Up and Running:

Or alternate title: “Yeah, Right!” and “Oh, Brother,” as one of my daughters would have said when she was in her early teens. She would have been rolling her eyes, too.

I got an e-mail the other day with the title “Imagine Facebook for Business.”

Pretty good subject line for an unsolicited e-mail. Got my attention. But I was already thinking “OK, that’s easy enough to imagine. We call it Linkedin.” Not what the e-mailer wanted me to think.

I visited the site in question…

[Tangent, off topic: I'm not going to give the URL, because this post without the URL can be edgy and fun but, with the URL, it would be mean. I don't know the guy. And although unsolicited e-mail annoys me, as this blog gets more attention, I get more of it; and what the heck, I don't wish him ill or anything. I put myself out there by blogging, so no harm, no foul--but no URL, either.]

… and the truth was more like imagining Craig’s List without the listings. Some photo services, some remodelers; a total, if I read it correctly, of 61 random businesses in several dozen different places. I searched for “editor” in ZIP code 97401 (Eugene, Oregon) and came up, of course, with 0 results, followed by ads for 20 random businesses in 20 random places. Dance lessons in New York, poop scooping in New Jersey (an interesting variation on editing my stuff, I admit, but a bit harsh), computer consulting in Oklahoma, bookkeeping in North Carolina, photography in Texas, and so on.

So why am I posting on this, in this blog? Three reasons:

1. Understand the upside and downside of the critical mass phenomenon. Sites like this work if–and only if–they have critical mass. Lots of big successes, including Facebook, Craigslist, Youtube, Netflix, Amazon and so many others, got on the right side of critical mass and managed to stay there. You and I can’t get there just by inventing some database function. You have to be original, or capitalized with tens of millions–and smart or lucky, or something else.
2. Exaggeration can make you look foolish. Don’t be the Facebook of this, the Youtube of that or the Netflix of something else unless you really have something strong to show.
3. What you really need, as a small startup, is focus. Let your dreams be as grand as you like, but focus your business down to a very sharp edge. For example, maybe this unnamed new site could have made it with focus on a specific type of business in a specific location. All the businesses it could gather in some small town, all the pooper scooper businesses nationwide or something like that. Find the long tail. Join it.

So this is a bit of a rant. Sorry.

Here’s an insight for fairness: Always separate payment for work from equity ownership. I posted arguing with partners over compensation earlier this week, dealing with a real problem in a real company. I got a follow-up question to that today, offering more detail and asking for more detail in return. It’s messy. It also looks like a good illustration for the rest of us.

So hypothetically, assume four people named A, B, C and D. They each have exactly 25 percent ownership in the new company. They are all working in different ways, but one is semi-retired and doesn’t need compensation, another has been working a lot at night and is keeping their day job, and two others have no other income and want to get paid. The argument is whether getting paid for your work should reduce your equity share. Literally, the question is:

Partnership has not agreed yet on compensation levels for all, only for equity levels for partners. Should those receiving monies have their equity levels reduced and shared among remaining partners?

The right way to solve this problem is to have foreseen it and agreed what to do and gotten it in writing. Point one here, and this is me advising you, reader, so you don’t make the same mistake, is read my three vital rules for early-stage equity ownership from last month. The executive summary of that is: “Get it in writing.” It’s too late for these four because they’re already in operation. But I advise you not to get into similar messes caused by not talking these things out ahead of time. Apparently they divided up the ownership very carefully, but they didn’t specify who gets paid and who doesn’t. That’s really tough to deal with after the fact. It would have been much easier beforehand.

