Revenue Models for Software Firms

Introduction

What are you getting yourself into?

Businessmen have long made money selling goods and services. In the past, pricing was easy. A physical good was carved, assembled or constructed and a simple markup was added. Now, the world's economies are much more complex, and many products (such as software) can be copied for free at any time. New and exciting revenue models have been developed, and it is vital for business owners to select the most appropriate one.

This page will examine the most common revenue models used by startups and online businesses. After reading it, you will have a strong understanding of the options available to you, the product and service characteristics that lend themselves to specific models and an awareness of the pitfalls to avoid.

What is a revenue model?

Revenue is the lifeblood of any business. It represents the money coming in from a firm’s customers. A revenue model is a description of how a business will structure the pricing of its products and services. The selection of the correct model can determine whether a business survives or joins the many that fail each year.

It is important to note that a revenue model is not the same as a business model, but merely an important part of one. Whereas a business model is concerned with the creation of value, a revenue model focuses solely on the aspect relating to billing methodology.

What if you need more help?

As a specialist in product pricing, I’m more than happy to consult on your latest business venture. Contact me via the contact form on the website.

1. The San Francisco Hipster
2. The Sellout
3. The Barker
4. The Blood Donor
5. The Man Behind the Curtain
6. The Leasing Agent
7. The Day Laborer
8. The Expert
9. The Godfather
10. The Beggar
11. The Handyman
12. The NSA
13. The Priest

The San Francisco Hipster

Profile:

Each year many promising software engineers leave the safe confines of the corporate world in order to follow their dreams of becoming dot com billionaires. They believe that a person can create a "cool" web application and then flip it for millions - or even billions of dollars.

What is being sold:

Many of those who select this business model share a critical misunderstanding. They think that the product being sold is their software. There are some acquisitions where this is the case, but many applications are relatively simple - any halfway decent team of software engineers could clone their application.

Much more common are acquisitions for an application's user base. An application with a cult-like following of engaged users is, quite literally, worth its weight in gold. Each dedicated user represents not only a future income stream for the existing product, but also a channel for marketing other products. The brand loyalty and connections can be exploited, when such actions are conducted by a marketing team with greater leverage than the original development team.

A recent trend is the "acqui-hire," in which a larger company purchases the smaller firm, not for the product, but for the team. An already-formed team with a history of impressive work is worth quite a bit. The team may have proven that it can deliver excellent products or has established an expertise that is worth significantly more than individuals who may (or may not) be able to work well together.

Examples:

• WhatsApp (instant messaging service) - Sold to Facebook in 2014 for $19 billion for its user base
• Mojang (developer of the game Minecraft) - Sold to Microsoft for $2.5 billion for its intellectual property
• Astrid (8-12 person development team of a "to do" list app) - Sold to Yahoo for an undisclosed sum in 2013. The product was retired soon after.

Advantages:

• Possibilities of massive payouts
• Allows focus on core product rather than revenue projections

Disadvantages:

• This approach is akin to playing the lottery. It's great when it works, but the problem is that it doesn't work all that well. It's an all or nothing play.
• Without income, it can be difficult to gauge the success of the efforts.
• This method requires the longest amount of time before earning revenues; as such, it is very dangerous. A single failure when looking for financing can lead to disaster.

The Sellout

Profile:

Many companies were funded through the sale of advertisements. Whether the older-style banner ads, or the more modern contextual-selected text ads, companies can, and do, make fortunes from advertisements.

What is being sold:

• Quantity - The larger the number of users, the more valuable the audience.
• Quality - Users who fit a narrow profile and are willing to spend more money are more valuable than other users. For instance, 1,000 upper-class car enthusiasts would be far more valuable than 1,500 random individuals.

Examples:

• Google - Although the company has branched into other revenue models, the vast majority of its income (north of 90%) comes from placing advertisements on its sites.

Advantages:

• Low startup costs. Many businesses can use pre-existing ad networks.
• Allows for possibility of private ad placements for increased income.
• Zero out-of-pocket costs will attract casual users (especially in the business-to-consumer marketplace).
• Can be used in tandem with other models. Many companies display ads to users on a "free" pricing tier, but remove them for folks on paid plans.

