December 15, 2022
Hey, everyone. I'm Aaron Epstein. I'm a group partner here at Y Combinator. And in this video, we're going to be talking about business models and pricing. There's three main things that we're going to cover in this video.
So first, let's talk about business models that build winners. If you're not familiar, a business model is a fancy term for how you make money. And it turns out the business models are important because we see founders that often get frustrated when investors won't fund them and their business won't grow. And oftentimes they're not sure why. And usually this is because they're not using a proven business model. And they're actually only a handful of business models that are responsible for nearly all billion dollar companies. And rather than trying to reinvent the wheel, you should actually just copy one of these.
Here they are. Nearly every billion dollar company is one of these nine business models. There's SaaS Business Models, which is software as a service, which is cloud-based subscription software that customers pay either monthly or annually in order to access the software. There's transactional business models that facilitate transactions and take a cut of those transactions. These are often fintech companies. And then there's marketplaces, which facilitate transactions between buyers and sellers. These are often referred to as two-sided marketplaces. And there's also hard tech businesses. There's usage-based business models. There's enterprise. There's advertising. There's e-commerce and there's bio.
And so in this video, I'm actually not going to get too deep into the specifics of each of these business models. Instead, we're going to have a business model guide that I've put together. This guide is going to cover the metrics that matter most for each business model, key takeaways for each of them, and other similar companies that you can learn from depending on which business model you are using for your company.
In this video, what I want to focus on is things that we can learn from the top 100 YC companies. The top 100 YC companies is pulled from ycombinator.com/topcompanies, which is a list of the most valuable companies that Y Combinator has ever funded. And so for the purposes of this video, I've gone through this list and I've matched each company up with their primary business model to try to see what interesting insights we can get from them. Now, some later stage and larger companies actually have multiple business models. However, for your purposes, as an early stage startup, you should just have a single business model that you're focused on.
And so here they are. These are the top 100 YC companies organized by business model. And there's some interesting things that we see here. First is that SaaS businesses actually make up 31% of the top 100 YC companies. Transactional businesses make up 22% of the top 100 YC companies, and marketplaces actually make up 14%. So just with these three business models, SaaS, transactional, and marketplaces, it makes up 67% of the top 100 YC companies. On the flip side, with business models like advertising and e-commerce, they barely register on the top 100 YC companies list.
If you're familiar with startup outcomes and venture capital returns, you know that there's a power law effect, which means that the biggest winners far, far outperform all other businesses by orders of magnitude. And this is true for the YC Top 100 companies list as well. Turns out that 50% of the overall value of the top 100 YC companies actually comes from just the top 10.
And so it's interesting to look at what insights we can get from these 10 companies too. Here they are. These are the top 10 YC companies by value. There's a number of companies here that you're probably very familiar with or use on a regular basis.
And what's especially interesting is that five of the YC top 10 are actually marketplaces. The interesting takeaway here is that marketplaces are most likely to build winner-take-all companies. They tend to become so big and dominant in their industry that it doesn't leave much room or market share for other competitors once marketplaces actually get huge. So marketplaces are 14% of the top 100 companies, but they actually create 30% of the overall value because so many are represented here in the top 10. And while marketplaces are really tough to get off the ground, they have a chicken and egg problem where you can't just build your product and then sell it to customers. You actually need to solve for both sides of the marketplace, the supply and the demand at the same time in order to get customers. However, Once they hit the inflection point and they start to work, they get massive network effects where each new user of the platform increases the value for everybody else. That's what makes them dominant winners. So you can think of companies like Airbnb. If you are looking to rent out a place short-term to stay, then chances are you would go to Airbnb because that's where all the inventory is. Similarly, if you wanted to buy or sell NFTs, you would probably go to OpenSea because that's where everyone is. That's how these become the big winners.
