Before the internet, most businesses would generate revenue directly from their customers, and invest in marketing to bring in more customers. Only mass media –including newspapers, magazines and TV — was ad-supported. In fact, even AOL made its money using this traditional business model.
The web became a big game changer. Suddenly, you could publish an interface that everyone with a web browser could interact with, anywhere in the world. Inviting other people, and accepting the invitation, became as simple as sending an email, and clicking a link, respectively. Suddenly, any website could become a “mass media” outlet, and sponsor itself with advertising revenue. New business models became possible. Ad networks for the internet appeared.
At its core, every successful company provides an experience where enough visitors want to progress to the next step, and become clients. In another article, we will talk about the psychological and social aspects of this, but here, we are just concerned with the numbers.
Let’s derive a general formula that describes how almost all internet businesses make money.
For a business to be profitable, its revenues must exceed its expenses. The fixed costs include software development, user experience design, and the usual overhead of bureaucracy and running a business. The variable expenses include the cost of acquiring a new client, the resources spent in serving this client (bandwidth, hard disk, support), and the resources spent in serving visitors who do not become clients. This can be expressed as a function of n, the number of clients, and time, t:
Profit(n, t) = Revenue(n, t) – Acquisition(n, t) – Serving(n, t) – Visitors(n, t) – Fixed(t)
- Acquisition(n, t) – the cost of acquiring n clients
- Serving(n, t) – the cost of serving n clients
- Visitors(n, t) – the cost of serving the visitors that led to the n clients
- Fixed(t) – the fixed cost, it amortizes over time.
When you want to start a business, figure out what your costs would be for this formula. I would recommend making an Excel spreadsheet and plugging in some realistic estimates of the revenues and costs. Then — and this is important — do a sensitivity analysis. Perform a Monte Carlo simulation where you perturb the various revenues and costs, and see what the constraints must be in order for you to make a profit. Often you will find that your business model depends on incredible luck or a huge number of clients in order to start generating a profit. It is not viable — yet.
Viral Can Work
One of the greatest game changers on the internet is that the viral coefficient can dramatically lower the your client acquisition costs, and make an otherwise un-viable business model viable.
Without users inviting other users, your acquisition cost would be a fixed cost per client: spend $5 on ads, get 20 visitors, and convert one to a paying client. Thus, if on average only 1 out of r visitors becomes a client, the cost of acquiring n clients would be:
Acquisition(n) = Ads(n • r) + Visitors(n • r)
Typically, the biggest expense here is the advertising — websites try not to spend too much on visitors who haven’t made an account yet. So when your users start to bring more visitors, really good things start to happen. Your advertising costs go down significantly.
But user invitations is not something you have to leave up to chance. By defining your concepts in useful ways, you can analyze your business model scientifically.
The Viral Coefficient
There are many ways one can measure the rate at which users invite other users. Let’s define the viral coefficient for a given week to be:
V = the number of new visitors that was brought to the site during that month by following an invitation link, divided by the total number of visitors at the start of that week.
By defining the viral coefficient this way, we are able to actually measure it at the end of each week. From this definition, one can see that V has compounding effects on your advertising costs, eventually eliminating the need for advertising.
- Typically, V is small for most websites — perhaps something like 0.1 . If it stays constant, you will get a geometric series: for every 100 people you bring directly using pay-per-click advertising, you will get 10 for free the next month, and 1 the month after that. The waves die out eventually, but the cumulative sum is somewhere near 1 / (1 – V).
- If V has been >= 1 for several weeks, you don’t need to advertise at all. Your user base is growing exponentially!
Notice that calculating the V required some very simple operations at the end of each week. However, this definition has a direct relationship to your business model, allowing you to see exactly how far your pay-per-click dollars are going.
Making Your Site More Viral
It’s pretty clear by now that the viral coefficient plays a crucial role in the profitability of your business. The bigger it is, the more profit your business can make, and the faster it attract users.
Be careful what you wish for, because all the other variable costs increase with the number of users. This is where the architecture of your back end servers really becomes important. If it’s not designed correctly, your costs will skyrocket quickly and you won’t be able to scale. This has killed quite a few promising sites. Sometimes, steady growth can be a good thing.
Increasing the virality of your site requires measuring it in the first place. By tracking links inside invitations, you can get a more in-depth analysis of how often the invites get accepted. You can take a google-like approach, and do A/B testing among dozens of different types of invitations. Since invitations are shared away from your site, you wouldn’t use the normal Google analytics tools, though. You’ll need special analytics to track invitations.
The platform we are building will allow you to get these types of analytics out of the box, see how your business model is performing, and figure out which steps you should take to improve your profits. Stay tuned.