Building your Business Model
By James Martin
June 26th, 2020
Proposing your business model is not always a straightforward task. To convince an investor of the credibility of your business model requires an explanation of the assumptions detailed in your model, how it is affected by the consumers, and how this might change over time. After reviewing some of the advice from top investors, we present our top tips on business models.
Honesty, first and foremost.
Most of us are aware of the importance of being honest, but to Bill Trenchard from First Round Capital, it is too important not to address. In the early stages of any startup, it is only natural to be knowledgeable on some areas of your business model and have gaps in others, especially when business models change with time. For Trenchard, things become frustrating when he meets founders trying to place a number or a value on a completely unknown or variable aspect of the business model. Instead, he believes it is far better for founders to explain, to a certain extent, how they make their money. This could mean stating how a company will charge for a product - free, paid, or premium - to understand the basic level of unit exchange between the company and the customer. Information on how much customer acquisition will cost and what the predicted worth will be over time are other important aspects to consider in your business model. Of course, most investors will understand that founders may not know all of this data at the start of a company but start by simplifying the model to this basic level, showing how you know this information based on the current data you have on a small sample size. Overall, the important feature is to be open about what it is you do and do not know. Aim to provide a means of understanding how the model will work and how it might change over time as you scale up the business and, most importantly, be honest.
Change is the only constant we experience. Even business models will change over time, and most investors take this on board. Instead of needing to understand the underlying economics of the business model, they want to know what it will look like in five to ten years' time when a company has scaled up, is coming up against competition from other firms and might need to enter a defensibility mode. Realistically a startup needs to have an idea of how the price of a product and the business will develop as it continues to expand. Is a startup looking to increase the prices of its products as the company scales, much like Google and Facebook, or does it aim to decrease the value of their services, like Uber or Amazon? Early-stage investors need to understand the model as much as possible, even if it's more of a hypothesis than a definitive statement.
According to Hunter Walk from Homebrew, he is looking for two aspects in particular when it comes to the business model. Firstly, founders need to demonstrate that they understand the scale a venture will require for venture capitalists (VCs) to invest. It might sound like a bit of a joke that any startup that has failed to mention it is going to make $100 million in the first five years will not attract an interested VC, however, in part, it's true. If you are a startup looking for funding from VCs, you have to demonstrate in your business model that you are not only able to build a significant business but also grow over time. Secondly, Walk expects founders to illustrate how the model is tied to the business's capital needs. Many founders begin by saying they will grow the company before attempting to make money. Still, the reality is, the amount of capital required to sustain such a business model is challenging to come by, especially if you are not a credible entrepreneur with years of experience.
In a slightly contrasting approach, Gigi Levy-Weiss from NFX cares very little for the business model itself, since no founder truly knows how it will look in several years. He believes it is important that founders demonstrate how they think and how they can build their thinking around a particular model to allow for evolution over time. Levy-Weiss wants to understand the assumptions portrayed in the business model by getting a team to detail the references used and where they were gathered, to enable a team to develop a particular model. If you can convince him your thinking is on track and you can build a responsive business with an evolving model, you might just be able to get him on board.
For some markets, the business models are more apparent than others. When Saar Gur from CRV meets with founders, he is usually most impressed by the entrepreneurs who have done their homework. That's to say, the individuals who have studied meticulously how a particular business was operating and what the business model looked like before monetization. He believes firmly in the saying, 'history doesn't repeat but rhymes', so when entrepreneurs come to him having studied the history of a business, even if the business model does not have firm convictions, at least the founders are coming from a strong point of view.
It is often useful to look at analogs of other businesses in the same or comparable industries with similar models. By recognizing the challenges, other films have faced and the benefits they have experienced, it can inform a founding team how and why a business model has been a success, or otherwise, which is ultimately, very useful for an investor.
Eyes on the Customer
When considering the type of business model for your product, one of the key aspects to bear in mind is your customers. After identifying the target customer, it is essential that startups deliberate how frequently these individuals will purchase their product and how much they will spend per transaction. Once this has been ascertained, a company can figure out how much profit each purchase will give. If your startup has a network effect business growth, then with more market power, over time, it is possible for companies to charge a higher rate, something to consider when designing your business model. If a company can acquire new users, a VC will want to know how - word of mouth by unpaid means or through sales reps or marketing buys? Knowing these channels will give vital information to VCs about how scalable the business could be. In essence, a good business model will indicate how profitable a company might be, channel ownerships, and customer acquisition.
Essentially, we could talk about the customer journey which is not always obvious to the business model but serves as an important aspect of the decision process about whom to sell to and how to monetise the products. By demonstrating the type of customer and their role in the model a VC can get some sort of context of the beliefs and assumptions behind a founding team's trajectory.