Marketplace Takeaways:
It also turns out that three of the YC Top 10 are transactional businesses, too. The main takeaway here is that transactional businesses far outperform because they're directly in the flow of funds. This means that they are the platform that money flows through, making it very easy for them to just take their cut. And so transactional companies are 22% of the top 100 YC companies, but they actually create 29% of the overall value. And this is because there is close to the transaction as possible.
This was advice that I received during my YC batch back in 2010. And that was to get as close to the transaction as possible. If you're a company like Stripe that literally processes money for companies or Brex that is the corporate card that they use to spend money, then you're directly in that flow of funds. And so it's really easy to take your cut. On the opposite extreme, if you are an affiliate business, multiple things have to happen before you ultimately get paid, which means that you are very far from the transaction, which makes those not as good of a business.
For transactional businesses, because they're so close to the transaction, they often become critical infrastructure for other companies that they build on top of. And that usually means that they are solving a top three problem for them. So you can imagine if you use Stripe as your primary method to get paid from your customers, the thought of ripping that out sounds terrible. You would never want to do that. And that's why these transactional businesses become so dominant.
Transactional Takeaways:
We also see that SaaS businesses are most likely to make the top 100 list. And this is because they have consistent revenue. So 31% of the YC top 100 companies are actually SaaS businesses. That's nearly a third. And this is because the recurring revenue makes them great businesses. This means that customers keep paying them every single month or every single year until the customer explicitly says to stop. So this has lots of benefits, including the predictable revenue that they get, which allows them to compound and grow their business.
SaaS Takeaways:
We can also see that very few advertising businesses become big winners. And this may be surprising because we're so familiar with so many companies that have built their business off of an advertising business model. There's Google, there's Facebook, there's Twitter just to name a few, but really only 3% of the top 100 YC companies use an advertising business model as their primary way to make money. And that's because advertising businesses need organic virality to win. They need to catch lightning in a bottle and become the hub where all users go to to hang out or to see live streams in the case of Twitch. But when that happens, they get really strong network effects just like marketplaces. So people go to hang out on Reddit and form communities there because that's where everybody else is. People go to Twitch to watch live streams because that's where all the streamers are. And so it's really important to remember that you should not use ads as your primary business model unless you expect to be a top 10 site on the internet. Otherwise, it's too hard to monetize and build a huge scale to become a massive company.
Advertising Takeaways:
So what are some overall lessons that we can take away from this list?
First, it's interesting to look at what's not in the top 100 list.
What's not in the top 100:
We also see that recurring revenue consistently creates winners. And this is because it is highly predictable. Once a customer has committed to pay, they're going to continue paying until they explicitly say that they want to stop paying. They also have higher customer lifetime values versus one-off transactions. And this results in lower customer acquisition costs, so you don't have to keep reacquiring customers over and over. If you have a one-off transactional business, then you have to invest money in acquiring that customer the first time, and then also keep putting more money into trying to get existing customers to spend more with you. That's not the case with recurring revenue businesses.
Recurring revenue consistently creates winners:
But recurring revenue only works when you have strong retention. It's not enough for your product to deliver value right up front and then never again. You need to keep delivering value over and over again. Otherwise, your customers will churn and stop paying. And then you can't scale a leaky bucket if you have lots of churn.
We can also see that some of the biggest winners are built with moats.
Biggest winners are built with moats:
So to recap, the best businesses generate recurring revenue, have high retention, Build defensible motes are as close to the transaction as possible. They scale with software, not people. And they're proven and use business models that are familiar to customers. And so it's important that you focus on innovating on your product. That's what should be new. And copying your business model from one of these proven winners.
The best businesses...
All right, now let's talk about pricing. It's important to think of pricing as a tool to help you learn faster. It can help teach you:
So to help you get started, I've compiled five pricing insights from the top YC companies.
The first is you should charge. This is actually the most common mistake that we see founders make. Often founders are afraid to charge for a number of reasons. They're often afraid that their customers are going to tell them no. They're afraid that their customers are going to walk away and never come back. And they're afraid that their customers are actually going to go and use their competitors product. But it turns out that charging is actually one of the most effective ways to learn a lot of really important things about your business.
