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EP245 Lecture 6


Revenue Streams

Now let's take a look and see if we understand revenue streams. On the top we have some examples of revenue stream possibilities. We could have direct, ancillary, asset, usage, or subscription. Why don't we match the best examples that go in each box. Why don't you put the number that corresponds to what you think the best examples are in the boxes underneath the revenue stream examples on the top.

Revenue Streams Solution

Obviously, direct--that would be a direct sales force--number 4. Ancillary would be number 2--referred revenue. An example of an asset revenue stream would be number 6--sale of ownership. Usage would be proportional users--number 7. And subscriptions would certainly be number 5 but also could be number 1.


Now, in summary, revenue streams might take the form of a whole series of potential strategies. But what's interesting is inside of each revenue stream, you may have different pricing tactics. Let me say that again. We just talked about revenue streams. If you think about it, we didn't talk about how much to charge. We talked about the potential ways to charge— licensing and intermediation and direct sales, etc. But how do you think about pricing itself? How do you set prices? Let's take a look. Pricing is kind of the tactics. The first thing you have to figure out is what's the revenue stream I'm going to use for the customer segment. But there are two types of prices. One is fixed prices. Fixed pricing is just like it sounds. There's no haggling. Here's how it is. It's the fixed price. Now, fixed price you can decide, well, how do I set that price. I'm going to take the cost of what it takes me to build the product, and I'm going to add some fixed markup—whatever I think my profit should be. It's very simple. It's cost plus markup. This gets me to the minimum price in the market. But you know what? I might know something that my competitors don't know. Because I've been out talking to these customers for weeks or months, and I know that they actually value my feature set, my value proposition, more than my competitor's. In an existing market, I will likely know something no one knows. I know exactly how much they value what I will offer. Instead of pricing based on cost, I could actually price on specific customer segments or on features I know they need. There's a third type of fixed pricing, and that's called "volume pricing." It might be that you want to encourage high volume, because you have economies of scale. So, you might price the product if you buy in quantities of 1-10 it's $1000, but if you buy in quantities of 10-100 it's $900. Therefore, you can keep stepping up the discount, but if you buy in hundreds of thousands or millions, instead of $1000 we'll charge $99. Know who does that? Go talk to Intel and the semiconductor manufacturers. They want to encourage high-volume purchases, and so they have stepped pricing that is oriented to create volume. Cost plus market, value pricing, and volume price are all examples of fixed pricing tactics. But there's another type of pricing. That's dynamic pricing. Dynamic pricing is exactly what it sounds like. Dynamic means it moves. How could you have prices that kind of move? I thought all pricing is written down on a piece of paper and never changes. If you ever think about it, pricing that you negotiate—yeah, we kind of have this price on paper, but that's just the starting point of the conversation. Negotiated prices is a dynamic price. But airlines are now a great example of another type of dynamic pricing, and that's called "yield management." If you think about it, once an airplane takes off they can no longer sell those seats. So, a month before the flight, those seats might be $500.00. A week before, those seats might actually go up to $600.00. An hour before, those seats might drop down to $99.00, because that plan is leaving, and if we have empty seats, we're not getting any revenue. So, yield management is actually pretty interesting based on experience, on time, etc. There are software programs and industries like airlines and car rentals, etc, that have perishable seats or time actually are quite good at doing this. Another type of dynamic pricing is real-time markets. The stock market is a real-time market. Then auctions like eBay are another example of dynamic pricing. Again, two types of pricing models—fixed and dynamic. How do you know which one to use? You've been out talking to customers. How do they currently buy and what's the revenue stream that's associated with these kind of pricing tactics? You need to be constantly thinking what's the right revenue stream for the right segment and, within that, what's the right pricing model. Is it fixed or is it dynamic, and which one are you going to pick?

Fixed And Dynamic Pricing Tactics

We just talked about the two categories of pricing tactics we can have. fixed pricing tactics and dynamic pricing tactics. Take a look at the choices here on the left and match them to whether they're fixed or dynamic.

Fixed And Dynamic Pricing Tactics Solution

It turns out we made this pretty easy. The first three—cost-based pricing, value-based pricing, or volume-based pricing— are all examples of fixed pricing tactics. That just means that the last three—yield management, real-time, and auctions— are examples of dynamic pricing.

