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A Real Cool Customer

Consumer-oriented start-ups get a lot of buzz. But you can make more money selling stuff to humble cube dwellers.
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I often meet people at parties and conferences who are starting companies, and they will invariably ask me, "Say, Joel, do you have any advice for start-ups?"

Since I know next to nothing about these people or their businesses, or even their industries, I usually just say, "Yes! You should raise all your prices!"

And we both have a good laugh, bwa ha ha, then the founder ignores me.

But my advice was most likely right. That's because almost every start-up I have ever seen has set its prices too low. Founders usually imagine that they are selling their wares to people more or less like themselves--which is to say, smart, discriminating consumers. But they would do well to remember that there is a stark difference between selling to consumers and selling to businesses. And if you ask me, all things being equal, start-ups should almost always opt to sell to other businesses.

It took me a while to figure this out at my business, Fog Creek Software. When we first started out, our pricing strategy boiled down to this: We imagined how much we would be willing to spend on FogBugz, a project-management tool we make for software developers, and then set the initial price at $40 per user.

This seemed like a perfectly reasonable price to me. But it was too reasonable, as it turned out. Over time, I noticed that whenever I talked with potential FogBugz customers, the question of price just never came up. They liked the software or they didn't, but price wasn't an issue. So we decided to try a little experiment and raised the price to $99. And the number of buyers actually went up.

When I thought about it, I understood why.

FogBugz is used to coordinate teams of developers, so the real audience is almost exclusively established businesses, rather than individuals like me or impoverished, bootstrapped start-ups. In fact, to corporate buyers, the higher the price, the more respectable FogBugz appeared to be.

Meanwhile, I noticed Fog Creek's spending habits were changing. When I started the company, my partner, Michael, and I were disciplined bootstrappers, and we would have a serious conversation about every expense. A hundred dollars was a lot. When we needed a firewall, I bought an old computer on eBay and built my own. When our gross revenue was $10,000 a month, total, even travel was an unimaginable luxury. We ordered cheap, ugly business cards over the Internet. I designed the first logo myself. It consisted entirely of the name Fog Creek Software in lowercase letters and underlined like so: fog creek software. Did you catch the creative part? You see, the g isn't underlined! Think of all the money we saved on toner.

As the business grew, our definition of the word expensive began to change. Should we buy a $400 off-the-shelf firewall? If it saves a few hours of time, why not? Later on, when we were looking for a domain name for a new line of business, we splurged and spent $10,000 to buy the URL Copilot.com. And we thought it was money well spent. For a one-time fixed cost, we were able to purchase a memorable, easy-to-spell brand that made us seem awfully legitimate while adding absolutely nothing to the incremental cost of the service.

As I was discovering, businesses spend money at rates that seem profligate, even obscene, to normal people. A hundred and twenty-five bucks for new business cards, $400 for a firewall, $900 for a desk chair, $10,000 for a really cool domain name--to most consumers, this kind of spending would seem outrageous and wasteful.

But what Copilot.com taught me was this: Businesses will happily spend large sums of money on fixed costs, because those costs can be spread out across so many of their customers.

Consumers, though, are a different story. On the whole, they tend to be very thrifty and price sensitive. They'll choose the $18 cell phone plan instead of the $21 plan if they believe they can live without the extra $3 in features. This thriftiness means a company does not make a lot of profit per sale, which means it's going to have to sign up a whole lot of consumers to make up in volume what it gives up in terms of margin.

And volume doesn't come easy. At the very least, a company will need to do something to reconfigure the brain cells of millions of humans so that 1. They know the product exists and 2. They want to buy it. This particular brain-cell reconfiguration takes a lot of work, and success is exceedingly unlikely for many start-ups. Even a Super Bowl ad can go only so far in changing consumer tastes.

That's one reason it is hard to sell to consumers when you're a start-up. Here's another: Though lots of small businesses describe themselves as the low-cost providers in their industries, actually being the low-cost provider is pretty difficult to pull off.

Yes, a small company has less overhead than a big company. But while you're scrambling to get a business off the ground, you're making lots of beginner's mistakes, and you're paying retail for your office equipment, so your costs are much higher than they ought to be.

And you know what? Lots of people who start companies seem to think it will be fun to make something or to sell something to consumers. But it's not that much fun to provide the cheapest product or service. You'll probably never, ever achieve the same economies of scale as Wal-Mart or China Inc. You don't have the buying power, and you don't have the division of people who have years of experience cutting costs. Trying to offer consumers the lowest price possible seems to me to be little more than an excuse to overwork yourself. Who wants to work out of a barn or a garage all day long? Blech. I get hives just thinking about those cheap swivel chairs sold at Staples.

Now, some of you will argue that the reason you're starting a company is not to have fun, per se. Instead, it's rooted in some deep passion you have for a certain type of business--even if it is a consumer business, where you'll be forced to compete on price. You might believe that what I've just said doesn't apply to you. But it does.

If you insist on starting a company that sells to consumers, you'll still need higher margins than the big companies in your industry, which means you had better develop some kind of luxury product. So you want to be a chocolatier? Try making an $8 candy bar. Competing against Hershey's at 75 cents is just too brutal for a new company, and $8 gives you enough margin to play with, even when you source cacao of the finest quality.

Of course, some companies sell to businesses and to consumers, but this is a tricky balancing act. If you raise prices too fast, you will lose consumers. But if you continue to charge low prices, businesses may think your product is cheap--and you won't be extracting very much money out of precisely the customers who are most willing to pay.

To successfully sell to businesses and consumers, you need to realize that you're building two companies, not one. You need separate product lines. Cisco does this well, selling home versions of its business products through its Linksys division.

If you attempt this strategy, just keep in mind that you had better make sure there's a good way to keep the businesses from buying the consumer product, because although businesses are willing to spend money, they won't just throw it away. This is why, for example, Dell asks you whether you are a business customer or a consumer before it lets you buy anything from its website.

At Fog Creek, we found our own way around this problem. Our Copilot service tends to be used by consumers on weekends and by businesses during the week, so we copied the cell phone model and just allowed unlimited weekend use free of charge. This didn't hurt our revenue at all, because paying businesses need the service on weekdays, and it brought in a lot more consumers to try the service on weekends; I hope some of them go back to work on Monday morning and persuade their employer to sign on as one of our new business accounts.

Meanwhile, we've raised the price on FogBugz to $129 and then $199. The product is getting better all the time, of course--it's not like we're charging more for the same old thing. And there are benefits to doing business with comparatively free-spending companies. The added revenue we get each time we sign up a new user means we can afford to hire more developers, we can provide better customer service, and we can expand at a much faster rate.

Joel Spolsky is the co-founder and CEO of Fog Creek Software and the host of the popular blog Joel on Software.

Last updated: May 1, 2008




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