The money question — What investors expect you to know about business models

If you have ever pitched your startup to investors for funding, the chances are that you have heard the following question:

How will you make money?

Thinking that this is purely a revenue based question, most founders respond with something along the lines of “we plan to follow the XXX business model and our expected revenue by year 3 is $XXX million”.

What most founders don’t realise is how important the money question really is. Your understanding of the business model you utilise, demonstrates your ability to run your business effectively.

Your choice of business model can add/ remove risk, complexity and also shapes the short and long term strategy that you use to grow. The business model you use will determine the long term success of your product.

A lack of understanding the business model (or byproducts of choosing the wrong business model e.g. scaling issues, running out of cash etc) are among the highest factors that startup founders said contributed to the downfall of their business. My own startup (StageLabel) was no different.

To gauge the value of an investment opportunity, among other criteria, investors look for the risks associated with the business model as the company scales and grows.

Here’s a short breakdown of the 5 most common business models, and what worries investors about each model.

E-commerce

E-commerce is one of the most common business models out there, but the simplicity and relevant ease in setting up an e-commerce business means that there is usually a lot of competition out there in the market.

For investors to invest in an e-commerce platform that can scale, they are looking for platforms with high margins (to counter for discounts, returns and exchanges and default products) as well as a strong growth rate of users. At scale, the importance becomes in the “stickiness” of your users, which is determined by how often the user comes back to your site and re-purchase new stock (i.e. the Lifetime Value of each user).

Subscription (boxes)

The “subscription economy” has been booming over the last few years, especially following on from the success of companies such as the Dollar Shave Club. The big appeal with the subscription model is that there is a clear revenue model, with the money received upfront for orders.

Due to the growing popularity (and as a result, competition in the space), many subscription companies rely on providing up front offers to provide an added incentive such as a free box (or two or three) which runs the risk of consumers signing up without them having a real interest in using the product. As a result, the lifetime value of the consumer is the most important metric that investors look for in subscription business along with a focus on the churn rate (the number of consumers unsubscribing each month) and the profit margin on each box.

Commission

The commission business model is most common in marketplaces, where you take a percentage combine a supplier with a consumer and take. Marketplaces are difficult to dethrone once in place, but building a strong marketplace is also one of the more difficult businesses to build successfully.

The biggest risk factors for investors with the commission model in marketplaces is growing both sides of the market to meet demand and leakage on one side of the market. At a more growth/ scale stage of the startup, the other issues become value based (i.e. if you are only making a few dollars per transactions, you need a large number of transactions occurring on your platform to achieve growth.

Freemium model

A freemium model is where you provide a product or service for free to consumers, with a view to offering higher value, additional features or gated products for paid users. This model is most often associated with apps and games (e.g. Candy Crush, Clash of Clans etc.)

Similar to the free samples or boxes offered in the subscription model outlined above, there will be a certain percentage of the audience in the Freemium model that will download the app but never cross the barrier to pay for features or additional content.

In the Freemium model, investors focus on the engagement of users with the app. The key metrics for this are; daily active users, average time spent on app and the overall stickiness of users (how long consumers continue to use the app after their initial download)

Enterprise SaaS

Another format of the subscription model is the Enterprise SaaS (Software as a Service) model where a party leases or pays a regular fee (often on a monthly basis) to gain access to software applications.

It has all the benefits of the standard subscription box covered above, with the added benefit that by reducing up front costs for software, it is easier to get into the hands of users.

However, due to the consumer that you are selling to, the sales funnel for Enterprise SaaS companies tend to be more sophisticated, with longer lead times often required to “close the deal”. There is also the similar challenges and risks faced in the churn rate of users, with the key metric of Life Time Value of users.

Does your current business model seem well suited to the industry and market that you are trying to cater for? I would love to hear your thoughts on Twitter