This is a guest post by Alan Gleeson is the General Manager of Palo Alto Software, Ltd, creators of Business Plan Pro. He holds an MBA from Oxford University and an MSc from University College, Cork, Ireland.
The phrase ‘business model’ has grown in use in recent months. However, there seems to be some confusion as to what exactly the term means, why it is important and how it relates to more established concepts such as business planning. This short article aims to address these deficiencies as well as to describe where business modeling is most useful and what the main types of business models are.
What is a business model?
A good starting point for the topic is to define the concept given the lack of a concrete definition to date. A business model is simply a ‘description of how your business intends to operate and make money’, or as Alexander Osterwalder, co-author of the book Business Model Generation, describes;
‘A business model describes the rationale of how an organization, creates, delivers and captures value.’
The most basic business model is the ‘direct sales’ model, which is simply a producer making something and selling it directly to a customer at a profit. However this pretty straight forward concept has propagated into numerous more complex models in recent years and, entrepreneurs need to be aware of the growing variety of viable business models given the competitive advantage that can be gained from their effective deployment. One of the key reasons the concept has become more popular of late is due to the growth of Internet startups where value need not always be captured from day one e.g. the Freemium business model.
The Business Model – An Introduction
In days of old, most business was arguably a lot simpler; you produced something and sold it for a profit, building up a good reputation over time so as to ensure ongoing patronage. Before the industrial revolution most sales were essentially local, and you had a much greater steer on competition, demand levels, customer preferences and pricing. You probably sold your products directly to consumers as the butcher, baker or candlestick maker.
Fast forward 200+ years and business for most has changed considerably. Firstly, a lot more creativity is needed to get noticed in a time-pressed world (not to mention in making a sale). You are also probably facing global competitors, and in many instances a widely dispersed audience who are increasingly difficult to reach in a cost effective manner. As a result, numerous alternative strategies have emerged to get your product to market, safely into the hands of the paying consumer and business model innovation has become increasingly popular as a means to ensure you do so profitably.
In many respects business model innovation is not new; price discrimination, where retailers sell what is essentially the same service to people at different price points (i.e. ‘early bird’ menus in restaurants, old age pensioner and student discounts etc) is a well known business practise that represents a form of business model innovation.
However the story of modern business model innovation really takes off with Gillette and in particular an early marketing strategy they deployed when selling their razor blades. They deduced that they could give away the razor handle for free, and could get consumers to pay for the blades. Of course a razor blade is useless without a handle and vice versa so the aim was to encourage trial and then to lock the customer in. Given the resultant switching costs and customer inertia, the result was often a lifetime of patronage for the more aggressively priced consumable (despite the fact the initial transaction was a loss-making one for the producer). In essence, by providing something at below the market price i.e. the razor handle; you can create a market for a secondary product (the razor blade) upon which you make ongoing profits. The perishable nature of the secondary product (the razor goes blunt) coupled with price points that are typically disproportionate relative to their cost result in a highly profitable arrangement for the manufacturer. Add patents into the mix and you, the producer can essentially act opportunistically and gain monopoly profits as the sole supplier.
As Chris Anderson author of Freemium described;
“Razors were bundled with everything from Wrigley’s gum to packets of coffee, tea, spices, and marshmallows. The freebies helped to sell those products, but the tactic helped Gillette even more. By giving away the razors, which were useless by themselves, he was creating demand for disposable blades. A few billion blades later, this business model is now the foundation of entire industries: Give away the cell phone, sell the monthly plan; make the videogame console cheap and sell expensive games; install fancy coffeemakers in offices at no charge so you can sell managers expensive coffee sachets.”
Relationship between a business plan and a business model
Finally, it is worth clarifying the difference between a business plan and a business model at this juncture. A business plan details the business opportunity you are seeking to exploit (usually as a document), whereas, a business model takes the form of either a simple verbal description or a one page visual representation.
The important thing to remember here is that you need to consider how complex your business is and who the intended audience for your business plan is. If you are a technology based start up looking to raise venture capital, then the VC is likely to want a PowerPoint Slide deck, and an executive summary of your business plan. A visual business model outline will also impress. However if you are a coffee shop looking for more modest investment the information requirements tend to be more modest i.e. a simple business plan should suffice.
