Note on Business Model Analysis for the Entrepreneur

Introduction

Nearly everyone has seen, heard and employed the term ‘business model’ but
how many people really understand what it means?
• It is assumed that business managers not only understand the term
‘business model’ but also that they know how to identify,assess and create
them.
• This note describes the primary elements and defining characteristics of a
company’s business model from the perspective of an entrepreneur. In
order to assess a potential business model, entrepreneurs must uncover
the nature of its ‘profit engine’ which is often obscured by ambitious
financial and market projections.
• Entrepreneurs must ask themselves whether their business concept can
be translated into a viable, profitable business venture and how much
cash it will take to achieve that result. Thus, this note introduces several
analytic techniques to enable an entrepreneur to answer the following
questions:
• 1) How likely is the business to turn cash flow positive?
• 2) How much time is required to ramp-up the revenue in order to turn
cash flow positive?
• 3) How large an investment is required to pursue the business
model?
• 4) What are the critical success factors and associated risks? In
addition to preparing the entrepreneur to answer these questions,
this note also provides several illustrative business models to
support the analytic frameworks presented.

Business Model Definition

• This note proposes a more focused definition of the term and is

specifically aimed at entrepreneurs who must decide whether a particular
business model justifies an investment of their time and resources. I
• A business model is defined as a summation of the core business
decisions and trade-offs employed by a company to earn a profit.
• It is a way in which a company generates revenue and makes profit from
company operations.
• As such, every entrepreneur must understand the specific business
decisions and accompanying trade-offs that resulted in the creation of a
 business model. In general, these business decisions and trade-offs fall
into four groups: revenue sources, key expenses, investment size and
critical success factors.

Framework for Analyzing a Business Model

A framework for analyzing business models must be applicable to the

numerous business models in the marketplace. In recent years, the number of
business models has increased dramatically for several reasons.
1.First, globalization has facilitated the transfer of business models across
geographic boundaries.
2.Second, technological advancements such as the Internet have fostered the
development of new business models.
3.Finally, the large infusion of private capital into new ventures has helped to
spur the creation of new, innovative business models.

As such, business model analysis requires a common starting point that is

equally applicable to a manufacturing business or an Internet-based business.
To this end, a company’s financial statements—the balance sheet, income
statement and cash flow statement—all serve as a fundamental starting point for
business model analysis. For early - stage companies, the pro form a or
budgeted financial statements are required and for existing companies, a
combination of actual financial statements and proformas are required. Other
useful sources of information include the mission statement, business overview,
strategic goals and operating principles of a company—all of which may be
found in a business plan, annual report, press clippings or media kits. To begin
the business model analysis, the following steps should betaken: ! Determine
the company’s actual and projected revenues and the timing of the cash inflows.
Disaggregate revenue data until you have uncovered the revenue drivers or the
key factors that influence total revenues. Determine the company’s actual and
projected expenses and the timing of the cash outflows. Disaggregate cost data
into discrete cost drivers. Determine the total investment required to achieve a
positive cash flow position, including working capital.

Plot cash flow versus time to generate a cash curve. This curve will illustrate the
maximum financing needs and the timing of positive cash flows and cash
breakeven. Perform a systematic sensitivity analysis of the business model to
identify the critical success factors or the levers that have the greatest impact on
the cash flows of the company.

A preliminary analysis of the company’s revenue sources, cost drivers,

investment requirements and critical success factors form the basis of business
model analysis. The following sections will facilitate more detailed analysis and
provide illustrative case examples for each key element of the business model.

Revenue Sources Definition

There are four distinct revenue streams that underlie all business models:

• Single stream: company relies on one predominant revenue stream

stemming from one product or service. Example: Annual subscription of
magazine or fitness club membership
• Multiple streams: company collects multiple revenues streams from
different products or services. Each revenue stream is sizeable enough to
have a meaningful impact on profitability.
• Interdependent: company sells one/several products or services in order
to stimulate revenues from another set of products or services. Examples
of interdependent revenue streams include razors and razor blades or
printers and printer cartridges.
• Loss leader: company collects multiple revenue streams but not every
revenue stream is independently profitable. One or several revenue
streams may serve as loss leaders and drive traffic to spur other
purchases. Combined, all revenue streams enable the company to
achieve profitability. An example of a loss leader revenue stream is a
grocery store selling laundry detergent below cost in order to stimulate
other purchases.

