Many media formats have active used markets. Visit any college campus during the first week of classes and you'll find a used textbook swap. Amazon has created an active marketplace for pre-owned hardcovers and paperbacks.

The videogame industry is no different with retail chain GameStop leading the way as market maker. Wall Street analysts estimate the size of the second-hand market to be $2 billion a year and accounting for 1/3 of the games sold in the U.S.

Leading game publisher Electronic Arts (EA) is rolling out a program to try and recapture some of that lost revenue. Included inside new copies of their games is a one-time code which unlocks new characters, weapons, and gaming levels. Anyone who buys the game on the used market will pay money (currently $3-$10) to gain access to this additional downloadable content (DLC). These codes act as both reward to purchases of new product and new revenue source from the secondary market.

DLC is growing source of additional revenue for software companies. EA is going to offer Tiger Woods Golf for free online with club upgrades available at a cost. Hipstamatic, a camera application for the iPhone, allows customers to buy lens, film, and flashes to creates a variety of vintage effects. Social gaming sites for kids like Club Penguin and Moshi Monsters use a philosophy of free membership with additional features added with a paid subscription.

So, the question is: what's your downloadable content that could create another revenue stream and give you more options?

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"You Have Options" is the final section of 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.

Shortly after Radiohead announced announced their pay-what-you-want offer for the digital version of In Rainbow, Paste Magazine made the same offer: choose what you want to pay to receive the publication for one year.

Here is what publisher Nick Purdy told Audience Development about the experiment:

If I had to do it all over again I would do the same thing. It paid for itself because we had enough new subscriptions and advertising. The PR value alone was worth doing it. As a sustainable model, I think there is some valid criticism that you undervalue your product—and it obviously doesn’t work when the ad revenue is not there.

For a young magazine that had not reached market saturation it was a fantastic way to get the word out about Paste. We got 30,000 subscribers out of that and they’re still with us. We would have needed 2 million pieces of direct mail to get that response.

We used it for only that one time as a subscription push, but for all of 2008 we continued to use it as a strategy at live events.

We’ve learned that people won’t subscribe at a festival, but they’ll come over to our table and pay what they want and take their first issue with them. It had a strange mystical power. And the shame factor drives the subscription price higher—the average Internet order was $7, versus $10 face-to-face. For a while it became a core strategy at festivals. We gained a few thousand more subscribers that way.

Pay-what-you-want works like free, creating a way for prospects to try your product or service. This case study also shows the potential for a stronger bond with high renewal rates for people who initially subscribed using the offer.

The final comment by Purdy about higher rates paid for people who paid in person at festival is interesting; does personal contact versus online anonymity increase amounts through some indirect peer pressure?

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You'll find more detail about Radiohead's In Rainbows pricing experiment on page 18 of 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.

“Luxury good prices are not directly linked to any type of costs.

The art of luxury pricing lies in quantifying the value-to-consumer regardless of cost, competitor or market prices.”

-from a marketing report by Simon Kucher & Partners, the leading consulting firm on pricing in the world

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This is great quote from Priceless by William Poundstone. It is one of the books I recommend 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.

A few days before Christmas I was in the grocery store doing the normal weekly shopping and a large chalkboard sign greeted me as I made the first turn: “Christmas Items 50% off!” I stopped.

The first item to catch my eye was the 42-ounce bags of holiday M&Ms. These candies are a weakness of mine and $4.28 for a large bag seemed like a great deal. And then I realized I didn’t know what a good price was for M&Ms.

Sitting next to them were small plastic candy canes filled with same red and green chocolates. The stocking stuffers were $2.28. They were eight times more expensive per ounce than the bulk bags. But then I wondered about those little packages at the checkout counter. I suddenly got very interested.

I searched out every package of M&Ms that existed in the store. The christmas clearance section had two seasonal versions. The store stocked three different package size in the candy aisle. The rack at the checkout carried the single serving above the larger Tear ’n Share bag. The Mars Company tempts customers seven different versions from grocery store entrance to exit.

The graph isn’t too surprising. The more you buy, the better deal you get. Mars is following what economists call the law of diminishing margin utility. Our satisfaction drops with each additional unit we buy and the only way to encourage us to purchase more is to keep lowering the price.

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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.

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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.

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.

I spent most of the day following up on the ton of responses on Fixed To Flexible.

So, let me start by saying thank you to all of you who read it and shared it with others.

I have been getting emails ranging from very general to very specific about pricing and margin. So, I want to share some of those queries in the form of blogs posts over the next week.

I also have some ideas that didn’t fit perfectly into the ebook and I was afraid it would get too long, so I want to post some of those thoughts as well.

We are going to go through a couple of revisions in short order. I already posted Version 1.01 with small typographic corrections. Thanks to Dylan, Sally, Joshua, and Iain for writing me with those annoying little errors.

Tomorrow, I will be posting Version 1.1. Didn’t expect a big revision so soon, but Phil Libin, CEO of Evernote, dropped me a note with some additional information about his business. It changes some of my conclusions in the Margin section. So, I’ll run through that in a blog post and then revise the ebook. Phil also agreed to do an interview and we will be posting in the next few days.

So, let’s get to work and find a bunch of ways to make these ideas work for you.