01. Business Model

Estimated Time

• Reading: ~13 minutes
• Video: ~63 minutes
• Activities: to be completed prior to the next week

Insights

• It is critically important for you to understand your business model early
• All great companies know how they will make money from the start
• Figuring out how much to charge may take some experimentation and negotiation

Pick a business model that aligns with your product and customers

• Selecting a business model is essentially deciding how you will make money
• You need to know how you are going to make money from the first days of starting your company
• Making money is the key to your startup surviving!
• This does not mean you need to start charging on day 1, but you do need to have an idea or plan for what your model will be
• Which business model you pick will depend on the type of product or service you're offering
• When it comes to venture scale businesses there are a few business models that scale better than others and offer great returns
• Subscriptions, both SaaS and consumer, and marketplaces are three of the major ones
• We'll dig deeper into these in the coming sections
• At a high level with a subscription model, an enterprise or consumer will pay a monthly fee to use your product
• With a marketplace, you'll take a percent of each transaction
• Ultimately it is up to you to decide how you will charge, but there are a few things to take into consideration
• Companies that sell business software should not sell it as a one-off
• It is much better to sell it as a subscription
• This way you generate recurring revenue
• You also reduce the chance of churn
• For example, with a SaaS product like Salesforce or Hubspot rather than making a one-time sale for $10k they might offer their product for $1,000 a month
• Within 1 year the customer has already spent more than the initial one-time sale and they are likely to continue paying the next year, and the next year...
• This is the power and advantage of an enterprise SaaS model
• Consumer subscription models work similarly but instead of selling into a large organization (like Salesforce or Hubspot do) they sell software to the individual consumer
• This is common today as people pay $18 a month for Netflix accounts or $10 a month for Spotify
• You need to take the time to get this right - the business model is key in setting you up for success
• Think about Uber - they are a marketplace
• You have a driver offering a service on their platform in exchange for money from a passenger
• Uber takes a percentage of that transaction and the driver gets a percentage of the transaction
• If for instance, Uber charged a monthly subscription for unlimited rides instead they'd be adding friction
• Passengers would have to decide "am I really going to use Uber 12 times this month to justify the cost of the membership?"
• Or passengers would need to sign up for a membership when really all they want to do is get in the car right now!
• It makes sense that Uber is a marketplace for these reasons
• There are multiple business models to pick from, you need to identify the one that makes the most sense for your product or service

Focus on a single business model

• A common mistake founders often make is trying to use multiple business models early on
• Founders who make this mistake are often focused on bringing in revenue in any way they can
• The hustle is great but it is probably coming at an expense
• For example, if you are selling subscriptions to some users and advertisements to others - who is your ideal customer?
• Who are you building your product for?
• Which of these should marketing spend time targeting?
• How should sales position the product?
• By having multiple business models you are essentially splitting your resources and team's capabilities in half
• And in some cases maybe even competing against yourself
• Additionally, multiple business models can lead to confusion
• Both internally and with your customers
• You have a problem if your team can't explain your business simply
• And you want your customers to quickly understand your business
• As a founder, you want to be focused on building a great product, delighting your customers, and building a team
• Knowing how you'll make money early will allow you to focus on this startup flywheel
• It is very dangerous for a startup when founders get unfocused
• Businesses with multiple streams of revenue can get clunky
• And have less chance of outlier success than focused business models from the start
• Example of single business models (at the start):
• Uber → marketplace, takes a percentage of every ride
• Calm → consumer subscription for meditation
• Slack → enterprise subscription for messaging app
• There are occasions where a marketplace may charge a fee to use the platform - but they are still focused on the marketplace as their main business model
• There is an exception - you could use two different business models to prop up your startup in the early days
• It isn't completely uncommon to use service-based revenues to build out your SaaS business
• We sometimes see this with early-stage startups, and it's a great way to get quick capital to grow your recurring revenue business
• However, make sure you differentiate "service-based" from "subscription-based" when tracking revenue and talking to investors!
• These need to be separate to better understand your own growth
• Competent investors will ask about the "quality of revenue"
• In other words, did someone pay you for a one-off service this month, or is this revenue recurring
• The quicker you move from partial service-based revenue to fully recurring revenue the better!

