What’s the plan, Stan?

Peter Thiel succinctly sums up the challenge in building a great enterprise. It consists of 2 phases. Zero to 1, and 1 to N.

Thiel suggests that Zero to 1 is where the true innovation takes place. No question, innovation is critical to keep an economy from stagnating. Yet, the engine for economic growth comes from rapidly scaling companies. Companies who are in the 1 to N growth phase. Good luck finding a high-paying job at social network pioneer Friendster. Sights are better set on that thumbs-up company in Menlo Park.

Recognizing Zero to 1 opportunities

In the tech world, there are few hidden Zero to 1 ideas. Venture capitalists pour money into fresh new concepts and hundreds of companies vigorously compete to emerge as the 1 to N giant in the field.

Let’s consider some non-tech businesses that have thrived due to well-timed scaling of Zero to 1 models.

  1. Subway. “Real-time, customized sandwiches.”
  2. Chipotle. “Subway for Burritos.”
  3. Lulu Lemon. “Yoga clothing for women who want to look good while working out.”
  4. Starbucks. “Gourmet coffee.”
  5. McDonald’s. “Fast, family-friendly value-meals.”

Go see “The Founder”

I’ve been a fan of Michael Keaton since “Mr. Mom”. If you haven’t seen “Mr. Mom”, you should definitely see that too. You may not get deep business insight, but you will laugh uncontrollably at least 3 times — I promise.

In “The Founder”, Keaton turns in a brilliant performance as Ray Kroc. Ray Kroc was a 52-year old salesman when he meet the McDonald brothers in San Bernadino. The brothers had built a massively popular hamburger joint in this small California town. They had a simple menu similar to In-N-Out’s current offering. They eliminated the need for silverware, plates, and roller-skating waitresses, popular at drive-in diners of the era. They built systems to ensure exacting quality control for all their burgers and fries. Exactly two pickles on each burger. Fries dropped into oil at 400 degree Fahrenheit for the exact prescribed cook time. They offered their food at prices and speed that was unheard of. Customers responded by coming in droves.

An operational model worth its weight in gold

Ray Kroc realized that the McDonalds had cracked the code to revolutionize how Americans feed their families. The McDonalds were modest folks with high integrity. They were mostly content to service the San Bernadino community. Their attempts at franchising were unspectacular as their franchise partners could not execute the quality-control and attention-to-detail that made the San Bernadino restaurant successful. Kroc convined the McDonalds to allow his to head up the franchise operations for McDonald’s.

Besides recognizing the genius of the McDonald’s menu and service process, Kroc understood the importance of keeping the stores clean, family-friendly and consistent. Like his chicken-slinging counterpart, Kroc was militant in demanding that all McDonald’s units be held to the highest level of quality-control.

A business model that ate money

Kroc happily discovered he was correct in his assumption that a well-run McDonald’s could deliver massive crowds of loyal customers in any town in America. After validating that fact, he ambitiously sought to expand the brand across the nation. His growth strategy outran his expansion capital. He could not grow McDonald’s at its full capacity due to the high-cost of launching new franchise locations. The monthly franchise fees based on store revenues were not providing the necessary fuel for expansion despite towns clamoring for their own McDonald’s.

A business model that mints money

McDonald’s was faited to slow its rate-of-growth due to the limitation of its franchise model. Kroc was not content to accept this eventuality. Along with his business advisors, Kroc came up with a genius plan to allow for unbridled growth. He and his team realized they could get unlimited loans from banks by owning the land and buildings for new McDonald’s locations. The problem with the original McDonald’s franchise model was that McDonald’s owned no hard assets. Bankers would not provide McDonald’s expansion capital based solely on future royalties. The banks wanted hard assets to backstop their loans. If customers got bored or stopped visiting McDonald’s, the royalty fees might disappear, leaving the loans insolvent. That was not a risk banks were willing to take.

After revising the franchise model, the initial franchise startup fee was increased significantly. McDonald’s Corporation took on the responsibility of finding ideal retail locations, purchasing land, and building the stores. The banks were willing to fund McDonald’s based on this revised model. Even if a store failed, the banks held the building and land as collateral. Besides the higher buy-in cost, the new model added an important new revenue stream in the form of a monthly lease payment to McDonald’s.

The original business model.

a) Small startup franchise fee paid to McDonald’s,

b) Monthly franchise fee based on a percentage of the store’s revenues.