Stripe is a great example of this. In the early days, Stripe wanted to test the amount of value that they were building in their product. So while most of their competitors were actually charging around 3% per transaction, Stripe decided to set their price at 5% per transaction, nearly double what their competitors were charging. And the reason that they did this is because they wanted to test how much value their customers saw in things like one-click signup and being able to get started quickly, and really in-depth, detailed developer API documentation that would help developers get started faster. And so rather than trying to undercut the competition in order to win customers, they did the exact opposite and set a really high bar for themselves to prove that they had built enough value into their product.
So where should you begin?
The next insight is that you should price on value, not on cost. And so there's three important components here.
And so founders often start with something called cost plus pricing. I would not recommend this. What this usually looks like is looking at how much it costs you to serve a customer and then adding an amount on top of that, say $10. And that's your price. But this actually ignores the full value of what your customers see in your product. So the difference between your cost to serve your customer and the price that you charge, that's your margin. That's how much you make on each transaction. And the difference between the price and the value that your customers see in your product, that's your opportunity to be able to raise your prices, to be able to capture more of that perceived value.
And now if your cost is higher than your price, well, that means that you're gonna have negative margins, and you cannot scale a business with negative margins. Similarly, if your price is higher than the value that your customers see in your product, that means they're just not gonna buy from you.
So how do you find your value? Well, there's a couple interesting ways to be able to do this.
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How to find your value:
1Talk to your users
2Keep raising prices until you get pushback
3.
The first is talk to your users. You can ask them about the problem that you solve and get them to articulate the value to you. And so what this often looks like is if you reach out to a customer and you get them on a call and you can ask them, what is the problem that you are hoping that our products could solve for you? And they'll often tell you, And similarly, if you have a user that's signed up for your product but is not actually paying you, you can reach out to them and talk to them and ask them the question, what problem were you hoping that our products could solve for you? And their response is usually going to be one of four interesting things.
"What is the problem that you are hoping that our product could solve?
Another way to find your value is to keep incrementally raising prices until you get pushback from users. And when you keep incrementally raising your prices, you will ultimately find the ideal price, which is when customers complain, but they still pay. This is actually a good thing. It overcomes that fear of charging a high price and customers walking away.
The ideal scenario is when you tell the customer a price, they say they have to think about it. They go back and then they come back to you a week later and they say, all right, that seems good. You're the best solution. We're willing to pay up. On the other side, if you were to actually charge a lower price and they say, yeah, that sounds great and accept immediately. Well, that probably means that you're pricing too low and you're leaving a lot of money on the table.
Ideal price
: when customers complain but they still pay.
That brings me to my third insight, which is that most startups are actually undercharging. You almost certainly are. And lower prices are not a sustainable advantage. Sometimes we talk to founders and they say, well, our product is just like our large competitor, except ours is cheaper. And that actually does not sound like a good idea. That's not a way to build a winner. All that means is that your large competitor can under-price you even way lower than your costs because they have way more money and are way larger than you until they put you out of business. So I do not recommend having price as your only differentiator.
It also turns out that when you charge more, you get higher margins and you're able to build a bigger moat. This means if you have higher margins than your competitors, you can pay more to acquire a customer, which means you can acquire all of the customers before they do.
It's also important to remember that pricing implies value. When customers are evaluating your product, they typically don't have a lot of signals on how valuable your product is, but the price that you're charging is actually one of the primary ones. So if your price is lower than your competitors, then your customers might assume that your product is less valuable than theirs. Similarly, if you charge a higher price, then your customers might assume that your product is even more valuable than your competitors. So that can work really well.
And so it turns out that raising prices is actually the easiest way to grow revenue. If you have a thousand customers and you want to double your revenue, well, it sounds pretty difficult to spend all the time, energy, and money to go get a thousand more customers. However, if you're able to just double your price, just changing a number on the website or changing the price that you're quoting to customers in a sales call, and your product supports that higher value, well you've just doubled your revenue with almost no work at all.