Disadvantages:

• Requires a large number of users to generate sufficient income for most businesses.
• This model may train users to associate the firm's product with low value offerings.
• Much of the value being generated flows to the product being advertised, rather than to the company displaying the ads.

The Barker

Profile:

Many firms create virtual storefronts to generate sales. A website can act as an excellent means of selling products such as downloadable software, textbooks or even tangible goods like toys. As the oldest revenue method, it is also probably the best understood.

What is being sold:

You are selling products to customers.

Examples:

• BestBuy.com

Advantages:

• Very straightforward and easy to understand model for both a firm and its customers.

Disadvantages:

• Requires a constant flow of either new customers or new products to sell to old customers.
• It can be difficult to price products properly.
• Companies will face intense competition from other sales platforms.

The Blood Donor

Profile:

In many ways, the blood donor is similar to the barker. The key difference is that (rather than selling products to end users), a blood donor sells components to other businesses. Typically, this method is utilized by firms selling software libraries.

What is being sold:

Products to be used to create other products

Examples:

• Epic Games (producer of the Unreal video game engine) - sells a collection of software used by an array of organizations including the U.S. Army, Warner Brothers, Electronic Arts and Singapore Polytechnic.

Advantages:

• Once companies begin to use such products, they will become invested in them and continue to use them for future projects. As expertise by users increases, they will be less likely to take their business elsewhere.
• Use by external companies will allow library vendors to co-opt their brand recognition to boost their own.

Disadvantages:

• This method often requires extreme specialization of focus.
• Acquisition of larger corporate clients may require longer sales lead times.
• Successful sales will require fighting the ever-present not-invented-here syndrome.
• Many corporations will find it difficult to balance configurability with ease of use by their niche customers.

The Man Behind the Curtain

Profile:

In this revenue model a product or service is sold to an intermediary who then brands it as his own.

Many generalists will purchase specialized solutions or additional inputs and then rebrand the solution in its entirety. The buyer benefits in this case by the enhancement of its brand. Armed with a breadth and depth of skills from men behind the curtain, a frontman will be able to market to many types of customers that would have been unserviceable by any of his individual constituents.

Although similar to the blood donor model, there are two significant differences.

• The solution that the man behind the curtain provides is typically a complete solution, rather than a component.
• There is a significantly reduced opportunity to build brand recognition.

What is being sold:

• Reduction of project risk
• Reduction of project cost (in terms of schedule and possibly cost)
• Potential enhancement of the buyer's reputation

Examples:

• Individuals who deal with Robert Half Staffing Agency - They provide labor and expertise, but the staffing agency is the party whose reputation grows.
• HubSpot - The firm allows clients to download technical papers and label them as their own work.

Advantages:

• Companies using this method can ramp up relatively quickly.
• Companies are able to take advantage of other firms' pricing and marketing power.

Disadvantages:

• This model will not allow a firm to build its brand recognition with a large audience.
• Firms using the man behind the curtain will become increasingly dependent on other firms.
• Much of the value generated will flow to the front man, rather than the man behind the curtain.

The Leasing Agent

Profile:

Similar to the barker is the leasing agent. Under this model, rather than selling a product outright, firms charge a fee on a recurring basis. Although many measures of increment can be used (such as number of calculations or CPU usage), units of time (monthly) is the most common.

What is being sold:

A solution to a problem that plagues customers

Examples:

• Netflix - Millions of customers pay a monthly fee in order to stream an unlimited quantity of movies.

Advantages:

• Leasing agents have the ability to sell to existing customers repeatedly via recurring invoices.
• Low up-front costs reduce customer reluctance to make purchases.
• Ongoing income stream flattens revenue peaks and valleys, leading to more accurate income forecasts.

