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Business models

Why does the business model matter?

You have to develop a great business model.” People keep telling this to aspiring entrepreneurs and corporate managers. But why…? Why does the business model matter so much? Or does it, really?

The answer is yes, it does really matter. Of course it does. We’re talking about what exactly to offer and how to create that offering, who to target as a customer, who as a user and who as a partner. And probably most importantly, we’re talking about how you can make money with what you offer.

Considering that you have several options for several elements of your business model, it is not always easy to make the optimal choices. For example, you can sell your product or service via one-time transactions, or on the basis of a more continuous customer relationship such as subscription, or give it for free and charge for something else or someone else.

Consider this example. I like to think of business models as the monetization of a solution to a specific problem. One such specific problem is that people must eat to survive. Some also eat to satisfy their other needs. A solution to this problem is food, right? How many different ways of doing business by offering food to consumers can you think of?

The most common answer to this question would be supermarket and restaurant. These are just the very basic higher-order business models. There are many other models as well. And within each of such business model type, there are multiple sub-categories.

For example, not every restaurant is a traditional dine-in. Fast food, high end luxury, food-entertainment combination, online-orders-only, cafeteria, self-cooking, subscription-based and pay-what-you-want restaurants are just a few examples of different types of restaurants.

All these examples of restaurant business models have different types of customers, operations, and pricing. Their value proposition is also different, ranging from convenience and speed to quality and health.

So why does the business model matter, exactly? And how?

Profit

Do you think Apple would be making more than 65% of the smart phone market’s global profit if it hadn’t created it its closed ecosystem of several interconnected hardware and software products that focus on continuous and superior customer service? Probably not.

It could have easily outsourced iTunes. But it didn’t. It could have just sold computers, phones and tablets separately on a one-time transaction basis. But it also offers that iTunes subscription, Apple TV and other services that are based on continuous sources of income from retaining customers. It could have made its devices technically compatible with other providers’ products, but it hardly did so.

If you decide to buy one Apple product, it pays off to have all your tech by Apple because they are compatible and connected and thus increase your efficiency. In this way, and combined with its great design and user interfaces, Apple is able to keep its customers, set relatively high prices and make huge profits.

And it is extremely difficult to copy Apple’s business model. Copying some of its product features is doable, but copying the system is hard.

Competition

Modifications of the business model enable differentiation and potentially comparably lower cost of operations or even marketing depending on the target customer group.

Why did Netflix become so big? While the company’s biggest rival, Blockbuster, was still focusing on the brick-and-mortar business model, Netflix started to quickly utilize technology; the Internet. First it offered the same service as Blockbuster – DVD rental – using a similar pay-per-rent model, but not as a physical store but online.

Soon the company introduced its monthly subscription model and dropped the single-rental model. Now it was possible for the customers to have flat-fee unlimited rentals without due dates, late fees, shipping and handling fees, or per-title rental fees. The rest is history; Blockbuster doesn’t exist anymore while Netflix has grown into a $215 billion company (market cap as of September 28, 2020).

A closely related reason for why business models matter, is disruption. The difference is that the new business model creates a whole new industry, or at least a new and more efficient way to organize it, and possibly even disrupts the existing one. This is basically what Netflix did with its streaming service later on.

Other examples of similar disruptors include Kickstarter, Airbnb, Taskrabbit and Uber (although Christensen argues that Uber is not a disruptor according to his theory). Their business models weren’t based on any specific novel technology unlike that of Netflix. Instead, they re-organized the existing models into multi-sided platforms that involved individuals on both sides.

Growth

Would Dropbox be an $8 billion company (market cap as of September 28, 2020) today with 2,300 employees if it sold its data storage service as an installable software on a CD via electronics retailers? Or if it targeted individuals (not companies) only? Probably not.

Instead, it uses a freemium business model and the cloud. Most of its users are individuals who receive a relatively small amount of storage space. Then, the rest consists of individuals and companies who pay for more storage space and extra services.

This business model, because it is cloud-based and anyone can use it in a standardized way on their own, is highly scalable. There’s no customer service needed, except a certain level of support, and there’s no huge sales force needed either. Dropbox’s number of users grew to more than 500 million in less than 10 years. And today about 15 million of them are paying customers. If the business model wasn’t so scalable, this would never have been possible.

As an opposite example, think about Groupon. It offers daily deals by small local businesses (merchants), but its business model is not very scalable and largely based on hope. The company has a comparably large sales force to negotiate each campaign with the merchants. It takes 50% of the sales revenue, which is quite much considering that the campaigns are typically attractive for consumers only if there’s a huge discount already.

The merchants have been struggling with this combined with lots of one-time discount hunters, who don’t really enjoy the brand but just the reduced price of the campaign product. Initially Groupon was growing fast but not sustainably. And that’s because of its business model.

Innovation

While the business model can also be an innovation itself, some business models facilitate innovative technologies better than others. Remember Xerox and its pay-per-copy business model innovation?

In short; Xerox had developed a new copy machine (model 914) that was technologically superior compared to all existing machines. Yet, it was expensive and companies didn’t want to buy it. So Xerox changed its business model from selling copy machines to leasing them and charging for their use, not ownership. The company grew its revenue from $30 million to $2.5 billion over the next 12 years.

Similarly, business models that allow for close relationships with suppliers, customers or users are more likely to foster innovative ideas. Yet, this doesn’t necessarily mean that the business model will have to suffer from reduced scalability or lost intellectual property. There are many ways you can increase the openness of your business model and still be scalable and keep your secrets.

Conclusion

The business model matters for your profitability, competition, growth and innovation. Just like technology can enable new business models, business models can foster new technologies as well.

Looking at the examples mentioned in this article, it seems like the choice of business model is easy. I can assure you, it’s not.

Companies have numerous potentially great and less great options, and they have to make big decisions that have long lasting effects and often involve irreversible upfront investments.

Then the question becomes, how do you know what the best model for your business is? Well, you don’t. But you can definitely do testing and try to exclude the worst alternatives and opt for those that seem to have the best results in your tests.

Therefore, your job as an entrepreneur is to find the best-fitting business model for your endeavor. And this requires a lot of testing.

Make testing a habit.

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