Four Myths About SaaS Revenue Streams

A recent article by Joe Procopio, a self-described “multi-exit, multi-failure entrepreneur”, outlines four crucial misconceptions that result in fatal mistakes when working out a revenue strategy for your MVP.

Cash is the reason most start-ups fail. Failing to generate stable and sustainable revenue streams is something that will certainly discourage investors. No matter how many users you have, if your revenue streams fail to cover your costs in the long term, then you won’t go far, as recent high-profile flops prove.

According to Procopio, who was Chief Product Officer at Automated Insights, among others, one of the main misconceptions that Founders face is differentiating revenue streams and pricing strategy. The latter has to do with how much customers are willing to pay for your product, but the first has to come much earlier in a company’s life and involves what the customers pay for.

There are three main decisions that must be made (among a number of smaller others) in order to define one or more revenue streams:

• Justification of the charge;
• Defining the value of the product or service
• Setting up a delivery mechanism.

But first of all, all entrepreneurs should ask themselves the same single question:

“Who is going to pay for this?”

Myth 1: Advertising as an “easy” revenue stream

It’s tempting to answer the above question with “not the customer”, arguing that third party ads will pay for the service that customers use for free.

There is a huge mistake in that sentence: if your product is free and runs ads, then the advertisers are your actual customers and the ones who benefit from your product are users.

That being said, let’s take a closer look into advertising as a revenue stream.

The problem with ads is that for them to be a sustainable revenue stream you need to do one of two things:

• Sell ads by pitching the the incredible ROI of your product (or your users really!) to justify what you charge for ad space; or
• Integrate some sort of algorithm/click-bait based native advertisement that is intrinsic within the product or service that you are providing, so that you can justify your charges with a super-targeted audience.

Either way, choosing advertisement as your primary revenue stream means designing your whole product around it, not just installing a widget and waiting for the cash to start rolling in, as many Founders seem to think, mistakenly.

While the delivery mechanism per se can be quite easy, advertisement almost always undermines the value of your product in the eyes of the end user, which can be a major liability as it negatively impacts the ROI of ads themselves, generating a dangerous vicious cycle.

Myth 2: The Lowest Common Denominator

Pitches about revenue streams, especially at very early stages, sometimes sound similar to this:

“There are millions of people that [go to university / travel often / commute], if we get a tiny portion of them to give us a pound, we’re going to make millions!”

That’s the premise of many good ideas, in theory. In practice, it doesn’t quite work that way. Sure, a pound is just a pound, but if you go and ask a stranger for a pound, they’ll probably give you a really bad look, right?

Right: no matter how cheap your product is, you still have to sell it, and selling something typically involves costs, and the lower the price the less you can afford to spend in order to sell your product. It’s another vicious cycle.

The key rule here is that your product or service has to deliver equal or higher value than its final price, and you can’t spend more than the price to deliver and sell the product.

That’s where the delivery mechanism comes into play: apps, for example, boomed as soon as smartphones became popular. They sold for less than a pound aiming for high volume and minimal delivery costs, but as soon as app stores started taking larger shares of the revenue, the chain broke and app developers tried to pivot towards advertising and in-app purchases.

Myth 3: Free Tier vs. Free Trial

Let’s get back to our framework: justification, value and delivery mechanism. Let’s try applying it to the free trial model.

A free trial is typically not a significant extra cost. With this model, you basically bet that providing the free trial would be cheaper than convincing the customer to buy the product straight away, which makes sense. You also get the ‘bonus’ of early onboarding and eased learning curve.

The delivery mechanism isn’t impacted by the free trial. If we’re talking about SaaS then this will be the same frictionless, easy process that you should set up for your core product.

Finally, value: let’s say you take a £100,000 car for a test drive. Is it still worth £100,000? Of course it is! Free trial don’t impact the value of your product, if anything they’re a chance to show it off!

If we try applying the same framework to the free tier model, however, we encounter frictions.

Justification and delivery mechanism are not different from the free trial. What’s really impacted by the existence of a free tier is value. When you give something away for free, it always subtracts value from its paid-for counterpart. That’s true for competition, so why would one self-sabotage with a free trial?

The typical reasoning involves growing the user base and then betting on up-selling or cross-selling, but that only works if a significant percentage of your users are looking for a higher level of service, which is often not the case. Typically this only works if the paid-for tiers offer significant advantages to the users, or if the free tier is so limited it’s basically useless.

Spotify’s free tier, for example, makes the music-listening experience absolutely dreadful by broadcasting frequent ads and not allowing to choose specific songs from mobile.

Myth 4: Crowdsourcing

Often referred to as “Network Effects”, strategies involving crowdsourcing are very common in the internet age. Facebook is a clear example: its user provide the content that other users want, so more users sign up and are exposed to ads which, eventually, pay the bills.

Network Effects used to be the talk of the town in the mid ’00s, but their time seems to be over. Consumers are now much more conscious of being the target of online ads and towards other kinds of network effects, like Uber’s.

In two-sided marketplaces like Uber, users pay other users acting as suppliers. Which is which depends on the point of view, but back to the original question:

“Who is going to pay for this?”

Some would say riders pay Uber its percentage for a ride, others would argue that drivers pay Uber a percentage of their earnings for being on the platform. That’s not a flaw in itself, but it is an ambiguity that has created (and still presents) many issues in Uber’s business model.

There’s nothing wrong with capitalising on crowdsourced content, products or services per se, but it’s important not to take these factors for granted thinking that network effects will skyrocket your revenue in no time.