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Business Modeling 101

Two basic rules of business:

1) Narrowly define your client
2) Go after them agressively

I've always been inspired by small business and now I'm in business to help them.

A little about me -- I've worked for some of the most recognized organizations in the world. Some of these include CitiGroup (AVP), Freddie Mac (Trader), GE Medical Systems (Analyst), JPMorgan (Analyst), SunTrust Robertson Humphrey (Associate), Harvard University (Visiting Fellow) and Intel Corporation (Sr. Analyst).  Most of these organizations have similar practices regarding financial operations, the difference is always more apparent in the dominant business model.

What exactly is a business model?  Here are a few definitions on the Web:

• The plan a company uses to generate revenue.
  www.netc.org/openoptions/appendices/glossary.html
• The combination of factors that describe the business, including the market the business will serve, the perceived value delivered to the customer, which determines profitability per unit of sale, and the sustaining factors that allow the company to thrive over the long term.
  www.milestonegrowth.com/financing/glossary.html
• A model of a business organization or process.
  www.bethesda.med.navy.mil/Patient/HIPAA/Glossary.asp

In financial or investor terms a business model is your financial model.  It can also be narrowly defined as gross profit (revenues - cost of goods sold).  This is how I was taught to define it as an investment banking analyst.  When comparing business models bankers will likely jump straight to your financial model and your gross margin projection.  A company with a high gross margin (gross profit/revenues) has a "good" business model and the company within an industry with the highest gross margin is said to have the best.  Larger companies are perceived to have better business models as they are able to benefit from economies of scale.  Is there a way to break this perception with your clients? 

It's easy to start thinking you are doomed as a small business, that the cards are inherently stacked against you and there's absolutely no way of competing with your larger more well established competitors.  This is what they want you to think, but it's only correct if you use the same business model.   Woman, veteran, minority and disabled owned organizations are especially vulnerable to "small business tilt".  The challenge is to find your edge.  

Regardless of size, your business model MUST be compelling and define your edge.  As a contract manager at Harvard, one of the hardest parts of my job was convincing small business partners to try something new.  Some of them only had to change a few minor areas to boost market share in the community.  One small business took my advice and landed a contract with a national chain through our partnership.  If you try to compete with larger organizations using "their" business model you're not maximizing your options.  Listen to what your customers need; they can help to define your edge. 

There are numerous types of business models. Some of these include:

i) Manufacturing (Direct Model) - A direct model which allows the manufacturer to speak directly to the consumer like a license or lease.
ii) Advertiser Model - Extension of traditional broadcast model. Search engines (portals) and classifieds (like Craigslist) that request a listing fee or user registration.

iii) Data Model - Data provided about consumer behavior. Examples include audience measurement services like Nielson or www.Alexa.com.

iv) Merchant Model - Wholesalers or retailers of goods. Examples include brick and mortar shops with a web interface or a Catalog exchange with mail order.

v) The Brokerage Model - Marketplace exchange. Investment banks are the best example of this.

vi) Affiliate/Commission Model - Similar to an advertising model, but thrives from purchases and not traffic.

vii) Forum Model - Blog or community forum. Examples are Twitter and blog sites.

viii) Subscription Model - Users are charged a periodic fee for service. Examples include Netflix and Internet services.

ix) PPV Model - Pay per view; On-demand model. Metered usage or subscriptions.

According to a study by Peter Wiell, et al, of the Sloan School of Management at MIT, entitled,  Do Some Business Models Perform Better than Others? A Study of the 1000 Largest US Firms, some buisness models do perform better than others.  The study goes on to say that, "...business models are a better predictor of financial performance than industry classifications and that some business models do, indeed, perform better than others. Specifically, selling the right to use assets is more profitable and more highly valued by the market than selling ownership of assets. [http://ccs.mit.edu/papers/pdf/wp226.pdf, p.2]

