The Simplest of all Business Models

Wi-Fi Signal logo

If you want to use Wifi at Pete’s Coffee & Tea you will have to buy something first.  At the counter they give you a code to use, that allows you about an hour of surfing time.

In many local coffee stores you technically have to buy something but once you do, you can stay parked in their tables for hours without buying anything. In Pete’s bigger competitor, Starbucks coffee, it is the similar unlimited free access plus access to premium extras like The Wall Street Journal.

Coffee shops complain about those who occupy tables for hours at a stretch, buy little or nothing and mooch on their bandwidth as well as electricity. Customers who do spend money at coffee shop and need good connectivity for an hour or two complain about the poor speed and difficulty in finding tables near outlets. General customers (who hire the coffee shop for, coffee) complain about the crowd and lack of seats to simply sit and enjoy their brew or have a conversation.

Free Wifi became a popular perk for coffee shops, restaurants and hotels to attract customers and keep them in their shops. If the customers chose your business over others because of free Wifi, you win. If the customers stay because of free wifi and continue to spend during their stay, you win. You have successfully used free wifi as lead generation tactic and customer retention  tool. (Freemium?). For instance, Panera bread saw its sales increase by 15% when they introduced free wifi.

On the other hand, what is free to customers, is not so to businesses. There are costs of operation (making sure there is enough capacity) and opportunity costs (both for the money spent on their big pipe broadband and the moochers). When everyone else offers free wifi it becomes difficult for a business to either stop offering it or start charging for it. Add to this customer dissatisfaction from providing poor internet service.

Look at where we are in the discussion. We are not talking about the compelling value proposition a coffee shop (or a restaurant) offers but talking about a perk. Let us not forget the primary job these businesses wanted customers to hire them for. If customers’ choice is made based on secondary and tertiary factors, the primary value proposition has become irrelevant. If a business fears their customers will walk next door for free wifi they are admitting that their product is an easily replaceable commodity.

That is a bigger problem they ignore while fretting about wifi costs. In focusing on free wifi as lead-gen activity they ignored the core customer segment they started with and the customer jobs they hoped to serve. While some may call free wifi (and Freemium?) as business model innovation, this is essentially losing sight of customer needs and your core competence.

If the customers didn’t hire your coffee shop for coffee, should you tie your business model to selling coffee? That is an incongruence between value creation and value capture.

On the other hand your strategy – to serve the most amazing coffee – need not be fixed. You can see the customer shift and decide your strategy is to serve those customers who have a connectivity need and are not satisfied with existing alternatives. You recognize customer issues with poor speeds in free wifi places and provide reliable speeds as differentiated feature. In such a case you cease being a coffee shop and become a workspace provider. And guess what, you now can charge for that value delivered.

The business model is back in sync with value capture matched to value creation.

That is exactly what is happening in Russia’s Clock Cafe.

“You don’t have to pay for coffee or tea or cookies. You should pay for time, and time costs — I hope — [are] not that expensive.”

And their target segment? Students and business folks who hire them for connectivity and hence pay for the value they get.  Nicely done. However, I think they fixed one mistake but introduced another – making coffee free. There really is no reason for them to offer free coffee, especially the premium kind they claim they deliver,

We have cappuccino, latte, espresso, Americano, and our coffee is not the cheap one

They are committing the flip side of free wifi at coffee shop mistake. Sooner or later they will run into the free wifi problem in reverse. Why bother with coffee or why not charge for it? Especially if the customers didn’t hire you for coffee?

When it comes to business strategy, starting with customer needs and choosing the ones that you can serve better than others remains the best approach. And when it comes to business models, charging for value you deliver remains the simplest of all approaches.

What is your strategy? What is your business model?

The Elevator Story and Value Staircase

Update 8/31/2011: I was surprised to read that there are still seven-story apartments in New York that do not have elevators and still rent to people. As you will expect, despite the location, the view and the benefits, these apartments are a bargain to those willing to hike 192 steps to get to their home. Apartments that go for $3500, go for $2000 – all because of no elevator.

Imagine you owned  a five story building in 1850 New York, years before the Elevator or more importantly the Elevator brake was invented. Despite the unobstructed views and the status the top floors provided you were not able to charge much for the rent.

There was clear value in the top floors and better yet there was more of it to come if you were to build more floors. Yet, no customer, except those in the most athletic form or those in dire need of a place with cheap rent, was willing to see that value and pay a price for  it.

What use is a feature when its value cannot be realized or the cost to use the feature  far outweighs the value?

In the case of tall buildings, it all changed when Elisha Otis invented a safe way to stop elevators and these stopped being death traps. An invention that had nothing to with you or your own efforts ended up unlocking the unrealized value from these top floors.

