Chapter 8 Introduction

In the 1989 film Field of Dreams, Kevin Costner plays an Iowa farmer who hears a voice that tells him, “If you build it, he will come.” Inspired by this vision, Costner’s character turns his cornfield into a baseball field (of dreams), and eventually the ghosts of deceased baseball players such as Shoeless Joe Jackson appear on the field as younger versions of themselves. The movie coined the popular axiom that “if you build it, they will come,” just as the players appeared after the field of dreams was built.

Although it’s a fun saying for film buffs and sports fans, this approach is one you will want to avoid in entrepreneurship. In fact, the entrepreneurial graveyard is littered with ghosts of startups that never gained traction with customers, never to be heard from again. (According to one recent study, seventy-five percent of venture-backed startups fail.)[1] Thus, you don’t want to blindly build a product and hope that customers will come.

Juicero is one recent example of product that conducted little-to-no customer discovery before launch. A cold press juicer made by this San Francisco startup cost $699 at launch. The juicer squeezed packs of cut up fruits and vegetables, but customers found they could just as easily squeeze the juice out of the packs by hand and avoid the hefty price of the juicer. Customer acquisition and customer retention are not easy processes by any means. You have to work to gain a customer and work even harder to get them to return. One study by the data analysis firm CB Insights of why 101 startups failed found that 42 percent of them joined the “entrepreneurial afterlife” because there was “no market need,” which suggests a customer (or lack thereof) problem.[2]

Current trends in entrepreneurial thinking reflect a customer-centric approach: From the start, entrepreneurs must infuse their insights into the planning process through a process called customer discovery – talking to potential customers to gain insight into their needs and pain points. The entrepreneurial journey should begin with finding what serial entrepreneur and educator Steve Blank calls the problem/solution fit – in other words, you have identified an important problem for your customer, and the solution that you have developed actually solves that customer problem.[3],[4] In a complementary approach, Netscape founder Marc Andreessen discussed the need to achieve product-market fit – that your solution has a clear market need.[5] In other words, if we go back to the Field of Dreams analogy, you can’t just build a baseball field and expect players to show up. You would want to talk to prospective players and fans to see if a field is needed, what type of field (corn-to-baseball?), why that field is needed, how that field would be used, and what features of the field would be most useful—before you invest in building the field.[6]

Business Models

Although there are countless varieties of business models, the Scaling Lean author Ash Maurya offers three common types: direct, multisided, and marketplace. Direct businesses are the most common and involve one-sided actors—that is, users—becoming your customers. A coffee shop is a classic example; other examples include retail stores, software as a service (SaaS), many mobile apps, hardware stores, and stores that sell physical goods. In multisided models, users and customers—multi-actors—are usually different people. Ad-based models, big data, and enterprise are common examples where the products are free to users, and their value is monetized by a different customer base. Marketplace models are a more complex variant of multisided models made up of two different customer segments of buyers and sellers. eBay and Airbnb are well-known examples of marketplace models.[7]

Although planning is important, adaptability within the planning process is equally important. That’s what the business model approach is all about: outlining an approach but changing that approach throughout if (or more likely when) you discover that your assumptions and educated guesses were wrong. For each new iteration, or version, the entrepreneur makes a minor change to the current business model to better capitalize on market opportunities.

Designing the Business Model[8]

According to Alexander Osterwalder and Yves Pigneur, the authors of Business Model Generation, a business model “describes the rationale of how an organization creates, delivers and captures value.” Nevertheless, there is no single definition of this term, and usage varies widely.[9]

In standard business usage, a business model is a plan for how venture will be funded; how the venture creates value for its stakeholders, including customers; how the venture’s offerings are made and distributed to the end users; and the how income will be generated through this process. The business model refers more to the design of the business, whereas a business plan is a planning document used for operations.

Each business model is unique to the company it describes. A typical business model addresses the desirability, feasibility, and viability of a company, product, or service. At a bare minimum, a business model needs to address revenue streams (e.g., a revenue model), a value proposition, and customer segments. In non-jargon English, this means you want to address what your idea is, who will use it, why they will use it, and how you will make money off it.

