How to Find a Business Model for Your Startup

A useful classification of online startups is to put them in two groups: Scale-First and Monetize-First. The first type is all about getting as big as possible, as fast as possible and then figuring out how to make money from the market. This Scale-First approach requires an often significant amount of capital to fund until either monetization or acquisition occurs. The other is about producing income as fast as possible and then using that cash flow to grow larger. This Monetize-First approach tends to be slower but comes with far less risk.

In his post Are you a Seesmic or Balsamiq Entrepreneur, blogger Jeremy Chone gives a good roundup of the pros and cons of both these approaches, using two well known startups as examples of each. Of course a brilliant example of the Scale-First approach is Google, who for a long time had a big question mark hanging over them regarding their business model. If you flip back to December 2000, you’ll find BusinessWeek published an article that literally had the words “But how will Google ever make money?”

Personally I fall most definitely in the Monetize-First camp. I like a business to be self-sustaining as soon as possible, and that means you need to have a clear plan from the out-set about how to actually make money. In startup literature this is called a business model and this post is all about finding one!

There’s More Than One Way to Skin a Cat

Most ideas have multiple ways you can monetize them. These are not however, created equal. To give an offline example, let’s say you wanted to open a cake shop. Now the obvious way to make money is to sell cakes, and arguably that’s the best business model for a cake shop. But that doesn’t mean that’s the only business model. You could for example decide to give free cake samples and then sell recipes. Or you might do cake baking demonstrations in the shop and operate some sort of ticket based show. Or you might sell advertising space on the windows of the cake shop.

I don’t know much about cake shops, but I would guess that the only really viable plan out of all those is the plain-jane business of baking and selling cakes. In fact, the idea of selling advertising space on the cake shop windows sounds laughable, that is until you realise that there are many, many online startups attempting pretty much this same idea. Is it any wonder that they run into problems?

The Problems with, and Lure of Advertising

Anyone who has ever put up Google Adsense knows that it is as easy to do as it is hard. That is to say that anyone can get Adsense code up in minutes, but it can be extremely difficult to make decent revenue out of it. It is possible, and certainly there are lots of “Make Thousands with Adsense” guys out there, but I know of many more failures than I know of successes.

At Envato we have some fairly large traffic and content sites but even with huge numbers we’ve only had limited success in getting ad revenue flowing. Using Adsense on Feeds for example nets us only a few hundred dollars a month, despite having a combined RSS count of well over 100,000.

Selling banner advertising has been somewhat more successful for us, but not as much as you’d think for an outfit with some 20 million pageviews a month. Perhaps we’re going about it all wrong, perhaps the ad industry has fallen off a cliff lately, or perhaps it’s just not that easy to make money selling advertising. Either way my cautionary tale on advertising is more to make other entrepreneurs think twice about making ad-money their planned business model.

While advertising is certainly a viable business model and there are some very large companies doing well with it, I don’t believe that advertising is the easy success formula that it sometimes is made out to be. Certainly I don’t think it should not be the first port of call for a budding startup.

Where is the Value Being Generated?

So let’s say you have some startup idea. Maybe an idea for a neat web app, or a plan for some amazing blog network, or perhaps it’s a kickass web service that isn’t currently available. How do you figure out how to make money?

Every business model can be boiled down to selling something to someone. Whether it’s selling advertising to people who want to market to your audience, selling a product, selling a subscription to a service, selling a third party product in an affiliate deal, or selling your whole startup to another company.

And the fundamentally unchangeable characteristic of selling is that you can only sell something of value.

If you don’t have anything of value, then you don’t have anything to sell. If you don’t have a big or useful audience, you don’t have anything to offer an advertiser. If your web app sucks then there’s no value in it for customers. If your service has major flaws then people won’t want to buy it. So then the question you should be asking yourself is:

Where is the Value Being Generated?

Wherever the value is in your startup, that’s where you can make money. Sometimes it isn’t even in your core product, but rather in the audience it attracts. If that’s the case then you sell advertising. So for Google, the value in their search service is partly for the users searching, but even more so in the fact that at any given moment they have access to millions of different audience subgroups that they can sell advertising for in an ever-changing market.

Sometimes the value is being generated not for your main user group, but in a smaller subgroup. On Envato’s Tuts+ tutorial sites we have a huge body of free-tutorial consuming readers, but there is a smaller subgroup of people who get so much value out of the tutorials they want to pay to get even more tutorials. So we have applied a freemium model to the sites and it’s worked out very successfully.

Every startup is different and that’s why there is never an easy one-size-fits-all solution to choosing a business model. In our cake shop example the real value is in the cakes themselves. Other things like people in the shop, recipes for the cakes and the cake making process have value too, but on a far smaller scale. So the logical thing to do is find a way to charge for the cakes.

Increasing Value Increases Either Sales or Price

Once you see that finding a business model is all about finding the value in your startup proposition you will naturally see that the more value you can add, the more you will sell OR the more you can charge OR even both!

For example for a web service operating on a freemium model you might see that the real value of your service is to the people who are willing to pay the subscription. Therefore adding value by making the web app better somehow, means that (a) they’ll be happier, (b) you can lure more of this type of customer and (c) you may even be able to justify an even higher subscription rate.

An Even Easier Method: Follow the Money

In some ways this is all common sense, but in others figuring out all this “value” stuff can seem a bit hard. But never fear for there is an even simpler way to figure out a business model. I call it Follow the Money!

You see there is one thing you can universally depend on. If you can figure out a way to help other people make money, you will always be able to charge them for it. This make sense because the net result is positive for your customers. They pay you, but they make more money themselves, which presumably covers whatever your service or product costs and then some.

Examples of what I’m talking about are services and products that save people money or time, that help them do more with what they have or that get them access to new ways of making money.

At Envato we operate a set of digital goods marketplaces where people can sell their creations, things like blog themes, graphics, music loops and so on. Because we help them make money in a way they may previously have not been able to, they are willing to give up a significant percentage of the revenue they make. At 37Signals, products like Basecamp and Highrise make small businesses more efficient, effectively meaning they can make more money, so naturally they are happy to pay for the service.

Follow the money in your startup plan and chances are you’ll find creating a business model is relatively straightforward. Not all startups are in areas relating to money, but if you are, or if you can find a business application to your startup, or if you’re making the choice between serving regular consumers or business customers, then this is a really important thing to keep in mind.

Experimenting and Iterating

Creating a profitable business is not easy, and thank goodness it’s not – because otherwise everyone would do it! However it is doable. And remember there is room and time to experiment and adapt. You may have to try a few different ways to make money before you hit on the one that works.

A while back I was reading about a neat service you may have used called YouSendIt which lets people send large files over email. The CTO and co-founder Ranjith Kumaran wrote up an article about how they got the freemium business model working for them and while it had some fascinating insights on that particular business model, what I was struck by was that this wasn’t their initial plan! Rather it was something they had adapted into, found suited them and then run with.

Remember that iteration is a powerful way to build a business and the iterative process can be applied to almost every aspect of startup life, including selecting and optimizing a business model!