Why investors love SaaS

• What is SaaS?
• It's when a business charges a monthly or yearly subscription for business software
• This business model creates recurring revenue for a startup
• Investors love recurring revenue because you start every new payment cycle with nearly 100% of your revenue from the last cycle
• This allows startups to increase revenue on a recurring basis while keeping fixed costs relatively consistent
• SaaS offers the opportunity for a "bottom-up" sale cycle
• This means selling into an organization from the lower-level employees, not from the executive level
• This land and expand method is a benefit of SaaS software
• Lower payments and fewer decisions allow your product to spread through a company quicker
• Bottom-up SaaS can also have a cross-pollination effect
• Meaning, when an employee who loves your product moves to another company they often bring it with them
• We'll dig deeper into SaaS in the coming modules

Why investors love SaaS + transactions

• This model is when companies charge a SaaS fee and take a small percentage of each transaction
• This is a popular business model in Fintech - companies like Stripe, Shopify, and Plaid leverage it
• This model allows these companies to collect the recurring revenue that is so valuable and predictable
• But it also allows them to grow alongside their customers
• These companies main source of revenue is the small percentage of each transaction, but they also charge a relatively affordable SaaS fee as well
• For example, in Q2 2021 Shopify had $334M in subscription revenue and $785M in transaction-based revenue
• This is ~30/70 split between SaaS and transaction-based revenue
• Shopify's standard plan costs $79/month, and they charge 2.9% per transaction for merchants using Shopify's payments processor
• It is nice to have a base of predictable recurring revenue but the opportunity to scale revenue the more often people sell on your platform is the reason Shopify focusses on the marketplace model

Why investors love consumer subscriptions

• Consumer subscriptions are when an individual (consumer) pays a monthly or yearly fee for a product
• These models are coveted by investors but not at the same level as SaaS
• It is harder to land and expand with consumer subscriptions than enterprise SaaS
• As a founder, one important thing to note -
• You don't need everyone to pay for your product
• You just need a small subset of users who will pay for a subscription
• People are becoming more and more comfortable paying for individual subscriptions
• From a psychological standpoint people like subscriptions:
• People like feeling in control and being able to cancel whenever they want
• Even if they'll likely pay 10x-100x over time
• Even though consumer subscriptions tend to have a high churn rate compared to other models the recurring revenue still appeals to investors
• A few examples of consumer subscriptions: Spotify, Calm, Netflix, and Fitbod
• Interesting insight: Calm used to sell their app for a "one-off" price of $10 in the early days
• They actually saw a jump in downloads and paying customers when they began to charge $5/month (or $60/year)

Why investors love marketplaces

• It is very hard to stop the momentum of a marketplace once it gets going
• They are hard to get going but harder to displace once they hit scale
• Marketplaces are two-sided by nature
• The two sides traditionally consist of "buyers" and "sellers"
• As a marketplace founder, you have to identify the sellers - the supply side
• Do people need a place to sell their product or service?
• Are they willing to pay a fee to leverage your platform?
• You also need the buyers - the demand side
• Are there people who are looking to buy what the seller has to offer?
• These buyers and sellers can appear in many forms, depending on the vertical:
• Uber has drivers and riders
• Airbnb has hosts and guests
• Amazon has third-party sellers and buyers
• Marketplaces rely on the total amount of all transactions on the platform to generate revenue
• Typically called GMV (or Gross Merchandise Volume)
• Marketplace businesses take a percentage of each transaction
• The GMV in a marketplace determines the revenue that a company will make since companies typically take between 5-20% of the total transaction cost
• This differs by vertical as well:
• Uber and Airbnb refer to this metric as "Gross Bookings"
• In Q2 2021, Uber had $21.9B worth of Gross Bookings
• Revenue was $3.9B - about 18%
• In Q2 2021, Airbnb had $13.4B worth of Gross Bookings
• Revenue was $1.3B - about 10%
• Investors love that marketplaces eventually become self-sustaining once they hit scale
• Think about companies like Craigslist, Amazon, eBay, etc.
• We'll dive deeper into Marketplaces in the coming modules

