Business Model, Schmizness Model

The term “business model” has bothered me for a long time.  I have always found it to be a glib method of characterizing a company’s relationship with its various constituencies, e.g., customers, suppliers, competitors, etc.  The problem isn’t really the concept.  The problem is that it’s a complex, multidimensional structure that doesn’t really lend itself to a summary sentence, at least not if you really want to understand the business.  Yet it one of those economic terms that has entered the popular lexicon as the rise of business schools in the 1970s and 1980s mainstreamed “businessperson” as a profession (like engineer, doctor, or lawyer).

Wikipedia does a decent job of summarizing the cacophony of ideas that are embodied in the term business model.  I won’t recount them here.  The reason the question “what’s your business model?” bothers me it that the inquirer often judges the answer based on its parsimony, as though simple is prima facie evidence of good.  Occam’s razor applied to business strategy. 

I myself will sometimes ask others the question, but I use it to test for complexity, not simplicity.  I use it as a Rorschach to see how deeply the respondent has thought about the market and which aspects of the business appear most salient to him or her. 

In preparing for this entry, I started to ask myself how do I think about a business model? And how do I test if business models are complete, coherent, and compelling?  When I worked at Bain in the early 1980’s the firm then specialized in ‘strategy’ and ‘business definition,’ equally amorphous concepts. (Amorphous is good when you bill by the hour).   We used to refer to three tests to define whether two companies were in the same business – similarities of cost structures, competitors,  and customers. 

So I sat down and drew this little graphic for myself to try and outline the key concepts that seem to appear in the “business models” of companies that I see in my practice.  I don’t claim this is complete or some form of ‘ground truth.’  It is a snapshot of the concepts that I most readily gravitate toward when I think about “what’s your business model?”   I am sure I have left out huge chunks that will become obvious when I go to my next deal pitch meeting tomorrow. 

 

I am not going to explain every facet.  Most of it is self-evident (I hope).  However, a couple of things are worth noting.  First, at the center are the terms “lever” and “return on equity.”  I think of all these bubbles as knobs or levers in the machine that is a business.  Not all are equally important, but all are impactful choices that Management has made about the business, even if the choice is to ignore this facet.  Second, the objective I want to maximize is return on equity, not growth, not revenue, and not necessarily even market share, though these may be part of what generates ROE. 

I have enumerated some of the common choices more for illustration than prescription.  I should point out the category of “enterprise asset” because I think of this as a separate objective beyond barrier to entry.  The “enterprise asset” is that intangible that is the difference between book value and enterprise value.  It is the reason why an acquirer is drawn to the business beyond the NPV of the earnings stream.  It is the strategic value or what accountants call goodwill.  This box is particularly important in early stage investing, as the exits are so often around acquisition.  The business should have a clear definition of its ‘residual value’ to a potential set of acquirers.

Hopefully some will find this useful as a checklist.   There is nothing Web 2.0 about this framework.  And there shouldn’t be.  Business is applied microeconomics -- Web 2.0 or pest extermination (perhaps a poor juxtaposition – I need an editor.)  Anyway I feel better for having shared my quick and dirty model of a business model.  Thanks for listening.

So, quick, what's your business model, anyway?

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P.S.  I woke up this morning realizing I had overlooked where to place "advertising" in the mix. (Doh!)  This is a big enough oversight that I thought I better modify this before I get blogwhacked.  I think of advertising and cost per action as "transactions."  The reason for this is that advertising is really a form of variable micropayment, i.e., an attention tax.  It scales with an action -- page view -- so it is a form of transaction to me. 

Comments

[Dan Marques]

Very interesting...

[Chris Bauman]

I have found it rather simplistic and undersatifying when I respond that my business is a "subscription web based application" to anyone who asks. But, it still seems easier than stating it as a "high sunk cost, subscription based revenue, easy barrier to entry, opt-in/opt-out, product line, restricted/unrestricted use, freemium, untapped lucrative market, style business model."

One question for you. As you evaluate deals that come across your desk, do you require that all of these 'knobs & levers' are completely described and analyzed before moving forward?

[Peter Rip]

Nope. It's my job to figure them out. And it's my job to figure out if the entrepreneur sees it the same way.

[soxiam]

I think part of the reason behind the oversimplification of so-called business model discussion is that there are now far more opportunities for the business sphere and the marketing sphere to clash and intersect. In the marketing space, your business model needs to be filtered down to easy-to-swallow bite size nugget. Nobody other than those who has something invested in the company would care to know how complex a company's business model is. Google makes money with PPC advertising. YouTube has no clue how to make money yet. These are the one-word answers we are comfortable with unfortunately.