Ah, but in this case it is already too late for what they should have done, and they asked me to offer some advice on what they can do now, not on what they should have done earlier (that should-have component is for you, not them). So here’s what I say they might do now (As a disclaimer, I don’t know the people and I have just a description in e-mail; I’m making recommendations as an entrepreneur, not as an attorney or an accountant. This is hypothetical and sketchy):

1. Ignore equity ownership for at least enough time to have a good, honest discussion about what salary levels should be for all four jobs. Be fair and honest, and take into account market values for jobs and what it would cost to recruit somebody with no equity ownership to do the job. Set salary levels for all the owners’ jobs. For those who are working hourly or part time or after hours, let them record their hours. You have to separate ownership from compensation for work. In your case, that starts with establishing who’s working how much. You don’t just ignore work.
2. Don’t let anybody work for free. That’s bad news. Businesses need numbers that reflect reality, and when you have owners working for free you are creating false numbers. It also breeds unfairness and resentment. Ideally you find a capital contribution to give the company working capital to support its expenses. Can all partners contribute equally? If not, then give the partners who contribute more money more ownership. Keep it fair, in writing and agreed upon in the beginning.
3. If you don’t have the money and can’t raise it to pay people for what they do, which leaves working for free the only option, you still have to record the value and keep track of it as money owed. And you have to be very careful with how you handle the bookkeeping and the tax implications. If it weren’t for tax law, you could book the work value as an expense for one side of the double entry, and as a debt–owed by the company to the person who worked for free–on the other side of that double entry. So if the owner’s work is worth $4,000 per month, you record $4,000 as a debit to payroll expense and $4,000 as a credit to liabilities. Unfortunately, tax law is there, so you have to be very careful about the tax implications. You can’t report unpaid wages to owners as an expense. And the tax man wants payroll taxes, too, from the company and from the employee. This takes some professional help to get you through it.

This, by the way, is why I often cringe at the phrase “sweat equity.” Real sweat equity is what you build in your own company when you work it alone. As soon as other people are involved, working for free causes a lot of problems. It fouls up your numbers, which means you have a distorted view of the business. It can also cause a lot of tax problems. What’s more, investors don’t like it, either.

Bad clients. Not just clients who pay poorly, but also the clients who agree to one thing and then demand another, who change specifications, compress deadlines or just make you feel bad. When you’re in business for yourself or in a small business, you don’t want to turn down clients. Right? But then again, there’s that temptation to let them go. Life is short.

Guy Kawasaki posted Is Your Client a Certified Orifice? last week with a reference to Robert Sutton’s book (right) and a link to a test to determine whether you have the client from hell. Sutton has some tips on what to do about it if you do. All of that is a reference to the book.

This reminds me of one discovery I made during my years of business plan consulting. Call him John Smith. He was extremely annoying. Twice he took a detailed proposal I’d done and changed the job midstream, both times making it a lot more work without offering any more money. Twice he let me propose a job in detail, accepted the proposal and then changed deadlines. When deadlines got shorter, I had problems with work promised to other clients. In addition, Smith was generally unpleasant to work with.

Smith, however, was not just a single client. He was embedded in a larger company. He dealt every day with other people in that same company who were also clients.

So I didn’t have the option of firing him. First, I needed the business. Second, I couldn’t risk leaving him with a negative he could use against me, behind my back.

What I did, however, worked out pretty well, so I pass it along to you. It might seem obvious. After two bad experiences, the third time he asked for a proposal, I didn’t say no. I just tripled the amount I would have charged anyone else.

That didn’t solve the “I need the business” problem, but I took the financial hit. As it turned out, there was more business available elsewhere, so that was a good lesson. I was better off freeing up the time for more pleasant projects with other people.

It did, however, give me a way to “fire him” politely and invisibly. After the first job I bid at triple the normal rate, he asked for one other (which I also bid high), and then never asked again. Problem solved.

I had a nice last laugh, too. About a year later one of the other people in the group, with whom I’d done a number of successful projects, shared with me that Smith didn’t understand my value. “He says you charge way more than you’re worth,” my friend said. He shook his head and chuckled, thinking not how expensive I was but how cheap Smith was.

So that was a lesson that I’ve taken into other business contexts: Sometimes the best way to say no is to say yes … “and here’s how much it’s going to cost.” And if the annoying client takes you up on it, you have your high price as a consolation prize.

