Exploring the Tech Startup Space
Chapter 3
A startup business model is a particular startup’s strategy for generating revenue and profiting from business operations. (Translation: it’s how a business makes money).
Startup business models fall into many of the same categories as traditional business models, but may conduct business through technology, rather than at a physical location. For example, Amazon.com offers the same marketplace model as a traditional department store, but they sell their goods online, rather than at a physical store.
Many startups don’t know how they’re going to monetize their products when they first start out, and spend a portion of their initial development searching for the right business model and pricing strategy.
While every venture firm segments startups differently, here are a few overarching categories that startup business models can fall into:
The term “marketplace” comes from the days when all shopping was conducted at a physical location. Think: shoppers at a bazaar haggling with vendors over the price of groceries, household items, jewelry, etc..
Now, a marketplace refers to a physical or online place where transactions between a buyer and seller occur.
Definition: A marketplace model is a platform that facilitates transactions between buyers and sellers. Typically, the marketplace derives revenue from a marketplace rake – by collecting a percentage of transacted revenue on the marketplace.
Some marketplaces will charge a fixed transaction fee, rather than, or in addition to, marketplace rake – for example, $2 for every purchase made on their platform.
Market: B2C (e.g. Uber, Amazon); B2B (e.g. EquipmentShare)
EXAMPLE
Uber collects both marketplace rake and fixed transaction fees on uberX rides in L.A.:
**Uber Keeps:** $1.65 rider fee/passenger **(fixed transaction fee)** + 20% of fare **(marketplace rake)**
**Driver Takes Home:** 80% of total fare, minus $1.65 rider fee/passenger
Understanding Marketplace Unit Economics
While consumer internet business models, such as social media platforms, largely equate popularity with success, marketplace startups focus on their ability to generate a profit. This hinges on unit economics – the amount of money exchanged during each transaction.
Profitability is centered around the concept that “it takes money to make money.”
Every business has to foot the bill for operational costs: keeping the lights on, paying their employees, and putting some money towards marketing/advertising in order to attract customers.
If a startup is unit economic profitable, their total margin on every transaction is greater than their cost to make the sale. (In English: if a company is unit economic profitable, it is breaking even or generating a profit on every sale).
If Numbers Are More Your Thing...
Key Metrics to Pay Attention to when Evaluating Marketplace Startups:
Total sales dollar value for merchandise sold or services provided within a given time frame.
Ask: How much does an average customer pay per ride?
Commission the marketplace charges as a percentage of sale price.
Ask: How much is Uber's take per ride?
Net Revenue = Rake * GMV
Ask: What is Uber’s average take per ride, minus the driver’s average take ride?
The total cost spent on acquiring more customers (through ads, marketing, or other means) within a given period of time, divided by the number of customers acquired during the same period.
Ask: How much money does Uber spend on marketing, advertising, and promotions to acquire a new user? What about the cost to hire and onboard a new driver?
Prediction of the total profit a marketplace stands to make throughout its entire future relationship with a given customer.
Ask:
Lifetime Value of Customer: What is the value of all the money a typical rider spend while an Uber customer?
Lifetime Value of Driver: What is the value of all of the rides a typical Uber driver gives while working for Uber?
Definition: SaaS companies develop software, which they license or sell to customers. SaaS startups monetize in various ways.
Some companies charge a one-time fee for lifetime access to their product, called a perpetual license sale. Companies that use this model often continue to monetize by charging additional fees for software upgrades.
However, most SaaS companies have transitioned to a subscription-based model, wherein users pay a monthly or annual fee for access to their software, and receive free automatic updates.
Sometimes, SaaS companies will charge additional fees for custom features or dedicated support. For example, a company may request a private training session to teach its employees how to use a recently purchased product, or may require a custom feature so that a standard product can meet their team’s needs.
Some SaaS companies employ a freemium model to jumpstart user growth, wherein entry level plans with a limited feature set are free, and more robust plans, with additional features, are paid.
Many startups pair their freemium model with a free trial (usually 30 days), to let new users demo the full feature set, and then choose whether to pay for it or lose access to the software.
Market: B2B (e.g. Salesforce), B2C (e.g. Adobe Creative Suite)
EXAMPLE
Perpetual Licensing Fee:
Until 2013, Adobe Creative Suite charged a perpetual licensing fee to purchase its popular design software programs, including Photoshop, Illustrator, and InDesign. The full set of Creative Suite products cost a hefty $2,500. Upgrades, like new features and bug fixes, cost extra.
