Making Money?

Okay, extending my thoughts from the last post, I think we should have a conversation about how to make money if you're a startup. Help educate me if I'm wrong on this: The basic concept is pretty simple, right? I create or obtain something of value, and I exchange that something for money. If the cost of creating or obtaining that something is less than the amount of money I get for it, I make a profit. Pretty straight forward. Everything stems from there, right?

Okay, let's subdivide this a bit. I'm hardly an MBA or hell, have any real experience running a business, but it seems to me we can be a bit more specific and still stay high level. The next concept is how you go about making money. Do you do it directly, or indirectly? What I mean by this is, do you make money directly from the consumers of your product or service, or do you make money from some other way?

The first is, again, pretty simple. I have a product, I then give it directly to you and you directly give me money. Transaction completed. This is how it works down at your local grocery store, right? You get the toilet paper when you hand over your $2.50, done. Okay, maybe you subscribe to a service instead, and so for every set of time you use the service, you pay me a certain amount of money. Or maybe I provide you with a service, and take a percentage of any money *you* make by using the service, plus maybe a fee. The idea here is generally I take money straight from the person who's receiving my product - I give you something and you give me cash or your credit card or some other way of paying. Simple

Then there's the indirect ways of making money. I can think of a couple big ones as they apply to startups: sponsorship or exit. Sponsorship is where I provide the product or service to the people who will use it, but find another entity to pay for it somehow. In other words, someone else pays me instead of the consumers of my product. The people who pay me get the value of being provided a communcation route to those people who consume my product, and though that may be important, it's not the real product, just an offshoot. Then if I get more money from the sponsors than it costs me to provide product, I make money.

Then we have the "exit" which to me is when you build some sort of product or service with value, though maybe not completely realized, and then sell the SOURCE of creating that product or service at the end of a certain time frame to someone else who will hopefully make money from the product itself. Obviously, if you have a goose that lays golden eggs, you probably won't sell the goose. (Unless SEC filing burdens make it more advantageous to sell portions of the goose in an IPO rather than continue to hold the goose privately... but I digress). But most people have a goose that lay normal eggs, and eventually they'll want to sell the goose. If that person makes more money from selling the goose than it took them to raise the goose (over time), they make make money.

For purposes of this discussion, we can stop there. We now know ways for a startup to make money: Direct, Indirectly via Sponsorship or Indirectly via an Exit. You knew all this, didn't you? The reason I laid it all out like this is if I'm missing something, I want you to tell me where I'm missing it, and where it fits into that hierarchy.

Now, let's think back to a time before high-tech. Say I wanted to start a business, right? So I somehow gathered some basic materials (maybe I took out a loan), I created or bought something of value, and then I started selling that product for more than it cost me to create or obtain it. Or maybe I simply provide a service for a fee, and that fee was based on how common or uncommon that service was - barbers vs. plumbers. Or maybe I was one of the guys who helped someone else sell a product, and then took a percentage from the sale. No sale, no money. Or maybe I helped you manage all that money you were making by taking some of it and loaning it to the first guy who later returned the loan with interest. You get the idea.

So now we're in the 21st century and we have high-technology and the internet and all of that, but here's the point I'm trying to make: The basics of making money still are the same. You have to create something of value and then find someone who wants to give you money for it. Yes, the concepts of products and services may have munged together a bit, and values for things are completely arbitrary - ringtones which are nothing more than 30 kilobytes of simulated music are a $4 billion market - but the basic tenet is the same.

Thus the question I ask of the startups I see is simply: How are you going to make money? It needs to be obvious, I think, especially in these post-bubble times. Are you creating a product or service that's good enough to charge money for? Great! Then why are you giving it away? Oh, you're giving it away so that you can attract a large user base so that you can then advertise to them? Fine... Will you make more money or less money that way than charging for the service directly? Are you just assuming one or the other? What if it's not practical to advertise to them? This happens a lot, what then?

Oh wait, you're creating a product, and giving it away, and not worrying about sponsorship, because you're not sure exactly what value the product has, but eventually you'll either create something of significant value or to sell the means of production for the lesser value products to someone else who feels they need to own it for whatever reason. And yes, it may take a while, but you need time to "evolve" the product. Okay, fair enough. You have to build and tune the factory before you can start cranking out the cool widgets, I get it. But are you really sure there'll be demand for your widget when you're done? You're not sure yet? Okay.

Hey, we've all heard of the success stories of the latter style of making money, right? Google went for years before they figured out how to monetize their search. They built the factory, then figured out the ultimate way of sponsoring their widgets later. It took some smarts, dedication, patient investors, and a lot of luck, but it happened. And Flickr did it all on warp speed, creating a whole set of evolving products and eventually selling the whole factory to Yahoo! just a year or so later. Bam!

But even with these examples, I have to say my preference when hearing about a new startup is to see an obvious business model right from the start. I guess in some way I just can't forget what happened during the bubble. Yeah, there was a lot of innovation, but there was just so much wasted effort as well. I guess to me, you're not really a business until you create a sustainable way of making money. I worded that very specifically because in these days of Text Ads, it's easy to claim your site is creating cash. My blog generates money, but it's hardly a business because it's not a sustainable income. At any point I could lose my rankings in the search engines, or the price of text-ads could fall and that would go away for good. So what I want to see from startups is an effort to create a lasting way to make money.

This is actually why I like 37Signals so much. Yeah, they drive me nuts because of the Ruby on Rails hype they generate, but they definitely shouldn't be rolled in with the rest of the startups I've seen lately in the sense that they have a real business with real products which they actually charge real money for, and which people are happy to pay for. They're not aiming to change the world just yet that I can see, but they've got a real business there and it's great for them, and for industry as a whole. What they're doing is a great example that the other startups, in my opinion, should follow.

Let me make an aside for a moment and say that I'm always fascinated by what I call "natural business people." These are the folks that have absolutely no problem making money. If I buy something for $2, I have this vague sense of guilt when I turn around and try to sell it for $4, and even worse if I sell it for $6. It may be worth $6 now, but I know how much I bought it for and I feel bad. People like Bill Gates for example, don't have this problem (remember the story of QDOS as the prototypical example).

The reason I mention those sorts of people is because first, I'm not one of them and I'm not sure if I ever will be. Secondly, and most importantly, I think it's those sorts of people who *also* have dreams of changing the world who are the people who make massively successful companies. Many times these are the guys that are paired up with the technical geniuses (or are very technical themselves) that figure out the disruptive trends, know instinctively how to make the big deals, or generally take advantage of any lucky breaks they get. The last is not to be overlooked, by the way. You can't control luck, but you've got to be prepared to take advantage of it when it strikes. The guys that understand the fundamentals of business in the ways I'm describing seem best apt to do that.

Whew, this is long winded, but I've pretty much conveyed my point. I think that we'll know what the next big startup is right away because they'll be generating real value and real cash right off the bat, the founder(s) will insist on it. But they'll also have that big plan as well - a somewhat naive, but in general beneficient attitude towards changing the world. Maybe it won't happen just as they planned, many of the companies profiled in the book Built To Last were started to do one thing, and then went off to do another. But in general I think it takes that special combination of talents to reallly hit it big. Anyone can be a rug salesman, buying low and selling high, and anyone can be a splog generator, creating ad traps that make ill-garnered money today and are gone tomorrow, and anyone can create a neat website which does some cool things that no one would actually pay for, and anyone can slap Text Ads on their blog and generate some cash and some buzz. But it really takes that combo to really break the mold, right?

When someone sees that startup, please point them out to me, okay? :-)


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