Revenue Models

Business models can incorporate one or several different revenue streams

depending on the company’s product, industry and customers. The following
revenue models are examples of how the four different revenue streams can be
manifested in a business model:

• Subscription/Membership: Customers pay a fixed amount at regular

intervals (week, month, year) in advance of receiving the product or
service. Examples include paying an annual subscription fee for a
magazine or a fitness club membership. Volume or Unit-Based:
Customers pay a fixed price per unit and receive a product or service in
exchange. Examples include retail operations such as a restaurant,
clothing shop or beauty parlor.
• Advertising-Based: End-user is usually exempt from paying a fee or pays
a fee equivalent to only a fraction of the true value of the product or
 service. Examples include network television stations and content-based
web sites.
• Licensing & Syndication: Customer pays a one-time licensing or
syndication fee to be able to use or resell the product. Alternatively, the
buyer may pay a separate licensing or royalty fee in a business-to-
business transaction, for example, a pharmaceutical firm may license a
drug from a biotechnology firm.
• Transaction Fee: Customer pays the company that facilitates the
transaction a fixed fee or a percentage of the total value of the transaction.
Examples include brokerage firms and auction houses.

Cost Drivers Definition

A cost driver is any factor that affects total costs.

Fixed: Items of cost that do not vary at all with volume. Examples include
annual rent,property taxes and management salaries.
Semi-Variable: Items of cost that include a combination of variable costs and
fixed costs. Therefore, a semi-variable cost varies in the direction of, but less
than proportionately with, changes in volume of output. An example is the
payroll expenses of a supermarket. A supermarket must employ a minimum
number of staff to operate the store regardless of sales volume. However, as
sales volume increases,more staff may be required to handle the increased
business.
Variable: Items of cost that vary, in total, directly and proportionately with
volume. Examples include materials cost (vary with total number of units
produced) and sales commissions (vary with total number of items sold).
Non-Recurring: Items of cost that appear irregularly or infrequently in the
company’s cost structure. Examples include investments such as purchasing a
building or equipment.

Cost Structures

The dominant cost driver of a business model usually characterizes the overall
cost structure. The following list is a subset of the most common cost structures:
Payroll-Centered (Direct): Semi-variable costs driven by employees directly
involved in the output of the firm. Examples include professional services firms
such as consulting firms and investment banks or manufacturing firms with
assembly line production.
Payroll-Centered (Support): Fixed costs driven by employees indirectly
involved in the output of the firm. Examples include Haute Couture fashion
houses or insurance companies.
Inventory: Primary cost center related to maintenance of raw materials and/or
finished goods inventory. Examples include manufacturing firms such as
automobile manufacturers or retailers such as car dealerships or jewelry
retailers.
Space/Rent: Costs driven by the high cost per square foot of office or retail
space. Examples include a restaurant located in an affluent neighborhood or a
service company such as copy centers located in downtown office buildings.
Marketing/Advertising: Costs driven by total marketing or advertising
expenditures required to attract and retain customers. Examples include Internet
content or commerce websites.

Investment Size Definition

• Maximum investment is the amount of cash required before a company

achieves positive cash flow.
• The total investment size of a business model depends on several factors
including the company’s revenue model, cost drivers and critical success
factors.
• A cash flow diagram provides the means for capturing and summarizing
information relating to the cash requirements of a business model

Examples of Total Investment Size

The following examples describe types of business models with markedly

different investment requirements:
• Software: Large upfront investment is required to build an initial software
product. If the product is successful, only relatively small follow-on
investments in sales, distribution and customer service are required to
capture a large software revenue stream.
• Retail: Capital requirements during start-up phase associated with lease or
rent costs, inventory and payroll. Financing needs remain relatively
consistent over time.
• Small Consulting Firm: Very small upfront investment for space, computer,
and phone line are necessary to begin serving clients. If the firm is
successful, larger follow-on investments may be required to hire additional
staff,lease large office space and build IT infrastructure.

Critical Success Factors Definition

• A critical success factor is an operational function or competency that a

 company must possess in order for it to be sustainable and profitable.
• Therefore, the success of a business model depends on both the creation
of a viable business model and the successful execution of multiple
operational functions.

Examples of Critical Success Factors by Revenue Model

Critical success factors vary by business model, industry and stage of

development. For example, a growing company’s success may rest upon its
ability to rapidly acquire new customers or to ramp up production fast enough to
meet demand. A mature company’s success may rest upon its ability to achieve
high capacity utilization or reduce unit costs faster than its competitors. The
following examples illustrate the critical success factors for three different
business models:

Subscription/Membership:
• The ability to retain customers for a long period of time;
• the ability to acquire new customers at a low cost;
• the ability to consistently increase share of wallet with customers.
Transaction-Based:
• The ability to command a price premium for a product/service without a
commensurate increase in costs;
• the ability to exploit economies of scale to lower fixed/variable costs as
sales volume increases.
Advertising-Based:
• The ability to maintain advertising revenues during counter-cyclical
economic period;
• the ability to increase advertising spending/customer.