How many people actually understand the term “business model”? It’s bandied about by entrepreneurs, financiers and consultants, but often they have different interpretations of the concept. A business model is in fact a description of the profit engine within the business; it clarifies how you are going to make money from the opportunity you have identified. In the process of building a business, it is fundamental that you take the time and effort to clarify and understand your business model.This is done by focusing on the following four issues:
1. Revenue. An entrepreneur must understand exactly who the customer is, why they will be willing to pay for the product or service they receive, and what the timing of that payment will be. Payment can be once-off, which is attractive early on when the business needs cash. Multiple annuity payments are usually more attractive over the long term. Simple businesses will typically have a single revenue stream. A start-up retailer,for example, may derive income purely from over-the-counter cash sales.
Complex businesses tend to have multiple revenue streams – a more mature retailer may earn revenue from sales, interest on credit sales, and payments for premium shelf space from suppliers. Start-up businesses should keep it simple early on, with one or two revenue streams, and increase those revenue streams over time.
2. Cost Drivers. Every entrepreneur needs to incur costs to create revenue. It’s important to understand the true nature and extent of the costs – either fixed or variable – you will need to incur to reach projected revenue and growth levels. Fixed costs imply that a set amount will be incurred no matter what is produced or sold; variable costs fluctuate depending on the amount of output that is produced and sold. It’s also important to understand the payment terms for costs that are incurred as these will affect cash flow.Extending payment terms with suppliers will help alleviate the cash flow strain early on in the life cycle of a business.
3. Investment Required. Once you understand the cash flow implications of the costs and revenue of the business, use this information to calculate what size investment will be required to sustain it through its initial negative cash flow. Almost all businesses go through a period during the start-up phase in which they spend more money than they make. Depending on the nature of the business, the amount of time and level of investment required to sustain it through this period will vary. Entrepreneurs must aim to accurately calculate the size of the investment required, and then add on some extra as a buffer before approaching investors.
4. Critical Success Factors. These are the qualitative factors that could have a significant influence on the outcome of the new enterprise. You must rely on research, intuition and brainstorming to identify these issues. This could include sourcing the right location, nurturing an important partnership, securing a big contract, creating a powerful brand or scaling up to a certain size. By pulling revenue, costs, investment and critical success factors into a single spreadsheet or diagram you will have a clear business model. To make it workable and flexible, you should make every effort to understand how the different components interrelate and what the impact of a change in one component of the model will mean for the others.
Play with the model enough to be able to answer questions such as: “If you only get 80% of your required investment what will the impact on costs and sales be?”; “If you don’t achieve one of the critical success factors what will the impact on cost, sales and overall investment be?” When you review a business plan, spend time on two specific things: determine that you are the right person to take advantage of this opportunity; and assess whether the business model is realistic, viable, sustainable and workable. If these two things are in place the chance of your business succeeding is radically enhanced.
