Wednesday, May 17, 2006

Choosing Wisely – Business Models to Profit By

(Cross Posted with an Article Written for IBD Networks)

Hopefully my posting last month, Business Model Friend or Foe, convinced you that if you are starting a Web 2.0 company, a business model can be your friend. This month we will dive into how to begin building an appropriate business model.

The best place to start is with the simple question - How does my business ultimately make money? Now I know what many of you are thinking, I don’t have worry about that - I’m going to sell the company to (fill in the blank). Trust me, you don’t want to depend on that. I predict public media companies are going to be more sensitive to having acquisitions become immediately accretive. Even if they don’t, I guarantee that you will be acquired for more if you are generating revenue. So you should at least consider the question - How does my company make money for the eventual acquirer?!

While pondering this question there is a simple equation to keep in mind that fits most Web 2.0 companies.

Gross Profit = (Amortized Lifetime Value of the Customer) – (Customer Acquisition Cost) – (Operating Costs)

Obviously, you want to maximize the first variable and minimize the other two.

Let’s start with the last variable first, Operating Costs. These costs will be dominated by salaries and benefits, capital equipment and bandwidth. Although you will be in a rush to bring your company to market, take the time upfront to consider the architecture that will minimize your server and bandwidth requirements and scale efficiently. The choices you make around architecture will live with you for a very long time. Two of the better illustrations of this are Google and Friendster. Google gained considerable cost and competitive advantage by creating an innovative, scalable and cost effective architecture. Friendster however made technical choices that proved not only to be expensive, but also hampered scalability and innovation - ultimately playing a significant role in the company not being able to continue to grow.

When it comes to salary expense consider the Build Before You Burn posting. Try to defer adding headcount as long as practical and make every hire count, hire people that are over qualified for the job you need them to do today but who can scale to what you need them to do in a couple of years.

Next let’s consider Customer Acquisition Cost. How are you going to drive consumers to your service/product and how much will it cost? There are many ways to do this and more are being invented every day; a few of the more popular methods are listed below. As you build your business plan, consider modeling several methods as you will not want to be dependent on a single marketing channel. Be conservative and realistic about the costs.

  • Viral Marketing – Being free it is obviously the most cost effective method for Customer Acquisition, but it’s also the most difficult to predict and control. Viral marketing is not a strategy you can depend on.
  • Search Engine Optimization – Potentially the second most cost effective method, but getting trickier and more competitive.
  • Search and other Performance Based Marketing – Again potentially effective, but the market is getting more efficient and competitive so you will likely have to pay more over time.
  • Tailgating – This is when you use free placement on another company’s site to drive traffic to you. This tactic that was successfully used by YouTube on Myspace and a number of companies on Craig’s List.
  • Affiliate Programs – similar to search marketing
  • Partnerships – these are difficult to forecast but potentially large drivers for the business.

At this point you have identified most of the costs associated with your business. Now you need to assess how long the customer will use your product or service. Be conservative and expect this to be a key number that will grow over time, but may start out lower than you think.

Now you have a pretty good view of the lifetime cost of a customer and how much revenue you will need to achieve to offset the expense and turn a profit. As with customer acquisition, there are many ways to monetize the customer and inventive entrepreneurs dream up new variations every day. The important thing is to develop a plan, execute on it and try several different methods. A few popular methods to consider are:

  • Advertising – Consider building targeting mechanisms into the product or service at from the beginning to achieve better monetization rates.
  • Ecommerce – What products might your customers be interested in purchasing and how can you construct your site so that it maximizes potential sales?
  • Lead Generation – Are your users potentially someone else’s customer too? Building in features that qualify and drive traffic to partners can be very lucrative.
  • Premium Service/Subscriptions – Most Web 2.0 products are free, but are you providing too much for free? Is there a part of your product that should be free and a part you could charge for as a premium upgrade?

Now you have all the pieces of data you need to develop a business model that becomes profitable over time. The process of developing the model and refining it as you execute should be iterative – feedback what you learn through execution back into the model. Develop a point of view of how your business becomes profitable and the steps you need to take to achieve profitability. It doesn’t mean that you won’t change your point of view over time, but it’s important to have path to profit so that you know when you’re off course and need to correct.

1 Comments:

Anonymous Anonymous said...

Gross Profit = (Amortized Lifetime Value of the Customer) – (Customer Acquisition Cost) – (Operating Costs)



Hey, I could make this into a slide!

;-)

May 19, 2006 6:21 AM  

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