assumptions.  For example, imagine you get an opportunity to bundle with the next release of a popular complementary product.   They want you to pay $4 per user (free or paid) and your Excel model predicts upgrade rates that will give an average lifetime value of $6 per user across your entire free and paid user base.  Great, this looks like a safe bet.  But when the company tells you they’ll drive 1 million new users per month, you start worrying.  If your assumptions are right, you’ll generate $24 million in annual ROI – enough to put you well on your way to an IPO!  However, if your assumptions are wrong, you’ll probably go out of business.  Generally you won’t decisions on this scale, but the example demonstrates why it’s a lot harder to aggressively grow your user base on unproven monetization assumptions.

I realize it can be a bit nerve-racking to implement your first business model, particularly if you have strong organic growth.  But it’s not a moment of truth you should dread – instead it is a baseline that you will work to improve over the life of your company. Business models can and should be honed over time to increase the value of your users whether or not the first iteration is fruitful. 

Of course, if you have an extremely viral product, then a business model may in fact hamper your growth.  But ultimately you’ll still need a business model to monetize this growth, so you might as well figure it out early.

Posted in Acquiring Customers, Business models, Freemium (Free-to-Premium), viral marketing
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The Right Business Model for Your Startup

The right business model is critical to sustainably drive scalable adoption of your startup’s product or service.  Typical business model choices for software, web services, and online media startups are advertising or direct monetization (licensing, subscription, virtual goods, ecommerce, etc).

I generally avoid customer development roles with advertising supported startups because it is very difficult to self-fund (via arbitrage) early growth.  I faced this challenge at Uproar in the mid 90s when building an ad supported business was arguably easier.  We had created very engaging online games that we were certain would eventually attract a large user base.  In the first month after launch I presented the games to the big Madison Avenue advertising agencies and they were initially excited about the integrated advertising opportunities.  However, when I explained we only had a few thousand users interest quickly faded. 

These guys had multimillion dollar monthly advertising budgets.  Even if we could offer a strong ROI on their advertising investment, it wouldn’t be worth their time setting up and managing the campaign.  Our potential contribution to overall results was a rounding error on their typical campaign.  And considering the custom integration work, it wasn’t going to appeal to anyone but the most “visionary” advertiser. 

It was at this point that I realized the life savings I invested in Uproar was in serious jeopardy.  I asked our CEO for the opportunity to focus on user growth so that we could eventually attract big budget advertisers.  We managed to generate a substantial audience (becoming the world’s biggest game site), but even then still suffered from rapidly dropping ad rates that plagued the entire web.  It seemed each time we doubled traffic, the online advertising rates cut in half.   

What I like least about an advertising supported business is that it is almost impossible to always do the right thing for your customers.  Your two primary customer groups have opposing needs.  Each time you try to please your advertisers, you damage the user experience – and vice versa. 

Of course it is possible to build a valuable advertising supported company that overcomes this challenge – just look at Google.  Google reconciled the needs of advertisers and users, improving the user experience and advertiser results with perfectly targeted advertisements.  In fact Google’s advertising results were so good that later as an advertiser I was able to scale a profitable marketing spend to millions of dollars without ever speaking to a sales person (the results sold the ads). 

Today most online marketers buy on tracked ROI.  So if you are considering an advertising model, I highly encourage you to develop one that delivers results that will minimize the need for a sales team.  I do not envy the salesperson that has to make a case on the abstract branding value of their web property.  As tracking continues to improve, it going to be a much harder to incubate a startup with advertising.  Long-term success will require years of high burn.

In my experience, it is much easier to build a lean startup using a direct monetization model such as subscription, software licensing or ecommerce.  With these business models, your customer acquisition can be self funded from the beginning because it works at a very small scale.  For example, if your users have an average lifetime value of $100, your breakeven acquisition cost is $100 less any direct costs of serving this customer (such as storage or bandwidth).  Of course if you can acquire the user for $50 and there is no marginal service cost, then you’ll generate a $50 marginal profit on this user.  With a good arbitrage model, it becomes much easier to sustainably build a customer base from day one keeping burn at a minimum.  And eventually enough marginally profitable users offset fixed costs – creating an overall profitable business. 

