Agile Strategy Institute

Shoshana Zuboff's article "Creating value in the age of distributed capitalism" gives a good overview of the transition from the industrial age to today's information age. She provides a great case example in the nursing home industry, Elder Power. The traditional nursing home business is high cost and provides variable care to many patients. Elder Power is innovating a new business model, which includes web technology, a volunteer social network, collaboration amongst local service providers, and leveraging unused local resources (spare bedrooms, school cafeteria, etc.). A great example of agile strategy in practice.

Understand granular customer groups

Today’s open and connected world throws into sharp relief the true number and diversity of customer groups in every market. In truth, this diversity has always existed – it was just hidden because of industrial age market structures. These customer groups vary greatly with regard to their needs and their willingness and ability to pay to satisfy those needs. And they are continually morphing, changing and evolving. As a result, it is very important to identify each viable customer group, and to continually search for changes in existing groups as well as the emergence of new groups.

In order to do so, we need to disaggregate 20th century market definitions into a much more granular understanding of existing and potential customer groups. In practice, this usually means breaking down traditional market definitions into a great many different types of customer groups, based on differences in needs. Since markets today should be defined in global terms, traditional market definitions may camouflage hundreds or even thousands of niche customer groups that are each large enough globally to be an attractive market for the right business model.

Recent research by McKinsey & Company, Inc. (see Viguerie, Smit and Baghai’s The Granularity of Growth) indicates that, in order to truly understand market demand and competition, rather than defining markets at the level of billions of dollars in annual revenue, companies need to think of defining markets at the level of perhaps $50 - $200 million in annual revenue – for the entire global market. This level of granularity is a major change in thinking for most companies. A useful tool in this respect is IndustryBuildingBlocks.com, which offers data on over 12,000 markets, compared with around 1,800 markets in the US government’s official North American Industry Classification System (NAICS) system.

This market fragmentation has created enormous opportunities for companies, both in existing traditional markets and in completely new markets. In existing traditional markets, there are many groups of customers who are either only partially satisfied by existing offerings, or are not buying at all, because the “good enough” mentality of the 20th century, when customers had to settle for a limited range of choices, has disappeared. Today’s customers demand complete satisfaction of all of their needs – extending beyond features and price to branding, customer experience and more. This means that in any existing traditional market there are large numbers of customers willing to switch, or willing to become first time buyers, as soon as an offering comes into existence that more closely meets their needs and price points.

In addition, there are today a whole range of new customer groups and customer needs associated with recent innovations that never before existed. For example, in the past five years innovations in mobile devices, therapeutics and energy storage have created thousands of brand new customer groups demanding a wide range of new types of products and services.

Of course this has always been true of innovation - before air travel in the 20th century, there was no need for airplanes, airports, airlines and the myriad different customer groups and needs associated with each of these. The difference today is that the rate of global innovation is creating new potential markets literally every month. A recent example as of this writing is the launch of Apple’s iPad, which has unleashed demand for a wide range of products and services that were only partially understood previously, and that most people didn’t even consider until seven months ago.

In summary, if you think at the right level of granularity, there are today endless high potential customer groups whose needs are not currently being met by current offerings – and who could be your company’s route to greatness.

 

10 Rules for Strategic Innovators by Vijay Govindarajan and Chris Trimble

In 10 Rules for Strategic Innovators, Vijay Govindarajan and Chris Trimble describe the fundamental difference between the organizational DNA of the established company (which they refer to as CoreCo), and the new innovative business unit (NewCo). CoreCo is all about planning, leveraging core assets, meeting customer needs, efficient processes and clear growth and ROI metrics. NewCo is about creativity, experimentation, learning, adaptation, flexibility and rapid response. They describe a powerful framework for how NewCo can survive and thrive in this environment.

Govindarajan and Trimble explain: ”(NewCo) must address the three unique challenges that arise from the unnatural coexistence of a new and mature business within the same corporation: a forgetting challenge, a borrowing challenge, and a learning challenge. NewCo must forget some of what made CoreCo successful. It must borrow some of CoreCo’s assets – the greatest advantage that NewCo has over independent start-ups. And it must be prepared to learn how to succeed in an emerging and uncertain market.

