Startups. The biggest movement in the technology world since the beginning of the 20th century. Never has it been so easy for teams of entrepreneurs, or even individuals, to create a business from scratch. The barrier of entry has been virtually eliminated thanks to the advent of cloud computing services, such as Amazon EC2 and Rackspace, which allow businesses to only spend hundreds of dollars for server infrastructure for databases and processing where, only a few years ago, entrepreneurs would normally spend tens of thousands for the same capabilities, and thousands more in upkeep and maintenance. Yes, I’ve said these words before, but the lack of significant upkeep costs is a significant factor in startup economics.

Businesses thrive when they have a positive net profit. For any business, profit can be measured by taking total revenue and subtracting total cost. Because total cost for startups is much lower due to the aforementioned cloud services, they can have a proportionally lower revenue and still hold significant profit margins. This allows them to more easily prove that their business is successful and lends the startup credibility when they attempt to expand by asking for venture capital. At the least, your business needs to make enough money to cover employee expenses, which is one reason why startups go “lean” and have less than 10 employees to save on costs.

But what’s the best way for startups to make money? Investors in your startup want to earn their capital back at some point in time, after all.There’s the tried-and-true method of getting customers to use your service, then charging a subscription fee. However, there are many startups, such as Instagram, a photo sharing service, that have no current method of earning money from consumers! (Instagram says outright that they have no revenue model! Most impressive use of transparency ever.) Is that business model, or lack thereof, sustainable?

If you click the image to go to Instagram, you make them spend $0.0001 in bandwidth too!

Dave McClure, a very successful investor, states that his five criteria for investing in startups are: Market, Product, Team, Customers, and Revenue. Revenue and Customers are two distinct points, even though an increase in customers implies an increase in revenue. Can startups forgo a revenue model if they compensate by having a killer product and team, and targeting the right market and obtain lots of customers?

99% of startups need a reliable, effective way to make money, or else they’ll go out of business. But for the remaining 1% who have an incredible product and team, they can defy the principles of microeconomics and manage to succeed without an explicit way of obtaining revenue.
First, let’s look at how internet startups typically make money in 2011:

1. Advertisement Revenue (Google, Facebook): The oldest, and still best, way of making money on the internet. Pioneered by Google with their AdWords platform in the 2000’s, where relevant advertisements accompanied internet searches, Google earned $billions and billions in revenue each year, and became the technology juggernaut it is today. Even individuals who are not creating a business, such as bloggers, can earn revenue on their own blogs by implementing an ad distribution network such as Google AdSense. Large scale startups and professional blogs, however, cut out the middle-man and distribute the ads themselves, which allows them to earn even more money.

2. Free/Premium Tiered Subscription Models (Dropbox): Subscriptions for services have existed well before the internet, with newspapers and gym memberships, and even with software such as shareware. However, due to the decreasing costs of IT from cloud computing, the cost per user is neligible, so startups can feasibly give away their entire service for free. This free service can be used to tempt the consumer into buying a premium version of the service with added perks; the revenue from a user paying for a subscription far outweighs the additional cost of the perks. Dropbox is one of the pioneers of this strategy: they offer 2GB of cloud storage space for free (which costs them less than $0.001/user), and users can pay $10/month for 50GB of space (which only costs them slightly more than $0.001).

3. Freemium (Zynga): Similar to #2, freemium is where the service is completely free, and customers can pay for perks or additional content a la carte. Zynga is the pioneer here with games such as FarmVille, where players can always play for free, but only for a certain amount of time; paying real money can help speed things up. It’s not my favorite business model; wayyy too many gaming startups, especially on the PC (League of Legends, Team Fortress 2) and iOS (everything in the Top Grossing section of the App Store), use this model, but it’s simple, effective, and down to an exact science. Many users are willing-to-pay for an advantage, and many aren’t; freemium caters to both of those types of users.

Most internet services will use one of these models, or some combination thereof. Hulu and Pandora, for example, uses #1 to earn revenue off of free users, but offer a premium service to exploit #2. There are exceptions for the more niche startups (i.e. which offer a physical product/services or use brand merchandising), but in general, the three models are safest for a startup, especially since all three are easily scalable.

Let’s look back at Instagram. Could they implement one of the three mentioned revenue models? Easily. Ads could be shown to the user on the iOS client or beside the picture on the web, although adding ads to a previously ad-free app usually upsets customers. Instagram could charge a subscription fee or an in-app purchase for premium filters, however “high-quality photo filters” is an oxymoron, and might not succeed in user adoption.

It’s highly likely that Instagram doesn’t intend to monetize itself at all, and instead use the product as a springboard for much better, larger things. Anyone in the Silicon Valley can make a product, but very few people can make good products, and very few startups are as popular as Instagram in recent months.

Beluga was a startup that specialized in mobile chatting. It was later bought by Facebook, and their team was folded into the company and helped develop the Facebook Messager app for mobile. GroupMe was another social solution, which was later bought by Skype. Both startups received multi-million dollar buyouts.

In 2011, positioning yourself for a buyout by a multibillion dollar corporation is a legitimate exit strategy. Yes, there’s a considerable amount of risk involved because there’s no certainty that someone will buy your startup. However, if the startup first builds a large userbase, larger companies will certainly take note, and in some cases, buy you out just to take your users as their own.

Instagram has many options, to be sure. Should startups follow in their foot steps? Well, obviously they should try to create an excellent product with an excellent team. But can the typical startup pull off having no revenue model? I would not recommend it. The off chance of a buyout or investment support drastically outweighs the inability to pay your employees and maintain your servers five or ten years down the road.

If you’re making a startup in 2011, make sure it has a way to make money. There are many tried and true methods, pick the one(s) which best fit your business model! If the opportunity hits to make it big, don’t neglect it, but be pragmatic and realistic with your expectations.



Max Woolf (@minimaxir) is a Software QA Engineer living and working in the San Francisco Bay Area for over 4 years and a 2012 Carnegie Mellon University graduate in Business Administration.

In his spare time, Max uses Python to gather data from public APIs and ggplot2 to make pretty charts from that data.

You can learn more about Max here, or view his portfolio here.