**Subscription-based:**
Now, users pay $50 per month for the full suite of Adobe products, called Adobe Creative Cloud (ACC). Users have access to free online tutorials and continuous software updates that make the programs run faster and give them access to new features. To jumpstart customer acquisition, ACC offers a one-month free trial to new users.
ACC is both a B2B and a B2C product; Adobe offers discounted business pricing for companies that purchase licenses for multiple employees, and individual licenses for personal use designing documents, editing photos, etc.
Key Metrics to Pay Attention to when Evaluating SaaS Companies:
Amount of revenue collected each month, given a subscription-based model.
Ask: How much did all your Adobe Creative Cloud users pay in monthly subscriptions in the last month?
Amount of predictable revenue a startup is expected to collect within a given year, based on subscriptions, and factoring in expected growth and churn rate.
Ask: How much do you expect all of Adobe Creative Cloud users to pay in annual subscriptions this year?
Increase of a company’s sales when compared to a previous performance (usually measured year-over-year or quarterly).
Ask: How much more money have you made this year, as compared to previous years?
Total revenue (rake x GMV), minus expenses.
Ask: How much money did you make this year, minus the cost of expenses (rent, labor, advertising, etc.)?
The number of people that become paying customers after performing a certain action, like completing a free trial, signing up for a freemium product, visiting the company website, etc..
Ask: What is the percentage of ACC free users that sign up for a paid subscription?
The percentage of customers who stop using/paying for a given service during a set interval of time. Churn rate can also be calculated based on revenue.
Ask: What percentage of customers stop using/paying for Adobe Creative Cloud each year?
Prediction of the total profit a company stands to make throughout its entire future relationship with a given customer, taking into account future revenue and churn.
Ask: How much does each ACC user spend the entire time that they’re subscribed to your product?
The total cost spent on acquiring more customers (marketing) within a given period of time, divided by the number of customers acquired during the same period.
Ask: How much money do you spend on marketing, advertising, and promotions in order to acquire a new customer?
Definition: Hardware startups design, manufacture, and sell physical technological products. Customers pay a fee to purchase the product itself and any associated software or services that rely upon the hardware.
Hardware companies can continue to monetize by releasing upgraded models with an expanded group of features or additional improvements, enticing owners of an existing product to buy the newer version.
In addition, many hardware companies will release a range of products that fit different use-cases, to encourage customers to purchase multiple items.
Market: B2B & B2C (Apple, Microsoft)
EXAMPLE
Apple is a B2B and B2C company. They sell physical devices (Macs, iPhones, iPads, Apple Watches, etc.) to businesses for employee use, and to consumers for personal use.
Apple couples revenue made from selling physical hardware products with revenue from its two online marketplaces, the App Store (where users can buy apps/software to access on Apple devices) and the iTunes Store (where users can purchase media like movies and music to consume on Apple devices).
Apple CEO, Tim Cook, hosts biannual product releases events, where he debuts new hardware products to the tech community. These events often generate much fanfare for new iPhone models, most recently culminating in thousands of people camping outside Apple stores to be the first to own an iPhone 7.
Few iPhone owners go more than three years without upgrading to a newer iPhone, and few Mac owners go more than 5 years without purchasing a new laptop.
Key Metrics to Pay Attention to when Evaluating Hardware Startups:
Income made from the sale of goods to customers over a specific period of time.
Ask: How much collective revenue does Apple make within a given month? How much within a given year?
Total revenue (rake * GMV), minus cost of goods sold (including operational costs).
Ask: What is the difference between all revenue earned, and all operational costs within a year? (Operational costs: the amount it costs Apple to operate for a full year, including cost of all brick-and-mortar locations, research and development, manufacturing, shipping, etc.)
The cash available for a business's daily operations, including manufacturing new products (current assets, minus liabilities).
Ask: How much working capital does Apple have leftover when total operating expenses are subtracted from Apple's total liquid assets (revenue, plus any other cash on hand, including venture funding)?
How frequently individuals purchase an upgraded product or replacement for a product they already own.
Ask: How frequently do customers purchase a new iPhone/iPad/Mac to replace the one they already own?
Definition: Consumer internet companies typically provide an online web and or mobile service to individuals for personal use.
In other words, they create platforms/services that are so much fun to use, their users want to share them with their friends.
Many extremely successful consumer web or mobile companies started out without initially monetizing their services (think: all your favorite social media sites), but have since found a way to generate enormous revenues.
Revenue generating consumer internet startups have a monetization strategy in place, while pre-revenue consumer internet startups have not yet settled on a way to make money.