The new business model.

a) High startup franchise fee paid to McDonald’s,

b) Monthly lease revenues,

c) Monthly franchise fee based on a percentage of the store’s revenues.

The McDonald’s leases gave Kroc additional control over his franchise owners. A lease set demanding quality standards that prevented franchise owners from deviating from McDonald’s corporate mandates. Kroc conducted regular inspections of McDonald’s locations to ensure that frachise owners were abiding by his rules. He would pull leases from non-compliant locations. Along the way, McDonald’s was building up a portfolio of real-estate assets that would grow to be the highest asset value of the entire corporate. Financial analysts and business reporters studying McDonald’s balance sheet discovered this surprising fact. They facetiously declared that McDonald’s was not a restaurant company, but rather a real-estate corporation.

It’s not enough to innovate

The inventor brain and the marketer brain are not always resident at one company. Even having both these skills may not be sufficient to achieve greatness. A great invention coupled with effective marketing and sales can still falter when hampered by a poorly crafted business model. A dangerous myth is that building a popular service or product is sufficient to ensure business success. Using Google and Facebook as models of great companies that took their time in crafting their monetization strategy is not wise. Google was close to needing an acquisition bailout before launching it golden goose, Adwords. In the case of Facebook, Zuckerberg understood the demographic meta-data he was compiling for Facebook’s users would be uniquely valuable for targeted marketing. Arguably, Facebook had a great business model in mind very early in their journey.

The three key elements to creating a business juggernaut are:

  1. Great invention.
  2. Great marketing/sales.
  3. Great business model.

Business with attribute 1 (without 2 and 3): BetaMax. Outcome: Failure.

Business with attributes 1 and 2 (without 3): Twitter. Outcome: Struggle to achieve financial viability.

Business with attributes 2 and 3 (without 1): Pet Rock. Outcome: Quick gains before vanishing.

Want a pet that doesn’t need to be fed? A Pet Rock cost $4 when it was introduced in 1975.

Business with attributes 1 and 3 (without 2): Starbucks pre-Schultz. Outcome: Sold to 1 to N genius.

Business with attributes 1, 2 and 3: Apple. Outcome: Most valuable company on the planet.

To be clear, it is not necessary to optimize or monetize from day one. The entrepreneur should visualize the business running at scale and with a viable business plan to support it. If the visualized model does not show generous profits as the customer base and the product matures, the business is being built with a structurally unsound foundation. Great brands have struggled and vaporized before a viable business model could be dicovered. Case in point, Napster and Netscape attracted huge and passionate customer bases in record timing. Unfortunately for these Internet superstars, their customers proved fickle and adverse to paying any fees for the products they were enjoying. As quickly as they gained their massive audiences, they lost them to competitors. In Netscape’s case, they ran into a giant competitor offering their browser free in order to suffocate a potentially dangerous threat. These two companies serve as a cautionary tale of innovative phenoms whose exponential growth did not translate into viable and lasting business entities.

Not as risky as launching without any business plan, but nearly as damaging, is building a business with a faulty business model. J.C. Penney’s had enjoyed a long and storied history of retail success before running into troubles as consumer and retail patterns rapidly changed in the 90’s and 2000’s. Though it would be unfair to classify J.C. Penney’s as an example of a business that built their business on a broken business model, they are an excellent case study of how difficult it is to redefine a business model once it has been established. Ron Johnson left Apple to take over as the CEO of Penney’s in 2011. He rebranded the company and pushed them towards a higher premium model. He touted an everyday fair pricing concept, radically reducing the number of sales promotions they ran. The customer base revolted immediately. JC Penney’s sales plummetted and Ron Johnson was fired in 2013 after less than 2 years at the helm. The customer DNA for J.C. Penney’s was not oriented towards Johnson’s new business model.

Fremium is more “free”, than “mium”

In 2011, Dropbox crossed the 50 million registered user mark. At that point, 4% were paying customers. Today the company is less forthcoming with the breakdown between “free” and “mium”, but certainly the “free” portion remains the vast majority.

Considering the value and popularity of Dropbox, their 4% paid metric is indicative of how difficult it is to convert free customers to revenue generating customers. Dropbox is now pushing towards the enterprise in search of answers to the revenue question. Whether they will achieve success with this corporate monetization strategy is unclear. Will Dropbox eventually drop their consumer free-loading customers and cede this business to Google Drive and Apple’s iCloud? There may be an argument for considering such a radical departure from their heritage if they being running on Wall Street’s ruthless, quarterly hamster wheel.