Common Startup Mistakes

A couple of mistakes—right on tactics—I just want to remind you about. I mentioned them earlier, but a common startup error on day one is let's price on cost. We know how much it takes to build our product. We'll just add a markup that is a profit, and therefore we have a price. How hard can that be? This is typically not a strategic way to price. You might end up here, but boy there's a lot more moves on the table. What you really want to think about is not just your internal economics, but the customer insight that you actually have. I want you do think about, yes, pricing on cost is maybe the first place we start, but are we leaving a ton of money on the table? Because the alternative to pricing on cost is pricing on value. As we said earlier, you know now your customer segment's perception of the value of your value prop. Is it about time saved? New efficiency created? Remember we talked earlier about pains and gains for this customer segment. What is it that they value? Why are you saving them a ton of money? Now, customers don't necessarily feel that they want to pay this way, but smart marketeers and smart startup executivies can convince customers that instead of paying on cost they really ought to be thinking about that your company is unique and providing the most value—not just the cheapest product.

Market Types And Pricing

Now, one other thing affects pricing, and we should think about it. If you remember our discussion about market type, we have existing markets, we resegment markets, we might be in a new market, or in a country outside the United States we might cloning an existing business model. But if we're in an existing market, we've got to think about competition. Is there a monopoly? Is there a duopoly? An oligopoly? That is, are there dominant players that really shape the pricing in our markets? What we really want to understand is what's their product? What are their costs and prices? And what pricing will make them feel the worst? More importantly, can we do strategies like bracket them? Can we undercut them? Can we niche or blue ocean strategy them? These are the things you want to think about. If there are dominant players in an existing market, you want to actually have pricing as a strategy, not just a reaction.

Single And Multiple Side Markets

One of the things I just want to reemphasize because we mentioned it earlier is the difference between single-sided markets and multi-sided markets. Now, in single-sided markets the customer is the user and the payer. That's a single-sided market. There are no separate users, and there are no separate payers. You're it. Congratulations. You're the customer and you're going to pay for it. But in multi-sided markets there might be users, but they're also might be very separate people who are payers. The example we keep using is Google, because everybody around the world has probably had at one time or another been a Google user. When you use the Google search bar you're one side of a multi-sided market. You're the user, but you're not the payer. You're not paying for the product. But in reality, you're paying implicitly, because there is another side. The other side are the people using Google Adwords to look for keywords. In multi-sided markets the company, your startup, typically cares about acquiring a massive amount of users and then figuring out how to monetize those users next. Google decided to go from millions and then tens of millions of users, and then the keywords came after. Now, depending on your investors, this might be their strategy. I tend to prefer that we actually try to look for who the payers are as early as possible, but this is a question you might want to ask your investors. Do we go for lots of users and then say if we get 10 million people the revenues will come? Or do we want to look at both sides of the market at the same time? Again, if you're in a physical channel, my suggestion is you want to take a look at users and payers simultaneously. If you say your business is advertising-based, some of the tactics are how do you get to 10 million monthly users? How do you become one of the top five websites? And how much do the payers actually pay? Now, if you wait 2 years to find this out, you might have gotten 10 million of the wrong users. Your job is not only to talk to the users in a multi-sided market. You're job is to get out of the building and talk to the payers. Because you have a hypothesis, an important one, which is how much will those payers pay for the users you think you're collecting. Guess what? If you're wrong, the time to know about it is now, not two years from now, and it's okay to be wrong, because most startups all you have is a series of hypotheses, and it's really easy to get caught up in the passion that says, well, if we get all these people obviously these people will pay us lots of money. But as soon as we get out of the building that obviously might turn into maybe not. What we want to do is get the facts as quickly as we can and then iterate and pivot. So, don't worry if your assumptions were wrong here on your revenue model. You just want to find it out before you start burning a lot of cash and building a lot of value prop around the wrong model.

Revenue First Companies

There are other companies who want to go for revenue first— typically, hardware companies, but not always. Sometimes on the web as well. The questions to ask are how long will it take to start doubling my revenue every month. When will I get to $100,000 a month? When will I get to $1 million a month? What are my assumptions about my business when I reach these milestones? What's changed to get there? There's nothing magic about these numbers, but when you start asking about, oh yeah, when am I going to get to $100,000? What has to happen in all those other pieces of the business model? Because if you think about it, you've been working hard on value prop, and you've been working hard on customer segments and customer acquisition and activation and channel. What did you need to do to get to the first $100,000 month, the first $1 million month? Boy, as a startup you feel great when those happen.

