Friday, July 22, 2011

Business Model Analysis, Part 1: Key Questions



Business model analysis is central to the lean startup approach developed by Eric Ries, Steve Blank, and others. When entrepreneurs “run lean,” they formulate hypotheses about major elements of their business model, then they devise experiments to test those hypotheses with minimal waste of time and resources.

But what exactly is a business model? We use the term constantly, with mutual understanding taken for granted. However, the term’s meaning is rarely spelled out, and when it is, definitions can vary widely. At the risk of compounding the confusion, I’ll offer another definition that is based on the concept of strategy taught at the Harvard Business School: A business model is an integrated array of distinctive choices specifying a startup’s unique customer value proposition and how it will configure activities—including those of its partners—to deliver that value and earn sustainable profits. These choices can be grouped into four broad categories pertaining to a startup’s customer value proposition, technology and operations plan, go-to-market approach, and profit formula.

The choices are listed below (and summarized in this single page PDF, downloadable from my Dropbox public folder). My goal is to be comprehensive—to include all of the important issues that an entrepreneur must address when designing a startup’s business model. In my experience, founders sometimes forge ahead, unaware that they’ve failed to consider some crucial issues. I hope the list helps prevent some “I-wish-I’d-thought-of-that-sooner” mistakes.

In a series of future posts, I’ll describe how my ideas about business models relate to work by John Mullins & Randy Komisar, Clay Christensen, Alex Osterwalder, and Ramon Casadesus-Masanell. I’ll also share some practical guidelines for conducting business model analysis. Finally, I’ll delve deeper into several topics that are salient for early-stage startups, for example, network effects, switching costs, and other sources of first mover advantage; attributes of a scalable model;  LTV/CAC analysis; viral coefficients; and “chasm” challenges.

After I incorporate feedback on the posts, my plan is to consolidate them into a note on business model analysis that will be available in the fall of 2011 from Harvard Business Publishing.

Customer Value Proposition

The starting point when designing a new venture’s business model is articulating a customer value proposition. This entails addressing the following questions:
  • What unmet needs will the venture’s product address?
  • In creating customer value, will the venture emphasize differentiation, by increasing customer willingness to pay relative to rivals’ offerings, or low cost, by reducing expenses that customers incur—again, relative to rivals’ offerings—for a comparable bundle of benefits? If it emphasizes differentiation, will the venture’s edge principally be vertical (i.e., outperforming rivals’ products on dimensions for which most customers would agree that “more is better,” for example, a car’s gas mileage) or horizontal (i.e., distinguishing itself on dimensions of taste that cannot be intrinsically rank ordered, for example, an Audi’s styling compared to a Saab’s)?
  • Which customer segments will the venture serve upon launch? How will targeted segments change over time?
  • Using Steve Blank’s terms from Four Steps to the Epiphany, will the venture serve: 1) a fundamentally new market, offering a radically innovative product; 2) an existing market, offering a product that offers superior relative performance against well-established benefit and/or cost metrics; or 3) a re-segmented market, offering a product that offers superior performance on familiar attributes strongly valued by a subset of the existing market’s customers?
  • How large is the total addressable market (TAM) for the venture’s product, and how fast is the market likely to grow?
  • What will be the venture’s minimum viable product for launch, that is, the smallest set of features needed to validate key business model assumptions? What is the plan for adding features over time, that is, the product roadmap?
  • To access a whole product solution, will customers need to acquire any complements or ancillary services from third parties? If so, who will provide them, and under what terms?
  • Will pricing be structured per transaction, per period (as with a subscription), or through some hybrid approach? Will prices/fees be: 1) fixed per transaction/period (e.g., a $20 book; a flat fee for a consulting assignment; a $10 monthly subscription to Netflix), 2) variable, based on a fixed fee per unit of activity (e.g., hourly billing for a legal case; a per unit royalty to a patent holder; a per minute charge for long distance calls), 3) tiered based on feature/service level (e.g., “freemium” pricing that is free for a basic product or $10/month for a “pro” version) or 4) linked to some outcome (e.g., “pay-per-click” advertising; a broker’s fee on a home sale)?
  • If the venture’s product is a physical good, will it be sold outright—transferring title—or will it be rented/leased?
  • Will the venture pursue a skimming strategy, that is, charging a premium to early adopters with high willingness to pay for the product? Alternatively, will the venture engage in penetration pricing to exploit strong scale economies or other first mover advantages?
  • Does the venture have opportunities to capture value through price discrimination, for example, through negotiated pricing, auctions, or discounts for early booking? Through bundling, for example, by including after-sale service with the product’s purchase? (See Part 7 of this series for an overview of bundling.)
  • Will the venture leverage strong, proprietary network effects? (See Part 2 of this series for an overview of network effects)
  • What switching costs will confront customers, and what will be the expected average life of a customer relationship? (See Part 3 of this series for an overview of switching costs.) Can the venture improve customer retention through incentives, for example, a penalty for early contract termination or a rewards program for heavy users?
  • Relative to offerings from likely rivals, how will customers’ willingness to pay (WTP) for the venture’s product compare to their expected total cost of ownership (TCO)?

