Silicon Valley is obsessed with business models. It’s one of the first questions we ask about any new venture: “What’s the business model?”
When I was teaching Entrepreneurship in High Technology at StanfordÂ in the early 1990s, and later working as a strategy consultant with SDG, I started wondering just how new any business model could really be. After all, we have thousands of years of business experience behind us–are we really still inventing new models?
So I started categorizing businesses according to some basic characteristics–mostly around what they were selling and how.
I found that some companies were based on people (e.g. services companies), some required a large up-front investment, but had low marginal costs of delivery (such as software), and so forth. I also noticed that people who were good at managing one of these business models often had trouble understanding or working in the others; their instincts were all wrong.
As I grouped them together, I noticed a pattern–and it struck me how old some of these business models really are.
The basic business models I identified were:
Disclaimer: These are business models, and have nothing to do with the specific products or services being offered.
These companies focus on services, such as law, accounting, or consulting.
People are billed out by the hour or the project (“trick”). Since there is a limit to how much you can charge for someone’s time, and most of that needs to be paid to the individual contractor, youÂ can typically only leverage up the business by hiring a lot of people. So you are limited by how many people you can reasonably manage. It is difficult to get extraordinary margins.
There is typically very little investment needed to start these businesses. They focus on having highly productive individuals and small teams, but are rarely concerned with broader organizational efficiency, as that is not their competitive advantage.
These firms are typically filled with many people of the same basic “type,” or skill set. Â As a result, the firms can become mini “think tanks” for their profession–often representing the cutting edge in both theory and practice.
These are product-oriented businesses. Profit is not based on the number of people you employ; it’s supply and demand and how much product you can obtain and sell, and at what margin. To sell more product, you need to manufacture or acquire more product. Â To make more money, you need to make bigger deals, and at a higher margin.
These businesses are often concerned with having good supply chains, sales and distribution–and may evenÂ sacrificeÂ the individual productivity of their people in order to achieve higher overall operational efficiency.
These are publishing businesses. They require a significant upfront investment before they can get any revenue. But having made the investment, they have very low marginal costs. They do not need to maintain any inventory; if they sell a copy of their product, it does not reduce the number they can sell in the future; they simply sell another copy.
These businesses will often give away a lot of product in order to seed demand–at levels that other businesses could not imagine. Whereas other businesses might use “loss leaders,” or give away perhaps 5% of their total volume, pornography businesses may turn that around and give away 80% or 95% or more of their product, making all of their revenue on the remaining 5-20%.
Examples of pornography businesses include: software, magazines, newspapers, recorded music, movies, online games, and even Intellectual Property licensing shops.
These are financial services firms. They make their money by understanding risk, by having a large capital base that allows them to lend or invest money, and by providing the services that allow other companies to make financial transactions (thus playing “the house”).
Gambling businesses can grow very, very large in terms of dollar volumes, with a relatively small number of people. However, they require significant care to prevent any one set of risks from swamping the rest of the business.
Gambling businesses often mitigate their own inherent risk by creating a portfolio of risky businesses which balance each other out. Properly designed, the system will have some areas losing money, while other areas make a phenomenal return–often for several years. This is intentional; the areas should be chosen such that different divisions will make or lose money at different times.Â Unfortunately, it can also create significant tension within the employees, who (following the prostitution model) often want to be compensated for their individual successes. The result is these firms can be somewhat unstable if incentives are not set up properly.
Gambling businesses are concerned with ensuring a steady supply of capital, as well as excellent “deal flow” allowing them to participate in the good bets. They are also highly sensitive to errors; one wrong step can sink the business.
Religious businesses include self-improvement services, such as education, gyms, and coaching. These businesses help their customers improve themselves, but make no guarantees as to whether that help will result in tangible benefits.
There are fewer examples of these businesses than some of the other models. However, they are pervasive. Colleges and graduate schools attract a lot of people each year; these people pay a lot of money for an education which may or may not help them achieve their personal economic goals. Self-help courses and churches also fall in this category. This is not to say that they do not help–just that it is a characteristic of these businesses that there are no guarantees. The evidence is often ambiguous, and thus requires a certain degree of faith.
So What Does It Mean?
I identified these business models as archetypes, with no value sentiment attached to them. Many people have drawn a comparison between prostitutes and attorneys, banks andÂ loan-sharks, or universities and churches; but that isn’t the point. Although many businesses are amalgams of these basic models, I find these distinctions helpful when thinking about and evaluating different businesses and opportunities, or when I find people struggling with their own company’s business model.
For the past few years we’ve seen the recording industry struggling with “online piracy.” They claim that if people get their product without paying them, it is theft. I am sympathetic to the ethical argument here, but it misses the practical business issue.
The recorded-entertainment industries (music and movies) are clear examples of the pornography business model. Consequently, they should plan to give away the vast majority of their product and make money on the remainder. In fact, they used to do just that–they actually paid radio stations to play their songs, so the consumers could listen to them for free, then buy the record.
Unfortunately, in the past decade industry leaders have acted as though they were in the drug model–even to the point of using words like “theft,” which had never previously been applied to the copying of copyrighted materials. Their failure to understand their own business has led to a lot of resources spent on enforcement, lawsuits, and other activities which fight the desires of their customers instead of serving them. This serves nobody, angers the customers, and ultimately harms the industry. The evidence has been plain: the industry actually grows during periods of high “piracy,” but has suffered when they successfully slow down the “theft.” If they really embraced the pornography model, they would make a lot more money in the long run.
By contrast, the online game industry, which arguably competes for the same mindshare and disposable income as the recorded-entertainment industries do, has been growing at an insane rate, even in the worst recessionary period since the Great Depression. How? By giving away their product to over 95% of their users, and making their money on the remaining 5% or less. They understand the pornography business model, embrace it, and are doing great.
The Bottom Line
You really need to understand a company’s business model before you can appropriately evaluate, prescribe, or implement their strategy. When professionals have spent most of their career in one of these models, they can find it tricky to understand another one. This can create problems for investors (who need to evaluate different companies), consultants (who advise the companies), or managers (who create and implement strategy)–especially those who move between companies, even in the same industry.
I’ve found that thinking explicitly in terms of these basic models can serve as a great framework for thinking clearly about strategy.