Here’s the question I got today in email:

I recently started a business with four others. Modest revenue has begun and two of the partners want to draw compensation. What is the trade off for them drawing compensation while others do not?

The question reminds me that a lot of people confuse getting paid for your work with making a return on an investment. Although the principles involved are plain and clear, tax treatments are anything but, so accountants and attorneys matter. So hold that thought for a bit. Let’s stick with the main points here.

All businesses should pay all employees fairly for their work and fairness is usually a matter of market value. A programmer might earn $40 per hour while a data entry clerk gets $20 per hour. Most jobs fit into some kind of categories and people either know or find out how much other companies are paying for equivalent jobs in an equivalent market.

Ownership ought not to make any difference. Businesses should treat owners who work as employees, and pay them fairly for their work. I mean legally and practically. Tax law wants owners who work in the business to be employees, and owners who don’t work in the business to not be employees. From the point of view of tax law, owners who work should earn salaries and the government gets taxes from both sides, from the business as employer and from the owner-employee as employee. On the other hand, money the business pays to owners who don’t work should be dividends, not compensation, and dividends get taxed differently. So the basic principle is that compensation is for people who work, according to the work.

Think of the meaning of the word and phrase: compensation and return on investment.

Aside from tax problems, mixing ownership return with compensation also fouls up the basic business numbers. If owners take wages for nothing then expenses are overstated and profits understated. If owners work for free and live off profits, or draw, then expenses are understated and profits overstated. Disguising business reality is not good.

In business plan context, I always recommend that the numbers include treating working owners as employees. Their compensation goes in the personnel plan along with that of all the other workers. Getting paid from profits may have tax advantages in some special cases, but it’s bad analysis. It clouds the real nature of the business.

So in your case, I can’t answer your question directly because you left out some critical information. Are the two partners who want to draw compensation working in the business? Are the two who don’t want that not working in the business? I think you can probably guess my answer. Pay any and all partners who work in the business a fair wage for the work they do, based on market value. And don’t pay those who don’t work. Then, at the end of the year, when the months close and all expenses are paid, the four owners take their share of the profits as draw, or not, or reinvest it in the business, or whatever. At least at that point the terms are clear, and what is left over after expenses is profits. Owners share profits according to their share of ownership.

Now, after all that as plain and simple principles, it wouldn’t be fair for me to not add that in some cases the intricacies of tax law determine some weird or twisted variations. For example, it’s quite common for sole proprietors in very small businesses to take regular draws from the business, but not treat themselves as employee. In that case it’s usually a tax-related alternate universe. And there are lots of other strange variations.

I say keep it simple in principle but expect to go over the details with either your attorney or accountant, or both. Just don’t lose site of that important fundamental principle that the business pays people who work, and profits for owners come from what’s left over after all the costs and expenses have been paid.

Over the holiday I ended up talking to some smart people about getting equity, as in shares or options, in a high-end startup. One of these people has a very high post in a venture-financed Web company with high traffic. Two others have been involved in venture-financed Web startups and had to sue later on matters related to initial share options.

Confusion over ownership comes with the territory. People naturally have different values for the idea, the work and the money. People are often awkward about putting these general ideas into specifics. Ownership of a company, however, is not vague at all; it is very specific. Legally it gets defined in numbers, not concepts. Whether it’s stocks, partnership shares or percentages, it’s specific. And then, to make matters worse, ownership changes as a company brings in investment in return for a portion of the ownership.

There is also a hidden problem: Company founders, the entrepreneurs, necessarily end up having to conform to investors’ rules when they bring in investors. The hidden problem is quite common. What happens next is that vague and general agreements made before the investors entered the picture are impossible to honor after the investors take their place.

So here are my three vital rules for dealing with early-stage equity ownership:

Rule #1: Get it in writing.

If ever there was a road paved with good intentions, this is it. Everybody intends to be fair, and they talk about fairness, but it’s just impossible to make it work until you get down to the actual details.

Rule #2: Get it in writing.

