How to fund on-demand applications

There are several ways of making money from on-demand. Advertising is the least effective, subscription remains the most popular, and transaction commissions will overtake both.

There are three three main ways of funding on-demand applications.

Advertising is by far the least effective of the three. It's probably a better option than selling perpetual licences for two bucks a time, but it will rarely produce enough income to fund operation and development of a service that offers real value to customers.

Subscription remains the most popular mechanism among vendors, mainly because it has the advantage of being simple to administer and easy to understand. There are two varieties, plus the option of combining them together:

  • Fixed rate, for example, per user per month, per company per year, or other permutations of users and time (per project per month is another example). Customers like this arrangement because they know what their commitment is going to be upfront.
  • Variable rate, where customers pay according to usage. This works best where customers can see a direct correlation between what they pay and the service that's delivered. Examples include website traffic analysis, ad serving (Whether it's DoubleClick DART or Google AdWords) and hosted storage. Notice I've cited Google here, because what it sells is more than just ads; it provides an innovative ad-serving infrastructure that has redefined how we think about online advertising. Its profitability comes from the extra value that infrastructure provides rather than simply an ability to place ads.
  • Fixed plus variable. There's a strong precedent for this in the cellphone industry, where the concept is well established of paying a monthly subscription for a base level of service and then paying for extra usage above a certain threshold. It hasn't yet taken hold in the on-demand space, but it's likely to become more commonplace.

Transaction commissions are set to become the most important funding mechanism for online applications as time goes on. There are several varieties, but I'll highlight just three of the most important here:

  • Trading fees. Ebay's auction service is the most well-known example of an on-demand provider that funds its service by taking a cut of the transactions it enables. Ebay subsidiary PayPal is another example.
  • Service commissions. Rearden Commerce is building a business out of providing access to business services, and a significant chunk of its revenues will come from taking a slice of what customers pay for the services they buy. Amazon Mechanical Turk uses the same principle, applied to a single service.
  • Aggregation fees. A variation on the above is when a platform or application brings together services and presents them to users, and takes either a commission or a referral fee when users take up the service. The prime example of this today is iTunes, but you can see it working equally well for business services. Where the services offered are highly complementary to the core application, you can imagine that it could become an important source of revenue in certain applications, and I predict this is the mechanism Microsoft is most likely to use to fund 'free' on-demand applications once it's discovered that plain vanilla advertising isn't going to work out.