How To Evaluate Your Business Model

19-February-2013
19-February-2013 16:52
in Small Business Planning
by Colin Smith

Have you ever wanted to get a handle on whether or not the business model you have chosen to translate your latest and greatest business idea into reality is really as good as you think?  One of the benefits of working with someone like ourselves is that you have an objective sounding board that can help you evaluate these things.  Our many years of small business experience has attuned us to what makes a really attractive business concept and model.  My idea for our blog post today is simply to tell you what questions most investors want answered when looking at a business to make a decision on whether the business model they are evaluating for investment is attractive or not.  I believe that there are ten distinguishing features of a business that is attractive to investors.  I'll lay them five of them bare here for you now for your enlightenment and consideration and follow up tommorrow with part two of this post which will contain the other five.

1. Is Your Competitive Advantage Sustainable? 

Investors love to partner with businesses that enjoy a sustainable competitive advantage.  In weighing up the attractiveness of your business, they will ask, is your product or service really any better than those of your competitors?  Most business owners when asked this question respond with very vague terms such as "improved usability" or "lower cost".  It's important that the differences are clear and large enough to motivate customers to switch from their incumbent provider to yourself.  If the differences are so small as to be imperceptible to most customers, you do not enjoy a competitive advantage.  I often hear from business owners I work with that they are the only operator in their target market.  If this is actually true (and it rarely is by the time you have counted effective substitute products as competitors), then "first mover advantage" is not inherently sustainable.  In fact, what happens more often than not is that, just as you start to gain traction, competitors with deeper pockets who have waited and watched you make the expensive mistakes which the first mover invariably makes as they find their feet will follow you into the market and all your first mover advantage will have done is provide a few month headstart.  

Your competitive advantage is likely to be sustainable, at least in the short term, if your business benefits from real intellectual property (i.e. a patent), a dynamic product line rather than a single product, a significant comparative cost advantage, a proven team with existing relationships with key people in the market or a strong focus or differentiation.  If the industry in which you operate had high barriers to entry, this will also help. 

2. Does Your Product Create Network Effects?

Network effects are present when what the customer is wiling to pay depends upon the number of customers with whom they can interact by using the product.  The classic example of this is the fax machine.  The first machine sold will have been absolutely useless and thus worthless but as the number of people to whom you could send a fax increased, the more valuable and important this technology became.  The internet is another example of an innovation whose value increased with increased user adoption.

Network effects are important for investors to consider as any business reliant on network effects to get their business where they need it to be must attract a "critical mass" of users so that the network effects take hold.  Determining what that critical mass is for that product or service and how much it will cost to get the business to that  point are key considerations in weighing up the attractiveness of a business.     

3. Is Your Business a One Hit Wonder?

Investors favour businesses that can predictably and consistently generate income over long periods of time.  If your business is product based, do you have a pipeline of products that are going to mitigate the "hit" risk for an investor?  Many people would be pleased with one succesful product, but in a world in which product lifecycles are getting shorter and shorter, investors are drawn to businesses that can make it happen year in year out.

4. Are Your Customers Locked In?  

This concept of customer lock in goes to the heart of the previous question about consistency.  Investors favour businesses with low churn rates of customers and high switching costs.  There are a number of things that you might do to increase the degree to which your customers are locked in.  Contractual commitment locks customers in for a time, as does selling an especially durable product.  Brand specific training and loyalty programs can also influence the degree to which customers are locked in to your products and services.  Whatever you think about  the ethics of locking in customers, the fact is that Investors love customers that are locked in to the businesses they own and deem them much more attractive than businesses that are less likely to retain customers.

5. How High are your Gross Margins Compared to the Competition? 

When businesses are valued, we tend to see a much lower price/earnings multiple for businesses with smaller gross margins because lower gross margins always translate into lower net profit margins. High gross profit margin businesses offer greater leeway to make mistakes or to cut costs given a downturn in demand.  That's why high profit margin businesses such as software companies always attract better valuations than do traditional low gross profit margin businesses such as grocery retailers.

As you can see, there are several things to consider that can have a dramatic impact on the attractiveness of your business model to outside investors or to the returns that you are likely to see yourself for your efforts. We'll conclude tomorrow with the other five questions to ask when determining the attractiveness of your business model.  If you want help evaluating your busines idea, even if you are still at the planning stage, with a view to making it as attractive as possible either to outside investors or purely for your own benefit; the person who will be investing a huge amount of time and money into your own business idea, then don't hesitate to have a no-obligation conversation with us here at Continuous Business Planning today.    

 

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