There are four basic labels for business models as defined by the study:  Creator, Distributor, Landlord and Broker [p.25].   The labels are fairly intuitive.   Landlord and Broker both exist because of the Creator and Distributor; they are the "derivatives" of the business modeling world.    These models reach success on good asset management.  Subsequently, both Brokers and Landlords have significantly higher operating incomes and market capitalizations than Creator or Distributor business models [p.22].   The market has effectively assigned more risk to these models, likewise the reward is proportionately higher.   As to be expected (or not) there were no significant differences among any of the four models regarding ROIC (return on invested capital) [p.24].  If a certain business model generated higher returns on investment we would all be using that model, theoretically.   I highly recommend reading this paper.  (I am trying to get my hands on the latest version) 

In reality, and in a time when more and more customers prefer freeze dried over slow cooked,  small business has the edge on big business -  you have the luxury and gift of agility.  Your organization is able to respond to changes in demand faster.   If you haven't applied this to you business model, stop here and process it.  If you have and you're still looking for ways to improve operations through your business model follow these steps. 

1. Review and align your business model with your mission. Everyone in the organization should be directly connected to increasing your profitability. If they are not, transfer them to a project that is. Everyone in your organization should be thinking about "how to decrease costs and increase revenues while improving quality (and staying legal)". Your mission must include some measure of this principle.

2. Find the optimal model. There are dozens of ways to increase your revenue while reducing costs. Finding the optimal model for your consumer base is key.

a. Create a financial model and play around with the variables that influence the model the most. A good financial model will help you to focus your attention on critical success ratios. Instead of guessing which areas to focus on or making a random to do list, you will know the top three areas to work on in order to improve your margin.

b. Operational costs are more than simply control functions in today's virtual world. In many cases a $12/month website can take the place of a fully staffed brick and mortar office space. What's the lesson here? If you're a small business, use the Internet as a way to disenfranchise big business. If you're a large business, use the Internet as a way to create a segment of your organization that can react to changes in market demand faster. There's a reason why recent academic studies in competition, strategy and organizational behavior are almost completely dominated by research on Internet models that revolutionized traditional business.

3. Stress test your model. Make sure you know what the implications of a decision are before you make any strategic changes. This is what your model is for. Most people think it's a tool just for investors, but investors also want to see if you know how decisions will effect the flow of cash in your organization andwill appreciate your ability to do this using your financial model. A sensitivity analysis makes broad changes to accounts within the model. A scenario analysis shows the effects of different scenarios on your business. Guess which one investors really want to see?

4. Treat marketing as an asset. I believe marketing is so fundamental to your business that it must be a part of your business model.

a. Most MBAs are taught that marketing is an operating expense, but for start-ups marketing is an essential part of product revenue that might take several years to recoup. Should advertising expense be capitalized, or expensed? Well, I personally think marketing should be capitalized.

b. What exactly does capitalization mean? It means that large business items can be recorded on assets resulting in a depreciation expense rather than taking the full cost against current revenues. This means that assets are debited (usually long term or fixed assets) and liabilities are credited. As expenses are realized through depreciation, liabilities are debited and revenue is credited as an expense. Instead of reducing gross margin calculations, capitalized expenses increase assets and liabilities to balance.

c. While capitalization will cost a little more in bookkeeping fees there are also several advantages; some of these include 1) less volatility in gross profit, 2) increased equity investment, and 3) potential tax benefits.

5. Do a Little Six Sigma Dance - Determine the 10 most crucial processes in your organization and map them out from end to end. I guarantee you will find redundant processes, duplicate services, etc. In manufacturing they pay people hundreds of thousands of dollars to do this. This is also a necessary step in most corporate quality initiatives such as Six Sigma or LEAN. The former helps to reduce errors and the latterhelpsinreducing redundant or unnecessary costs (waste). When tasked with mapping out Intel's equipment supply chain I found control issues and redundant processes. Intel is one of the most control oriented organizations I've ever worked for. You WILL find areas for improvement in your organization if you do this properly.

