I published Fixed to Flexible on Tuesday. Everything was going well. People were starting to read it. They were starting to talk about it.

When I check my email Wednesday morning, I had an email from Evernote CEO Phil Libin:

Just read your ebook. It’s in my Evernote now. Great job, thanks!

Your Evernote math is a bit off.

Ugh.

I asked Phil if he would help me clean up the math and answer a few questions about the company. He agreed and the results follow:

Todd: So, I seem to have messed up the math a little.

Phil: It was my fault for being confusing. When talking to the BBC I switched back and forth between talking about all users and active users. Active users are people that have used Evernote in the past 30 days. That’s important because someone who doesn’t use the system in a given month, doesn’t cost us anything that month. So that 9 cents per month figure is for active users, but you did the math as if it was 9 cents per month for all users. Only about 30% – 40% of our users are active in a given month, so the mistake makes our margin looks a lot worse than it really is.

I ran the numbers from January 2010. At the end of the month, we had 2,335,676 total users and 41,598 premium users. Total variable expenses (hardware + software + hosting + network + operations staff + support staff) were $68,641. Total revenue from active premium users was approximately $145,000. I say “approximately” because this is recognized revenue, which trails cash, but is more relevant for gross margin calculations. The gross margin comes out to about 53%.

The gross margin increases every month because revenue per user grows (conversion rates go up because long-time users are more likely to convert) while variable expenses per user decline (Moore’s law + efficiencies of scale).

There are other sources of revenue (as well as fixed expenses), but they don’t move around much, so the gross margin is by far the most important factor. We launched the service into closed beta in February of 2008. Gross margin went positive in January 2009.

T: What other factors need to be taken into account?

P: There are many other factors, enough to fill a book. Maybe we should write one together. The gross margin is the single most important factor, but the other stuff that you have to worry about are fixed costs (which can be huge in a high-tech startup), fundraising, team building, product development, marketing, execution, lunch, etc.

The general recipe I try to follow is:

1. Invest heavily in the product; focusing on things that will make your customers love you and things that will keep your variable costs low when you scale. Make your product free so that you don’t have to pay for traditional marketing.
2. Raise a little bit of money and put all of it back into the product.
3. Slowly introduce paid features but always keep the “main” product free. Get to positive gross margins.
4. Raise a lot more money and put it all back into the product.
5. Grow until your gross margin makes you fully profitable.
6. Put all the profit back into the product.

People ask about exit strategies, but my goal has always been to get big enough and profitable enough that the last thing you’ll want to do is exit. That’s when you’ll exit.

T: My original hypothesis was that you would benefit from declining costs in line with Moore’s Law/experience curves. Do you continue to see prices falling in processor power, storage, and bandwidth?

P: Moore’s law moves mountains on the decade-scale, but it’s not quite fast enough for the planning purposes of a tech startup. For a really quickly growing startup that’s always doing something new, you have to multiply Moore’s Law by Murphy’s Law; “The number of things that will go wrong will double every year.” Sure servers get cheaper, but you probably bought the wrong ones anyway…

The real medium-term cost savings comes from efficiencies of scale and getting better at what you do. For example, we currently have about 60 servers in the data center and four operations guys to maintain them (both included in the variable costs for gross margin calculations). When we get to 600 servers, we won’t need 30 ops guys, probably 10 will be enough.

T: I have always found the two options at Evernote interesting. There is some good research that says three options increases sales. What has been the thinking?

P: You’re probably right. We just haven’t had time to get into heavy price theory yet, but we might experiment with different price tiers down the road. We decided to go with a single, low price for the premium version to keep the decision for users as simple as possible.

I don’t know much about the black-art of pricing, so for my last 13 hour flight to Japan I brought three books on pricing strategy on my Kindle and a copy of the Lord of the Rings trilogy, “just in case”. Wound up reading LotR for the sixth time and still don’t know anything about pricing. Well, I know one thing: there will always be a free version of Evernote, and it will always be the “main” version.

T: Many entrepreneurs are at home dreaming of their version of Evernote, lured by extremely low cost of bits. Freemium still seems like a tough model. What do start-ups need to think about when rolling out a freemium model?

P: Here are three things I think about:

1. Make a product that a billion people will fall in love with and use for the rest of their lives.
2. Make it easy for a single-digit percentage of them to pay you a few bucks a month once in a while.
3. Make sure your variable costs are low enough that you can make a mountain of profit if you get #1 and #2 right.

If you can’t see how you’ll do all three things, go with another business model.

T: Thanks writing me to correct my assumptions and taking the time to answer some questions.

P: My pleasure. Thanks for actually writing a book about this!

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You might be interested in the ebook Free to Flexible: Four Simple Lessons About Cost, Price, Margin and The Options Available to The 21st Century Business. You can download it here.