A canvas is a display that would-be entrepreneurs commonly use to map out and plan different components of their business models. There are several different types of canvases, with the business model canvas and the lean canvas being the most common. There are hard-copy canvases modeled after an art canvas as well as digital versions. The original physical canvases are meant to serve as visual tools, used with sticky notes and sketches. Business Model Canvas[10]

As developed by Osterwalder and Pigneur (authors of Business Model Generation), the business model canvas has nine components, as shown below in Figure 8.1. The purpose of each of those nine components is outlined below in Table 8.1.

Figure 8.1: The Business Model Canvas

Attribution: Copyright Rice University, OpenStax, under CC BY 4.0 license

Table 8.1: Business Model Canvas Components and Purposes[11]

Early on, the biggest focus tends to be on fleshing out the right side of the canvas. This is because:

• They are, in many ways, the most critical aspects of starting a new venture (customer segments, value propositions, channels, and revenue streams).
• They are the most fluid. Revenue streams, channels, and value propositions will likely differ for the differing customer segments. Also, as you iterate and adapt throughout the customer discovery process, they could likely change.
• They follow a logical temporal order. In other words, there’s no need to focus on the costs of building a company for which you won’t have customers.

The Lean (Model) Canvas

Entrepreneur Ash Maurya, author of Scaling Lean and Running Lean, deviated from the standard business model canvas to create the Lean Canvas. It overlaps the business model canvas in five of the nine components: customer segments, value proposition, revenue streams, channels, and cost structure (see Figure 8.2 below). Rather than addressing key partners, key activities, and key resources, the lean canvas helps you tackle problems, solutions, and key metrics instead.

Figure 8.2: The Lean (Model) Canvas

Attribution: Copyright Rice University, OpenStax, under CC BY 4.0 license

As Maurya explains, “Most startups fail, not because they fail to build what they set out to build, but because they waste time, money and effort building the wrong product. I attribute a significant contributor to this failure to a lack of proper ‘problem understanding’ from the start.” Maurya next added a solution block to the lean canvas, which corresponds well with features on a minimum viable product (MVP) – a version of your offering that has the “bare minimum” features in order to be usable by a customer, who can then share feedback that can be used to refine the offering. Lastly, the lean canvas also adds an “unfair advantage” block. This aim to helps an entrepreneurs determine what gives them an edge, typically in the form of something hard-to-replicate that competitors will struggle to copy.[12]

Business Model Canvas vs. Lean Canvas

While the business model canvas and the lean canvas are similar in format, there are differences in how they are used. It is generally accepted that the lean canvas model is a better fit for startups, whereas the business model canvas works well for already established businesses. The lean canvas is simpler, while the business model canvas provides a more complete picture of a mature business.

Yet both the business model canvas and the lean canvas are designed for constant iterations, allowing for multiple versions and changes throughout the entrepreneurial process. In addition, both tools invoke a customer-focused design; as such, customer discovery is a critical process when using both canvases.

Additional Considerations when Developing Business Models

A few components of the business model are particularly critical early on, when trying to move from business idea to viable business opportunity. As such, it is critical to understand a few additional concepts for thinking through those components.

Value Proposition

Entrepreneurs play a key role in determining the value of their products. Of course, there are financial measures of value such as economic performance, job creation, wealth, and growth measures. But more often than not, value creation at the outset of a new startup venture lies outside these financial realms and addresses instead individual value to customers. The value proposition in a business model, for example, is a summary describing the benefits (value) customers can expect from a particular product or service. Your value proposition describes the benefits customers can expect from your products and services.[13] The value proposition is an integral part of the business model.

There are a few tools and templates available to help entrepreneurs think through their venture’s value proposition. Osterwalder and Pigneur wrote Value Proposition Design as a sequel to Business Model Generation. Their value proposition canvas building on the business model canvas by pulling out the customer segment and value proposition blocks and encouraging more in-depth exploration of those blocks to achieve a good fit between the two. It aims to help entrepreneurs to address and tackle customer pains, gains, and jobs-to-be-done trigger questions, and to design pain relievers and gain creators. The complementary and accompanying activities and resources can be useful for a deeper dive into and understanding of customer value creation in the form of value proposition, although there are other approaches to conceptualizing your value proposition as well.[14]

According to the entrepreneur Ash Maurya, the author of Scaling Lean and Running Lean, finding the intersection of your customers’ problems and your solutions is how you create a unique value proposition. In Running Lean, Maurya offers the following formula for creating an initial value proposition in the canvas, as shown in Figure 8.3 below. In particular, he argues that entrepreneurs can determine their value proposition by considering customer needs and potential objections within a specific period of time.