Fast forward to present day. You have a product that you know adds considerable value to the segment of customers you are targeting. Yet customers do not see it that way. Your own sales team do not see the full value. Definitely your competitors are making sure it stays that way.

You can improve your value messaging to help reduce the selection cost, credibility gaps, risk aversion and reference price effects. Yet, no amount of value communication from you is going to help reduce the cost of doing business – the effort customer needs to exert to use your product.

You need an elevator to climb back up the staircase. Something that makes it very easy for your customers to adopt and use your product without changing their behavior, business process or the way things are usually done.

Unfortunately there is no Otis to invent a generic one for everyone. It is you who have the task of making it very easy for your customers to use your product.

Until that elevator is invented, your product’s value and price remain unrealized.

The Value Step Function

Your product adds incredible value to your customers, your messaging and value proposition is all done right and yet your customers do not see that value. Neither are they willing to pay for that value. Most of the customers are simply happy with cheaper alternatives even though these are a very poor imitation of your superior product.

No, you did not overprice it and the messaging is almost flawless that your product name has become a verb.

What is the roadblock? This is because the value perceived by customers is not a linear function of product features. Value is a step function – an initial package of features causes a step increase in value perceived but  after that point it can level off for a very long time or until another shift occurs at which point it makes another step jump.

It is the value step function that prevents a true innovation from gaining market share and  capturing value. Customers are so delighted by the first order benefits, because these lift the customers out of the misery of ordinary and status quo, that they lack appetite for the second order benefits.

Since the incremental value perceived is negligible to most customers, the marketers find it hard to translate their high value proposition into customer utility and hence higher willingness to pay. Even with greatest marketing, only a sliver of customers pay the premium.

Take for example the case of TiVo. It is  a verb now and its customers are true apostles and yet there are only 1.5 million TiVos in a market with 30 million current DVR customers and another 60 million prospects. Forrester analyst James McQuivey explains:

“A basic DVR made by a cable company is so much better than what you have when you don’t have a DVR at all. It’s a little bit like making it just outside the gates of heaven, and it’s so pleasant and warm that you don’t realize that just a couple of steps away there’s a better experience to be had.”

This is a case of Value Step Function.

This is not totally new, this takes us back to customer driven product development and pricing. A product does not have  pack a full suite of features nor does it have to be far ahead of the competition and its alternatives. It only has to be just ahead in the minds of the customers and offered at a price that matches the value. Once you know the price customers are willing to pay it is a question of whether or not you can produce it at a cost that delivers you profit.

Do you know your customers Value Step Function?

Say you want 10% increase in customers in your freemium startup

Say you want to increase customers (those who pay for the service as opposed to freeloaders)  by 10% in your freemium business. You have two options:

  1. Blue Pill: Increase user base by 10% – if the proportion remains the same, % customers goes up by 10%
  2. Red Pill: Convert your freeloaders into customers

Which one would you pick? You pick the option that delivers higher incremental profit, that is new revenue less the marketing costs and operational costs.

Let us use some numbers – because of the ubiquity let us use numbers published by EverNote (otherwise there is no connection to EverNote).

Current number of users:  2.7 Million
% customers:                        2%
Revenue/year/customer:  $45
Fixed Cost/year: .09*2.7M =$243,000
Incremental revenue from 10% more customers = $243,000 (just coincidence)

Incremental profit is $243,000 less cost to acquire and support 270,000 more customers.

Incremental Operational Costs: Let us assume you are at capacity and need to add new capacity to support 10% more customers. A moment’s reflection will convince you that this is not an unreasonable assumption. So adding 10% more customers would incur $24,300 incremental cost for capacity enhancements.

Incremental Customer Acquisition Costs: These are the marketing costs. Despite the claims that “free is free marketing”, there is a cost to acquire 270,000 new users especially after already  acquiring 2.7 million users. This is going to take time and will  cost $5,000- $10,000. But to keep with the freemium model assumptions, let us treat the marketing costs as $0.

For option two, both these costs are zero and you only need to convert .22% of the freeloaders compared to acquiring 270,000 new users.

So  converting even a tiny fraction of your freeloaders delivers you higher incremental profit than growing your total user base by 10%.

Is your choice the  blue pill  or the red pill?

Now my selling point – any solution that enables this conversion will add $24,300 in value to you. The value scales as more of your freeloaders are progressively converted to customers.

The value can grow further,  if a solution can find 10% of freeloaders who will never pay and hence enables you to fire them – that is another $24,300 in value for a total of  at least $48,600.

Would you be interested in sharing a fraction of incremental value-add for that solution?

Brag! Let the World Know that You Can Play Didgeridoo While Riding Unicycle

I was watching CyberChase a PBS Kids program (with my 5 year old). In one of the skits (CyberChase for Real) they do at the end of each episode, Harry (played by Mathew Wilson) was looking for a job. He wonders,

I can play didgeridoo while riding a unicycle but I do not see anyone hiring for that.

