People often throw around the term business model in discussing startups.
But just what is a business model? Which ones work best and why? How do you know if your startup has the right one?
A business model explains which consumer pain your startup chooses to relieve, why your solution works better than competing ones and how big a wedge a company can drive between what customers are willing to pay and the costs.
I recently spent three hours with some clients, executives from Beijing, to discuss these questions: I presented several business models and their financial benefits.
After sharing the idea of the business model canvas, developed by Alexander Osterwalder to help entrepreneurs design a customized business model, I gave the Chinese executives an hour to “paint” a new business idea. (We did not use the interactive tool; they wrote their choices on a white board and addressed the class in Chinese. With the help of a translator, I asked follow-up questions.)
They did so brilliantly, picking two business ideas that clearly passed these three tests.
Read on for a quick review of the six most interesting business models I presented, some of which they found inspiring.
1. Hold a reverse auction. In a reverse auction, extremely price-sensitive buyers name their price for a service. If the seller accepts the price, the buyers must commit to the seller’s terms.
That’s the service that Priceline offers to desperate, price-sensitive travelers who give up convenience for the lowest price on accommodations, rental cars and airline tickets.
Priceline profits because plenty of consumers feel they are winning with their bid that’s just a tad higher than a price that would be too low for Priceline’s suppliers to accept.
And Priceline’s financial statistics reveal the greatness of this business model: 22 percent revenue growth, 50 percent profit growth and a 46 percent increase in stock price on average over the last decade. Priceline’s revenue per employee (it has 9,500) has been about $716,000, roughly six times the leisure industry’s average.
2. Orchestrate demand aggregation. Assemble all the sellers and buyers for some stuff in the same virtual location. This will give sellers the deepest pool of buyers and vice versa. That’s the idea behind eBay, of course, and it keeps working because buyers and sellers give each other very tough ratings and the use of PayPal provides a level of security in case things don’t work out.
The financial results for eBay indicate that this model works but it’s hardly a booming one. On average over the last decade, the company’s revenue grew 17 percent, profit climbed 14 percent, and the stock price rose a mere 5 percent. The company’s revenue per employee (with 33,500 in total) was about $479,000, roughly 40 percent more than the retail industry’s average.
3. Cut prices to gain an industry share and profit later. Target a huge market and sell a product at the lowest price with fast delivery and great service. As the company grows, expand the product line, negotiate volume discounts with suppliers, invest in technology to speed up customer-response time and cut waste from the operations. Then deliver the lower costs to customers in the form of lower prices.
That’s Amazon’s business model and it has let the company grow at a 27 percent annual rate over the last decade to $74 billion and its stock has risen on average 22 percent a year. While Amazon’s revenue is about $634,000 for each of its 117,300 employees, its net profit margin is a minuscule 0.37 percent.
4. Set up a modern franchise business. Figure out how to run a local retailer and turn this business wisdom into a system that can be sold to entrepreneurs around the world. Find hungry entrepreneurs who share this vision, sell them a business handbook, train them and let them handle the burden of finding new locations and leasing land.
That simple idea is what Ray Kroc turned into a gold mine of golden arches. Operating in 100 countries, McDonald’s has experienced just a 4 percent revenue growth over the last decade but its stock price has climbed 13 percent annually. Of the company’s $26 billion in sales, a considerable chunk, 20 percent, goes to the bottom line. The company is people intensive: Revenue per employee (with 440,000 in total) averages slightly less than $64,000.
5. Offer a product at the highest price. Find customers whose survival depends on a product that nobody else can provide. Then charge them half a million dollars a year to use it.
That’s what Alexion Pharmaceuticals does. In the U.S., 8,000 people have a disease that causes their immune systems to wipe out their red blood cells every night. Some of these people arrange for insurance companies or the U.S. government to pay $569,000 a year so they can take Alexion’s Soliris to stay alive.
It’s a great business model. In the last decade, Alexion’s stock has soared 2,250 percent a year and its revenues have spiked 106 percent annually to $1.6 billion, with 16 percent of that going to the bottom line. Its revenue per employee (with 1,774 employees in total) is on average more than $874,000.
6. Set up person-to-person exchanges. A company has a couple of cars that sit in the garage for all but three days a month. Some young professionals living in the city need a car seven days a week to commute and do errands. Find trustworthy people who will pay to drive those cars, and both sides will be better off.
That’s the idea behind person-to-person business models. It seems to be working for Airbnb. With 600,000 listings in 34,000 cities, Airbnb has people pay 3 percent to list their accommodations and the renters fork over 6 percent to 12 percent. With a quarter billion in revenue, Airbnb was recently valued at $10 billion.
Would one or a combination of these six ideas work for your startup?
Editor’s note: This piece has been updated to reflect the fact that Airbnb has listings in 34,000 cities not in 33,000 countries.