I was recently in a meeting with a group of entrepreneurs and investors. One of the investors asked the CEO of a new company to define the business model for his firm. The CEO described what his business did and to whom he sold his product. I could see that the investor was growing impatient as he waited to have the question answered.
The entrepreneur missed the point of the question. What the investor wanted to know was how the business was going to make money. Guy Kawasaki suggests that you answer two questions as you begin to define your model: (1) Who has your money in their pockets? and (2) How are you going to get it into your pocket? His recommendation is to develop a simple and specific explanation of 10 words or less.
A more lengthy definition of a business model might be that it is "the summation of the core business decisions and trade-offs employed by a company to earn a profit" ("New Business Ventures and the Entrepreneur," McGraw Hill). The authors of the reference book suggest that an entrepreneur be prepared to analyze four components in testing the business model for the firm: revenue sources, cost drivers, investment size, and critical success factors.
Revenue sources: What are the basic revenue sources? What is the size of the total market? What is the TAM (total addressable market)? Are there multiple revenue channels? In addition to the source issues, the decision needs to be made as to how the revenue will be received — on sales of units, as a subscription, a license, fees, etc.
Cost drivers: The easiest method to analyze the drivers is to utilize an income statement and develop a spread sheet of the components. You need to know which costs are fixed, variable and those that only occur on an infrequent basis such as major purchases. The next step is to break the costs into categories such as labor, benefits, rent, marketing and sales expenses, etc.
Investment size: How much money will you need before the company achieves a positive cash flow? After projecting the revenue, subtract the costs of doing business, including the major purchases. The point at which you need the most cash may be months into the future as you continue to use cash to build your product and your customer base.
Critical success factors: Once you have developed the above components, you need to test each of them in order to determine which of the factors are the most critical. Develop a range for each revenue source, cost component and the various levels of investment. Then test each of them within your model by applying the high and low points in the range. You may find that a small adjustment in one of the cost components will have a major impact on profitability.
For example, losing a supply source that has given you a competitive advantage may mean the difference between operating at a profit or at a loss. I recommend that you develop this analysis in a spread sheet, giving you the opportunity to explore any number of alternatives.
One local technology company studied the critical success factors for its business model and decided that it needed to rethink how it developed software. The CEO began exploring offshore alternatives and found that the programming costs in India were 10 to 20 percent of what he was paying in Utah County. An 80 to 90 percent downward swing in his biggest cost factor will make a big difference in the company's ability to compete in the market and to produce a profit.
A crisp and well-thought-through description of your business model will be beneficial to you as you talk to investors, customers and potential employees and will help you be a more effective manager.
Gary Williams is affiliated with the BYU Center for Entrepreneurship. He can be reached via e-mail at cfe@byu.edu.