Later he tries  out for the job of  handing out menus for a sandwich shop while wearing one of those larger than life tomato costumes. Finding low conversion rate (or high bounce rate) he starts by analyzing the  menu. Harry concludes that  the sparse menu, listing just four sandwiches, was the reason for low conversion rate. He spruces it up by enumerating all possible sandwiches based on  meats, toppings and bread types. As he hands out the new menu with 60 different sandwiches, the conversion rate goes through the roof.  Harry’s boss was happy with all the business.

If we stopped the story here one could be absolved for treating this as a case study of applying, data, analytics and experimentation to add business value and the employee getting rewarded for it.

Alas, that was not the case. The sandwich shop owner walks out and says,

You did a good job driving lot of customers to the store but we want lot more marketing than someone just  standing with tomato costume and handing out flyers. We hired a guy who can wear the tomato costume and play didgeridoo while riding a unicycle. Please hand-in your costume.

That is sad but not totally unrealistic ending to the story.

To start with Harry did not tell his manager about what he is capable of and how all his different skills can add value to the business. Next, when he saw a problem with menu design he went ahead and fixed it.  He did not tell his boss about his methods or results. The hope (we can only surmise) was that “Great work will speak for itself”,  which as Harry and we found out later was not the case.

This is the number one myth listed in the book, “Brag! The Art of Tooting Your Own Horn Without Blowing It“. In this very well written book, author Peggy Klaus, makes a convincing case for the importance of letting the world know what you are made of, your accomplishments  and how having you in a team is valuable to that team.

You can assign blame on the boss for not taking the time to know her employees, what they are capable of,  how to effectively engage them and finally reward them for their accomplishments. That is leadership failure. In the long term such lack of leadership will affect any organization and hopefully such bad bosses would be cast aside. But in the short term, it is you who suffer from your failure (or reluctance) to make your value proposition and your failure to position yourself in the minds of your “customers”.

If you do not position yourself someone else will and to your detriment.

If you can play didgeridoo while riding a unicycle and crunch multivariate regression at the same time – Go Brag! Let the world know.

The Value Waterfall

[tweetmeme source=”pricingright”] You have a great product – be it a software offering or a physical product and your economic value-add analysis shows that your product creates considerable value for the customer. But does your customer see it that way?  Since price represents your fair share of the value created, do you get a fair share if there is a gap between the true value created and the value realized by the customer?

What is stopping your customers from seeing the full product value?

In the context of Price Realization, I wrote about Price waterfall (first introduced in the book The Price Advantage). Price waterfall shows the price leakages that reduce your price realization. Another common, yet not so obvious, factor at work is the value leakage – the loss in value perceived by your customers. This is the  Value Waterfall. In pricing and cost-benefit analysis marketers focus on the costs incurred by them and the value created for the customers but not many consider the costs imposed on the customers in selecting and using their product. Value leaks are the costs incurred by the customer that leads to the following Value Waterfall:

There are five factors that decrease the perceived value of your product, creating the Value Waterfall:

  1. Credibility Discount:  While your calculations may be supported by analytical rigor, there are generalizations and assumptions that went into your estimate, not to mention some bias. Does your customer trust and believe your numbers? This is the credibility discount applied by your customer.
  2. Selection Cost: I wrote about the cognitive cost to customers in selecting a product. Be it evaluating all the options available in the market or evaluating the multiple versions you offer, there is a definite cost to the customer. The effect of these costs carries over from initial selection to product usage and hence decreases the product value.
  3. Cost of Doing Business: These are the costs to customers in adapting their buying process, business processes and operations, training their employees,  etc so they can start doing and continue to do business with you and use your product. For example, do you only deliver on Fridays? Do you fit within their procurement system? Does your billing cycle fit customer’s accounting needs? The net is another reduction applied to the product value.
  4. Risk Aversion Discount: What is the risk your customer is taking in going with your product? Are there social concerns – how will they be perceived by their friends, peers or their bosses? For instance, if you are selling bike helmet, will it make them look more dorky? If you are selling SaaS, are they worried about availability?
  5. Reference Price Difference: What does your customer consider as the substitute or alternative to your product? What is the price they pay for that? That is their reference price. If customers had always relied on cheap offering, despite its low value-add, they will be evaluating your product base on this reference price regardless of the true economic value from your product. Reference price has been proven to decrease customer’s willingness to pay for the value-add.

So despite starting with a large pie, the one you gets a share of is considerably reduced in size due to value leakage.

What can a marketer do about it?

How can you not only stop the value leakage but also turn each incident into a value addition?

Stay tuned for Value Staircase.