[Bri]

To be frank, I think the reason the "business model" culture has taken hold is that 90% of VCs have no idea what they're doing. It's so much easier for a clueless investor to get excited about the latest buzzwords than to get excited about a long, complex description of something that's actually a good service. Start ups know this and market themselves accordingly (as Peter was saying).

I experienced this when I was describing a site I had already made to two VCs. It was an ad-supported site for teachers and students. They kept calling the site "a new technology" and saying "What other technologies are you working on?" I kept thinking, "This isn't a new technology. It's the same Linux-Apache-PHP configuration that's been around for 10 years." Through further discussion, I came to realize that they simply had no understanding of the Internet at all. To them, it was much easier to call things "new technologies" than to spend time to learn the nuts and bolts of the longer, more complex reality.

Even for VCs who understand the Internet and invest in Web 2.0 comanies, a fair number seem to lack any understanding of what might actually work. I'm sure we're all familiar with certain VC blogs that go gaga everytime a site with "AJAX" launches. While AJAX is a great buzzword, it is not a source of revenue.

Don't get me wrong, I know a lot of great VCs who really understand business, but I think they're the exception to the rule.

[Anshu Sharma]

Yes, VCs seldom know how things work but that is not their job. The CEO of Verizon does not need to know how phones work, the CEO of Coca-Cola does not need to know how fizz works, etc. In fact, it is this outside-in perspective that allows VCs to invest in companies that you and I may see as Linux, Apache, MySQL based web sites. The 'value' is in the application not the technology.

[Bri]

Anshu, you raise a good point. VCs don't need to know the nuts and bolts. However, I think the post is saying that they need to understand more than the one-sentence "business model," which some do and some don't. The point is that it's much easier to sell a removed VC on a few buzzwords than a long complex explanation.

[Susan Jones]

Gee, I'm sure glad you added the advertising bit *whew*.
I sell the stuff.
Thanks for the share, it was a good read!
www.westcoaster.ca

[Baris Karadogan]

When a VC asks "What is your business model?" He's really asking "How are you going to make money?" That's what a business model is.

Simplicity is important. It reveals how well an entrepreneur understands his business. If you understand it well you can explain it simply. Most often it can be simplified. If it can't then probably the entrepreneur doesn't yet understand how he/she is going to make money. That's where the VC works with the entrepreneur to figure it out. So the question is a litmus test in disguise.

Most successful businesses can simplify their business model. Jim Collins calls this the "hedgehog principle".

For example, the cable tv business model is "buy content wholesale, sell retail". It's that simple.

When I see an Internet company, the question is still the same. How are you going to make money? The answer usually has to be simple, something like "I am acquiring a custoer for x, monetize it to y, and the difference will pay for my operations z and leave xx for profit." At that point we have an understanding of the fundamentals of the business and have a basis to do diligence on, and ultimately make a judgement call on what x, y, z will end up being.

Responding to another comment, what a VC wants to see is not that all the 'knobs and levers are completely described', but the most important few, ones that will drive the business model, are identified.

[sourabh niyogi]

Nice ontology/checklist. It doesn't emphasize the levers enough. For your Rip diagram to become enterpreneurship classics (par chasm/tornado, mavens/connectors/..), improve your diagram so that the levers are visually depicted. Expand this to include pictures+stories of the POWERFUL levers of the well-known and emerging (MSFT, GOOG, CRM, etc.), overlaid on the same diagram. Give a tour at the MIT Enterprise Forum, Sloan and other bschools. Heck, write a book!

The levers do not get explicitly emphasized yet: Enterprise forums and b-schools spend a lot of time on the institutions of 90 second pitches and 10 slides (to please your species, it seems), requiring people to oversummarize the "levers". I think there are entrepreneurs whose instinct is "oh, but my business is a lot more complex than that, because the way we will be viral is __, the way we get lock in is ___", etc. which gets badly summarized.

I'm not sure if the entrepreneur should take your post as a license to ignore the 30pt maxims of
http://blog.guykawasaki.com/2005/12/the_102030_rule.html
or whether the "If you really knew your levers, you'd be able to summarize your levers well in 90 secs/10 slides" would still hold.

[Atul Tiwari]

The business model is great , it is exhaustive too. It is concern for every VC about the Business model which actually make the understanding for the business better. Many at times we find this evolving , hence forth the importance of the model being flexible comes into picture but the question is -what will make a model flexible?

[michael choniski]

To drill down the definition or purpose of a business plan for a VC, it is one step deeper than "how are you going to make money?", it is "How are you going to make money for me and my investors?" So, the bottom line of all the discussion of product, market competitors, technology, schedules, etc. is "Valuation and Liquidity Prospects" which is the answer the guy is trying to get to when he reads the exec. summary.