Often, pre-revenue startups intend to first grow a base of highly engaged users, and monetize their product later on.
Market: B2C
EXAMPLE
Non-revenue: WhatsApp
In 2014, a regulatory filing classified WhatsApp as a “profoundly unprofitable” product. However, this didn’t stop Facebook from acquiring the popular messaging service for [$21.8 billion](http://dealbook.nytimes.com/2014/10/28/facebooks-21-8-billion-acquisition-lost-138-million-last-year/?_r=0).
Despite WhatsApp’s extremely minimal revenue generation, Facebook saw value in swiftly accumulating 450 active users in one fell swoop. Since the acquisition, WhatsApp has continued growing its user-base, and now caters to over [1 billion monthly users](https://www.statista.com/statistics/260819/number-of-monthly-active-whatsapp-users/), though it remains unprofitable.
Key Metrics to Pay Attention to when Evaluating Pre-Revenue Consumer Internet Startups:
How many people frequently engage with a product/service over a given time period.
Ask: How many users send messages on WhatsApp each month?
The number of customers that remain engaged with a product/service over a period of time.
Ask: Of all the people that signup for WhatsApp within a given year, how many of them go on to continue using the app monthly?
How frequently a user engages with a product, on average, over a specific period of time, and the amount of time a user spends engaged with a product across a single session.
Ask: How many messages does each user send on WhatsApp per day? Per week?
How much time does a given user spend engaged with WhatsApp per day? Per week?
EXAMPLE
Revenue: Snap Inc.
In late 2012, Snapchat (now Snap Inc.) founder, Evan Spiegel, got to meet his role model, Mark Zuckerberg, for the first time. Unfortunately, the meeting was [less than amicable](http://www.forbes.com/sites/jjcolao/2014/01/06/the-inside-story-of-snapchat-the-worlds-hottest-app-or-a-3-billion-disappearing-act/#3f63bb3855ec).
Zuck sat down with Spiegel and co-founder, Bobby Murphy, and explained Facebook’s newest product: Poke, a mobile app for sharing photos that automatically disappear a few seconds after they’re viewed.
According to Spiegel, the meeting essentially amounted to “We will crush you.”
Lucky for Snapchat, Poke ultimately flopped, and drove more Snapchat sign-ups in the process. Zuck soon returned to Spiegel and Murphy, hat-in-hand, and singing a different tune: $3 billion for all Snapchat’s business.
For a company not yet generating any revenue and lacking a clear path to profitability, the offer seemed to good to be true. So investors were shocked when Snapchat turned down the deal, and wondered whether the company would fizzle out without any cash flow.
Over time, Spiegel proved that his instincts were right. The Snapchat valuation skyrocketed from $3 billion in 2012, to to over [$15 billion](https://www.crunchbase.com/funding-round/d3b59185afa9236677c700a019023ce2) in March, 2015. By Fall 2015, Snapchat generated its first [$3 million](https://www.inc.com/aj-agrawal/how-snapchat-can-become-profitable-through-advertising.html) in revenue by running 8 ads in 6 weeks’ time.
Since that first $3 million, Snapchat has launched dozens of ads, including sponsored filters (users can demo sunglasses and other products), changed its name, and launched its first hardware product: Spectacles – wonky shades that double as a camera and integrate with Snapchat – retailing at $130 a pop.
All in all, the newly christened Snap Inc. stands to generate millions in revenue in 2016, alone.
Key Metrics to Pay Attention to when Evaluating Revenue Generating Consumer Internet Startups:
How many people frequently engage with a product/service over a given time period.
Ask: How many users send/view Snapchats weekly? Monthly?
The number of customers that remain engaged with a product/service over a period of time.
Ask: What percentage of users continue viewing/sending Snapchats after signing up?
How frequently a user engages with your product, on average, over a specific period of time, and the amount of time a user spends engaged with your product across a single session.
Ask: How many Snapchats does a given user send/receive per day? Per week? Per month?
How much time does a given user spend engaged with Snapchat per day/week/month?
The increase of a company's sales when compared to previous performance (usually measured year-over-year, or quarter-over-quarter.)
Ask: What is the difference between Snapchat's total revenue in 2015 and the total revenue in 2016?
The amount of money each user spends on your product/service over a specific period of time.
Ask: How much money does each company spend on advertising on Snapchat each month?
Definition: eCommerce businesses sell goods online and charge a markup on products sold.
