Most people never think of technology from an economic point of view. Instead, we focus our efforts thinking about the nuts and bolts of the technology. Tim Chou, a current lecturer at Stanford University, spent his career focusing on Enterprise Technology. He believes that it is important to know a variety of business models to better understand how we can sell to customers. In a talk given at Alchemist, he outlined seven important models of how software companies drive revenue, and offered further insights into the sales process.
Model One: The most typical, yet still extremely effective model: license the software to the user and then charge for support and maintenance. Tim gives the example of Oracle, which previously was a $15 billion corporation with $12 billion coming from support and maintenance.
Model Two: Make your software open source, but monetize the support and maintenance. Tim emphasizes that Red Hat is the only real example of success for this model.
Model Three: Outsource. “I’ll take over your mess and I’ll do it for less.” He explains that the amount of money to manage software is 4x the price so in most cases 75%-100% of the budget is fully allocated for the next year. Therefore, by outsourcing, you reduce the cost structure to purely human labor in China, India, Eastern Europe, etc. However, Tim goes on to outline two major flaws with this model. One, you are unable to maintain a low cost of labor for outsourced labor as workers will eventually want wages that match the workers in Silicon Valley. Two, the primary reason of system failure is human error.
Model Four: Tim explains, “The customer pays for the software and maintenance, while I’ll manage security, performance, etc. for a set price per user per year.” In this case specialization is key. If you can standardize the hardware and software then you can replace human labor with machine labor, crushing cost structures and increasing reliability.
Model Five: You alter the payment terms of Model Four. This can mean paying monthly or by other terms.
Model Six: Every business application company since 1999 has delivered in this model. It involves removing the at-home and at-customer aspect of the model, in order to standardize and reduce cost structures even more. In justification, Tim explains that while operating in model four or five, cost structures can be taken down to about $50 to $70 a user. On the other hand, students of model six can get down to $5 per user.
Model Seven: In reality, Facebook, Amazon, and Twitter are all software companies. What’s different is the way they charge for their service, whether it is ad-based models or embedding it in the transaction. An example is buying a book on Amazon, which is essentially paying for the software. In order to justify that there is an extra step in standardization, Tim argues that Google would otherwise charge around 70 cents per user per year in order to break even for searches. He explains all of their software is extremely standardized so their cost structure is entirely reduced to power (electricity).
Understanding your Customer is Key to Choosing a Business Model
These seven models offer a wide variety of choices to founders — however, in order to know which business model is right for your customers, you’ll need to talk to them! Tim believes in this day and age, we can now target our customers by first knowing who they are instead of just throwing your product out there. We can apply Geoffrey Moore’s idea of Crossing the Chasm to people who will buy into your vision and help you cross the chasm. Tim explains, a lot of the time you can tell if a potential customer is only interested in following the mainstream if they ask, “What is your ROI?” They are not your early investors. They are only interested to see if others have bought. Customers before the chasm are not large corporations, rather, they are individuals.
How do you Sell?
Once you know your customers, the challenge becomes how to sell to them. When broken down, there are two methods of selling. Both methods of selling involve “preciseness:” low and precise selling (e.g. Amazon selling $10 books, movies, etc.), and high but imprecise selling like business software, where you need fewer sales due to high value. The challenge is sitting in the middle where selling price is still high and is still imprecise. Tim makes the analogy of big screen TVs. Just like enterprise sales, there is an education cycle before you buy where you ask friends, read reviews, and do your research. Ultimately, you find that “selling is education and education is selling”.
The challenge is that your sponsor (the guy who thinks what you’re doing is cool) is unable to answer questions to others about your software. Tim explains that the key is the art of storytelling. It really matters who is saying what. Without the right character telling the story, there is no credibility. Stories are a key part of learning as it activates a different part of the brain and your information is more believable.
There are three types of stories: Man versus man, man versus nature, and man versus self. When telling a story about your product, communicate it in 3–5 points, identify the problem, and identify the value of your solution. By comparing the situation before your product to the situation after your product, you create value.
What does this mean?
It is no surprise that in order to sell to customers, you must understand your customers. It is important to understand that while your customers’ ability to use your product relies entirely on how you structure your business model. Their role as a customer lives entirely inside the model you choose to adopt. Therefore, when analyzing your product’s reputation, you can not overlook how your model is structured. By being aware of which business models work and which ones don’t, you can begin to better understand your customers as a whole.
About the Alchemist Accelerator
Alchemist is a venture-backed initiative focused on accelerating the development of seed-stage ventures that monetize from enterprises (not consumers). The accelerator’s primary screening criteria is on teams, with primacy placed on having distinctive technical co-founders. We give companies around $36K, and run them through a structured 6-month program heavily focused on sales, customer development, and fundraising. Our backers include many of the top corporate and VC funds in the Valley — including Khosla Ventures, DFJ, Cisco, and Salesforce, among others. CB Insights has rated Alchemist the top program based on median funding rates of its grads (YC was #2), and Alchemist is perennially in the top of various Accelerator rankings. The accelerator seeds around 75 enterprise-monetizing ventures / year. Learn more about applying today.