Business Models: The Forgotten Middle Children of Startup World
By Andy Barkett (Engineering Manager, Facebook)
I hear a lot of elevator pitches. The most common conclusion to the pitch is, “Well, what do you think of my idea?” Honestly, I love most of the ideas and yet hate most of the pitches. It’s hard to answer, because the question can mean three different things:
- What do you think of my cool product idea? -OR-
- What do you think of my idea for a new business model? -OR-
- How do you like my business plan?
What’s the difference between these questions? And perhaps more importantly, how do you turn an idea into a business model and how do you turn a business model into a business plan?
First, let’s define these terms:
Step #1 – What is a Cool Product Idea?
This is an idea for some new service, website, app, device, widget, or whatever. Ideas:
- Are usually focused around a new product or service.
- Can be creative. There are no limits to what an idea can be.
- Can be thought of in 1 minute by 1 person.
- May or may not be unique. Both are OK.
- Don’t have to answer questions like, “How much will it cost?” or “How will I make money?”
- Are presented casually to friends or possible collaborators.
I have heard a lot of great ideas. Trying to jump straight from an “idea” to a business plan rarely works, and is often a big waste of time.
What should come next, after an idea, is a business model.
Step #2 – What is a Business Model?
The business model is a description of why and how much a customer would pay for the product or service, an explanation of how much it would cost to produce the product or service, and what the company will do with the difference (which in accounting parlance is called “gross margin”).
The business model will:
- Answer the question “How much will a customer pay and why?” — Also, address the issue of how many such customers are out there.
- Show what it would cost to produce the product or deliver the service — This includes licensing costs, manufacturing costs and the wages of service providers. Note this is NOT the cost of developing a product. This is the cost of providing and selling the product or service. Sometimes you’ll see this called “variable cost.”Gross Margin = Price per unit – Cost per unit
If you sell a widget for $3 to someone in need of a widget, and it costs you $0.50 to produce a widget and $1 to find a widget customer, that leaves you with a gross profit of $1.50. What do you need to spend that $1.50 on? If you have to buy a machine that costs $1,500 (big cost), then you need to sell 1,000 widgets to break even. This is the heart of the business model.
- Identify other big costs — These could be up front R&D costs, costs to buy land or equipment, or whatever else is needed.
- Require some research — Conversations with experts, potential customers, and potential collaborators are essential. Expect to try out competing products and explore how others solve the problems today (or fail to).
- Validate! — Don’t just say you can sell your widget for $3. Instead, survey people and find out what they’d pay. Show them a sample widget, or a drawing of a widget, and see how they like it. Give them a $5 bill and the opportunity to buy your widget or a competitor’s. See which they choose. Buy Google AdWords advertising your widget and see how many people click on them. You can never do enough validation, ever.
Your business model should fit on a single page, maybe two. If you can generate a successful business model, then you’re… well… really in business! You’ve got a business model. You know the product. You know you can sell it. You know how much it will cost and how much you’ll make for each one. You know your other big, fixed costs.
After the business model, now you’re ready for a business plan.
Step #3 – What is a Business Plan?
The business plan shows people how you’re actually going to execute on the business model. Who’s going to do what? Where will the money come from? How long will it take? These are all pieces we didn’t worry about when generating the business model.
- Address timelines — When will various things get done? How long will it take to break even?
- How will you finance your business? — Even if your model is profitable, you may need a lot of cash at certain times. You usually get paid some time after selling something profitably. Maybe you need to scale up to a certain size before you can break even.
- Do you have the right team? — Are you covering all needed skills? Do you have people correctly committed and incentivized?
When an investor criticizes your business plan, they’re usually really criticizing the business model. If the investors like the business model itself, they’ll often help you develop the full business plan.
|What is an idea?
||What is a business model?
||What’s in a business plan?
Editor’s note: Got a question for our guest blogger? Leave a message in the comments below.
About the guest blogger: Andy Barkett is an Engineering Manager at Facebook, managing an infrastructure engineering group. Andrew is also a successful entrepreneur. He co-founded Greenlight Apparel, a fair-trade, organic clothing company, and has worked on several other startup projects. After making a small, profitable web-based game in 2003, he worked at Google for a few years after participating in two large, venture-backed startups.