As of 2015, only 8.1% of all retail commerce occurs online – the rest happens in person, at brick-and-mortar stores.
eCommerce adds a layer of convenience to the shopping experience – customers can browse, compare prices, and make purchases without leaving their homes.
Tech eCommerce companies distinguish themselves from traditional eCommerce companies (think: Overstock.com; Nastygal.com) through the use of technology to establish a competitive advantage.
Often, tech eCommerce companies will utilize consumer data to produce products that are more in line with their customers’ needs, or will develop a tech-based solution to improve distribution.
eCommerce subscription boxes are also rising in popularity – customers pay a monthly fee to receive a curated surprise shipment of anything from the latest clothing styles (Le Tote), to dog treats and accessories (Bark Box).
Market: B2C (Le Tote); B2B & B2C (Amazon.com)
EXAMPLE
Memebox, the popular Korean cosmetic startup, originally launched as another beauty subscription box company.
But when subscription beauty boxes began to lose traction, Memebox repositioned itself to remain competitive within the beauty industry. Memebox distinguishes itself from non-tech competitors like Sephora through its use of data.
Memebox collects [“tens of millions of data points about what customers want”](http://fortune.com/2016/08/10/memebox-korean-beauty-products/) based on sales and feedback, and uses this data to decide which third-party products to stock, and to develop their own in-house brands to cater to current trends.
In addition, Memebox adheres to a six month product development cycle to ensure that they remain on-trend, as opposed to typical beauty companies that can take as long as 18 months to develop and release a new product.
The combination of these strategies has helped Memebox avoid product flops and create very successful in-house product lines. For example, one in-house brand, Pony Effect sold 20,000 units within the first 5 minutes it launched on the Memebox site.
Memebox continues to sell themed subscription boxes, though these only account for 1-2% of revenue. They have also opened brick-and-mortar locations in Korea which has been tremendously successful – generating around $1,100 in sales per square foot.
Key Metrics to Pay Attention to when Evaluating eCommerce Startups:
The number of people that visit a company website/app within a given period of time.
Ask: How many people visit Memebox.com or use the Memebox app within a given day/week/month/year?
The number of people who become paying customers after visiting an eCommerce site or app.
Ask: What percentage of the people who visit Memebox.com or use the Memebox app within a given day/week/month/year make a purchase?
The amount of money that each customer spends, on average, on a single order.
Ask: How much is the average Memebox order?
The percentage of customers that make multiple purchases from an eCommerce site.
Ask: How many customers return to Memebox.com or use the Memebox app to make a second purchase after placing an initial order?
The prediction of the total gross margin the eCommerce site stands to make throughout its entire future relationship with a single average customer.
Ask: How much does an average customer spend throughout their entire time as a Memebox customer?
The total cost spent on acquiring more customers (through ads, marketing, or other means) within a given period of time, divided by the number of customers acquired during the same period.
Ask: How much does Memebox spend to acquire a paying customer, including marketing costs?
Many API startups employ a usage-based business model; customers pay based on how much/how often they use the software.
Your phone company likely also bills you according to a usage-based model (unless you have unlimited data). At the beginning of the month, you are allotted a certain amount of data; if you exceed this amount, your service provider will likely charge you an additional fee based on how much data you’ve used.
Market: B2B & B2C (Amazon Web Services)
EXAMPLE
If you’ve ever entered your credit card information online to make a payment, chances are, you’ve interacted with Stripe, a payment processing API startup.
Stripe’s API allows businesses to seamlessly and securely process payments on their websites and mobile apps. All customers have to do is enter their credit card information.
This ease, simplicity, and the ubiquitous need for Stripe’s software has skyrocketed the company to a [$9 billion valuation](http://fortune.com/2016/11/25/payments-stripe-valuation/), making it one of the 5 most valuable startups in the world.
Stripe monetizes by charging small vendors based on usage – 2.9% + 30 cents per transaction using their software. They also offer a suite of enterprise features, like discounting capabilities and dedicated support, to B2B companies that use Stripe on a wider scale.
**Key Metrics to Pay Attention to when Evaluating Usage-Based Startups:**The number of customers using a startup's service within a specific period of time.
Ask: How many active users process payments using Stripe per year?
The amount of measured usage each average customer accrues within a specific period of time.
Ask: How many transactions does the average customer process using Stripe per month? Per year?
A startup's strategy for charging customers for their product/services.
Ask: How much does Stripe charge customers for each payment processed?
Total revenue, minus the cost to the startup company to make the sale.
Ask: What is the difference between Stripe's net revenue, and the emound they need to pay to process that revenue (cost of goods sold)?