Govindarajan and Trimble present the four elements of organizational DNA as staff, structure, systems and culture. They explain that each of these elements need to be carefully considered to decide which of them should “forgotten” by NewCo and which should be “borrowed”, in order to maximize NewCo’s ability to “learn”.

Govindarajan and Trimble conclude that NewCo should have a distinct approach in most respects, and leverage CoreCo’s strengths and assets in one or two key areas. “The NewCo organization must be built from scratch, with new choices in staffing, structure, systems and culture. This is the only way to defeat the powerful forces of institutional memory.”

Organizing for innovation

Established corporations introducing new products, technologies or lines of business need to think carefully about how best to organize to succeed.

Extensive practical experience as well as a rapidly growing body of research indicates
that the established organization is ill-
equipped to support the successful development and launch of new products
and businesses.

Executives at established companies must recognize that the new venture will require the careful creation and development of a discrete organizational structure with its own resources, processes and values in order to incubate, cultivate, and harvest the business opportunities of the budding innovative enterprise.

In this article, we will review some of the leading research into organizing for innovation, and then summarize key guidelines for executives.

The Design of New Organizational Forms
by Jennifer Herber, Jitendra V Singh and Michael Useem

In their excellent chapter “The Design of New Organizational Forms” in Wharton On Managing Emerging Technologies, Jennifer Herber, Jitendra V Singh and Michael Useem explain: “Dominant players often fail to adapt because it means dismantling the very organizations that have led to their success. Past adaptations become inertial constraints, leading to a kind of “competency trap”. The organizational architectures that companies have built to propel their success can become as outmoded as feudal kingdoms in an age of democracy”.

Herber, Singh and Useem discuss six emerging organizational forms. These include virtual organizations, network firms, spinouts, ambidextrous firms, front-back designs and sense-and-respond firms. These are all examples of dynamic, adaptable organizations well suited to innovation.

Cash and valuation curve

The third tool is the cash and valuation curve. When the cumulative cashflow of a business is plotted over its lifetime, it ideally takes on the shape of the well-known S-curve (exhibit 3). 

Exhibit 3: cash and valuation curve

In the beginning of the business, the cumulative cash curve trends downward, as cash is steadily invested to build products and launch the business. Once revenue begins to come in, the cash curve turns, and begins to trend upwards. When sufficient revenue has been generated, the cash curve gets to breakeven – i.e. at this point, the business has generated sufficient positive cashflow to pay back the total investment. Thereafter, the cumulative cashflow is all surplus – i.e. pure “profit”⁸.

The valuation curve more or less follows the cash curve, because valuation is fundamentally a function of cash flow⁹. In the early stage, the valuation is typically relatively low. As the business moves into positive cashflow, the valuation increases to reflect this.

A primary goal in managing the economics of the business is to move from the blue dotted lines in exhibit 3 to the red lines. By minimizing upfront investment, accelerating revenue and increasing profit margins, you get to cashflow breakeven far more quickly and use far less capital in doing so.  Thereafter, the goal is to increase the surplus above the breakeven line, to increase the total positive cash generated over the lifetime of the business. Doing so will drive the valuation up to reflect this increased cashflow.  

*  *  *

In summary, this paper has presented an overview of the “economics” component of a business model, It has emphasized the need to see a business as an integrated economic engine, and to understand the economic impact of every business model design decision. Three useful tools have been presented:  an integrated cashflow model, a key driver analysis and the cash and valuation curve. Understanding and applying these tools will contribute significantly to business model design and business success. 

The business model objective: maximizing cashflow and value

Key driver analysis 

The second tool is a key driver analysis. Each of the elements of the cashflow model – revenue, direct costs, gross profit, overhead costs, profit, investment, cashflow and funding  - are a result of different business model decisions. Understanding how these business model decisions drive cashflow is critical to business model design and optimization.

The key driver analysis, based on an approach developed by McKinsey & Company, Inc., comprises two steps. The first step is to think first about the key operating measures that underlie each element of the cashflow model. In exhibit 2, for example, gross profit in a sample business might be viewed as a function of two key operating measures – number of customers and gross profit per customer. Further, gross profit per customer might be a function of two other operating measures – product volume per customer and unit margin per product. 

