The Trap of the Bad Revenue Model

It always puzzled me why services like Evite and Hotmail that were once considered groundbreaking more or less stopped releasing new features.  You can probably think of your own examples.  I believe the most important reason is the lack of a strong revenue model.  These companies start off with venture capital funding and offer a free service to reach critical mass.  They eventually plan to generate revenue from advertising or similar sources, but overall the revenue per user ends up being quite low.  Once they get past the venture capital stage, they often can’t afford to spend a lot on further product development and be profitable at the same time.  So they get stuck in a bad equilibrium where they can’t afford to build features that could pull in higher revenue and end up trying to optimize a mediocre business at the margins.  These companies are also tempted to start sacrificing the user experience in order to eke out more revenue.  Sites that bug you with pop-ups, excessive ad content, or other annoying tactics are basically admitting that they can’t afford to offer a good experience because the revenue per user is infinitesimal.  They’re perpetually scrambling for pennies.

That low-revenue scenario seems to have been the fate of most social networks except for Facebook, which luckily cracked the piggy bank of social gaming (not to mention raising an enormous amount of money).  Bebo is a great example.  They are apparently profitable for the moment, but AOL is getting ready to shut the site down (or sell it) because they can’t afford to build out the more robust product necessary to compete.  MySpace may yet end up in the same boat.

A lot of online content destinations are in similar situations.  If your business model consists of riffing off of news broken by old media sources, generating a thin advertising revenue stream, and making a profit by keeping costs extremely low, you end up being a break-even business and not having the resources to build the company into something more meaningful.  This is a fundamentally weak strategic position to be in because there’s little or no unique content at the heart of it.

Finally, I would also lump Digg into that category.  Digg is a good example of how companies with a weak revenue model end up cutting corners on user experience.  The Diggbar enabled them to grow traffic and revenue numbers, but they had to damage the user experience to do it.  I’m curious to see whether they can get out of that cycle now that Kevin Rose is back in charge and the bar is being done away with.

Good old-fashioned price segmentation

So how do you avoid falling into this trap?  It’s basically a customer and price segmentation problem.  You have to find the power users, the ones who need more features than average and are willing to pay for those features.  Finding those customers, building the right feature set for them, and doing it all before you’ve trained them to expect it for free are all a bit challenging, of course.  The popular term for it these days is freemium.

LinkedIn did it by offering monthly subscriptions to recruiters and others who needed to make lots of contacts without relying on slow and iffy introductions.  Apparently, less than one quarter of LinkedIn’s revenue now comes from advertising.

Google did it with Gmail and Google Apps.  I find this example particularly interesting.  Yahoo and Hotmail tried to upsell premium individual users to premium subscriptions for more storage, but that strategy never worked very well.  Google correctly realized that the power users who would pay for additional functionality were companies, not individuals.  Google Apps is now the email system of choice for many small companies, and the product is also making inroads into universities and larger companies.

Other freemium examples that have recently gotten attention include Flickr, Skype, and Evernote.  They have all done a good job of building scale and encouraging trial with a free version and then converting users with the greatest requirements and greatest willingness to pay to a premium paid version.

I also like what GigaOm, the technology blog, is trying to do by offering paid research reports on top of its basic news coverage.

What they should have done

So let’s second-guess the strategies of other online companies and think about how they might have improved the revenue model.

Evite – They should have created a premium version for corporate events or those that required more attractive or customized invitations.  Fund-raisers, weddings, and networking events are all potential segments that they didn’t manage to capitalize on.  Eventbrite is one company that seems to be doing this well.

MySpace – Attractive customers to go after would have been either music buyers or musicians themselves.  They could have been a great lead generation partner for a music vendor like Amazon looking to better compete with iTunes.  I can also think of a lot of premium marketing features they could have offered to musicians and labels looking to better promote themselves.  Of course, now social gaming is an even more obvious option, and perhaps that revenue source will still keep the site afloat.  At this point, however, they seem to have been lapped by Facebook in terms of both functionality and user engagement.  They’re on the wrong end of the network effect now.

Offline revenue challenges

The same dynamic occurs in a lot of other industries, especially in ones where the economics are driven by capacity utilization and low marginal costs.  Brutal price competition, among other reasons, has made it difficult for any airline to truly offer a differentiated experience.  Since marginal costs per seat are basically zero, the incentive for airlines to compete based on price is often overwhelming.  The resulting poor margins prevent investing in any unique competencies to create differentiation.  However, airlines are making some progress in breaking out “premium” services like checked bags and priority lines and charging for them.  Of course, it’s harder to do so after you’ve already established customer expectations that those things are free, and the airlines are definitely experiencing some backlash for trying to squeeze more money out of unhappy travelers.

Of course, much of the character of these industries is also determined by customer behavior.  We’re almost all price shoppers when it comes to air tickets, so maybe we shouldn’t be quite so surprised that we get what we pay for – a cheap ticket, not a great experience, and getting nickel and dimed where the airlines can get away with it.

The strategy implication

Every company should work on the price segmentation strategy will be from day one.  The specific segment or features might not be clear initially, but you should at least have a set of hypotheses to test.

Offline, companies should get better at emulating the thinking behind the freemium model and charging more for premium version or additional services.  Avoid loading up your core offering with tons of premium services and then being forced to sell it at a low margin once price-based competitors enter.

What are your war stories about developing a strong revenue model?

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  • LeveragePoint

    RT @brekiri: Why do a lot of online companies seem to stop innovating? It's the trap of the bad revenue model:

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