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Investing in startups: how strong does the business model need to be?
Beneath every startup’s polished exterior is the business model which drives its progress. How well it has been engineered is a vital consideration of the savvy investor.
Initially, they may hear about it via a swift startup pitch or neatly presented brochure. At this surface level, the model could be instantly appealing to the investor.
A revenue-generating model that seems well-oiled and certain to succeed is potent in itself.
If the market it will be applied to is in desperate need of disruption, the attraction may be even stronger.
This is just the start of the business model assessment process, however. Sophisticated investors must cross-examine those behind the startup, probing for potential deficiencies in the model.
Of course, the model must be strong enough in itself to stand up to scrutiny. But so too must the many factors that feed into the model dictating its performance.
All the assumptions it depends on, like customer numbers, conversion rates and the ability to compete with incumbents, should be questioned thoroughly.
Many startup investors consider the business model as one of five overriding areas of focus. The other items in this ‘5 Ms of startup investment’ are Management team, Market, Money and Momentum. Every element is inter-linked, making evaluation of the model somewhat pointless if the other Ms aren’t also analysed.
For example, a finely-tuned model in a lucrative market breaks down if the management team is not equipped to keep it running smoothly.Similarly, the money-making machine stutters if there aren’t the marketing funds needed to win paying customers.
So the business model influences - and is influenced by – all other parts of the business. But what about the model itself? Are there any startup business models that are guaranteed to succeed?
Startup business models come in many guises and, if the entrepreneurs are innovative in any way, will have their own nuances that separate them from others.
The classic categories of retail, franchise, manufacture and distribution remain relevant today. Numerous sub-divisions and re-imaginings of these basic models also exist.
A few examples are:
- Subscription: while long established in many consumer markets, recent years have seen this approach disrupting previously untapped territories such as software, in parallel with the rise of Software as a Service (SaaS).
- Customisation: think bespoke or opulent additions to cherished products like Land Rover Defenders or Mulberry handbags. Both third party businesses, and fashion giants such as Nike, which allows customisation of its own products, are getting in on the act.
- Marketplace: eBay is the poster child of this model, which puts supply and demand in the same room, and takes a cut of the transactions that ensue. The rise of the so-called ‘sharing economy’ has seen more recent successes surface, including Airbnb.
- Freemium: offering services for free, with a paid-for premium option on top, has worked well for the likes of Spotify, Dropbox and LinkedIn.
Clearly presenting investors with a lot to consider even at this stage, delve deeper into signs of strength within the business model and there’s a lot to investigate.
Signs of business strength
Most sophisticated investors are well aware that building a business is much harder than planning it on screen or paper.They are therefore looking for indicators that the model will work in practice, rather than hypothetically, and that the business can thrive in the real world.
Is the idea well protected from replication? Is the cost of customer acquisition realistic? Is cash-flow healthy enough to maintain the progress needed to succeed? Is there strong demand in the market for the product or service?Also, investors are looking for signs of what will happen when unexpected challenges emerge. How will the people behind the business react? Do they have what it takes to turn their idea into profitable success?
These are just some of the many considerations that can point to a strong business model, and every investor has their own criteria to work through before backing a startup.
Now it’s quite common for business models to evolve over time as the company matures. But the ability to adapt to this is key.Adaptability is important to investors. The stereotypical entrepreneur passionately believes in their idea and will do whatever it takes to make it a reality.
Certainly, passion is an essential ingredient in the startup tonic. But what if the market and customer behaviours don’t play out as expected? What if exposure to real trading conditions reveals a gaping flaw in the business model? Will the entrepreneur willingly change their business model to respond?
Flexibility is arguably just as important as passion in establishing successful startups.
Is the investment prospect likely to rigidly stick to its plan, even if all evidence suggests it should change? Or, is the model adaptable to the shifting dynamics of the wider world?
One way to test this is to question whether the business is actually monitoring the wider market.Is there a continual dialogue with real or potential customers through focus groups or market research? Does the model allow for the performance of customer acquisition methods to be scrutinised and adjusted accordingly?
A commitment to ongoing research and development, with adequate resources assigned to it, also suggests an adaptable startup.Instead of an unswerving belief that its product is the definitive solution, regardless of what the market is saying, an R&D-focused firm is striving to keep moving forward, tweaking and improving along the way.
A lesson in the dangers of business models that are not adaptable comes from the collapsed video rentals empire Blockbuster. After unbridled success from its launch in 1985, the 21st Century brought with it a new up-start called Netflix, which even offered to buy Blockbuster for a reported US$50m in 2000.
By 2008, the video chain still hadn’t recognised the need to respond to this growing threat. Blockbuster CEO Jim Keyes told financial services platform the Motley Fool in 2008 that Netflix wasn’t “even on the radar screen in terms of competition”.
The company collapsed two years later, having failed to adapt to the age of digitisation. Netflix, meanwhile, continues in its push for global domination today, despite a recent dip in performance.
There are, of course, plenty of counter case studies of entrepreneurs who changed their business model to succeed. Twitter was borne out of a startup that had simply planned to syndicate podcasts via the blog-reading tool RSS. Facebook started as ‘FaceMash’, a site where Harvard students could judge whether their fellow campus peers were ‘hot or not’. The revered jewellery institution Tiffany & Co actually started life as a stationer.
Being able to adapt is essential in building businesses, and the startup model should reflect that.
The importance of the startup’s business model
The strength of a startup’s business model is extremely important - but only as part of the bigger picture.
The model is one of several considerations for the investor. We’ve talked in-depth about the ‘5 Ms of investment’ previously and listed the other vital areas to examine, but you may also have some additional items on your investors’ checklist – perhaps based on personal experiences in business or investment.
Ultimately, only once the startup opportunity has been analysed from every angle - and you feel confident the opportunity is right for your portfolio - should you think about investing your hard-earned funds.