I know, it’s awkward. The other person says “trust me,” and you ask him or her to put that in writing. There you are in the excitement of startup, everybody pitching together, and it just feels bad to be the one who brings up the problem. It’s deflating. But it’s also really important. Swallow hard, breath deeply and explain that these things are supposed to be put down in writing. Things change quickly. One person’s idea of fairness is different from another’s, and those ideas change over time.

Tip: Set this up right, before you start talking, that it should be in writing because that’s the right way to do it. “Hey, Mabel, do you mind, but I think before we even broach this topic we should understand that it needs to be written. This is because it’s so easy to misunderstand, situations change so quickly, and sometimes you don’t have the options or control later that we both assume now.”

Rule #3: Get it in writing.

What is especially tough about all this is that so often promises, given honestly, become impossible to keep later on, because situations have changed. Investors are involved, and they have control clauses, and they can say no.

Having something in writing is a very powerful defense against this changing or cascading legal situation. Investors are 10 times more likely to have to honor–and I mean legally have to honor–a written document than a promise.

Brad Feld offers a very useful answer to an important question Tuesday in Ask the VC, a discussion that also belongs here in this blog. First, the question:

Q: … as an early-stage company looking to raise a seed round of under $500k ASAP to help us grow, what are your thoughts about outsourcing fundraising to a place like Vfinance so I can focus on running the business? Are there any drawbacks?

And then the answer:

A: (Brad) This is a bad idea. You should not do it. Even though fundraising–especially for an early-stage company–can turn into a full-time job, it’s an important one for the founders to do.

You need to treat fundraising as a priority. Presumably the reason you are raising $500k is to be able to hire a few people to help you leverage your time better as you are trying to get your business up and running. If you don’t put enough energy into this, you fall into a classic chicken and egg problem where you don’t have the money to build out your team, but you don’t have enough time to go raise the money because you are busy doing everything because you don’t have the team.

Take a deep breath and realize that fundraising has to become the most important thing you are doing at this stage. Find an early investor or advisor that knows you, likes you and has credibility and hopefully a network of other investors and advisors. Ask this person to help you with introductions to other angel investors. Manage these introductions like a sales process–once you have a pipeline of potential investors, spend the most time with the ones that appear to be most interested. At the earliest stage they are investing as much in you as they are in the business and idea, so make sure you are on the front line of this effort.

Start every day off with this. Fundraising should be the first thing you spend time on each day until you get it done. Once you take 100 percent responsibility for it and make it your priority, it’ll get easier.

Thanks Brad, that’s a very useful post.

You fall in love with your plan, and love is blind. You don’t see the fatal flaw.

I know a man who jumped headfirst into a new venture based on building a chain of used CD stores. The punch line? It was 2000. Napster was already there. Do you see the fatal flaw? He didn’t. And this was a man who’d had a string of successes.

Love is blind.

So here’s a trick that might, sometimes, if you’re lucky, help you see the fatal flaw.

1. It takes imagination. So close your eyes, relax your shoulders, take a deep breath and let it out slowly.
2. Jump in your imagination to the future. Go to three years from now.
3. Now pretend that, there in the future, you know that the business you are starting now, your baby, your dream, is over. It failed. I know, that’s hard, but it’s a game; it’s only in your imagination, so make that leap.
4. You’re sitting at a table, maybe in a coffee shop, maybe at lunch, and somebody asks you: “What happened? Why did it fail?”
5. Now, using your imagination, your intelligence and what you know about your business, answer that question. This is fiction now, so you have to tell a story. Make it believable. What happened?

This helps you think about flaws. Was it competition? Did the management lose interest? Was there not enough money? Did some new technology come in?

I don’t know for sure, but I believe that if my friend with the used CD stores had done this exercise, he would have come up with the possibility of a change in the way we deal with music, meaning Napster, downloading, iTunes and so on.

And, for the record, I haven’t done the research, either, but what do you think? Would you like to own a used CD store? What do you think has happened to the sale of used CDs?

“Believe in yourself. Don’t take no for an answer. Never quit. Don’t accept second best.”