Review of these four business models

• The four models: SaaS, SaaS + Transactions, Consumer Subscriptions, Marketplaces
• It is not uncommon for founders to do some blending of these models, but at the core, they have one main business model
• The thing all these business models have in common is their ability to scale
• What advantage does this provide the founder?
• Founders can keep fixed costs relatively similar while growing revenue rapidly due to simple and scalable business models
• This means they can pour the profits back into building their business
• Selling software has high margins
• Instagram sold to Facebook for $1B with only 12 employees
• Think about some of Jason's outlier successful investments and look at their business models:
• Calm (Consumer subscription)
• Uber (Marketplace)
• Superhuman (SaaS)
• Thumbtack (Marketplace)
• Grin (SaaS)
• LeadIQ (SaaS)
• Fitbod (Consumer subscription)
• Robinhood (Fintech)
• These four business models are highly successful and investors tend to love them

So, which business models do most venture capitalists stay away from?

• Businesses that are hard to scale are hard to get VCs excited about
• With the four models above you write the code once and essentially (more or less) ten users or ten thousand users could begin using it
• That is not necessarily the case with the following models

1. One example of a hard to scale business is hardware
• The famous saying "hardware is hard" exists for a reason
• Hardware has historically low margin and scales much slower than software
• Pro tip: If your hardware item has a software component, you can sell HaaS (Hardware-as-a-Service)
• This is much more appetizing to investors
• Ex: Density, Cafe X
2. Another example is Direct to Consumer (D2C) or anything CPG (Consumer Packaged Goods)
• Again there are lower margins and they scale slower than software
• For D2C to truly stand out you need at least one of these differentiators:
• Elite product and brand
• For example, Eight Sleep, Warby Parker, Dollar Shave Club
• Elite acquisition strategy
3. Advertising based business model
• This is when you are making money through ads on your platform
• Think, for example, Google, Facebook, Amazon, Yelp, Twitter, Snapchat...
• The downside is that this business model only works if you hit massive scale
• This is why investors are typically skeptical - it is really hard to hit massive scale
• Often the product is available for free and paid for by these ads
• Another hesitation with advertising-based business models
• Company budgets are dependent on the economy
• Advertisers ad budgets are usually the first to get cut if there is a downturn
4. Service-based
• A service-based business is not venture scale

• Remember back to our venture scale vs lifestyle business module
• Having a lifestyle business is far from a negative term
• However, just know that it is harder to get venture backing when you go this route
• Typically the business models mentioned in this section are not "venture scale" businesses
• Meaning they probably won't get to $100 million in revenue in under 10 years
• Although, it is not impossible
• Jason has invested in companies that most venture capitalists stay away from, but they are far and few between compared to SaaS, Marketplaces, Consumer Subscription, and Fintech

When to pick a business model?

• Most great companies know how they will make money from the start
• Even if you don't turn on revenue from the very beginning it is important to know how you will make money
• Often, if your idea for your startup is really clear it becomes obvious what the business model should be
• For example, Netflix wants you to consume more content on their application
• If they charged you a transaction fee for each movie or episode you watched you'd think twice about your next binge session
• Instead, they charge you a flat, predictable fee each month and encourage you to watch as much content as you can
• If you can't decide on a business model, or have multiple business models it might be an indication that you haven't clearly defined the problem you are solving

How much should you charge?

• Deciding on a price is a key piece of your business model
• Talk to your users about how much they would be willing to pay for a solution to their problem, even before you are building

Most startups postpone pricing decisions until after the product is developed. They HOPE they can make money rather than know they will at the outset. In this Lesson of Greatness, pricing guru Madhavan Ramanujam shows us that without a price, you literally don't have a product. Therefore, we should follow some of the best practices aligned with having the willingness to pay discussion early and in the most effective ways.