Technology and Operations Plan  

Having defined their customer value proposition, entrepreneurs next should consider the following choices for technology and operations management:
  • What activities are required to develop and produce the venture’s core offerings?
  • Which of these activities should the venture perform in-house? Put another way, to what extent should the business be vertically integrated? Who will perform outsourced activities, and under what terms?
  • What are the cost drivers for key activities (e.g., unit volume, capacity utilization, number of customers)? Can the venture exploit scale economies in operations by substituting fixed for variable costs? By leveraging learning-by-doing opportunities?
  • Will the venture create any valuable intellectual property? If so, how will this IP be kept proprietary?
  • How strong are first mover advantages (FMAs) related to technology and operations management, for example, scale economies in production or preemptive access to scarce production inputs? How do FMAs compare to late mover advantages, such as opportunities to reverse engineer pioneers’ products or leapfrog leaders by leveraging new technology?
  • Given capacity and hiring constraints, will rapid scalability be possible?

Go-To-Market Approach

A go-to-market plan specifies how a new venture will generate and fulfill demand, addressing the following choices:
  • What mix of direct channels (e.g., in-house sales force; company website; wholly-owned retail stores) and indirect channels (e.g., wholesalers; independent reps; value-added resellers; franchisees; third-party retailers) will the venture employ to educate prospects, configure and deliver its products, provide after-sale service, give feedback for future product development efforts, etc.? What margin will channel partners require? Should any partners be granted exclusive distribution rights?
  • Does the venture have strong incentives to race for scale due to network effects, high switching costs, or other first mover advantages (e.g., economies of scale in production; opportunities to preemptively acquire scarce assets, patents, or capacity)? How do these incentives compare to factors that may discourage aggressive investments in customer acquisition, in particular, scalability constraints and late mover advantages (e.g., opportunities to reverse engineer pioneers’ products; to leapfrog them with superior new production technology; to free ride on their missionary marketing efforts; and to avoid their positioning errors)? (See Part 4 of this series for an overview of factors that encourage and discourage racing for scale.)
  • Given the expected lifetime value (LTV) of a customer, what average customer acquisition cost (CAC) will the venture target? (See Part 6 of this series for an overview of LTV and CAC calculations.)
  • What mix of free and paid demand generation methods (e.g., mass and targeted advertising; product sampling; trade promotions; “freemium” pricing; public relations; customer word of mouth) will the venture employ at each stage of the conversion funnel (i.e., awareness > interest > trial > repurchase)? What will be the resulting shape of the funnel? What will be the average CAC for each paid demand generation method?
  • If the venture relies heavily on free customer acquisition methods, how will its product’s design encourage virality, and what will be its viral coefficient? (See Part 5 of this series for an overview of virality and viral coefficients.)
  • If the venture sells a fundamentally new product, is it likely to confront what Geoffrey Moore describes as a chasm between early adopter and mainstream customer segments? If so, what is the plan for crossing the chasm? (See Part 8 of this series for an overview of chasm issues.)