Arbitrage supported customer acquisition can even work on a freemium model, but your allowable acquisition cost for a free user will be much lower when you average revenue across the whole free user base.  Still, over time you can add additional monetization channels to boost your allowable acquisition cost and expand the number of viable acquisition channels.  Ultimately freemium businesses become more defensible than “premium only” businesses, because you’ve built the premium portion of your business to compete in the toughest economic scenario.  I’ve blogged about freemium several times already, but have a lot more thoughts to share as I’ve helped several additional startups implement the model since my last freemium post.  Look for a more comprehensive post soon, but in the meantime here is a link to my earlier freemium posts.

Posted in Acquiring Customers, Business models, Freemium (Free-to-Premium), Pricing Your Product
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How to Determine the Optimal Price for Your Web Service

For the startups I help take to market, one of our most important projects is determining their optimal price.  Unlike companies in established categories with high unit costs, optimal pricing for a software startup mostly relates to maximizing revenue.  An optimal price allows the startup to grow at the fastest possible rate by maximizing profitable investments in customer acquisition programs and/or offering a free version to drive broad user adoption. Considering most software startups simply guess a price, determining your optimal price can become an enormous competitive advantage.  

The optimal pricing project is part of the overall “optimization phase” I describe in my metrics driven go to market approach presentation. 

There are three key factors to consider when determining your optimal pricing:

1. Price sensitivity– You want to find the price that generates the highest yield per 1000 trials (or visitors, DLs, etc.).  You can find this number by determining how many units you would sell at each price.  For example, if you have a 10% conversion rate at both $8/unit and $10/unit, then $10 is obviously the better price for you.  But let’s say at $20/unit demand drops to 8%.  Despite lower demand, yield is higher at $20 so it would be a better price than $10 ($1600 per 1000 users at $20/unit compared to only $1000 per 1000 users at $10/unit).  I estimate max yield pricing first through surveys and then through experimentation at several price points.  Around launch your volume will be too low for a meaningful sample size, so be sure to launch with “introductory pricing” which should be at the low end of your expectations.  Adjust the price when volume allows you to hone in on the optimal pricing.
2. Marginal cost– For web services it’s important to understand your cost per unit to avoid pricing at a loss.  This marginal cost is essentially a floor on your pricing.  If you have bandwidth and storage costs that are $5/user/year, then your business would not be sustainable if you priced your service at $4/user/year.  For most downloadable software, there is no marginal cost per user (beyond marketing costs).
3. Growth strategy– I generally prefer one of the following pricing strategies for innovative products.  One is a Market Builder pricing strategy where the majority of your users are coming through your demand generation initiatives.  Demand generation is expensive (unless driven through viral tactics) and therefore requires premium pricing to create a high allowable user acquisition cost.   An example of a company that took a Market Builder approach to grow the personal remote PC access category is GoToMyPC, which combined premium pricing with aggressive radio demand generation.  An alternative strategy is a Market Drafter pricing strategy.  Freemium pricing is ideal for a market drafter.  Essentially as the Market Builder creates awareness for the category, the Market Drafter swoops in and offers a much better deal (SEM is a good place to focus for a Market Drafter).  This strategy only works when a Market Builder is aggressively investing to grow the category.  I prefer the Market Drafter position when possible (see this post for more details on why).  In the long term, the Market Builder must focus on differentiation to justify its higher prices (or reduce prices)

Once the optimal price has been established, there are many tactics that can used to boost response rates.  These include:

• Setting the price a bit higher than the optimal level and then frequently discounting it.
• Using a decoy super premium version to make the version with the “real price” seem cheaper.

My favorite pricing model for driving demand is Freemium, combined with carefully researched max yield pricing on the premium version of the product – then applying the response boosting tactics listed above.   An insightful read on Freemium pricing is Josh Kopelman’s post “The Penny Gap.”  It is an exploration of the “power of free” in driving customer adoption and suggests that elasticity of demand is not linear.  At the price of zero, demand soars. 

Dan Ariely also makes this point in his book Predictably Irrational.   He concludes “Zero is not just another discount.  Zero is a different place.  The difference between two cents and one cent is small.  But the difference between one cent and zero is huge.”  He supports this point through the following experiment:  He first offered a Lindt Truffle for 15 cents and a Hershey Kiss for one cent.  Participants (who could only select one) purchased the Lindt Truffle 73% of the time and the Hershey Kiss 27% of the time.  When they were both discounted an additional penny (making the Hershey Kiss free), demand for the Hershey Kiss shot up to 69% and demand for the Lindt Truffle dropped to 31%. 