Disadvantages:

• Many existing customers will express strong opposition to price increases.
• Requires that firms provide an ongoing benefit (value) to their consumers

The Day Laborer

Profile:

This model is often referred to by other names such as "freelancing," but this should not be confused with the expert revenue model (described later in this book). It requires the demonstration of a basic understanding of a skill, technique or capability that is commonly in demand by employers. All effort is made to ensure that the image projected is one of meeting a threshold (or defined minimum) that is required to perform a service. Evidence supplied will likely include relevant certifications, coursework and (possibly) evidence of past successes in a given domain. Supporting materials for a day laborer may include writings that demonstrate a technical proficiency and may delve into obscure topics in the technical space. Work produced under this model is generally focused on the execution phase of a project and involves tactical execution to a much greater extent than strategic vision. Individuals and firms working under the day laborer model will often consider it to be of a transitory nature in an effort to move toward the expert model.

What is being sold:

• Labor and expertise to be used as directed by a customer

Examples:

• Any profile on LinkedIn or Github

Advantages:

• Requires minimal effort
• Limited growth potential, unless willing to switch to other models
• Pricing power resides with customers, so little effort required to determine pricing strategy.

Disadvantages:

• Income is directly dependent upon hours worked, creating an income ceiling.
• Much of the value created by a firm is captured by the hiring company.

The Expert

Profile:

The expert gives away his knowledge and the fruit of his experience for free. As he teaches, he builds both an audience and a reputation. These products are then used to generate a demand for his consulting services. Those following this model focus on selling results (what) rather than effort (how). Because the expert is able to act independently and can frame the problem to be solved, he is traditionally given significant leeway and is afforded a higher compensation than the day laborer. Because of this, it is vital that his reputation is built upon a history and expectation of results rather than a simple listing of skills and technological frameworks. Common methodologies for accomplishing this feat are testimonials, writings and books that link the use of technical concepts to the achievement of business objectives.

What is being sold:

• Expertise, credibility and ability to provide solutions and to reduce risk to the customer

Examples:

• Seth Godin - Marketing guru and blogger provides an enormous amount of content on his site, including a blog updated throughout the week.

Advantages:

• A move away from technical details and toward business objectives will yield greater incomes per unit of time worked.
• Skills obtained will often be less subject to the effects of the technology treadmill, because they often involve concepts rather than tools.
• Once an expert's credibility has been established, it will often feed upon itself (via network effects). Large quantities of writings will lead to higher visibility (SEO)
• The availability of free resources will act as a marketing funnel with low barriers to attract new customers.

Disadvantages:

• Many experts will make the mistake of billing by time rather than value. This can (and will) lead to significantly reduced income levels.
• May require hiring additional staff to assist
• Difficult to establish credibility over competing voices
• Requires delivery of significant value for free, before revenues can be generated

The Godfather

Profile:

The godfather revenue model is just what it sounds like. The godfather takes a cut out of any transaction that occurs in his territory. Typically this involves the building of a platform upon which other parties sell their products or services. Everyone wants to be a godfather, because it's great to be able to sit back and have people give you money. The main difficulty comes from the fact that one must create a two-sided marketplace (one side represents sellers and one side represents buyers) in order to achieve success. The textbook approach is to provide significant value to one side before attempting to serve the other. This may require that the company temporarily step in as either the buyer or the seller in the marketplace until the platform is able to become self-sustaining.

What is being sold:

• An environment where business can be transacted

Examples:

• Etsy - An e-commerce website that features handmade items
• eBay - An online auction

Advantages:

• It is very difficult (though not impossible) to lose market share because competitors will have to tackle the two-sided market problem in a field where a working solution already exists.
• This model requires minimal ongoing work (other than infrastructure and maintenance) to maintain.
• Minimal creativity is required for ongoing success.

Disadvantages:

• It is very difficult to solve the two-sided problem. Extensive marketing (rather than technical) expertise is typically required to attract both buyers and sellers.
• New entrants must often locate an extremely niched domain in order to avoid competition with existing players.

The Beggar

Profile:

Many technologists love to rely on the beggar model. Rather than setting a price for their products or services, they ask for donations. This model is (as a rule) a mistake and should not be selected. If firms are not interested in an upfront exchange of money, it is wise to select another model, such as the expert.

