It is now close to gospel that internet advertising and B2B SaaS are among the last century’s most profitable (legitimate) business models. They have more similarities than differences.
Both internet advertising and B2B SaaS benefit from a meager marginal cost of production (which is the core driver of their margins). Once the platform and audience are in place, an additional advertisement doesn’t cost much, just as selling an additional license doesn’t require a new software build. Both rely on a strong B2B sales motion — selling licenses to enterprises or selling ads to SMBs. Both have sizable go-to-market and customer success functions, ensuring the all-too-critical sales and service motion is well run. Both attract and incentivize account executives with lucrative variable compensation packages.
These businesses are as much about sales excellence as they are about product. The product needs to be great, but without sales, the business doesn’t generate those nosebleed valuations.
If your startup naturally falls into internet advertising or B2B SaaS, congratulations. The margins are significant. The valuations are high. However, you’re not the only one with this idea — it’s hugely competitive, and every other B2B SaaS company or internet advertiser is trying to eat lunch. And these are formidable giants we’re talking about.
While not as profitable, a different model businesses use worldwide is “capturing spread,” which may apply to your startup, depending on how you answer the following questions.
Before we get there, what is “capturing spread”?
Capturing spread is the idea of making (usually) a small amount of revenue on a more significant flow of capital. Financial services firms across the world primarily use this model. You buy an ETF (exchange-traded fund) from your broker, who charges you 0.5% per year for the product. However, it only costs them 0.45%. The difference is infinitesimally small — 0.05% (or 5 bps), but it adds up if they can attract billions of dollars (and they often can).
Remember, volatility is the enemy of valuation, and “up and to the right” is the goal.
Let’s run the math: 0.05% on $1 billion is half a million dollars of straight EBITDA. If the spread increases to 0.2% and attracts $5 billion, the profit hits $10 million.
Some very profitable businesses follow this model. Think of your favorite stablecoin, one that U.S. Treasuries and USD cash back. Over $50 billion in assets are invested in the stablecoin, held in U.S. Treasuries yielding ~5%. The stablecoin pays out to its holders but nowhere close to 5%. Let’s say it pays out 3% through a mix of rewards. It gets to keep 2% of the $50 billion — a whopping $1 billion.
How can you assess whether capturing spread may be proper for you? Here are a few questions to ask and consider:
Can you attract a large amount of capital or flow?
Typically, the spread a startup or business can capture is small (usually less than 0.1%, maybe up to 1%, rarely above 1%). The more competitive the market, the lower the spread. Let’s say it’s 1%. Try to back out what it would take for this startup to get a $1 billion valuation. If the multiple of this business is 20x, a $1 billion valuation requires profits of $50 million a year.
To generate those profits at a 1% spread, the startup needs to attract $5 billion of capital. Can your startup attract $5 billion of capital or flow every year? Can $5 billion of GMV flow through your business every year? Can you process volumes of $5 billion?
Can your business charge a % of capital or flow?
Not every business can charge a percentage of capital. If yours can, the spread business model is suitable. If your startup charges per seat, you’re not in the spread but the B2B sales model. If you’re paid by deliverable, you’re in the services model.
The spread business model only works if you’re paid as a percentage of the capital you manage. It’s more complicated than you think — businesses naturally don’t like paying for things as a percentage because the costs scale up. It’s much easier to charge someone a fixed fee than a percentage when usage is expected to scale.
Can services be delivered for a smaller percentage of capital flow or fixed cost?
Say you managed to get capital/flow and charge a percentage each year. You have revenue. But to generate operating profits, you must deliver your services for a percentage less than what you charge. Or even better, for a fixed fee.
Let’s return to our example. You attracted $5 billion of capital/flow and charge 1.5%. If you can deliver your service at 0.5% costs, your spread is 1% (1.5% – 0.5%), and your profits are $50 million. However, if your service costs 2%, you’re losing 0.5% each time and will run at a loss of $25 million.
Even better, can you provide your services at a fixed cost? If yes, it’s simply a scaling problem. Everything else is profit once you accumulate enough capital/flows and charge a percentage that covers the expenses.
Can you reduce the volatility in the capital or flow?
Ideally, the amount of capital or flow grows fast. Failing that, you want your capital or flow to be as stable and predictable as possible. Investors hate businesses that make $100 million in profits one year but turn a loss next before bouncing back to $150 million in profits the next. They’d much rather have a business that makes at least $50 million and grows yearly.
Remember, volatility is the enemy of valuation, and “up and to the right” is the goal.
Where does this leave us? If you answered no to the previous questions, should you try to shape your business to capture spread? Absolutely not. There are better business models (in B2B SaaS, and internet advertising).
However, if you answered yes to the questions above, consider this well-understood and powerful business model for you to help shape and grow your business.