There are several other great pricing psychology nuggets in Predictably Irrational; I highly recommend reading it.  It goes well beyond the three basic pricing factors presented above.  Some useful points include:

• A higher price not only positions your product as superior, people may actually have a better experience using the product.  He presents a fascinating experiment that shows people got more relief from a $2.50 pain killer than a 10 cent pain killer, even though they were both just vitamin C.  He concludes “the perception of value, in medicine, soft drinks, drugstore cosmetics or cars, can become real value.” 
• When we encounter a new product, we accept the first price that comes before our eyes as the anchor.  This price has a long-term effect on our willingness to pay for the product from then on.  He uses the example of black pearls.  Initially there was no demand for them, but when they were anchored to the finest gems in the world with premium pricing, demand shot up. 
• Differentiation gives more flexibility to increase price.  His example here was that Starbucks differentiated the coffee shop experience allowing them to more than double the price of a cup of coffee compared to Dunkin Donuts. 

Finally remember that technology prices tend to drop over time.  Keep this in mind when determining allowable acquisition cost based on a user’s lifetime value.  Lifetime value will probably be lower when considering future pricing pressure.  It’s better to be ahead of the curve in driving prices lower, which often requires innovation that allows you to profitably offer the service at a lower cost than competitors (for web based services with marginal costs).

Posted in Freemium (Free-to-Premium), Pricing Your Product
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More Freemium and Startup Marketing Thoughts

Same excuses for a lack of meaningful blog posts recently…  But the good news is I’m nearing the end of my immersive interim VP marketing role, and will soon transition to a part time advising role.  This should free me up to spend more time with the blog.  

Until then, here are three very raw startup marketing thoughts that have been running through my head lately…

1. Freemium will be a dominant business model in software and online services. It is easiest to execute when disrupting large existing categories with strong demand.  It is more challenging to execute when growing a new category through aggressive marketing spending. Getting all the pieces right will dramatically improve your ability to market and grow a freemium business.  Premium only is rarely a viable option – you will eventually lose to the company that introduces a freemium model in your category.
2. Early stage marketers that aren’t looking at the full business picture likely won’t be successful.  Most of the obvious marketing levers are irrelevant without the right business model, product/market fit, tracking systems, etc. Early stage marketers need to spend time perfecting the whole economic picture.  Marketing might not even be the right title to give this role, but the marketing function is a critical component.
3. The traditional Silicon Valley rift between engineering and marketing is shrinking.  The increasing importance of analytics in marketing means effective marketers can more easily connect with mostly left brained engineers. Additionally, some of the most leveraged online marketing activities require close coordination with engineering (such as viral marketing and conversion optimization). The trend of great marketers coming from engineering backgrounds will likely accelerate (and no – I don’t have an engineering background).  Still, all tech marketers will need to have a good balance of right brain and left brain talents.

I plan to expand these thoughts in future posts.

Posted in Freemium (Free-to-Premium)
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Fremium Will Squash Premium

The biggest threat to an established premium only software business is the arrival of a fremium player.  The best way I can think of to demonstrate this is through the following hypothetical scenario:

You’ve built a premium subscription software business model.  Your sales dwarf competitive premium offers because you have very efficient customer acquisition and a great product with strong customer retention.  Your marketing metrics are strong.  You have 1 million customers, for which you paid an average of $50 each to acquire.  The average projected lifetime value for each customer is $100 with a typical subscription length of three years.  So you paid $50 million and will eventually generate $100 million.  Your marginal cost of providing the software is minimal, so you are now focused on acquiring as many subscribers as you can for around $50 each.  

Now imagine a fremium player enters the space.   At first you don’t notice much decay in your business.  You’ve got a marketing machine that’s generating enough cash flow to efficiently outspend the fremium competitor 10:1. And you have the benefit of a high lifetime value to justify the high customer acquisition spending.  The fremium competitor only has an average lifetime value of $10 per user (averaging their free and premium users).  Their average acquisition cost is a fraction of that because of high response rates to their “free” advertising messages and strong word-of-mouth.

Fast forward a year or two.   The premium only company starts to see retention rates plummet.  A few subscribers are going for the competitors ½ price premium version but most just choose the free version.  It’s only a matter of time until the entire Premium only installed base learns about free offer.

What should this premium only company do?  If they launch their own fremium version, they will sacrifice much of their paid base to their own free offering.  They paid a lot to acquire these users with the expectation that they would recover the cost through a high lifetime value.  A fremium offer at this point become pretty hard to swallow. 