What is being sold:

• Sympathy. That's the only reason that any money will be transferred. Rational economic actors will feel minimal incentive to donate money for a product or service that is effectively free.

Examples:

• None - Beggars don't become famous.

Advantages:

• Requires minimal effort
• Won't risk upsetting anyone by requesting money
• Does not require getting over the hump of asking people for money

Disadvantages:

• This model will generate minimal income (if any).
• Donation requests look tacky and damage the owners' reputations as well as their ability to command high fees.
• Corporations (the type of customer that has the highest ability to pay) are unlikely to donate large sums of money for what is effectively a free product or service.

The Handyman

Profile:

A close relative of the beggar is the handyman. This is a slight improvement, but is still very difficult to pull off. In this model, a company creates a product and then charges for support and product changes.

What is being sold:

• Support (risk reduction) and the ability to add or enhance features

Examples:

• Red Hat - The firm develops a distribution of the Linux operating system that (minus various trademarks) is available for free. It then sells support contracts for an "official" version of the Red Hat Linux distribution.

Advantages:

• Ability to charge large sums for support contracts
• Ability to build brand recognition
• Ability to establish an expertise in a specific product that is unmatched by others

Disadvantages:

• This model requires an initial and ongoing investment of resources in the creation of the base product.
• Companies are pitted against their customers as it creates an incentive to reduce ease of use, limit out-of-the-box functionality and add functionality for exceedingly narrow use cases.
• Other firms have the opportunity to offer competing support contracts without having to subsidize the initial or ongoing costs of product development.
• Substantial opportunities exist for freeloaders to extract value without providing remuneration.
• Other groups may be incentivized to fork the base product (if open source) or to create substitutes (if closed source).
• Each change to the product will be billed to a single customer, so enhancements that have low value to an individual user but create tremendous aggregate value will not be developed.

The NSA

Profile:

Many people hate the NSA approach, but it doesn't have to be nefarious. This model involves selling information about a user or selling information that the user generates. This model will often require large numbers of users, so it tends to work best with products that are popular and grows via network effects.

What is being sold:

• Information about people or information generated by people

Examples:

• LinkedIn - Sells data about people's contact information, career history and interests.
• Duolingo - Sells translations performed by users learning a new language.

Advantages:

• Lack of monetary cost may tempt many price-conscious consumers to use the product.

Disadvantages:

• This model may require massive numbers of users and/or data.
• Many users will not willingly share data unless given a valid incentive to do so.
• Many corporations may not wish to buy data unless it is properly validated, categorized and useful.
• Many corporations may have a strong preference for purchasing solutions, rather than utilizing services that would sell their proprietary data.

The Priest

Profile:

Often confused with the hipster model, but it's even less likely to succeed. This model represents the complete absence of strategy, yet we must include it as it is so popular with startups.

Paul Graham, co-founder of Y Combinator, famously said "not to sweat the business model too much at first." Many people have taken viewpoint to its extreme, insisting that first should focus solely on the creation of a product, and assume that the revenue model will suddenly appear as manna from heaven before all resources are expended.

What is being sold:

• Nothing

Examples:

• Too numerous to mention

Advantages:

• This model requires no decision making whatsoever and allows developers to focus on the "fun" aspects of the business.

Disadvantages:

• This model will cause extreme heartburn, heartache and other problems when it inevitably fails.

Conclusion

Go forth and earn

Now that you’ve read this page, you know the main revenue models that can be used to make money online. As a quick check, can you tell me under which model I released this document? Are you sure it’s just one?

If you have questions or an idea you’d like to discuss, please feel free to contact me. I’d love to hear your thoughts on this page and to learn how you plan to utilize the information contained herein.

Shameless plug

If you’d like to learn more about establishing specific pricing, don’t forget to take a look at my book on software pricing. You could also just hire me for a consult. And if you haven’t done so already, don’t forget to sign up for my low-volume mailing list for insightful information like the type found in this book.