Profit Formula

Analysis of a new venture’s profit formula does not require an entrepreneur to make additional choices about business model design. Rather, this analysis evaluates the venture’s long-term economic viability, based on assumptions about its customer value proposition, technology and operations management, and go-to-market plan. To confirm that these assumptions yield a profitable business, an entrepreneur must answer the following questions:
  • What contribution margin (revenue - variable costs/revenue) will the venture earn? What will be its unit economics, that is, contribution per unit of product sold?
  • What fixed costs will the venture incur? What breakeven level of capacity utilization and sales volume does this imply?
  • What share of the total addressable market does the breakeven sales volume represent?
  • How much investment in working capital and property, plant & equipment will be required per dollar of revenue? Can the venture reduce working capital by delaying payments to suppliers? Receiving payments from customers before delivering its product (as with subscriptions)? Shifting inventory to partners?
  • How will the venture’s contribution margin, fixed costs, and investment/revenue ratio change as the business scales?
  • Given projected growth, what is the profile of the venture’s cash flow curve? In particular, how deep is the curve’s trough, and when will it be reached?
It is useful to analyze a new venture’s economics by following accrual accounting principles for the timing of revenue recognition and the depreciation and amortization of investments. However, for resource-constrained early-stage startups, managing cash flow is absolutely crucial. For this reason, when designing business models, most entrepreneurs should put accrual accounting on the back burner—at least at temporarily—and focus on cash flow using this formula, which captures the key metrics in the questions above:

(TAM × REV/TAM)-(REV × VC/(REV))- FC -(∆REV × INVESTMENT/REV) = CASHFLOW

In the formula, TAM = Total Addressable Market, VC = Variable Costs, and FC = Fixed Costs.

Projecting the formula above over time—and taking into account any interest payments and taxes—yields the venture’s cash flow curve, which plots cumulative cash flow from operations. The curve reveals the two most important facts that an entrepreneur needs to know about her business model: what is the magnitude of maximum cumulative negative cash flow, and when will that point be reached?


So, is this the right list of issues? Do any questions seem too trivial or vague? Have I left out anything important?


12 comments:

  1. Great post Tom. I find that real-world examples help entrepreneurs to understand these concepts the best. Would be interesting to go through each bullet point with some recent successful companies like Dropbox, AirBnb, or Groupon.

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  2. Thanks, Trevor. The posts that follow, building on these ideas, will use far more examples. I wanted to keep this long post from becoming even longer!

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  3. Good to see the focus on contribution margin rather than gross profit margin; the latter can be very misleading. CM per hour can also be very revealing as an alternative to CM per unit: can tell you a lot about the most profitable way to utilize capacity.

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  4. Really nice simple overview of the book 4 steps to epiphany from Steve Blank :)

    Great post I'm anxious to read the other.

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  5. For the profit formula, I think it's important to consider resource velocity which is a business model element defined by Innosight (Clayton Christensen and Mark Johnson). Resource velocity measures how quickly cash flows through your company, instead of how much. It gets you thinking about key drivers like lead time, inventory turns and utilization rate.

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  6. Emily: If velocity is high, won't that yield a low investment/sales ratio?

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  7. Great summary Tom. We often use abstractions like "Business Model" without ascertaining how much context we share with the receiver of the abstraction. This can result in all kinds of miscommunications and inefficiencies. Thanks for getting us on the same page on this one.

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  8. Great information to market your business more effectively.
    go to market strategy

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  9. this is a copy paste from a Harvard Business School - document 9-812- 096 and so are the other parts following this one. Its a complete word by word copy paste job.

    Its upsetting when people do this and not mention their sources... Plagiarism...

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    1. Thanks for your sensitivity to plagiarism, Khushbu. Please note that I'm the author of both this blog and the HBS document you mention. The document was published after I wrote this series of blog posts -- consistent with the plan I mention in the fifth paragraph of this post. I felt that paragraph addressed any potential issues related to future self-plagiarism.

      Authors frequently preview work on their blogs to get feedback and improve it before final publication. That's what I was doing here.

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  10. Hi Tom - thanks for a great series of posts. I've just started wading through them, but I'm stuck on your cash flow formula above - as I see it, the components inside the first set of brackets cancel out to leave behind just VC (TAM/TAM, Rev/Rev). Is this right? Am I missing something? Clearly VC - FC - (Inv/Rev etc) does not equal cash flow...

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    1. Thanks, Richard: I did omit the crucial revenue term in the original post. I've fixed the formula.

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