Exhibit 2: key driver analysis

Identifying these operating measures in this way tightly links them to the cashflow model. In this example, the managers of the business know that in order to increase gross profit, they need to increase the number of customers, increase the product volume per customer and / or increase the unit margin per product. These operating measures can be built into real-time reports that provide continuous feedback on business performance.

The second step is to identify the key business model elements that drive each of these operating measures. There are typically several of these for each operating measure. For example, number of customers might be a function of the size of the target market (a “markets” decision in our business model framework), to what extent the product offering is superior to competitors (a set of “products” decisions), the effectiveness of the sales and marketing effort (part of the “processes” decisions) and a strategic partnership (a “people” decision). 

In this way, you tie the decisions you make in each of the business model components – markets, products, processes and people – directly to operating measures and the cashflow model. This approach thus gives you complete visibility to the integrated economic system at the core of your business model.    

Integrated cashflow model

We now describe three tools that are very useful in designing the economics component of the business model:  an integrated cashflow model, a key driver analysis and the cash and valuation curve.

Integrated cashflow model

The first tool is an integrated cashflow model that comprises all of the elements of the economics of a business (exhibit 1). What follows is a brief overview from a general management perspective. Interested readers can consult one or more of the myriad texts available for more detail⁶. 

Exhibit 1: cashflow model

Revenue is the foundation of the cashflow model for a business⁷. Without revenue, there is no business. Revenue is a function of volume, price and timing – the number of products or services sold, the average price per sale, and the timing of the payments e.g. as a lump sum or in monthly installments. The business model ideal is recurring revenue – i.e. each customer generates repeated revenue for the business.  

Gross profit is revenue less the direct costs of the product or service. These might include parts and labor for products, and direct labor for services. Managing gross profit is critical, because if revenue does not at least cover direct costs, then every time you sell a product you actually lose money – and as the old joke goes, you can’t make up for it on volume!

It is also useful to analyze all direct costs (also known as variable costs). For example, if sales commission is a cost incurred on every sale, this should be included in a total direct cost analysis. This way you can clearly see to what extent your revenue covers your total direct costs. However, for comparison purposes with competitors, and in presenting financial plans or results to investors, traditional gross profit definitions should be used to avoid confusion.

Overhead costs are generally fixed, i.e. they do not vary directly with revenue or number of products sold. These can be divided into cost categories reflecting your primary processes (research and development, sales and marketing, etc.).

In exploring your business model’s economics, recognize there is typically a risk – return tradeoff between fixed and variable costs. Having low fixed costs and high variable costs is less risky but may be higher cost overall (because there are fewer scale economies). This is the preferred model for early stage businesses where volumes can vary significantly, and may not consistently cover fixed costs. The goal here is to minimize risk and get to profit as quickly as possible.

High fixed costs and low variable costs are more risky but may be more efficient, especially in static, growing markets where scale economies can be very important. This is true for established businesses growing at a predictable rate. Here, the risk is reduced due to the stage of business evolution and the maturity of the market. The emphasis should be on efficiency and cost reduction.

Gross profit less overhead costs result in the business’ profit or loss. In practice there are different measures of profit (operating profit, EBITDA, net profit, etc.), but these are beyond the purview of this paper. Revenue, direct costs, gross profits, overhead costs and profits are all reflected in the income statement of a business.

In addition to revenue, costs and profits, the cashflow model also needs to include investment and funding (the balance sheet elements of the economic model).  Investment is basically spending cash in advance of receiving revenue from customers. It comes in two variations. Long term (also known as fixed or capital) investment is incurred to buy or build the necessary foundations for the business such as the initial product development, initial creation of systems, equipment and processes, etc. These are normally one time, relatively large expenditures. Short term (working capital) investment is incurred to produce product inventory and allow customers to buy now and pay later.  In our experience, failure to properly understand and manage both types of investment is a common problem for many businesses.  

Cashflow as the term is commonly used normally refers to profit less investment i.e. the net cash generated or used by the business. The objective is to generate net positive cashflow – i.e. to make sufficient profits to cover both short and long term investment.

Where the cashflow is net negative, it must be funded, either through debt or equity. Equity and long term debt is normally used to fund start-up losses and long term investments. Short term debt is best used to fund short term investment – though many entrepreneurs, this writer included, have used short term debt to fund business start-ups!

Every businessperson needs a sound understanding of this integrated cashflow model in order to make sensible product, market, process and people decisions.

