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.