Not all business models are created equal.
A good business model is one that permits the business to grow without bounds. A bad business model is one that introduces constraints on the growth of the business, either in terms of market potential or the ability to scale the workforce. The strength or weakness of a business model is tested by putting it under the pressure of growth.
A good business model alone will not make an effective business. On the other hand, a bad business model practically ensures an ineffective business.
I’ve spent a lot of time over the past few months thinking about what’s working and (more importantly) what isn’t working in my consulting business. I’ve devised a list of characteristics that entrepreneurs should look at building into their business model to make sure they aren’t limited their potential for growth out of the gate.
Characteristics of the “Perfect Business Model”
Sell a Product, or productised service.
Billing hourly is generally a bad thing. This is because when you’re billing hourly, you’re imposing a glass ceiling on profitability. It makes it much harder to grow the business.
When you’re charging $100 per hour, you’re actually implicitly encouraged to deliver slowly – even if you can do something in 10 minutes, it makes sense financially to stretch it out to 60 minutes so you can bill an hour. The system rewards you for taking more time.
If you are charging on a per-project or per-product basis, you spend 10 minutes doing the task and move on to the next thing. You’re rewarded for completing work quickly and effectively. The system rewards you completing as many projects as possible.
How does this relate to scalability? It IS possible to increase the number of projects completed by an employee in a day (by improving processes, tools and employee skills). It ISN’T possible to increase the number of hours an employee can work in a single day.
One of the biggest growing pains for any business is cashflow.
Service businesses that bill hourly often have problems with cashflow because they need to wait until work is complete to receive funds. That means they often need to go into the red to pay costs of operation (such as utilities, wages, etc.)
Single sale businesses have problems with cashflow because revenue can widely fluctuate on a month-by-month basis, especially if the product or service is seasonal. One month the business might be making six figures, the next nothing. It’s highly risky to make capital allocation decisions in this kind of environment.
Recurring revenue alleviates this by providing your business with the “fuel” it needs to grow every month in a predictable and scalable fashion.
Target a market segment that already has (and spends) money.
One of the most important processes when creating a business is to decide who you’re going to sell to. This enables you to create a sales and marketing strategy.
But many aspiring entrepreneurs shoot themselves in the foot before even starting by choosing the wrong target market. You want to select a market that not only has money, but is also used to spending money for products or services similar to the one you are offering.
An example: doctors and lawyers are a good target market. They earn large amounts of money (6+ figures), and are used to paying for many services (marketing, HR and operations tools, etc).
B2B (business-to-business), not B2C (business-to-consumer).
With the previous point in mind, it makes much more sense to target business owners instead of general consumers.
This is because business owners have a much better intuitive and intellectual understanding of ROI (return on investment) when compared to consumers. That is: business owners are willing to pay for things that will increase their revenue or decrease their operating costs.
Consumers typically don’t take ROI into consideration when making purchases, and so see everything as a cost. Consumers want everything for free (or as close to free as possible).
Businesses that have low COGS (cost of goods sold) are less risky than those that have a high COGS. This is because failure becomes cheaper when your COGS are low. This is also why software businesses can be very attractive when compared to businesses that sell physical products.
With a low COGS business, it’s easier to operate in an agile manner: if a campaign fails, you lose time and some capital, but you can easily iterate and relaunch. On the other hand, if a campaign fails in a high COGS business, you might be filing for bankruptcy.
Built for Growth.
In order for a business to be scalable, it needs to satisfy an important requirement: all of its constituent pieces (including you, the business owner) need to be replaceable.
The replaceability characteristic provides two benefits. It provides your business with fault tolerance: no single team member has the potential to “break” the business should they leave. It also provides your business with the ability to add staff members painlessly.
We can achieve this with two things: automation and standard operation procedures (SOPs).
Perfect businesses need to have at least one defensible advantage over potential competitors.
Businesses that can be replicated are highly risky. If your primary advantage in the market is being able to do pretty much what everyone else does, but slightly cheaper, it’s only a matter of time before someone else replicates your business model and reduces the price. From there, it’s a race to the bottom.
A defensible position might be in providing awesome customer support, a better user interface or a unique brand experience. Your defensible position (and hence USP) is highly individual – it will depend on the structure of your business and your personality.
With all that said, making any decision about your business model is going to involve compromise. In reality there is no such thing as the perfect business model – but some are undoubtedly better than others.
I’d like to hear what you think. Have I missed anything? Do you disagree with any of the points above? What do you think makes a good business model?