Figure 8.3: Ash Maurya’s Formula for Value Proposition

Attribution: Copyright Rice University, OpenStax, under CC BY 4.0 license

Former Harvard Business School Professor Clayton Christensen developed what is called the jobs-to-be-done framework. This approach aids companies in determining how to create products and services that customers want to buy by getting at the causal driver behind a purchase. Christensen uses the term “job” as shorthand for what an individual wants to accomplish in a given circumstance, often with social, emotional, and functional dimensions. For example, two jobs that a newspaper does for its readers are to inform and entertain, whereas the jobs to be done of a newspaper are completely different for another customer segment—advertisers. A newspaper’s jobs to be done for advertisers, for instance, may include promotions, attracting customers, or selling products. The jobs-to-be-done approach has also been incorporated into the development of business models in the form of customer empathy maps and value proposition canvases covered.[15]

Customer Segments

The target customer is integrated into the canvas from the start. It is arguably the most important component of the business model – because if you don’t have a customer, you don’t have a business. To that end, there are various tools available to help you develop a better understanding of your customer.

For example, the customer empathy map is a portrayal of a target customer (the most promising candidate from a business’s customer segments) that explores the understanding of that person’s problems and needs (Figure 8.4). Osterwalder and Pigneur used a customer empathy map as part of the design ideation phase of developing a business model canvas.[16]

Figure 8.4: Customer Empathy Mapping

Attribution: Copyright Rice University, OpenStax, under CC BY 4.0 license

There are differing versions of customer empathy maps, but most seek to answer common questions pertaining to the customer, such as:

• With whom are we empathizing?
• What do they need to do?
• What do they see?
• What do they say?
• What do they do?
• What do they hear?
• What do they think?

Customer empathy maps also strive to address customer pains (in this case, fears, frustrations, and anxieties) and gains (wants, needs, hopes, and dreams).[17]

Phillips, Proctor & Gamble, Microsoft, and Yeti are examples of well-known companies that make use of customer empathy mapping because, according to the journal Entrepreneur, every transaction can be turned into a meaningful and valuable customer interaction.[18] Once a company analyzes the results of customer mapping exercises, it may very well lead to new products that serve customer needs and/or wants.

For example, Philips used empathy mapping to detect a high level of fear in young patients immediately before an MRI medical procedure, so it invented a miniature version of the CAT scan equipment used in the procedure called the “kitten scanner” along with toy animal characters that were used to dispel the fear of MRIs among children. Proctor & Gamble created a new advertisement that was released for the 2012 Olympics visualizing the trials and tribulations of mothers raising young athletes, demonstrating Proctor and Gamble’s awareness that some of its customers wanted or needed empathy for the sacrifices they had made to help their children succeed. Likewise, Microsoft has attempted to demonstrate empathy with customers’ privacy concerns by developing an interactive website that explains not only how data is stolen but also how we can better protect our own data.[19]

On their company website, the now-famous Yeti cooler company publicly praises the value of empathy mapping, explaining that it leads to better products. Yeti doesn’t just create one on its own – it actually asks its clients to work with the company to create an empathy map.[20] Thus, empathy mapping for Yeti is part of its product development process.

Revenue Models[21]

There are multiple revenue models in existence to pick from.

Finances are the backbone of your business model and directly affect your venture’s resources and ability to execute on your objectives. For early-stage entrepreneurs, a robust revenue model will provide a higher level of independence along with the security that they need to hire a skilled team and scale.