Doesn’t that sound just like the language we–experts, teachers, entrepreneurs and even bloggers–use about starting a business? Passion is everything, never give up and so on.

Yes, I think so, too. We do hear that a lot. Which makes me more interested in yesterday’s New York Times piece Unhappy? Self-Critical? Maybe You’re Just a Perfectionist, by Benedict Carey.

Above all, be true to yourself.

That quote at the beginning of this post is straight from his lead paragraph. He adds, right after that:

It’s hard to argue with those maxims. They seem self-evident–if not written into the Constitution, then at least part of the cultural water supply that irrigates everything from halftime speeches to corporate lectures to SAT coaching classes.

He goes on to explore how perfectionism is less than a blessing when it’s related to depression, suicide and other mental-health problems.

I’d like to stick for a moment to the idea of “relentless move-ahead-no-matter-what-never-quit” as a characteristic of startups, successful businesses and entrepreneurship.

And say, with thanks to the reminder from Megan today, “no.” Not always.

That’s why you want to plan a business before you start it. Just dedication and passion and belief don’t mean your business will work. It takes market fit, market need and delivering.

And, following that reasoning, the summary of the Starting a Business chapter of Hurdle: the Book on Business Planning says:

I’ll always remember a talk I had with a man who had spent 15 years trying to make his sailboat manufacturing business work, achieving not much more than aging and more debt. “If I can tell you only one thing,” he said, “it is that you should never leave yourself without an exit. If you have no exit, then you can never get out. Businesses sometimes fail, and you need to be able to close it down and walk away. I wasn’t able to do that.”

The story points out why U.S. government securities laws discourage getting business investments from people who aren’t wealthy, sophisticated investors. They don’t fully understand how much risk there is. Please, as you start your business, make sure that you understand how easily money invested in a business can be lost.

If I could make only one point with budding entrepreneurs, it would be that you should know what money you need and understand that it is at risk. Don’t bet money you can’t afford to lose. Know how much you are betting.

I think that concept–know what you’re getting into and don’t do it if it won’t work–is as important a concept as “never quit.” This is business.

Seth Godin’s brilliant 2007 book The Dip has a related message. He talks about when and why to quit. In business, that’s important. It’s not personal; it’s business.

There’s a double win for Up and Running with a story I found this weekend on The New York Times. It’s an interesting about-face for a Web winner who’s now investing in print magazines with an edge. And it’s also another turmoil story of founders arguing about whose idea is whose, and who owns what. This is in Web Readers to Fill the Pages in The New York Times.

The about-face comes first. Cnet.com founder Halsey Minor is backing 8020 Publishing, which is developing hard-copy printed magazines.

“I spent my time at CNet talking about how print was going to be challenged by the Internet and specifically how we were going to make magazines go away,” he said. “But two years ago I realized I was still reading over 100 magazines a month. I like holding them and turning the pages. And the images are better than on the Internet.”

The flagship publication, called JPG, is a user-generated on-demand photo magazine.

Online readers vote on their favorite submissions appearing at JPGmag.com. Then a tiny staff of 10 designs a layout for the winners and about 50,000 high-quality slick-looking magazines are printed six times a year. They are sold through $25 annual subscriptions and on newsstands for $6 each. The online version is free. Readers can also download and print a PDF file of the entire magazine free, because the publishers assume that physically holding a high-quality magazine is more satisfying than viewing it online and therefore will not cannibalize newsstand sales. Even with that freebie, Mr. Minor says that 70 percent of his magazines on newsstands are purchased, a surprisingly high sell-through rate; most magazine publishers would be thrilled with 50 percent.

That’s cool, but that’s not the end of the story. Part of my charter in this blog is to help you foresee, and therefore prevent, the ownership and idea disputes that come up in a startup when they aren’t well-defined from the beginning. This happened with 8020, the company Minor is backing.