• The summary above is from a ten minute podcast summary, Lessons of Greatness: Price Before You Build that highlights even more great points on how to think about pricing
• You can find the full episode here
• If you charge too little you run the risk of consumers thinking your product is not good enough to buy or isn't far along enough for their needs
• Also if you charge too little you are leaving money on the table and run the risk of not being able to cover expenses
• If you can't cover expenses long term then your business can't be successful
• On the other hand, if you charge too much you run the risk of people not giving it a shot
• Offering a free trial is one way to allow customers the opportunity to use your product for a set period of time before paying
• Jason had a great conversation with Sourcegraph's CEO Quinn Slack on E1285 of This Week in Startups [this segment specifically is worth a listen]
• Understand the return on investment (ROI) that you offer the individual or organization and spell it out for them
• For an enterprise SaaS app, being able to have data that backs up saying something like "On average we save developers 20 hours a month. That means for a developer making $125,000 a year we are saving $1200 per developer per month. If you have just 4 of your developers leverage our tool it'll already pay for the $40k a month we charge."
• It may take some experimentation at the start to find your sweet spot on pricing, but over time pricing should be increasing
• Consumers expect to pay a little more for the product a year from now, especially if they are receiving a lot of value
• You can always offer discounts or grandfather in users if necessary
• One good test, as you get to know your customers - ask yourself: "If we doubled the price would any of our customers leave the product?"
• If you can clearly say "no" then why wouldn't you?
• Even if 20% would leave, but the remaining 80% are paying 3x, 5x, or 10x more from a revenue perspective you're in a great spot
• Really what you want is pricing that is fair and your customer doesn't have to think about it
• Consider offering a discount on annual subscriptions over a monthly one
• You've seen this before with consumer subscriptions:
• You can pay $10 a month
• Or pay $99 for the year [save $21 instantly]
• Or pay for the year and get two months free!
• There are several advantages to this
• You lock in your customer for a year and limit monthly churn
• You have guaranteed time to study the customer's usage and build a relationship with them
• The customer doesn't have to justify paying for your product each month
• There are similar ways to do this with Enterprise SaaS
• You can offer to lock in for multiple years at a discounted price
• Add additional services for the first few months
• You want to find ways to make it a no brainer that the customer should pay for your product
• It is important to have an idea of where your pricing stands relative to your competition but it isn't something to chase
• It is more important to know who your ideal customer is and delight them than worry about your competition
• Granted if you cost 20x more than your direct competition customers will want to know why they should pay that premium price
• It is valuable to know your metrics
• It is also important to know - at what number of customers and at what price can you be profitable at your current burn rate?
• Set monthly, weekly, and daily goals for acquiring customers to know if you are on track
• For example, based on our burn we need 1,000 customers at $20 a month in the next 12 months
• So we need ~85 new customers a month
• Which is ~20 customers a week
• So 4 new customers a day
• Additionally, once you have customers - how engaged are they with your product?
• Engaged customers who are finding value rarely churn because of price
• This is especially true at the enterprise SaaS level
• If a customer is not engaged perhaps they are not your ideal customer
• At LAUNCH Scale, Jason had a round table conversation with investors Ben Ling, Clara Brenner, and Jeff Clavier on several topics around revenue and revenue models
• Below is that Q&A session where you can hear their different perspectives on early revenue, multiple revenue models, and revenue quality

• 45:47 How important are price and valuation in decision making?
• 49:10 Importance of early revenue and strong board governance
• 52:28 How many of their biggest hits had multiple revenue models?
• 58:00 What is "venture-scale" in terms of growth rate?
• 1:02:40 How to train new associates to understand the importance of revenue quality?

Additional Resources

• David Sacks: Legendary Startup Product Expert Interview
• Summary
• How To Price Your Early Stage Startup Product
• Startup Pricing 101
• What is a business model and how to choose the best one for your venture

Activity

• Note: we will spend several weeks with this, Business Model, section. There are activities suggested for each week, but this pace is simply a suggestion.

Week 3

• How will you make money?
• What will you charge?

• What percent of transaction fees are common for my marketplace?
• Do Enterprise SaaS companies in my vertical typically offer tiered pricing?
• What does the average free trial consist of with other consumer subscriptions?

Week 4

• Who is the buyer and decision-maker?
• Are they also the user of the product?

Week 5