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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.
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.
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