business models and business modeling

The Opportunity

Business Modeling

Business Planning

Test Marketing

Business Modeling

Introduction to the Business Model

Experienced entrepreneurs understand that the business model always precedes the business plan. In fact, a convincing business model is often all that is needed by a savvy entrepreneur to make the commitment to pursue a fast moving opportunity. Conversely, a business plan takes several months to put down on paper during which the window of opportunity may shut. For this reason, entrepreneurs who need to be agile and fast moving place more importance on formulating the business model than on writing a business plan.

Almost everyone talks about business models these days but only a minority truly understands what they are. Even the academics disagree and contradict one another when it comes to formulating a definition.

So let's review some of the research into business models.

The Business Model as a One Page Diagram

The business model is defined by some as the profit engine of the business. It is where the rubber meets the road, so to speak. The business model is normally distilled into a diagram on a single sheet of paper showing the following elements of the proposed venture:

1. how and where the business acquires cash from customers,

2. how it uses its cash (tracks cash streams from clients and customers to the business and through the business to its suppliers),

3. how products and services flow from suppliers and the business to clients and customers in the reverse direction and, finally,

4. it shows how the business connects (through sales and marketing channels) with its clients and customers.

If you get the business model right, then the harder you work, the more money you make. If you get it wrong, then the harder you work, the more money you lose.

As stated above, the business model should be a one page diagram summarizing how the proposed venture will fit into the value chain between customer and upstream suppliers--if any--and create the value added which will result in profits being made.

The Components of a Business Model

In their paper, The Role of the Business Model in Capturing Value from Innovation, Henry Chesbrough and Richard S. Rosenbloom present a basic framework describing the elements of a business model. They list the following six components of the business model:

1. Value proposition - a description the customer problem, the product that addresses the problem, and the value of the product from the customer's perspective.

2. Market segment - the group of customers to target, recognizing that different market segments have different needs. Sometimes the potential of an innovation is unlocked only when a different market segment is targeted.

3. Value chain structure - the firm's position and activities in the value chain and how the firm will capture part of the value that it creates in the chain.

4. Revenue generation and margins - how revenue is generated (sales, leasing, subscription, support, etc.), the cost structure, and target profit margins.

5. Position in value network - identification of competitors, complementors, and any network effects that can be utilized to deliver more value to the customer.

6. Competitive strategy - how the company will attempt to develop a sustainable competitive advantage, for example, by means of a cost, differentiation, or niche strategy.

A good business model draws on a multitude of business subjects, including economics, entrepreneurship, finance, marketing, operations, and strategy. The business model itself is an important determinant of the profits to be made from an innovation. A mediocre innovation with a great business model may be more profitable than a great innovation with a mediocre business model.

The Two Dimensions of a Business Model

Management consultant Joan Magretta adds another layer of important detail to business models in her outstanding article Why Business Models Matter, which is excerpted from her book, What Management Is. Magretta shows that a business model actually consists of two halves: the numbers side and the narrative side.

The numbers side focuses on financial aspects of the business: do the numbers add up? Can overhead be covered to achieve break-even and then make a profit?

The narrative side covers the underlying assumptions of the plan. Will customers actually buy and why? Will other players whose cooperation is needed in the marketplace actually cooperate with the new venture?

Many rookie entrepreneurs make their fatal planning mistake on the narrative side by jumping to conclusions over the level of support that will be forthcoming from established players in the industry. It pays to be paranoid and automatically assume that others will not be interested in giving you a helping hand in establishing a beachhead in the market.

Magretta illustrates this key point in a story about Priceline's WebhouseClub. (You can add in other failed buyer aggregators as well such as Mobshop and Mercata.)

"Here's the story Walker tried to tell. Via the Web, millions of consumers would tell him how much they wanted to pay for, say, a jar of peanut butter. Consumers could specify the price but not the brand, so they might end up with Jif or they might end up with Skippy. Webhouse would then aggregate the bids and go to companies like
P&G and Bestfoods and try to make a deal: Take 50 cents off the price of your peanut butter, and we'll order a million jars this week. Webhouse wanted to be a power broker for individual consumers: Representing millions of shoppers, it would negotiate discounts and then pass on the savings to its customers, taking a fee in the process.

What was wrong with the story? It assumed that companies like P&G, Kimberly-Clark, and Exxon wanted to play this game.Think about that for a minute. Big consumer companies have spent decades and billions of dollars building brand loyalty. The Webhouse model teaches consumers to buy on price alone. So why would the manufacturers want to help Webhouse undermine both their prices and the brand identities they'd worked so hard to build? They wouldn't. The story just didn't make sense. To be a power broker, Webhouse needed a huge base of loyal customers. To get those customers, it first needed to deliver discounts. Since the consumer product companies refused to play, Webhouse had to pay for those discounts out of its own pocket. A few hundred million dollars later, in October 2000, it ran out of cash - and out of investors who still believed the story."

The lesson here is to never assume anything other than a complete lack of cooperation, if not a full assault on your venture, by vested interests. Think about it this way, why would anyone be willing to let a johnny-come-lately shoehorn into their market for a share of their profits?

Generic Online Business Models

Here is an overview of generic business models found on the Internet.

More Interesting Business Model Articles

An article on business modeling by venture capitalist Bill Gurley.

One more on software vs. hardware business models by Bill Gurley.

Excellent Resource on Business Modeling for Startups

Modeling techniques can be highly beneficial to startups. This is an excellent resource and well worth the nominal investment.