The startup was not without turmoil. Mr. Powazek (along with his wife, Heather Powazek Champ, also at the magazine since its founding) left 8020 in May, saying that a power-hungry Mr. Cloutier had pushed him out. On his blog, Powazek.com, he accused Mr. Cloutier and Mr. Minor of minimizing his contributions to the new and old versions of JPG. He was particularly upset that the earliest issues had been taken off the site.

Mr. Powazek said he did not realize his influence would be diminished so severely when he agreed that Mr. Cloutier should run 8020. He also laid claim to the idea for 8020, pointing out that he and his wife put together the first e-mail-driven version of JPG without Mr. Cloutier.

While he no longer has a role at 8020, Mr. Powazek still owns a small percentage of JPG. Mr. Cloutier does not dispute that the partnership ended badly or that the first issues were taken off the Web site. But he said it was necessary to distinguish between the incarnations of the magazine, since the new one was so different. And he said Mr. Powazek obstructed the introduction of the new company and magazine and alienated the staff members by refusing to let newcomers contribute to what he saw as his baby.

There is a lesson there for you, with your startup. Make it clear between founders before there’s money: Who does what? Who owns how much, and why? What are the roles each of the founders play? Get that straight ahead of time. These bad feelings sometimes lead to serious legal problems, and most of these can be avoided by making things clear from the early stages.

The good news in this case is that the venture goes on. Its goal is to make money as a hybrid of print and web revenue.

Nevertheless, Mr. Minor and company are so happy with the business model that they have produced a second user-generated magazine called Everywhere, devoted to travel. It went on sale last week.

The JPG and Everywhere sites have lots of what the staff calls easy jumping-in points, features meant to get users involved without intimidating them.

“Ask someone to write a magazine story, and they freeze up,” said Mr. Cloutier, who has designed magazine websites and helped start “CurrentTV.” “But say ’send us a postcard,’ and it becomes easy.”

Users can submit photos, writing and travel recommendations to Everywhere and comment on everything. If a comment is popular enough, it might end up in print under someone else’s photo.

8020 tries to make the magazine more readable by limiting advertising. Web ads are subtle, no pop-ups. The dozen or so advertisers in the print issues are limited to the first few pages, the back and sponsorships of special sections. Adobe Systems, Sony, Epson, Audi and Virgin America have bought ads.

8020 can afford to limit advertising because, Mr. Minor said, it does not need it to make a profit from them. It says it makes money on each subscription and newsstand sale–the opposite of the traditional magazine business. And while JPG’s circulation is only 18,000 subscriptions, the company said it needed to sell just 30,000 to break even on each issue.

The small print runs and low overhead leave money for quality paper, an increasing rarity among magazines. It is also reflected in the content. Data, like hotel phone numbers and addresses, is likely to be on the web but not in a print version of Everywhere. Longer stories and photo essays might be featured solely in print. Now they will see whether users share their vision.

In the meantime, Mr. Minor and the 8020 staff are kicking around ideas for the next magazine. Mr. Minor said he was in the venture for the long haul. “I would be really upset if it didn’t work because it should work,” he said. “We should be able to build a large media company based on people publishing for themselves.”

This week’s Carnival of Small Business includes The Biggest Mistakes People Make When Starting Their Online Business, from Kenton Newby. I might be prejudiced because it includes some things I’ve been writing about for a while, but it seems to me like a useful list. Some highlights:

• Thinking they don’t know anything someone else would be willing to pay for.

Good point, and good to put on a list of mistakes; in this case it’s their number one. Many people just never get started because they think everybody else knows more. I think they’re waiting for some magic answer that they think others already have, but which they can’t find. It’s tough, but you have to know that the answers aren’t always written in the sky.

• Setting prices too low.

Yes, please. I think it’s the most frequent error in startups. You don’t have to be the low price offering. Your pricing is your first message about quality.

• Not aggressively testing and tracking.

Yes, thank you, it’s like planning without following up, a waste of planning. The web gives you amazing resources for tracking results. Use them.

• Moving from one strategy to the next.

