In my previous posts, I’ve discussed how products can get more users through ads and user-generated content. However, for a business to grow, it must also make money from those users. In this post, I’ll discuss how different types of products lend themselves to different pricing models, and why more and more technology products are moving towards a subscription pricing model.
Back in 1995, a company called Microsoft was dominating the operating system market with Microsoft Windows. Even today, over two decades later, Microsoft Windows holds almost 40% market share.
So how do you pay for Windows? It’s simple – you pay a flat, one-time fee. That’s it. I use the term “value” throughout this post to refer to the benefit the user receives. In this case, the value is an advanced, user-friendly (at the time) operating system and all the security and usability benefits that come with it.
This idea of a one-time purchase was popular in the early dot-com bubble, as it was guaranteed up-front revenue at a time when convincing users to pay for a digital product was rare. Today, this model is rare for software products, for several reasons:
- Software requires upkeep due to bugs, security vulnerabilities, and platform changes. With a one-time fee, there’s no guaranteed recurring revenue making it difficult to pay for that upkeep.
- It’s extremely difficult to predict the right price – if you charge too much you’ll get no users but if you charge too little you’ll start losing money quickly when user growth slows down.
Then, around 2000, a company called Google was rapidly rising in popularity for their famous search product. And how do you pay for Google Search? Even simpler – you don’t.
Google Search pioneered the advertising pricing model. Google’s advertising model consists of users using their search engine to see search results with ads mixed in. Businesses can purchase those ad slots based on different search keywords, tags, or demographics. The more coveted ad slot, the more costly the ad slot. For example, ads on searches for “t-shirt” would be more expensive than “black dress shirt with polka dots” since the former is searched more often resulting in more users seeing that ad slot. And also because nobody buys a dress shirt with polka dots. Seriously.
But the users seeing those ads neither earn money nor pay money for using Google Search. Of course, users receive the value of access to a free, high-quality online search engine.
So what does a marketplace model look like? Think Airbnb or Uber – the product is just providing a platform to simplify the connection between supply and demand. For example, Uber is not providing actual rides, but rather connecting drivers (supply) with riders (demand). Similarly, Airbnb isn’t providing actual rooms but is rather connecting homeowners (supply) with people looking for a place to stay (demand).
Marketplace models have become extremely more popular in the past few years and have grown increasingly complex. For example, Opendoor connects homeowners looking to sell with prospective buyers, and they do this by actually purchasing and holding on to the home. Instacart connects grocery stores with people who want to do grocery while also employing contractors to do the shopping and deliver the groceries.
So how do these companies make money? For each transaction (ride given, night booked, house sold, grocery order delivered, etc.)they take a small commission, which is usually reinvested to provide an even better service to both the supply- and demand-side users.
Next we’ll explore the usage-based model, where users pay a fee directly proportional to how much they use the product. This pricing model is primarily used by B2B products, such as Amazon Web Services (AWS).
By using a usage-based pricing model B2B business can offer their service practically for free to small customers. This reduces the barrier for new customers to start using their service. Then, as the customer scales in size the business makes proportionally more money.
In addition, over time customers become more locked in to the business’ service. Switching from AWS to Google Cloud might be cheaper on a per-month basis, but if customers also have to factor in the cost of removing AWS from their software and integrating Google Cloud, which can take weeks, it might not actually be worth it.
Subscription – the next dominating pricing model?
Most companies seem to be adopting a subscription model, in which users pay a recurring flat fee to continue using the product or receiving the service. The most popular example is Netflix – having a subscription gives you unlimited access to their software platform and the content available through it.
However, many legacy companies are trying to switch to this pricing model:
- Microsoft has been moving from one-time purchase (Office 2019) towards Office365, their subscription model, cloud service with almost identical functionality.
- Apple is moving from a one-time purchase (iPhone) to a services model, with recurring revenue via iCloud, Apple TV, and Apple News (rumored to be announced in just a few days).
- YouTube is trying to move from an advertisement to a subscription model via YouTube Premium, which gives access to additional content and removes all ads.
- Amazon is testing moving from a marketplace (buyers and sellers of goods) to a subscription model via their Subscribe & Save campaign.
The subscription model is the most superior model for most software companies today for several reasons:
- Software requires a recurring investment to support its upkeep. A subscription model provides this recurring revenue.
- Users paying for a subscription aren’t monetized through ethically questionable ways like targeted ads or selling their location or personal data. Rather, they’re paying upfront for something they clearly understand. Remember, if you’re not paying for the product, you are the product!
- Lastly, companies can focus solely on gaining more users through growth best-practices and through building new features and functionality to increase the amount users are willing to pay.
The subscription bug is spreading like a fire throughout technology companies, and it makes sense. With decreasing infrastructure and scaling costs and increasing regulatory pressure and government involvement you can expect more business to continue making the transition to subscription pricing models.
As we go forward, expect the subscription model to become more nuanced and differentiated, with additional aspects such as freemium models (Grammarly), free trials (Asana), and special pricing tiers for different user segments (Slack), and many more flavors of subscription emerging.