If you believe Chris Anderson’s recent Wired article – this scenario will play out in every software category.  If you are thinking about launching a premium  only software product, consider going fremium now.  It will be a little harder to get traction, but you will have a much more defensible business down the road.

Posted in Freemium (Free-to-Premium)
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Chris Anderson "Gets" Freemium Business Model

There has been a lot of attention this week on an article called Free! Why $0.00 Is the Future of Business published by Chris Anderson in Wired Magazine. It is an excellent overview of the drivers behind the important trend of companies offering free versions of their products. He plans to release a full book on the subject next year.  For those who aren’t familiar with Chris Anderson, he’s the author of The Long Tail, a book that kicked off a frenzy among internet entrepreneurs and VCs a couple of years ago. It highlighted the impact of unlimited online shelf space.

Every time I start reading this “Free…” article I interrupt myself to write down more thoughts on free business models.  It’s bringing back years of thinking about the best ways to execute these models.  In fact I’ve spent most of the last 13 years in the “free” space.  I plan over the next few weeks to make several “brain dump” blog posts on the subject.

A quick recap of my specific experiences with free business models.  In 1995 I made an angel investment in a “free” company call Uproar.com.  When the service neared launch in mid 1996, I joined full time as VP Marketing.  Our business model was to require users to complete a detailed registration form to be able to win cash and prizes in “free” online game shows.  We used this detailed registration information to target advertising.  While “free games for cash and prizes” was the hook, we created a very sticky site through community and a great game playing experience.  Ultimately this free online experience combined with a systematic approach to customer acquisition propelled the site to the 8th biggest web property worldwide in terms of total usage time (a key metric for ad supported websites).  Uproar was acquired by Vivendi Universal in 2001 for $140 million but the bubble valuation peaked at about $1 billion.

From March 2003 until Dec 2007 I led marketing for a more classic “fremium” service called LogMeIn.  For confidentiality reasons I won’t go into details about the executing the model, but the LogMeIn home page states the service has “Over 30 million devices connected worldwide for remote support, access & backup”. 

Through both opportunities I gained lots of insight in executing this model.  I especially learned that, in a competitive category, it’s much better to be the fremium player than the premium only player.

Posted in Business models, Freemium (Free-to-Premium)
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Demand Harvesting – The Easiest Driver for Startups

I always begin a new startup marketing assignment by looking for any untapped existing demand.  Demand harvesting is much easier than demand creation – and it has a faster sales cycle.  You don’t have to convince someone they need your category of product, you just need to be easier to find/buy and have a better value proposition than the other guys. 

The first question to ask is “where would someone seek my product category?”  Twenty years ago the most obvious answer would have been the yellow pages, but today it is Google.   A lot of information has been published on getting the most out of SEO or SEM and there are also many experts you can tap in this area. Beyond Google, I’ve found it is helpful to survey existing users for other places they would potentially look.   It’s great news when discover healthy demand for your product category. 

The next step is to analyze the solutions competing for that demand.  The best situation is to discover heavy unmet demand and no competition.  That is about as likely as winning the lottery, so don’t count on it.  More realistically, there will be a few companies with varying offers competing for that demand.  In this case, you should hope for weak execution from these existing competitors.  If you can be significantly more effective at extracting money from each prospect, you can afford a more prominent promotion at the initial point of connection and begin capturing market share. 

If you discover that the existing competitors are executing well, you’ll have to differentiate your offer with a better value proposition for at least a segment of the existing prospects.  This was the situation in my last company.  We faced a well entrenched competitor who was harvesting the majority of existing demand and spending millions every month creating new demand.  Rather than simply trying to out-execute them (they were extremely efficient), we decided to counter with a free-to-premium offer. 

This gave us a high response rate among existing main category searchers but also played into a new trend that had been developing over the last few years.   In discovering a new expensive software solution, many prospective customers now check for free alternatives.   For this new segment of demand, we quickly became the dominant market player.  Once we had these users engaged on the free product, we could patiently upsell various complementary premium services. 

Whether competing for existing demand or creating a brand new product category, you’ll eventually have to begin creating demand.  This is a much more difficult and unpredictable art that I’ll cover in a future post.

Posted in Acquiring Customers, Demand Creation, Demand Harvesting, Freemium (Free-to-Premium)
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