Starting a Company

How Not to Charge Your Customers

Written by James Garvin for Gaebler Ventures

Firms like Facebook and Twitter are rigorously scrutinized in the media for not charging their users access to these platforms. Many critics argue that since both social platforms have millions of users, they should be able to charge a few dollars for every user and generate hundreds of millions in revenue. We'll analyze what would happen if they did charge their customers and what you can learn from how to properly charge your customers if you provide free services.

Facebook and Twitter are undoubtedly two of the fastest growing services ever.

Their ability to connect people in ways that were not possible before has provided our society with a new means of digital and real time communication that provide us with a social element of always being "connected". Aside from being great services, the single factor that allowed both Facebook & Twitter to grow as big and as fast as they did, is that these services are free to its users.

Now that both platforms have hundreds of millions of users and are both unprofitable, many argue that it is time for them to start charging access and use of the platforms. Charging your free user base may be a very costly mistake for firms like Facebook and Twitter as we'll show in the following example: For the sake of this example, let's assume that Twitter currently has 200 million users and makes $300 million in advertising revenue (which is close to Facebook's ad revenues). Let's assume that Twitter decides to charge all users $1/year. What would happen to their # of users? I would estimate that easily half of Twitter's current users would cease to use the service, especially if you think of the number of people who have subscribed to Twitter, but are not active users.

So now Twitter has 100 million users, each paying $1/year providing Twitter with $100 million in revenue. What about their advertising revenues? With 200 million users, Twitter was earning $300 million in ad revenue or $1.50 per user. Advertising revenue isn't a direct correlation to the number of users. Meaning that with only half as many users, Twitter will not simply only get half of their $300 million of advertising revenue. There are several formulas to determine the "network effect", but for the sake of this example we'll use the following formula (N*Log(N)), where N is the number of users. This formula should be standardized to the current value of the network which we established as $300 million per 200 users or $1.50 per user.

I will spare you the math for this example, but the value of the Twitter network from the advertising revenues is now only $130 million, a far cry from the $300 million they were earning with 200 million users. If Twitter is able to extract $100 million in subscription revenue from its 100 million users and is able to obtain $130 million in advertising revenue, their total annual revenue is now $230 million, $70 million less than their $300 million they were earning from just advertising with their 200 million users.

This brief example of charging users access to a free service demonstrates the difficulties that not only Facebook and Twitter have, but also newspapers have in trying to sell their information that consumers have received for free since the advent of the internet.

So what should firms like Facebook and Twitter do to increase their revenues to become profitable and what should you do if you provide free information or services? The answer is to price discriminate. Find ways to charge heavy users of your service, much like internet providers such as Comcast have been doing to users who exceed monthly bandwidth restrictions. By continuing to provide free access to users who value basic use of the service and charging high users, you can effectively get the best of both worlds and increase your revenues with out sacrificing the number of users.

James Garvin began his education studying biotechnology. In recent years he has turned his interest in technology to helping two internet startup companies. The first business was an online personal financial network and the second was an e-marketing platform created to help entrepreneurs demo their web sites. Currently a student at University of California Davis, James is spending his summer incubating two new online businesses and writing about his entrepreneur experiences.

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