Frustrating sometimes, but Strategy Needs to be Consistently Applied Over a Long Term to Work. Better to have a mediocre long-term strategy consistently applied for years than a series of brilliant but contradictory strategies that never last long enough to matter.

You’ve heard of Moby Dick and the one that got away? How about 20 really bad investments? This list, posted today on insideCRM.com and compiled by its editors, is a reminder of what burn rate really means, with a hint of what valuation once meant (traffic, not sales; notoriety, not fundamentals). It’s also a an excellent illustration of why venture capital firms aim for deals that look like they can deliver 100X returns–because there are a lot of losers along the way.

My personal favorite, Webvan, ends up as number three on this list. I was hoping for Webvan to succeed, because I hate shopping for groceries, and some of my family members were customers. Then they bought thousands of white vans and warehouse facilities, and crashed.

This company that once had about $800 million in venture capital ended up with $830 million in losses, with about $40 million on hand.

Number one, Amp’d Mobile, apparently decided to focus on people who didn’t pay bills, or so it seems from the description. I thought it had died because of the apostrophe in the name, always a bad sign.

While other mobile providers check for an ability to pay bills within 30 days, Amp’d let it go to 90 days and marketed to these risky customers. It has been reported that 80,000 of the company’s 175,000 customers were unable to pay their bills.

I won’t spoil the suspense, though, go read the list. And remember it the next time you want to complain that VCs are too focused on fundamentals.

The most common mistake in startups is underpricing. No, I don’t have data to prove it, I haven’t done the study, and I’m not going to. I’ve seen it for several decades. Somewhere in the back of our entrepreneurial minds we still get stuck in the mistaken idea that startup companies are supposed to win by having the lowest price.

Sorry, but it just isn’t true. We got that mentality somewhere back in the nineteenth century with classic economics, particularly the idea of “elasticity.” When they said a lower price means higher volume they were talking about lumps of coal. They had no idea about price positioning and strategy, or buyer preferences; and very little about working capital.

Thanks to Andrea Learned of Marketing Profs Daily Fix for pointing to Ray Fisman’s article Will Customers Pay More To Do Good in Slate Magazine.

First, the researchers recorded the weekly sales of the towels and candles without labeling any of them as fair-labor certified, measuring purchasing decisions based solely on taste. After a few weeks, Hiscox and Smyth spent the night at ABC sticking fair-labor labels on one brand of towels and one brand of candles. When the store reopened, sales of the now-labeled fair-labor towels jumped by 11 percent relative to sales of the unlabeled brand. For candles, the effect was even greater—an increase of 26 percent.

A few weeks later, Hiscox and Smyth were back in the stockroom, marking up the prices on the labeled towels and candles by 10 percent. Quite remarkably, this increase made people buy even more towels and candles (a 20 percent increase for towels and 30 percent for candles). The authors suggest this may be because the higher prices made the products’ fair-labor claims more credible.

Obviously the intended main point of this research is the impact of fair-labor practices on buying preferences. Still, notice how increasing the prices also increased the volume. A 10 percent increase in price produced a 20 percent increase in sales of towels and 30 percent in sales of candles. In this case pricing was what we call “inelastic.” A higher price meant higher volume.

Inelastic markets are quite common. A couple of generations of marketers have been telling and retelling the story of the introduction of Pillsbury cake mixes, which failed miserably in 1951 at 10 cents a package and then succeeded spectacularly just two years later when they were reintroduced at 25 cents. The point was that the lower price wasn’t credible.

What isn’t so common is research pointing this out, in plain terms, as in this study. The point is that the low price isn’t always that attractive; not for a lot of things. In this case the higher price makes the labor practices claim credible. In many other cases higher prices make other claims credible, like organic food, healthy ingredients, safer medicine, better professional services, more enjoyable vacations, cleaner rooms, safer cars, faster cars.

The low-price high-volume strategy works great for Costco and Wal-Mart, both of them huge companies with huge budgets and enormous capital to make a promise and keep it. Don’t think that this necessarily applies to your startup.