6. Acknowledge working capital. First of all, what is working capital?

a. The definition of working capital is (current assets) - (current liabilities). It's a measure of the liquid (ready) assets in the organization. For this reason, analysts refer to it as "working". Financial theory is full of ideas on this subject. While corporate bankers might use a surplus as a "cushion of protection" against a loan, investment bankers might see it is as an inefficient use of short term leverage. Some might even see a surplus as a sign of poor financial leadership. Ultimately, it will depend on the industry.

b. Implicit in working capital considerations are your revenue recognition policies. If you've squeezed everything out of your turnover ratios consider developing easier ways for your customers to pay. How can you help them to facilitate credit if needed? Can you create a package deal? Payment models are particularly important for serviceorganizations.

7. Close the funding gap. You must come up with ways to raise capital if you don't have it, and you must be sure to scrutinize every project with a fine tooth comb if you do. Large and small businesses alike have difficulty obtaining funds when they really need them. What does that tell you? Well when it comes to business survivability the ability to "create" value is at the top of the list no matter who you are. And it's not an easy thing to do, but here are some best practices....

a. Big business has known about "structuring deals" for a long time. If we can bring loans to the microcredit sector why can't we bring investment banking product to start-up enterprise? I'll come back to this in a minute.

b. CEO vs CFO vs CPA (Visionary/Leader vs. Translation Specialist vs. Editor). Investors want you to be able to validate assumptions with certainty.As a CEO you're probably great at selling your product. You're passionate about it, but don't care about all the details. That's ok. You're supposed to have this approach, but your CFO should be different (and your CPA should not be your CFO or your Admin Assistant). Your CFO or business consultant should be more concerned with providing the sell to investors. They translate your energy and enthusiasm into a presentation investors and bankers want to hear. Your CPA will edit (audit). Your ability to do this literally builds value into your product. Value iscreated by credibility and your business model will be your most relied upon tool when speaking to investors.

c. Detail the investment opportunity and come up with the best way to sell it. Give your investors a combo meal; make it easy for them to see a return. I have yet to meet someone with money to invest that turned down a well thought outinvestment opportunity.

d. Exchange houses make investing easier by providing a guarantee. The average investor assumes that trading on the NASDAQ is safe. That is, the NASDAQ is a safe betting house. If you go to Vegas and you have $50k, you want to know you're dealing with some trustworthy bookies. The House only helps you to make good on your bet, they don't have anything to do with your decision to bet, or what you place your money on. Does that sound safe? You must create the sanctity of the stock market and provide a return that beats 12%. That's it! Personally I would rather do business with someone I know and can touch over someone with a ticker symbol that I've never met; I'm referring to private deals and your opportunity to sell yourself by being safer than an exchange bet.That's why investors love theprivate "structured" deals I was talking about in point (a). Read up on how these deals are structured by doing research on private equity offerings. For instance, you can develop 3 different stages of funding. Request money for stage 1, define your deliverables and pay these people back. Do the same thing for Stage 2 and 3. I'm in the process of writing an article about this subject now so check the website for updates!

8. Finally, consider your buying power. According to Porter's Five Forces of Profitability, profitability is defined as a function of 5 different forces: 1)the threat of new entrants, 2) bargaining power of suppliers, 3) threat of substitute products or services,4) rivalry among existing competitors ; and 5) the bargaining power of buyers.http://hbr.harvardbusiness.org/2008/01/the-five-competitive-forces-that-shape-strategy/
Call the contract manager up.

a. Ask if you can set up a meeting to discuss your product.

b. Tell them what you offer andshow them your cost model. What can you do for them?You need to know what distinguishes you from both the incumbent and the competition.

c. Ask them if they actually make the purchases or if they maintain the contracts and if it's a mandated community?

d. Prove that you know the challenging nuances of the organization you want to sell to.

e. Also be sure to mention any relevant purchasing buzz words like sustainability, low energy, value added, CRM Analytics, minority programs, e-purchasing, community connections, etc. Anything that can make the contract manager seem brilliant for choosing your product.

f. Even if you're just starting out, you'll be better for this exchange. The more you do it, the easier it will become and the better you will be.

About the Author

Biba Bryant, MBA
www.bibabryant.com