Start-ups Need a Business Model
Series: What start-ups critically need - that mature companies don't.
This Venture Wings Series is designed to distinguish how start-ups are different from mature businesses and why understanding these distinctions are critically important to your success as an entrepreneur.
What is the purpose of a business?
The purpose of a business is to make money.1
You may stop reading our substack right now after reading this statement because it is so basic. But most of my clients have a blindspot in that they did not answer this first question correctly.
Let that sink in.
In fact the book, The Goal (in which the author goes over this business purpose) was required reading in our MBA Class at UCLA, and this question was one of the first ones asked in our Week 1 lectures. (The Goal is still a great read for understanding why a business exists and how to organize and motivate your team around this goal).
A business makes money with its business model.
A business model is HOW the business makes money. Expressed as unit-economics, a business owner knows in very simple arithmetic terms, how his / her business generates cash, what “units” they sell, at what price, through what channels at what cost of goods sold and with how much overhead and capital expenditure. The business model contains facts of revenue and expense and units sold and expresses how well the business generates profit and at what margin. Knowing your model lets you grow your business. One friend whom I deeply respect for her scientific expertise, when presented with a 3-year financial plan template asked “Who is responsible for doing these financials?”. Of course my answer was “You are”.
A start-up doesn’t have a business model. Mature companies do.
This is the another fundamental difference between how a start-up is critically different than a mature company. Mature companies have well-established business models for making money. They have factual data for every lever of their business model. In Steve Blank's Customer Development Process he describes a start-up as a faith-based organization in which its founders believe that they can work their way to discover a business model and turn their business model assumptions - into facts.
Your business model and its unit economics are the most basic of financial disciplines to have for starting your company. If you don’t want to know your unit economics, if you don’t want to create your financial model, you should reconsider starting a business OR find a co-founder who can do this with you. It’s not hard to understand so you can take a business finance class, or entrepreneurial finance class, or work with a coach to acquire these start-up skills.
A business model is NOT a pricing sheet or 3 pricing tiers.
I see pricing sheets used in investor decks as their business model - even with experienced entreprenurs. But pricing sheets or for example- the 3-column subscription tiers (Silver, Gold,Platinum) are a part of the business model - but are not the actual business model. A great way to know if you know your business model - is to describe your business on a naptkin expressed as unit economics. (More to say here in another post including examples of unit economics).
But every investor will size you up and evaluate your business sophistication - based on how well you know your model, how you talking about it’s leverage, its growth, how you can control it, protect it, and how your model is designed to grow and by what means and make larger margins over time. And how your model creates leverage to out perform your competition.
An example of a great business model: “Search”
This will seem really hard to believe but the entire business model for Search was expressed by one simple equation when I worked for Overture.com (which was acquired by Yahoo in 2003 for $1.63B and became Yahoo Search Marketing.
RPS = PPC x CTR x COV
where :
RPS = Revenue per search
PPC = Price-per-Click
CTR = Click-thru-rates (of search ads)
COV = # of ads “covering” a search result
We had 100’s of team members working and analyzing the perfomance metrics that went into each of our model’s inputs that drove RPS. When I hired on, CEO Ted Meisel called our business model “bulldozing quarters” because we made 100’s of millions of dollars $.25 at a time ($0.25 was the average price-per-click across our 4B search queries per month). Ted also told me it might take up to two years for me to learn everything about this business model. It took me much longer because I used to be an engineer and the concept of a business model was quite foreign to me - despite having an MBA. As a product manager, a “business model” was a different context for me altogether compared to how the product works.
A start-ups exit value is determined by its economics at the beginning.
Strange right? Which economics the founders choose for their start-up is a primary driver for its exit value. How good is your start-up at generating cash? What are your margins? What are your profits? How much cash do you expend to reach, engage and convert your customers? How much cash do you expend to make and deliver the product or service? How much cash do you retain each month? Are your margins expanding over time? Do you have a defensible moat for your revenue-generation? All of these questions (and many more) are determined by your business model. Investors will zero in on your business model and their investment decisions will be made based on how much they like your business model and/or believe it will become more attractive over time.
So in summary, entrepreneurs must know how their business makes money. They must know what their business model is, must be able to quickly write out their unit economics and be able to clearly communicate their business model to others - especially financing partners.