What of ad-based?

The Hail Mary of fledgingly businesses without a solid business plan is ad-support. Pewdiepie is a millionaire, so how hard can it be to earn via ad-support?

The answer is very, very hard. YouTube is approaching one billion hours of videos on its platform. Forbes listed the top earners for 2015. The 8th highest earner, Rosanna Pansino, earned an estimated $2.5 million in 2015.

If you like your odds with the above numbers, you may want to enroll in some statistics and probability courses and get a reality check.

Plan for success, hope for the best

At the inception of a business, a business model will be based on assumptions that will invariably prove incorrect. Iterations will be required before the business plan is right-sized to support the opportunity. Too many startups begin with a focus on innovation and customer acquisition without understanding if the business will grow and thrive as it matures into a self-sustaining operation. Entrepreneurs are overly optimistic about the ability to convert free or money losing customers into high-profit revenue streams. Many businesses like Dropbox realize that their free-loading customers cost too much to convert to paying customers, and instead target a different customer segment altogether. The marketing and sales strategies for corporate sales are very different than the growth-hacking tactics for consumer freemium registrations. When a business radically changes its business model, or worse, finally introduce one without careful forethought, customers and team members are in for a shakeup. An internecine battle for the soul, control and direction of the company is fought. Often times the key early employees are pushed out as the business tries to reinvent itself with what they hope to be a more viable business model than their original plan or lack-thereof. Early adopters find the company abandoning their support in search of more profitable customers.

While these battles are raging, a competitor with a superior business model may copy their product or service offering and pass the innovator. The discipline in paying attention to the business model before running full speed ahead can serve the fast-follower well. The fast-follower is not only looking to master the product offering and customer acquisition strategy, but also to build a lucrative business model. They can focus on landing profitable customers, and can avoid getting distracted by the demands of low or negative value customers.

A large audience can be a blessing and a curse for a business. Customers expect support regardless of if the business is making or losing money on the transaction. A Groupon customer is just as demanding, if not more so, than a customer paying full price. The business can’t tell a customer they aren’t going to give them their normal high-quality customer experience because they are losing money on the deal. They have to do their best to impress the customer in the hopes that the customer will come back at full price. The problem is that many Groupon customers are content to move from deal-to-deal rather than paying full price to a business they have tried before. Great, you reach 1000 new Groupon customers. How many of these 1000 can you convert into repeat or lifetime customers? A business with a broken business model can attract value buyers who seek out insanely great deals. As the brand tries to increase their margins, these previously loyal customers may flee the brand in search of a better deal. The business is then back to square one. The business need to come up with a price point and service offering that attracts the right customers. Back to the J.C. Penney’s example. It is easier to build the next Nordstrom’s than transform J.C. Penney’s into a premium retailer.

Pro-Tip: It is far easier to reduce prices that to go through the painful exercise of justifying price hikes to price sensitive customers.

The Southwest argument

Right about now, you are thinking this post is stupid. What about Southwest Airlines? How is that a the discount airline is the most valuable airline in the industry?

Here’s the answer. Southwest has a great business model. It is a model that consistently produces profits. How?

a) They ask their customers to forgo assigned seating,

b) they use older and smaller airports, which translates into lower gate fees,

c) they have one standard aircraft, which reduces maintence and employee training costs, and

d) they utilize a point-to-point versus a hub-and-spoke system.

This is a radically different approach to running an airlines than most traditional airlines. The big boys have tried to out Southwest Southwest. Instead, they ended up receiving a Ron Johnson J.C. Penney’s-like experience.

Who’s Ted? Ted’s dead baby, Ted’s dead.

McDonald’s is another great example of a discount provider who rewrote the rules in order to create a great enterprise. Up until their real-estate ephiphany, Kroc had mastered 2 of the 3 attributes required to become a great business. He gained the great invention requirment from the McDonalds brother, and excelled at the marketing and sales requirement. The real-estate approach was the answer to the business model problem. Kroc was astute enough to recognize the defect in his original business model, and driven and ruthless enough to implement the new plan to perfection. The rest is history.

How does “The Founder” end?

“The Founder” pits the innovators, the McDonald brothers (0 to 1), against the scaling expert, Ray Kroc (1 to N). Guess who comes out on top? You can watch the movie to find out, but I bet you can guess the answer.