Agile Strategy Institute

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.”

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.  

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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.

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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.

How do you evolve your stakeholders and business model over time?

All markets, especially for technology-based businesses, are continually changing and evolving. As a result, your business model needs to continually evolve to meet the needs of stakeholders in a dynamic system, where each stakeholder has new options becoming available to him or her all the time. New products are launched for customers, new career opportunities open up for team members, new partnership opportunities for partners and new investment opportunities for capital providers. Your value proposition to each stakeholder group needs to continually evolve to remain attractive in the face of these competitive pressures.

At the same time, the contribution your business model needs from stakeholders also evolves. Not only is the market evolving, but also your business migrates along the S-curve (the technology, product or business lifecycle), from creation, through growth and then maturity. At each stage of its lifecycle, a business typically needs different contributions from its stakeholders, which often means its needs different stakeholders.
Changing stakeholders is challenging for many businesses. A feeling of gratitude and loyalty has developed to the customers, team members, partners and investors that helped the business through the previous stage. It can be emotionally difficult to recognize that the business is now at a different stage, and that it makes sense to replace some or many of the stakeholders to allow the business to continue forward successfully. There are also built in reward systems that strongly favor continued tenure for current stakeholders.

However failure to evolve the stakeholders in a business in line with the internal business evolution and the external market evolution is one of the prime causes of business failure. Many start-ups fail to transition successfully into the growth phase. Start-up stakeholders need to be skilled in and comfortable with the uncertainly, experimentation and creativity associated with this phase. They are seldom equally skilled and comfortable with the attention to detail and systemization of the business required for successful rapid growth. Similarly, at the end of the growth phase, the stakeholders in a business are often entrenched and well respected – after all, look what they have achieved. Such stakeholders are not usually the best positioned for the continued refinement, cost and efficiency optimization and exploration of exit options associated with the maturity phase.

How do you manage stakeholders to ensure the value exchange is implemented properly?

Once you have your stakeholders in place and the value exchange between them agreed, it is an ongoing challenge to manage them to ensure that they contribute as promised, and share in the value created by the business as agreed. Customers need to be chased for payment, team members and partners managed to ensure they are performing their roles correctly, and capital providers, particularly equity investors through the board of directors, managed in terms of expectations.

To do so, it is important to “triage” your stakeholders for purposes of ongoing management. Large customers, senior team members, strategic partners and the board should be a primary focus of the CEO and senior management. Other stakeholders should be managed through the kinds of core processes discussed above. There is a large body of knowledge around managing each of these stakeholder groups, which is not necessary to replicate or summarize here. From the perspective of business model design, it is important to ensure that the business has in place effective ways to manage each stakeholder group and individual stakeholder, to address any problems that come up and to ensure the value exchange continues to be mutually rewarding. Any lack of attention to your stakeholders’ needs will lead quickly to an unraveling of the business model.

Most importantly, you need a clear set of mechanisms for strategy and decision making that takes into account the goals and needs of all your stakeholders. These might include the board of directors, management team, user groups and partner councils, all of which play important roles in the overall direction of the business.

Evolving your business as a value exchange between stakeholders

How do you define the optimal value exchange between your stakeholders?

As intimated in the above discussion, the value proposition to each stakeholder actually needs to comprise two elements: what contribution is required from the stakeholder, and what value they will get in return. This is the essence of the value exchange between each stakeholder and the other stakeholders. Customers contribute a price and receive a solution; team members contribute skills and receive compensation; partners contribute solution and value chain components and receive payment or a share of the price; capital providers provide funding and earn a return. Each of these value exchanges needs to be negotiated with the individual stakeholders, in the context of the negotiations with all the other stakeholders.

To do this successfully, you need to make clear and tangible both the contributions expected from and the value to be received by each stakeholder. In addition, each stakeholder needs to feel that the value exchange for him or her is fair and reasonable, and that the value exchanges for all the other stakeholders are fair and reasonable. Significant problems arise when stakeholders’ understanding and expectations of contributions made and value received are misaligned, or where some stakeholders feel that other stakeholders are making a proportionately smaller contribution relative to their share of the value.

A key tool in managing these negotiations is the business’ economic model. This will be discussed in a forthcoming paper in more detail, but essentially it is typically a spreadsheet model of the business’ projected operating and financial drivers and performance. Initially this model is developed based on a number of hypotheses, and it sets the initial parameters for the value exchange to be negotiated with each stakeholder group. As negotiations proceed, these hypotheses are validated or changed as needed. For example, the price customers are willing to pay, the salaries employees will accept, the commissions channel partners require and the returns investors seek are all validated or changed.

Your task as the business model designer is ensure the overall economics of the business model continue to make sense with these adjustments, and that the negotiations with stakeholders are informed and guided by their impact on the overall economics.

Focus initially on a small group of early adopters and key influencers

These latter two components explain the “Catch-22”3 facing early stage businesses – you need to offer superior value propositions to attract stakeholders, but those value propositions in turn partly depend on having the right stakeholders. This is a well known problem for start-up entrepreneurs – you need investors to enable you to hire team members and find partners, who will then build the solutions and win the customers – but the investors want to see your customers, team members and partners before they invest. Even within stakeholder groups there is this “chicken and egg” problem - prospective customers want to know which other customers have bought, prospective team members want to know who else is part of the team, and the same with partners and investors.

So what do you do?

The answer is to focus on a small group of prospective stakeholders in each of your target categories in parallel, and to facilitate dialogue amongst them around your business model. Through such a group conversation amongst prospective customers, team members, partners and investors, each can get tangible evidence that the other stakeholders are interested and will derive value from participating in the business model.

In doing so, ensure each of the prospective stakeholders you include in this dialogue meets two important criteria: they are intrinsically early adopters, interested in and comfortable with new ideas, products and businesses, and they are also key influencers in their respective fields, able to set the trend and attract other stakeholders.

Then build stakeholder attraction into core processes

Once a business is up and running, it must design into its core processes the ability to continually attract stakeholders. Attracting customers becomes the responsibility of sales and marketing; attracting team members and partners is a responsibility shared amongst the primary functions and support groups; and attracting capital providers is a responsibility of general management and finance⁴.