Two weeks ago we discussed business models and why entrepreneurs should strive to understand how the business that they hope to build delivers value. You can read that column here. Briefly, in that column we said; 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.”

Today we will continue our conversation about business models by focusing on the third question that our definition of a business model raises; How does the business capture value? An entrepreneur should be able to describe how that entrepreneur’s proposed business will create value, deliver that value to its customers and in-turn capture some value for itself and its investors.

Michael Rappa’s statement about business models emphasizes the importance of revenue streams. Revenues comprise the cash that a startup’s customers exchange for the product or service that the startup provides. In the process of this exchange, a transfer of ownership or usage rights takes place – in an outright sale, the customer assumes ownership. In a lease, licensing or rental agreement ownership remains with the seller, but the buyer is granted usage rights for a contractually agreed period. Revenue streams can be one-off or recurring.

I have no argument against the suggestion that entrepreneurs should focus keenly on developing and growing revenue streams. However, my experience has taught me that entrepreneurs must focus equal attention on profit, and on the related issue of costs.

Why?

In order to reach self-sustaining growth, a maturing start-up must quickly put itself in a position to invest in areas that are critical to its ability to create and deliver value to its customers – it has to invest in those assets that make its revenue streams possible. Costs represent the price the company pays to obtain the resources it must bring together in order to create and deliver value to its customers. A company earns a profit when its total revenues exceed its total costs. A successful business model should lead to an outcome in which customers perceive the entrepreneur as adding value. They demonstrate this by paying more for the product than it cost the entrepreneur to produce it – leading to a profit for the entrepreneur.

Earning a profit makes it possible for the startup company to invest in the assets that are most critical to its ability to create and deliver value. Controlling and managing costs effectively while growing revenues will ensure that the start-up maximizes its profit.

How does your business capture value? You should be able to describe how your startup will grow revenues, manage costs, invest for growth, and maximize profits.

This is not a static process. It should be dynamic and ongoing. Your startup will not be operating in a stagnant market. Therefore, your product and pricing strategies will need to adapt from time to time in response to competition as well as other market forces.

Let’s talk again in two weeks. On deck? Business models – part 4; we’ll close our discussion of business models by connecting the dots and making some observations.