Friday, July 20, 2007

Model this

I like to chortle, and hanging around entrepreneurs is a tasty tonic for chortling. Two hearty chortle-inducing questions:

  • Who are your competitors? We have none. (If so, then you do not have a market.)
  • What is your business model? Well, it’s, um, well, um, well, we’re not sure … what’s a business model? (Or, the entrepreneur will severely complicate a relatively simple concept and/or litter his reply with contemporaneous jargon or bschool blah-blah.)
If you create a company that sells products or services, you have a business model, whether you know what it is or not. However, few entrepreneurs set out to create a business model. Entrepreneurs create companies through the translation of ideas into saleable products and services; the business model just happens, morphing with time, experience and maturity. They could care less about their biz model … they just know that what they’re doing and however they’re doing it works.

What is a business model? My take: It’s how you create and deliver value to customers to make money. A well-designed and superbly executed model maximizes the value and profit you extract from your market in a sustainable and defensible manner.

I recently discovered EarlyStageVC, an insightful blog authored by Peter Rip, a general partner with Crosslink Capital and former Bain guy. If you have an inkling for entrepreneurship or an interest in private equity, visit Rip’s blog … it’s worth the trip.

Rip authored a post last summer, Business Model, Schnizness Model. Here’s an excerpt and accompanying graphic:
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 … 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 liked to read the sports page in business school, and a professor would occasionally catch me. “Mr. Soderquist, what’s the answer to the question?” Dumbfounded, I would make eye contact and utter, “to increase shareholder wealth?” In retrospect, I could have answered, “maximize leverage to enhance return on equity.” Enough daydreaming; back to business models.)

Like most insightful blog posts, Rip’s includes a flurry of comments. Here’s one that resonates with me and echoes previous posts herein:
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.
Cool commentary, and it inspired me to dust off Collins’ Good to Great and revisit hedgehogs. Collins asserts that for companies to go from good to great requires a deep understanding of three intersecting circles (what you are deeply passionate about, what you can be the best in the world at, and what drives your economic engine) translated into a simple, crystalline concept (the Hedgehog Concept). One of his unexpected findings: The good-to-great companies are more like hedgehogs – simple, dowdy creatures that know “one big thing” and stick to it.

Simple, dowdy creatures ... that's worth a chortle.

Post-script (14 Feb 08): Worthy treatise about business models -- particularly for early-stage technology companies -- at Ask the Wizard. One graph:
I generally believe that for many technology companies, you need not necessarily have any idea how you will make money when you get started, and if you show good progress on the product and customer adoption, you need not make any commitments to a business model for some time. You do need to intimately understand where you sit in the proverbial value chain and what your position there means for your company, but you don't need to know precisely how you will extract value. In fact, I'll go farther and say that focusing on business model too early can hurt a company's prospects. When asked about Google's lack of a clear business model when he backed the company, John Doerr is said to have responded "With this kind of traffic, we'll figure it out". It's hard for some people to make sense of this when juxtaposed against their own experience pitching VC's, during which an obviously best-guess business model is grilled and questioned.

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