While a business plan has somewhat of an image problem in certain circles, wedded as it is in many people’s minds to the image of large, unwieldy and impractical documents, modern business planning is flexible, agile and concise, and more about goal setting than bound physical documents. This planning process brings numerous benefits for the entrepreneur, not least an ability to look at the operation holistically, to ensure internal focus and to ensure that cash flow management is a key priority
With start-ups, one of the main challenges they face is gaining market acceptance, and custom in sufficient volumes to transition to profitability (the vast majority of start-ups fail). Hence a key skill is to know when to ‘pivot’ to an alternative product iteration until a viable business model gains traction, a concept author Eric Ries first described;
“I want to introduce the concept of the pivot, the idea that successful startups change directions but stay grounded in what they’ve learned. They keep one foot in the past and place one foot in a new possible future. Over time, this pivoting may lead them far afield from their original vision, but if you look carefully, you’ll be able to detect common threads that link each iteration. By contrast, many unsuccessful startups simply jump outright from one vision to something completely different. These jumps are extremely risky, because they don’t leverage the validated learning about customers that came before.”
Ries is a key proponent of something called the Lean Startup movement, which argues that startups need to develop products and markets by embracing a methodology focused on testing, agile development, constant iteration in response to customer feedback and customer centricity. Steve Blank, author of The Four Stages to the Epiphany, another proponent, agrees arguing that;
‘A startup is an organization formed to search for a repeatable and scalable business model.’
Hence, a strong knowledge of different business models and a willingness to test and learn are important skill for startups who may naively feel there is only one primary model for their business.
While Ries and Blank talks about the need for entrepreneurs ‘to pivot’, authors of the book Getting to Plan B, John Mullins and Randy Komisar4 essentially argue the same point advising entrepreneurs to recognise the importance of having a ‘Plan B’. They argue that many start-ups build business plans on flawed assumptions and fail as a result. They prescribe a systematic process which bears many similarities to the Customer Development methodology described by Blank, where the entrepreneur is encouraged to iterate, replicate innovation seen elsewhere and to ensure that they are learning from their experiences. It goes without saying that from their perspective also, strict adherence to a business plan in the face of conflicting customer evidence is the complete antithesis of business modeling and business agility. Interestingly such flexibility may not always sit too well with investors, so it is important to keep them up to speed with regard to any changes in direction. Of course when such changes are in response to evidence from customer feedback they are more likely to be respond favourably to the changes.
Lessons for Entrepreneurs: Arriving at a viable business model
Given the significant uncertainty entrepreneurs face (not least in terms of customer demand for a new product or service), they need to be increasingly flexible in order to survive, a characteristic that was not always desirable. As I alluded to above, investors have traditionally wanted some degree of certainty with regard to what type of business they were investing in, and in the past such protection was often provided by documents such as the Memorandum of Association which set out the line of activities a company could undertake. However such inflexibility is no longer appropriate, a point author Steve Blank argues in his blog post where he states that the primary role of an entrepreneur is to iterate and test assumptions and hypotheses they have made with regard to customer behaviour and demand until they find a commercially viable business model.
‘Your startup is essentially an organization built to search for a repeatable and scalable business model. As a founder you start out with:
1) a vision of a product with a set of features,
2) a series of hypotheses about all the pieces of the business model: Who are the customers/users? What’s the distribution channel? How do we price and position the product? How do we create end user demand? Who are our partners? Where/how do we build the product? How do we finance the company, etc?
Your job as a founder is to quickly validate whether the model is correct by seeing if customers behave as your model predicts. Most of the time the darn customers don’t behave as you predicted.’
Blank is arguing that the primary function of an entrepreneur is to find a commercially viable business model which can be scaled. Implicit in this view is that due to the uncertainties and assumptions that entrepreneurs have to make, that they need to be completely flexible with their business plan.
The need to flexible is important for startups that often become fixated with developing a product or service to the neglect of other areas such as (a) ensuring there is evidence of demand or (b) that customers can be acquired profitably, or (c) how they intend to create brand awareness etc. With product focused offerings it is important for startups to change course or to pivot in response to feedback from customers.
Finally, It is also worth noting that the level of flexibility advocated is more suited to technology start-ups and is not possible in all businesses, particularly if there are large sunk costs, significant capital outlays or resolute investors who are ‘resistant to change’.
In summary, if you are starting a new business (particularly an Internet-based one) and are seeking investment, the business model will be an important compliment to your business plan. Any prospective investor will be very keen to understand your business model clearly i.e. how you intend to generate cash, and whether it appears that you can do so profitably. However they will also understand that Plan A’s do not typically succeed, so they will be keen that you are not blindly wedded to a business plan that is not achieving its goals.
It is thus recommended that entrepreneurs take time to map out their business model (Implicit in this is the realisation that all is subject to change depending on feedback from users and subsequent customer adoption rates). Once you have iterated to a winning business model can you scale in confidence and move from start up mode to ‘business as usual’ as a thriving business!