The business model objective: maximizing cashflow and value

This paper discusses the fifth component of a business model, economics. Previous papers have described the definition of a business model¹, and its other four primary components: markets², products³, processes⁴ and people⁵. “Economics” refers to the central focus of a business model, its financial model. 

A business is fundamentally an economic enterprise, and the primary goal of a business from the perspectives of its primary stakeholders (employees, owners and partners) is to maximize its value (so as to maximize each stakeholder’s share of that value).

Some readers may argue that businesses also have important non-economic goals. In agile strategy however, we make a clear distinction between a company and a business. A company is a human organizational entity, with vision, values and other non-economic aspects. Normally the primary purpose of a for-profit company is to own and maximize the value of one or more businesses, but it can also have other purposes. By contrast, a business is an economic entity – specifically the value exchange between its stakeholders and its customers. In this sense, a business has a single purpose – to make money for its stakeholders by delivering value to its customers.

A business does so by selling a product or service that customers want and will pay for (because the value of the product or service to the customer is worth more than the payment). It then shares that customer payment amongst all the people (stakeholders) who help provide that product or service to that customer.

These people or stakeholders fall into two main groups – those who actually do the work of providing the product or service (employees and partners) and those who provide capital to the business (owners / investors). Most businesses need capital because of the timing of these payments – normally a business has to share the payment with its employees and partners to provide the product or service before it receives the payment from the customer.  

This simple description identifies the five components of a business model. The customer is the markets component; the product or service is the products component; the providing of the product or service, encompassing all the activities needed to create, market and deliver the product to the customer, is the processes component; the employees, partners and investors contributing to and sharing in the value are the people component; and the payment and how it is shared amongst stakeholders is the economics component.   

This simple description also illustrates how a business is a seamlessly integrated economic engine. The customer you choose determines what product or service you can sell and at what price. The processes you choose (how you will make, market and deliver the product or service to the customer) are dependent on the nature of your products and markets, and in turn determine which stakeholders you need. Conversely, the stakeholders you choose can impact which markets you pursue, which products you offer and what processes you implement. Each of these choices, and all of their underlying details, has a material impact on all of the others, and collectively they determine the economics of the business. To maximize the economics of the business, you need the optimal balance of markets, products, processes and people.

In addition, this simple description illustrates the key elements of the economics component: revenue, costs, profit, investment and funding. The payment from the customer is revenue to the business. The share of that payment that it gives to its employee and partner stakeholders are costs to the business (where “partners” includes all vendors, channel partners, etc.) and the share of that payment that it gives to its owner stakeholders is its profit.  The capital it receives is funding, and paying that capital out in advance of receiving payment from customers is investment.  

Which other stakeholders do you need to address?

Finally, there is a range of secondary stakeholders who can play important roles in the creation and evolution of a business. Influencers include the media, trade associations and other interest groups that can help educate your market about your business and its solutions. Government is an important stakeholder in all industries through the rule of law and regulatory authorities, and is a very prominent stakeholder in some industries such as communications, healthcare and energy. The broader community within your market, and its perception of your business and its solutions can be an important stakeholder, as can be the general public wherever you do business.

* * *

In summary, this paper has presented an overview of the “people” component of a business model – how to attract the right stakeholders and define the right value exchange between them in order to maximize the value of the business model to each stakeholder.

• Understand that a business is essentially a value exchange between stakeholders.
• Begin by thinking about which types of stakeholders make sense for your business model, starting with customers, then team members and partners, and then capital providers.
• Then undertake a systematic effort to find the best stakeholders in each category, not just the first you come across.
• Facilitate a discussion amongst prospective customers, team members, partners and capital providers around your business model to attract your initial stakeholders.
• Develop an effective value exchange formula for each stakeholder group that makes clear what is to be contributed and how value is to be shared.
• Over time, develop effective processes to attract and manage stakeholders, with your CEO and senior executives focusing on the most important stakeholders in each category.
• Put in place clear strategy and decision making mechanisms to guide the business based on the goals and needs of all stakeholders.
• Carefully monitor your internal business and external market evolutions, and make sure you evolve your stakeholders in line with your business needs at each stage.
• Finally develop effective approaches to managing secondary stakeholders such as influencers, government authorities and the community.