We began our discussion four weeks ago with the introduction of a frame of reference that would guide our conversations about entrepreneurship and African start-ups. That raised a number of questions from readers. We addressed those questions here two weeks later.  As promised this week we will turn to business models.

Among the numerous questions entrepreneurs and small business owners must ask themselves is the quintessential question; what is my business model?

According to Michael Rappa; “In the most basic sense, a business model is the method of doing business by which a company can sustain itself – that is, generate revenue. The business model spells-out how a company makes money by specifying where it is positioned in the value chain.” Alex Osterwalder and Yves Pigneur say that; “A business model describes the rationale of how an organization creates, delivers and captures value.”

Other definitions exist, but taken together, these two statements provide us with enough basis for understanding what we should expect to learn from an adequately developed business model.

The business model should tell us how the entrepreneur expects to create value. To do this, the entrepreneur must decide what activities are core to the business the entrepreneur wishes to start. For example, the activities that create value for a software entrepreneur will certainly differ from those that create value for a microelectronics entrepreneur. Though the two businesses might rely on software in order to deliver the product or service on which each of them hopes to build a business, one might develop a business model in which software is central to value creation while for the other software might be peripheral by comparison. More specifically, the microelectronics entrepreneur might require a much smaller investment in software design and development in comparison to the software entrepreneur.

The question of how the entrepreneur creates value is also important because the answer to that question will often contribute to an understanding of the customer base that the business can expect to rely on.  If an entrepreneur expects to create value by delivering a personalized experience to guests of luxury hotels rated 3-stars or better, one immediately expects that the customer base available is limited to the set of people that can afford to stay in hotels within that category for business or pleasure. Obviously, that means that a large swath of people is excluded from that entrepreneur’s expected customer base. It also means that the business must develop a revenue model that will work given the narrow customer base for which the business model has been designed.  More on this later.

This might seem trivial at its face. It is not. Understanding the customer base for which the business expects to create value is central to many other decisions that the business will have to make as it matures and approaches the launch of its product or service on the market. How will the business communicate its existence and information about its products or services to its customers? Related to that, through what media should the business advertise itself? Some media will convey high credibility to discerning customers more than others. What is the trade-off? Consumer behavior is dependent on income. Does the entrepreneur understand how this will affect the business that is being established given the decision about how the business will create value? Does this mean that the business will be a price-taker (acceptance of the price as determined by the market), or does this provide the business with some pricing flexibility (pricing power)?

A business model describes how an organization creates value. Do you understand how your business creates value? Does that information affect how you make the numerous other decisions that must be made in every facet of the business? If not, you are running your business less efficiently than possible and leaving your revenue and profit sources open to attack by more astute competitors.

Spend a lot of time thinking about the question; How does my business create value? The answer to that question, and the implications that arise from that answer will improve the decisions you make in other critical areas of your enterprise. Equally important, revisit this question often. Usually the answer will not change. Once in a while, large-scale market dynamics will lead you to modify your answer in a way that could potentially lead your company to profits where others have not started to look yet. That is how some companies create new products and markets, and use first-mover advantage to create defensible positions before their competitors have time to fashion an adequate response.

Let’s talk again in two weeks. On deck? Business models – delivering value (part 2 of 4).