Assessing a Business Model Attractiveness

In our previous posts, we learnt how to visually represent the business models of different companies using the Business Model Canvas. Our first post, Understanding Business Model Fundamentals, answered why we should study Business Models and how Business Model Canvas helps with the visual representation of a Business Model. Then, we attempted to represent the business models of Google, VISA, and Twitter over the Canvas. In this post, we will learn how to assess the attractiveness of a Business Model from an Investor perspective.

Bill Gurley (Venture Capitalist at Benchmark Capital) wrote an interesting article titled, ‘All Revenue is not create equal – The keys to the 10x Revenue Club’ on 24th May 2011 over his blog at http://www.abovethecrowd.com. In this article, Bill talked about 10 distinguishing traits that warrant high price/revenue multiples and thus higher valuations. These traits are described as follows:

1. Sustainable Competitive Advantage – Here, an Investor is looking for answers to the following questions: Do you know your competition well? What kind of advantage do you have over your competition? Can you sustain it over time? How difficult is it for your competition to provide the same product or service that you provide? Does your business have high barriers to entry?

2. The presence of Network Effects – As per Wikipedia, a network effect is the effect that one user of a good or service has on the value of that product to other people. When network effect is present, the value of a product or service is dependent on the number of others using it. Network effects are present in two-sided markets. Example markets include credit cards, composed of cardholders and merchants; operating systems (end-users and developers); video game consoles (gamers and game developers).

There are two types of network effects: A same-side effect, in which increasing the number of users on one side of the network makes it more valuable to users on the same side; and a cross-side effect, in which increasing the number of users on one side of the network makes it more valuable to the users on the other side. The question to ask is whether your products create Network effects. What kind of Network effects do they create?

3. Visibility/Predictability are highly valued – Investors favor pricing models that provide a high level of predictability & consistency in the future. They would ask you whether your business is vulnerable to the “hit” risk. Do you have follow-on products to your great initial hit?

4. Customer lock-in/High Switching Costs – Investors favor companies with low churn rates of customers and High switching costs. The switching costs can take many forms like Hardware lock-in, Data lock-in etc. How are you creating Customer lock-in with your products or services?

5. Gross Margin Levels – It tells how much leverage exists in the business. Companies with lower gross margins will trade at highly discounted price/revenue multiples because lower gross margins translate into lower net profit margins. You need to answer how your Gross margins compare to that of your competition? If they are high, how will you protect them over time? If they are low, what is your strategy for increasing them?

6. Marginal Profitability Calculation – As per Bill, Investors love companies with scale. Investors will value a company more if higher revenues create higher profit margins, all other things being equal. Marginal Incremental Profitability calculations help Investors understand how well your business is scaling. Investors would ask whether higher revenues translate into higher profit margins for you.

7. Customer concentration – Investors prefer a highly fragmented customer base versus a highly concentrated one. This is because concentrated customers have “market power” whereas small customers are “price takers” in the market. Do you have few big customers or many small customers? Do you have a “long tail” of customers?

8. Major Partner Dependencies – As per Bill, Investors will discount price/revenue valuations of any company that is highly dependent on another partner in some way or another. How much dependent are you on your partners for your value proposition development or for Go-to-Market (GTM) channels?

9. Organic vs Heavy Marketing Spend – Investors love companies where the products/service sales are achieved through “word of mouth” process and the cost of new customer acquisition is low. Lower the marketing spend, the better it is. Does the visibility of your business increases through word of mouth? How your marketing spends compare to that of your competition? What are your Customer Acquisition Costs for new customers? How do they compare to that of competition?

10. Growth – The faster you are growing, the larger your future revenues and cash flows will be. As per Bill, High growth also implies a company has tapped into a powerful new market opportunity, where customer demand is seemingly insatiable. How your business growth compares to that of your competition or your Industry? Are you growing faster than or slower than your Industry?

Different Investors can add more criteria to the list above. But, we would restrict ourselves to these 10 criteria to test the attractiveness of different business models. These criteria force us not only to analyze the financials of a company but also to look at a firm’s position in the context of an industry. These criteria will also help us gain a better understanding of different businesses and industries.

We would be using these criteria to test the attractiveness of different business models. So, let us give a name to these criteria. Since, Bill Gurley first outlined these in his article, we will refer to these as ‘Gurley’s Test’.

These 10 criteria can be visually represented over the Business Model Canvas as follows. The visual representation will help us easily remember these 10 criteria. In the upcoming posts, we will apply Gurley’s Test to different businesses and see how they score.

Please click the image below to see it on full screen.

 

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  1. Comparing Facebook and Google Business Models « Understanding Business Models

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