Desperately Seeking Business Models

underpants-gnomesOne of the most common questions I get from entrepreneurs is “how baked does my business model or monetization strategy have to be to 1. get into an incubator 2. raise seed money from VC’s or angels?” Of course, it is really hard to give a specific answer to a generic question (“it depends” is my favorite answer :) ).  But just like everything else about starting a company, being in LA also complicates the conversation given the lack of seed stage capital as well as the resultant historical propensity of LA companies to focus on revenue sometimes to the detriment of scale or even user satisfaction. So instead of giving a direct answer, I’m going to try to provide a framework to really better decipher the question.

First of all, the question itself is often a red herring.  When a potential investor (angel or vc) says he or she is passing because of business model or monetization concerns – half of the time its just an easy way to say “no” that sounds semi intelligent and thoughtful (and hard to decipher). Yes, it’s a cop out. I confess that when I’m lazy or distracted – I use it too. If the vision is ambitious enough, if the value proposition is unique enough, and if the product is thoughtful enough – monetization or business model related hurdles are things any value added investor will be happy to roll up his or her sleeves and work with the entrepreneur to figure out.   In short, there are probably ten different things you should really be worried about BEFORE tearing your hair out on “monetization strategy.”

A great vision, value proposition, and product; on the other hand, will not overcome the “small addressable market” problem.  Reading between the line, often when someone has concerns around business model and/or monetization – the real concerns is around IF the company can make a lot of money in the long run; not HOW the company will make money.  IF = addressable market. How = business model.  A very thoughtful bottoms up model around the total market opportunity is absolutely one of the most important “check boxes” for an entrepreneur to complete.  The exercise has nothing to do with going to a Forrester report and pulling out numbers that ends in “B”.   Dumbed down . . . it is. . . “if I charge 5% transaction fee and I own 100% of the market how much annual revenue would I have?” or “if I charge $45 per seat per month, if everyone in the industry in my target user segment buys a seat, how much annual revenue would I have.” or “if everyone in my target customer segment that is reachable via my chosen acquisition strategy pays $30 every 5 year to buy my widget, how much money would I make annually.” Often, because it can end up being a catch-22, I’ll want to see the math done in multiple ways to see if the market can sustain a large business regardless how the revenue model question lands. Personally, I’ll take the “HOW” risk all day long for the right team – but not the “IF” risk.

Now. . . here comes the exception to the “IF” rule :)   The only time I break the “IF” rule is for consumer “utility” startups that have “struck a nerve” in discovering a new and rapidly adopted user behavior. Facebook, Pinterest, Instagram – I want (wish) to fund/help those companies because they have either created a whole new consumer behavior OR help digitize an existing but relatively new offline behavior.  People often ask if LA could ever support the creation of a company like a Facebook/Pinterest/Instagram (and even Google) –  companies that focused on serving the end user and achieving scale before finding the right business model. Call me a dreamer – but I would like to.  Not because of jealousy, but because I believe there isn’t one formula to building a great company and that we need to be supportive of entrepreneurs who’s vision and ambition transcends the day to day constraints of where we live. (But make no doubts about it, the hurdle is super high)

For an enterprise / B2B startup, I also want a deep dive analysis of the industry value chain and the profit margins for each of the participants in aggregate.  This is very much related to the addressable market question – it tells me whether the marketing size model passes the sniff test.  For example, if your addressable market math assume that you can sell office management software to dentists for a price of $200,000 a year to 1M dentists, but the average profit per dental office is only $100K and only 1% of the total revenue is spent on IT –  I would ask you to tear up the model and start over.

For “widget” and “free-mium” consumer businesses, the analysis that absolutely needs to be done is to understand price elasticity curve of the product/service you are selling – do an actual survey if possible (conjoint is great for understanding the feature + price trade off). The consumer psychology for willingness to pay is complicated and irrational – the only way to know for sure is to get out of the office and ask/test.

So. . . . . .

1. In general, don’t get too caught up in nailing the business model at the early stages of starting a company.

2. Answer the total addressable market question thoroughly and logically, and many people won’t get too hung up on finding a business model.

3. If you are a free consumer utility, show usage and engagement traction and prove it to me/any investor that you have either successfully changed consumer behavioral (harder) or is riding an “almost impossible to stop” tidal wave of changing consumer behavior (easier).

4. Enterprise startups need to do a lot of home work around value chain, cashflow, margins, and turnovers of the various participant businesses in the industry.

5. Consumer startups that sells a product or service need to build a preliminary price elasticity curve based on rational assumptions (not as good) or survey/test (better).

Lastly, hold guys like me accountable – don’t let us cop out by using “concerns about the business model” as an excuse to pass on working with an entrepreneur. Of course, there are times that it’s a legitimate concern, but a deeper discussion around the market size, value chain, value prop, willingness to pay etc is so much more productive and helpful to the entrepreneur.

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