Business Model vs. Revenue Model vs. Revenue Stream

Before we delve into the different types of revenue models, we should differentiate the terms “business model”, “revenue model”, and “revenue stream”, as they are very often mistakenly used interchangeably. Alex Genadinik, creator of the Problemio.com business apps, describes the relationship between those terms as follows:

• ‘‘A revenue stream is a company’s single source of revenue. A company can have zero or many revenue streams, depending on its size.
• A revenue model is the strategy of managing a company’s revenue streams and the resources required for each revenue stream.
• A business model is the structure comprised of all aspects of a company, including revenue model and revenue streams, and describes how they all work together.’’

Types of Revenue Models

There are numerous types of revenue models, so this list in no way attempts to list them all, especially since so many of them go by other names in the startup community. However, below are ten of the most popular and effective revenue models employed by companies, both big and small.

Ad-Based Revenue Model

Ad-based revenue models entail creating ads for a specific website, service, app, or other product and placing them on strategic, high-traffic channels. If you have a platform that generates a lot of traffic, you can profit by selling advertising space. We are all familiar with digital promotions as this is a preferred marketing strategy of giants like Google and Facebook. There are four main categories of advertising strategies: display, video, mobile, and native. Data plays a critical role in measuring ads performance, and you should be able to provide advertisers with precise metrics like CTR (clickthrough rate), CPC (cost-per-click), CPM (cost-per-impression), and many others.

Advantages: Making money from ads is one of the simplest and easiest ways to implement revenue models, which is why so many companies utilize ads as a source of revenue.

Disadvantages: In order to generate sufficient revenue to withhold a business, you will need to attract millions of users. In addition, most people find ads annoying, which can lead to low clickthrough rates and, therefore, lower revenue.

Affiliate Revenue Model

Another popular web-based strategy is the affiliate revenue model, which works by promoting links to relevant products and collecting a commission on the sales of those products. It can work in conjunction with ads or separately. This method is basically a contract between a supplier of a product/service and a promoter where the promoter redirects buyers to the sellers, who then finalize the transaction. Popular companies that offer affiliate marketing schemes for partners are Amazon and Shopify.

Advantages: One of the most obvious benefits of employing an affiliate revenue model is that it generally makes more money than ad-based revenue models.

Disadvantages: If you use an affiliate revenue model for your startup, remember that the amount of money you make is limited to the size of your industry, the types of products you sell, and your audience.

Transactional Revenue Model (direct and web)

Countless companies, both tech-oriented and otherwise, strive to rely on the transactional revenue model for a good reason. This is one of the most upright ways of generating revenue, as it simply implies a company providing a service or product and customers who pay for it. Note: This may also be called a “unit sales” or “asset sales” model.

Advantages: Consumers are more attracted to this experience because of its clarity and the wider set of options.

Disadvantages: Because of the directness of the transactional revenue model, many companies employ it themselves, which means more competition and price deterioration, and therefore, less money for everyone who uses this model.

The transactional revenue model can be broadly split into two categories – web sales and direct sales.

• Web sales have grown radically in the last few years and are suitable for a huge variety of offerings, including software, hardware, and even subscription services. At the same time, relationship sales are incompatible with the web sales model, so if your company is related to consulting or big-ticket items (high-value items such as houses, appliances, and cars), you should consider employing a model that goes together with your offering better.

• Direct sales can be inside sales, in which someone calls in to place an order (or sales agents call prospects), and outside sales, which is a face-to-face sales transaction.

Direct sales models are efficient with relationship sales cycles, enterprise sales cycles, or complex sales cycles that entail multiple buyers and influencers. However, these kinds of operations often require hiring a sales team of some sort, which means that it isn’t optimal for small ticket price items. If your offering is priced below the $1,000-$2,000 range, you’ll have trouble building a scalable company by selling directly.

Subscription Revenue Model

In the subscription revenue model, you offer your customers a product or service that they can pay for over a longer period of time, usually month to month or year to year. Subscription as a Service (SaaS) providers usually give users a free trial before they start charging them monthly or yearly. According to recent research, companies like Netflix, Spotify, and millions of others adopting the subscription-based revenue model, constitute an industry that has grown over five times in the last seven years.

Advantages: If your company is far enough along in its development, this model can generate recurring revenue and can even benefit from customers who are simply too lazy to cancel their subscription to your company (which is the dirty little secret of a subscription-based model).