Market Type And Revenue

Now the last thing I think I really want to mention and it really does belong in this lecture is the affect of market type on revenue. This is really interesting, because you might have heard about startups about something called the hockey stick, and the hockey stick is actually this kind of curve. Now, it turns out that what the hockey stick really represents are startups in a new market. Wow. That's kind of interesting. Why? Well, if you think about it, in a new market on year 1 you have no customers, and so your revenue is essentially flat. In year 2, revenue still might be flat. Year 3, it might be flat. Year 4, oh my gosh, something changed about the market. There might be a tipping point, an inflection point, where sales literally go exponential and start to skyrocket. What happened is a market that didn't exist all things have just come together, and it's become the year of online education, or it's become the year of the network, or it's become the year of the mobile phone or smart phone. The unfortunate part is most startups that are in a new market see something that looks like this and go out of business. What we're really hoping for is that we could influence and affect this tipping point by our customer strategies, our value proposition, and our get, keep, and grow strategies. But the key idea is we want to hoard as much cash as we can, because almost no startup in a new market can affect the diffusion of innovation by itself. Other things need to happen. By the way, this little bump in year one— this represents the fallacy in new markets. In almost every new market you could find crazy people just like you who'd be happy to buy one for their lab or their home. Such early adopters—they want to have one. Startup founders look at that curve and say, "Look! It's just going to look like this," and start scaling their sales and marketing and spending and then it all collapses again, because it really was an early adopter sign, not mainstream adoption. We want to be careful about what our sales curve looks like. Now, what's really interesting is if we're an existing market— and remember, in an existing market what do we know? Well, there are customers and there are competitors. What we have if by our definition a better or higher performance product on axes that the customers have defined. Our job in an existing market is simply year-after-year, if we execute pristinely, simply to take share away from the incumbents. So, our sales curve in an existing market literally should be one of taking shares. Finally, in a resegmented market, this is kind of a hybrid of both new and existing. What's happening in years 1, 2, 3, etc, in the early days is you're actually getting revenue from the existing markets. That is, people might actually kind of find you are an okay substitute, but really don't understand your unique value until some tipping point where they realize, oh my gosh, you're just not another vendor in an existing market, you actually solve better a set of needs for a niche or you're a low-cost supplier that really makes you unique and special and revenues take off. And so what you have to do is husband your cash but not as much in a new market and figure out how to get you differentiated from the mainstream in existence.

Draw The Diagram

So in summary and <u><u><u><u><u></u> model for this class,</u></u></u></u> the best thing that you could do is start drawing the diagram. So what I want you to do is draw the diagram of both your revenue streams and your pricing, and I want you to actually put numbers in. So let's assume this is your company over here. What you've discovered is that there are 3 different customer segments; look at that. Tenants, property owners, and leasing companies. I want to know if this is subscription, what is the revenue stream that you have between each one of these customer segments, and what are the pricing tactics?

Key Revenue Model Questions

Some of the revenue model questions: What is it my customers are paying for? What's the value? What is it when they look at my company and my products? By the way, what capacity do they have to pay? They might love it. In fact, everybody who looks at a Ferrari or a Tesla model S might say, yes, I'd love to pay for that, but—you know what?—my wife won't let me or I just don't have the money. That is, is the total available market of potential users your needs for revenue? You might have built a product so expensive that the customer segment you've targeted just can't afford it. Then how will you package your product? By package I don't mean what kind of pretty box is it in. Another mistake startups make, particularly engineering-driven startups, is putting every possible feature into the first product, not thinking that perhaps—well, wait a minute. Maybe we could decompose the product—that is, take it apart— and offer these as add-ons or as ancillary products or separate products, etc. How you package your products should not just be an engineering functionality decision. It should be a value-based decision. As we said, the same with pricing. How will you price? What kind of tactics will you use?

Market Size And Share

Another thing to think about is what's the market size estimate? How big is this and what's the percentage marketshare realistically you could get? How many can you distribution channel actually sell? If you have your own direct sales people, do the math. How many customers can they call on it at what price? As you start putting all this into a spread sheet you actually start building the classic income statement balance sheet and cashflow we haven't even had you do yet. If you think about this, this entire conversation we've had was how to get the basic data so you can put together a revenue model that's based on fact rather than fiction. You are going to start thinking about, well, if I have a direct sales force, how much can they sell in dollars, or if I'm using an indirect channel, what's realistic number they sell for other customers? How much will it cost to have this distribution channel? Hopefully in the last lecture you start thinking about the cost of you channel— how many customer activations, how much it will cost to get customers into my physical store or my virtual website. Then as we talked about earlier, how much will it cost to acquire a customer? And by the way, not only how much does my customer acquisition cost but what's their lifetime value? How many units will they by from each of these efforts?