Over the past 8 weeks we have discussed business models and why entrepreneurs, especially those forming startups in new and emerging industries, should spend as much time as it takes to develop a business model that works.
Based on requests from Tekedia’s readers we have combined that 4-part series into one document that you can find in one PDF file here.
To recap, 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.”
Ndubuisi Ekekwe left a comment, and asked a great question after we published the final installment of the “What Is Your Business Model?” series. If this is your first visit to Tekedia, Ndubuisi is a Tekedia Contributor as well as the founder of FASMicro Nigeria Ltd. FASMicro is Tekedia’s parent.
Here is Ndubuisi’s comment; This is revealing: “It might take several attempts before the startup discovers the business model that works best – reflecting an industry in its earliest stage of development”
What do you advocate for someone to do when doubts arise because the model is failing? How do you determine that optimality where something is possible and staying put is [a] waste of time? It happens that someone can fail too early where a little more patience might have turned the table. How do we make this call?
Unfortunately for me, there’s no easy answer to that question. In today’s column I will try to raise some of the questions that I believe one should consider when one is confronted with a situation like the one Ndubuisi has described. Along the way I will make a few suggestions about possible answers, I do not guarantee they will be the right ones, but I hope my suggestions will be reasonably good “starting-point” candidates.
Once again I am making the assumption that we are considering a single-product startup. The entrepreneur has formed the startup to operate in an innovative new industry that is still undergoing rapid growth and development.
Possibly the most important issue that is raised by Ndubuisi’s comment is that of alignment. The entrepreneur must seek alignment with the market by solving the right problem, and marketing that solution to the customer base that actually needs or wants it. Depending on the exact startup, this might not necessarily be the same customer base that the entrepreneur envisioned from the outset. As an example, it is rumored that Viagra was originally intended as a cure for cardio-vascular diseases. The entrepreneur must also seek alignment with the startup’s investors. Investors seeking a 2-year exit should be avoided by an entrepreneur that foresees a viable exit for investors only in year 5 or later. In other words, not every investor is a desirable one. Some may be more desirable than others. Mutual suitability depends on there being a happy marriage between what the startup can deliver and what investors expect.
A related issue is that of time. Startups and entrepreneurs in the situation I describe need to perform numerous tests. Assumptions have to be tested and confirmed or rejected; for example assumptions about customer needs, wants and willingness to pay must all be formulated, tested and rejected or kept. Business models have to be designed, developed and modified based on the realities the startup confronts once it has developed its product to satisfaction and has taken the step of introducing it to the market.
Putting the concepts of alignment and time together, it is important for entrepreneurs to avoid unrealistic enthusiasm when courting investors. A venture capitalist will be much less patient than family members will be if the entrepreneur made unrealistic promises at the outset of the startup’s relationship with the venture capitalist and other investors. That is to be expected. After all, no investor has an unlimited amount of capital, or time for that matter. An investor’s skepticism should increase in direct proportion to how unrealistic the investor perceives the entrepreneur’s claims to be about what the startup can accomplish.
I believe in the saying attributed to Carl Sagan that extraordinary claims require extraordinary evidence. As an investor, I would expect to point out to the entrepreneur what I consider to be an extraordinary claim, and what evidence I believe would be sufficient to allow me to accept that claim. In return I expect the entrepreneur to have evidence ready to support any claims I find hard to believe, or be prepared to work with me in reaching a common understanding of why the claim I find hard to believe is not so outlandish after all. In this case, founders and entrepreneurs with a technical background should choose investors that have a willingness to understand the intricate details about the technological innovation that forms the basis for the startup. Remember my comment about alignment?
Another issue raised by Ndubuisi’s comment is that of scarcity. Resources are scarce. Capital is scarce. Time is scarce. Eric Ries’ concept of the Lean Startup starts to address the issue of scarcity and how entrepreneurs can work around it. Essentially, the entrepreneur must conserve the startup’s resources while it works its way towards the point of self-sustaining viability – a product that works, for a customer base that wants or needs the product, at a price that earns the startup revenue and then profit. The issues that have to be considered in adopting the Lean Startup approach are numerous – we have touched on some of the tradeoffs that entrepreneurs must make in other columns. For example, should the entrepreneur be paid a fat salary from the very outset, or should that money be used to finance other activities critical to the startup’s survival and success?
Personally, I have a positive view of founders that are willing to forego a salary altogether if possible, or accept just enough to get by until the startup is making enough revenue to support a founder-CEO’s salary, what ever that number is. One approach? Raise as much capital as you can from investors, and then conserve that capital for as long as you can while your startup develops and test the product and build itself into a company that can stand the reality of competition. It is worth noting that the lean startup approach is easier to implement in certain industries than others – software is great for that approach, heavy machinery is not a very ideal candidate.
The final issue raised by Ndubuisi’s comment is that of failure. How do we know when a startup has failed? Who is defining failure – the entrepreneur, the market or the investor? It seems obvious that the investor is likely to walk away once the investor feels that the business model, the product or the startup has failed. However, the fact that the investor perceives failure in and of itself does not make this true – investor’s make mistakes too after all. It is also not so obvious that market rejection at a specific point in time is necessarily an incontrovertible indicator of failure – remember that one of the assumptions that I believe should be tested is the assumption about the startup’s customers.
In the face of market rejection, an entrepreneur that wishes to continue along the path on which the startup embarked with absolutely no adjustment related to the business model or the product must test his assumptions and confirm that the rationale that made this a good idea to begin with still exists. So when can we agree that a startup has failed? When it has made demonstrably inadequate progress in developing its product, failed to identify its customer base, failed to start generating revenues, and run out of capital or investor interest or both. An unprofitable startup that can demonstrate that revenues are increasing rapidly, and that costs as a percentage of revenue are declining fast enough to promise profitability within an acceptable window of time will be able to find an investor willing to back it, especially if the opportunity is one that promises to grow more attractive with time.
The Startup Genome Project attempts to answer the question “What makes startups succeed or fail?” Their study is focused on internet startups, but I believe the results can be applied to startups in other industries or sectors. They find that premature scaling is the single most important reason why startups fail. Premature scaling might apply to premature scaling of the startup team, premature customer acquisition – revenue growth outstripping ability to deliver, or overbuilding the product. They found that startups with founders that learn are more successful than their counterparts. Also, startups that pivot once or twice perform better than others. A startup pivots when it changes a major part of its original business – for example, a hardware manufacturer that decides to shift focus and become a software supplier. I recommend reading the Startup Genome Report in its entirety. It is quite insightful.
I hope this discussion has given you some ideas about how you might go about answering the question Ndubuisi asked for yourself. It is a question that every entrepreneur will no doubt face at one point or another.
Let’s talk again in two weeks. On deck? A business model case study – as originally promised for today.