Disadvantages: Because this model depends so much on having a large consumer base, it is critical to maintain a higher subscription than un-subscription rate.

Channel Sales (or Indirect Sales)

The channel sales model consists of agents selling your product for you and either you or the reseller delivering the product. The affiliate revenue model is a good companion to this one, especially if your offering is a virtual product. A classic example of channel sales revenue model is wholesale merchants supplying regional distributors.

Advantages: The channel sales model is ideal for companies with a product that’s an incremental sale for their channel and can produce an accumulative profit.

Disadvantages: Don’t employ this model if your product requires you to evangelize your marketplace or if your product competes with your partner’s, as they will push theirs and not yours.

Commission Marketplace

The commission marketplace is most often an e-commerce platform where intermediaries sell services or products and charge a commission. This is a perfect revenue match for rentals, physical products, or one-time services. Among the most successful startups that rely on this cash flow plan are Uber and Airbnb. Note: This model is related to the intermediation model. Consider, for example, the example of a real estate broker who acts as an “intermediary” between buyers and sellers to assist with completing a transaction.

Advantages: The commission-based revenue model is lucrative because of its scalability, flexibility, and monetization potential for all parties involved.

Disadvantages: This type of mediatory service requires plenty of software development and administration workforce for handling orders, payments, shipping, and other processes that might be relevant.

Licensing

This revenue model is widely embraced by data and technology providers (as well as pharmaceuticals). As the name suggests, the licensing income strategy is about managing the rights to use an offering. After signing a legal agreement, the copyright owner receives payments from people or organizations that want to use their products or services. The licensing deal can be temporary or permanent; it can grant access to an unlimited number of clients, or it can be exclusive.

Advantages: This revenue model advocates for intellectual property protection. When fulfilled properly, licensing can deliver a steady income while simultaneously promoting a concept or a trademark.

Disadvantages: The downfall of this type of monetization might be hidden in the small print of the contract between the licensor and the licensee. If too many extra clauses on how to use the product are apparent, it becomes easy to breach them.

Retail

The retail revenue model demands setting up a traditional store in which you offer physical goods to your customers. Keep in mind that this brick-and-mortar style of sales requires shelf space (that you’ll have to pay for) at existing stores and is designed for companies that have logistics and storage capabilities.

Advantages: Retail sales are a great way to offer deals and complimentary products to an existing customer base and help boost brand awareness.

Disadvantages: The retail sales route is not ideal for early-stage companies or companies that offer digital products like software or apps.

Donations

This is probably the newest revenue model on the list. It became known through the emergence of crowdfunding platforms like Kickstarter and Patreon where users vote for a product or a service and support it financially. People who pay for the development of an MVP may even become investors and can later benefit from dividends when the project they have endorsed grows.

Advantages: This revenue model can generate fast returns and win you high visibility. It is also a smart way to get feedback, test a business idea, and examine your audience closer.

Disadvantages: You will need a large and loyal community backing you up in order to drive solid revenue. Users who are willing to pay for an idea or a piece of content will likely expect you to interact with them, so save some time for that as well.

Freemium Revenue Model

The freemium model is one in which a company’s basic services are free, yet users must pay for additional premium features, extensions, functions, etc. One of the biggest companies to use this model is LinkedIn, the most popular business social media platform. Another example is the email marketing platform MailChimp – on the free plan, you can still send out emails, but only utilizing basic features and addressing a limited number of contacts.

Advantages: The freemium model offers something free to users, which is a great way to give them a taste of your product or service while simultaneously enticing them to pay for something later on.

Disadvantages: This model requires a considerable investment of time and money to reach out to your audience, and even more effort to convert free users into paying customers.

Final Thoughts on Revenue Models

As stated before, this doesn’t cover every revenue model used by startups, but by highlighting the most popular ones, you should have enough information to pick one(s) that will work for your startup.

Do your research, considering the value of your product, the market, and your competitors. Finally, don’t forget to check in with your target customers, too, because they are the ones to pay for your services, and their opinions and preferences matter the most!

Chapter 8 References