Building a Business Model

You know how you sometimes say "the other day" as if it was last week, or maybe the week before, when actually it was several months ago? Well, the other day, I attended a presentation by Garage Technology Ventures on The Art and Science of Building Your Business Model. It was presented by Bill Reichert, who is the managing director there. He is also the creator of The Art of Startup Finance, part of the Kaufman Founders School. The focus is on building a business strategy with a clear pathway to profits.

Bill started off by giving a little of his background. He started as a graduate student, before doing startups so young was fashionable. He started a software company, which back then meant you had to write a business plan, since you needed to raise money to even get started, unlike today's lean startup environment where you just need a couple of laptops (and some ramen). But that company crashed and burned. So he did it again, and the second time the company went public. 

He then wrote a 125-page business plan complete with detailed forecasts...and nobody read it. By the 1990s, nobody read business plans any more, even though everyone was still teaching business plans. For the past 20 years, all VCs have cared about is what is your biz model. But few people understood what was meant by that.

Bill's definition: How you will make money.

Bill's next cautionary tale was his third company, in 1990. He pulled a team out of SRI that came up with a computer that was basically just a piece of glass. They built it but it was unbelievably expensive. Everyone thought it was wonderful until they found out the price. So he ran into the brick wall of the biz model issue at 500mph. There was no way to make money.

For company #4, he was more humble. That one went public.

He then started Garage Technology Ventures (GTV) with Guy Kawasaki as an entrepreneur-friendly VC, with lots of outreach. A key part of GTV is that you must have a biz model, a path to profitability.

1 Value Proposition

There are nine key elements of a business model, and the central one is the value proposition. That's why it is in the center of the above diagram. Items one through six are the strategy of the business, and seven through nine are the economics. But remember the basic definition. The business model is how you will make money.

What is your core value proposition for your primary target customers? In a two-sided market, there may be different propositions for the two sides (e.g., AirBnB for travelers and for landlords). For other customer/stakeholder categories?

What is your "metric of merit", how much better are you than the competition?

2 Product Roadmap

What is your initial product offering? "Don't worry, be crappy."

How will you evolve that over time? This means three to five years, since very few successful companies are built on a single product.

New features, new markets, new geographies, new products?

3 Target Customers

Who are your target customers? Or customer categories/segments? Can you define them precisely?

How will you expand your customer base over time?

This one is tougher than it seems. You should be able to define the prototypical customer clearly. The term GTV uses is "customer personas" (age, economic class, which country, owning what hardware or software, etc). Can you define them precisely (not necessarily people, could be businesses, but we care about who is the buyer in the business)? Customers may not know what they want (Henry Ford famously said that he didn't ask customers what they wanted since they would just say faster horses). Bill Gross of idealab would build websites and see if anyone was interested in the product.

4 Competitive Advantages

What are your key competitive advantages, for each category of competitor and for each category of customer?

Why can you uniquely deliver your value propositions?

How will you sustain your competitive advantage in the future?

You need a sustainable competitive advantage and need to be able to articulate it to customers, partners and investors. Everyone knows SWOT analysis. It’s an OK tool, but these days just tick the box. You need to be honest about what are the key competitive advantages for each category of competitor and each category of customer. Why can you alone deliver against the rest of the competitive landscape? It's not good enough to just be “high and to the right” on a chart. A real competitive advantage is something the customer will value and pay for. Being first into a new market, first mover, is never an advantage. You can see this if you just pick any sector and think about who was the first mover (Apple was not the first smartphone, Uber was not the first ride-sharing service, Facebook was not the first social network).

5 Marketing Plan

Marketing is different things to different people. In the context of a startup, it is fundamentally about generating qualified leads.

How are you going to get the message out to our target audience?

How are you going to get customer leads to come to you?

The marketing plan is about filling the top of the funnel by generating leads. You need to find a way to deliver the message and get customers to find you. For a web-based business, there are tools to measure the effectiveness, but it is best to focus on a few simple things (like conversion rate). It is all execution and discipline.

6 Sales Plan

Closing the deal: How are you going to sell your product? Direct, channels, partners?

How are you going to convert qualified prospects/leads into customers?

How will your proliferate? Some options are Freemium, land and expand, start with initial product and layer on features over time.

7 Pricing

What is your pricing for each of your target customer groups? Why is this compelling for your customers?

In whatever domain you are working, it is pretty obvious what the choices are. However, early in new market, it can be hard to figure out. Do we separate the subscription from professional services? Is there hardware that they pay for even though the value is in the software? Why is the pricing compelling?

8 Costs

What is your cost structure? For developing and delivering product? For acquiring new customers and upselling old customers? For providing service and support? For all other activities aka overhead?

The key metrics:

• CAC customer acquisition cost
• CLV customer lifetime value
• CLV/CAC = customer value multiple (return)
• CAC/MRR = payback (months to recover CAC)

To scale a business costs more than you expect. Everyone underestimates the cost of 2.0. And 3.0 is twice as expensive as 1.0 since you have to throw away1.0 because all the platforms have changed. The VC universe says about costs that “they make them up so I never look at them” so entrepreneurs think that they are not important. But if you don’t start the discipline early on and get better and better at hitting numbers, then you will get into deeper and deeper trouble when you scale. Be disciplined about expenses from early on. Keep track of your cash. VCs will ask about unit economics, e.g., CAC cost to acquire a customer, or the value of a customer. If customer can only buy one thing, then that is the total value, but a lot of businesses have renewals and upsells so the customer's lifetime value CLV is how much can you sell a typical customer over time. People work out an “average” customer but actually most businesses are 80:20 or 95:5, so you have to segment them into high-value customers, who buy a lot, and long-tail customers who buy a little. Throw out the long tail and only think about the high-value customer and focus on them. CLV/CAC is return on investment in acquiring customers (if it is 2X then CLV is twice the cost of acquisition, which is pretty much minimal). Other number is the payback number, how many months of subscription does it take to pay back the cost to acquire the customer (2.5 years is capital intensive, six months is exciting).

9 Revenue Streams

What is your initial primary source of revenue? How will your revenue streams evolve over time?

A common mistake is that entrepreneurs dream up nine different revenue streams (product sale, installation, data reselling, etc). But almost every company has just a single dominant revenue stream.

Putting It All Together

You know some things with high degree of confidence, others you don’t know precisely (since may be multiple possible customer types, pricing models, etc). The initial business model is a set of hypotheses about how the world works and how your business will work, that you have to go out and test. This is a big challenge in the whole Silicon Valley VC model. Pitch the vision, get to the financial model, be confident as if it is the truth. However, a whole lot of stuff had to happen just right for it to be true, but you could not waver in confidence when pitching. Then three months after funding…oops, we were wrong.

You must do the best job you can and be honest about what is true, and what is a hypothesis, and communicate with investors. 

Beware of templates—they are just guidelines. But if you nail the nine elements, you will have most of what you need to figure out (but may be missing some specific things for your business. e.g., nothing about regulatory issues, which might be significant (medical), or geographical rollout issues (such as Uber).

Know the critical issues, the ones that determine success or failure (e.g., big hairy legacy player like Netflix or Amazon, for others it might be FDA, for other does the technology even work). Note the skepticism you get when talking about your business to other people, especially experienced ones.

Have a validation plan: continuously test and validate with real/prospective customers.

As always when writing about startups, I can't better Paul Graham's five-word advice to Y-Combinator companies: "Build something other people want."

The Art of the Start

It was a book. Now it is also an online class with Bill and Guy Kawasaki.

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