But what if users won't pay more? This usually means one of two things.
There's a third option too, which is you could give a lower price in exchange for one of four key things.
Give a lower price in exchange for...
It's also really important to remember that pricing isn't permanent. This is another common fear that we see from founders where they're afraid that they have to nail their pricing the first time or they're going to lose their customer and never have a chance to get them again. Or sometimes founders are afraid that the set of customers that they're talking to are the only ones they're ever going to get, and so they have to close them all. And if that's the case, you should probably work on a different business.
But it actually is relatively painless to be able to increase prices on customers over time too. And there's a couple of different ways to do this.
How to raise your prices:
Netflix is a great example of this. This chart actually shows price increases that Netflix has made over the last seven or so years. And it's really interesting to see that they are not shy about raising prices on their customers. And now Netflix has 221 million paid subscribers. And they've been able to figure out how to raise prices because that is the easiest way for them to grow revenue rather than continuing to try to scale subscriber growth at the same rate. So if Netflix is able to find a way to increase their prices on 221 million customers, you should be able to figure out how to do it on your handful of early customers as well.
And the fifth insight is to keep it simple.
This is an example of a pricing page for Quicken. And as you can see, it's very complex. There's five different buy buttons. There's prices. There's 349, 399, 599, 899. There's crossed out prices. There's $1 off with a symbol right next to it. It's really complicated to figure out, even if you want to be a Quicken customer, which plan you should go with.
And so this likely results in decreased conversion rates. So it's important to remember that when you're creating your pricing, you don't want it to create friction that prevents customers from signing up and paying you.
On the flip side, here's a great example from GitLab. They have three very clear, simple plans with clear pricing. And so their pricing and their pricing page is not going to be the thing that adds more friction and prevents customers from signing up and paying them.
And so I'll leave you with this story of segment, which helps companies capture and use their customer data. When they started out, they were a couple of engineers that were not used to paying for products themselves. And so they thought they had to give their product away for free in order to get anybody to use it. And then they wanted to raise money from investors. So they decided, maybe we should actually charge our customers money so we can show revenue growth. So, tail between their legs, they reached out to all their free customers, and sheepishly told them that they were actually going to start charging them $10 per month which was $120 per year. And so they were really nervous about telling their customers this. But surprisingly, their customers started responding to them with messages like, I hope you would charge me more than that. Otherwise I'm worried about keeping my customer data with you, right? The low price was signaling to their customers that maybe their product wasn't valuable or it couldn't be trusted in the long term.
In order to grow even more, they hired a sales advisor. And that sales advisor told them, you should not be charging $120 a year. Instead, you should be charging $120,000 per year. This is an enterprise product. And this scared them to hear this. It was unfathomable to them that anybody would ever pay $120,000 a year for their product. And so when they were going into their first sales meeting with their sales advisor, The advisor told them, if you don't tell this customer that your price is $120,000, then I quit as your sales advisor. So they went into the meeting and at the end, when it came time to talk price and the customer said, so how much is it? The CEO got really read. And he got nervous and he said, $120,000. And the customer responded, how about $12,000? And they ultimately ended up agreeing on $18,000 as their price.
While they didn't actually get the thousand X price increase, they were able to increase their price 150 times from $120 a year all the way up to $18,000 a year and it wouldn't have happened if they didn't ask for the higher price. And so they used this philosophy to continue growing their deal sizes all the way up to six figures and beyond and ultimately led to their acquisition by Twilio for more than $3 billion. So the story of Segment hopefully is instructive to you that they started out giving away their product for free, ultimately ended up selling to huge enterprises and building a business worth over $3 billion.
So to wrap up the five key pricing insights:
1You should charge.
2You should price on value, not on cost.
3Most startups are undercharging and you probably are too.
4Pricing isn't permanent. Don't have fear that you need to get it right the first time. You can change it over time as you learn more and build more value into your product.
5Keep it simple. Don't add complexity, which adds friction to customers giving you their money.
