Module 12

1. For start-ups, the need to scale up can be costly; discuss how business model design can help
overcome this.

Answer:
When it comes to sustainable growth in business, the following milestones are great predictors of
success.

 Recurring Revenue
 Revenue Diversity (many customers that generate smaller amounts of revenue)
 Repeat Customers (subscription businesses)
 Low Attrition
 Repeatable Systemic Offerings to Your Customer
Looking at both product- and service-oriented businesses, let's examine the tactics that can help
you achieve the milestones above and let you judge for yourself: when it comes to scaling
efficiently, are all businesses created equal?

Services vs. Products: Defining the Way You Scale

If two companies don't deal with cost and revenue in the same way, there's no way the same
scaling strategy will work for both. A software company that incurs the majority of its production
costs early on in the product development stage is never going to scale in the same way as a
digital consulting firm, where operating costs remain fairly constant over time.

Each one is different, so you should begin developing your scaling strategy based on that one
rudimentary distinction: is your business more service- or product-oriented? One thing all good
product-oriented businesses have in common is that they're inherently more scalable than even
the best of the best service companies.

If you're running a service-oriented company, you've already put yourself at a huge disadvantage
when it comes to scalable growth. Service businesses can often be complex and people-oriented,
making it harder to eliminate redundancies and increase automation.

The work these businesses do usually becomes increasingly commoditized over time, often to the
point that the company can't keep up -- as soon as the advantages that come with offering a
bespoke service disappears, they struggle to keep their margins wide enough. That being said,
there are certainly steps service-oriented businesses can take to maximize efficiency, but in
comparison to the scalability of a product-oriented business, service companies start off at a
disadvantage.

It's Not All Doom and Gloom for Services Companies

That said, the natural ability to scale doesn't shield product-oriented businesses from their own
set of challenges. For them, the problem isn't so much dealing with the cost of running the
business once the product exists -- it's the up-front product development costs, coupled with the
risk of market acceptance. In other words, there's no real way of knowing whether or not the
product you're investing in is going to succeed and offer any kind of substantial return.

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 So while product-oriented companies might be able to employ simpler scaling strategies, the
disadvantage for service businesses is by no means insurmountable. The brilliance of Uber, for
instance, was to offer a service through a business model that's primarily product-oriented, selling
its map algorithm and driver fleet management services rather than rides themselves.

It's true that service-oriented businesses are inherently less scalable, but that doesn't mean they
can't achieve all the milestones I mentioned earlier -- it just means it'll take more creativity to do it.

Consider a Hybrid Approach

Any service-oriented business trying to scale is taking a serious risk, but there's also a lot of up-
front uncertainty in building up a product-oriented company, which can put you in deep with
investors and debt. Some companies have had success bringing the best of both worlds together
by leveraging a "solutions"-based model to incorporate both products and services into what they
ultimately offer their customers.

While challenging in its own right, this business model can hedge on cash flow requirements and
also feeding into product development cycles through service experience. It's worth considering if
you want to raise less debt and equity early on when trying to scale your business.

2. Selling a product is great, but generating recurring revenues is better. Discuss the value in
developing a ‘cell phone monthly subscription’ business model.

Answer:
1. Recurring Revenues Smooth the Effects of Seasonality

Every brand has a “favorite season”. For some industries like swimwear or snowboards the literal
four seasons directly impact sales but for other brands annual events like Christmas or back-to-
school season are their key drivers. This effect is what we call “seasonality”.

2. Recurring Revenues Build Long-Term Customer Relationships

Recurring revenues also help paint a much more accurate picture of a customer relationship over
time. For many businesses, customer relationships are something that starts with advertising and
other pre-sale initiatives which introduce the customer to the brand, and end with a customer’s
successful purchase of a product. While this view of customer relationships isn’t wrong, it also
isn’t complete.

3. Recurring Revenues Give a Higher ROI on Acquisition Costs

Customer acquisition is an important but sometimes costly part of doing business. In previous
posts we’ve written about costs and the best strategies for reducing CAC, but today we get to
explore a different way of thinking about the metric: return on investment (ROI).

3. Discuss the problems facing the newspaper industry and the options open to it to make money.

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Answer:

Newspapers are struggling financially, but ad revenue is predicted to recover slightly in 2010. The
underlying issues are not just business-driven, but include issues of structure, culture and the
industrialized foundations of distributing newspapers. This list is not a comprehensive one, but
these are some of the things that newspaper leaders should be considering. And though print
itself may not survive, the organizations behind them provide value to a democratic society, often
covering and providing news that blogs with more limited resources can’t always dig up. We
welcome comments below with other suggestions of things you think newspaper leaders should
try or invest in. Let’s have some dialogue about this topic.

1. Putting web first and reporting from multiple platforms

That might seem like a no-brainer, but this fact is a double-edged sword. Newspapers are often
still treating their websites as an afterthought because their advertising revenue is largely still
coming from print. At the same time, the shift to getting more revenue from websites won’t
happen until the websites are the first priority.

2. Go niche

The mass-broadcasting model just doesn’t seem to work as well on the web. More and more,
people are finding value in the specific subjects or areas they find most interesting or that impact
them directly. The vertical supply chain of newspapers, an industrialized model of a collection of
sectioned news stuffed into one paper, is simply becoming less valuable to more people,
said Stowe Boyd, managing director of Microsyntax.org, a nonprofit investigating the embedding
of structured information in micro streaming applications like Twitter.

3. Offer unique content in print

Bradshaw’s point speaks to the idea that newspapers need to stop treating their websites as a
dumping ground for print stories and treat each somewhat independently, carefully selecting the
stories better suited for each media.

4. Journalists as curators and contextualizes

The link economy is very real and the time to invest is now. The brutal reality is that currently
newspapers own less than 1 percent of U.S. online audience page views and time spent. Linking
to other articles and curating information will not only be helpful to readers but make newpapers
more visible on the web.

5. Real-time reporting integration

Social media is allowing the audience and “the people formerly known as sources” to report
themselves. For example, the Fire Department in New York City used a live video stream on their
website to broadcast the rescue efforts following the recent Hudson River air collision live from a
helicopter, allowing visitors to the site to comment via chat next to the feed. They had more than
300 viewers watching and chatting as the news unfolded and often times those viewers had the

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news first. They were, after all, the source that a lot of the other media outlets were getting their
information from.

6. Internal culture: Startup vs. corporate

Many newspapers today are built around a very corporate and bureaucratic structure. There is a
reporter and an editor and an editor’s editor and the editor of all editors, and well, you get the
point. Scott Porad, CTO of Pet Holdings, points out that the problem with corporate environments
is that 80 percent of the time is spent planning and only 20 percent is spent doing. While at his
startup only 5 percent is spent planning and 95 percent is spent doing. Mark Briggs recently wrote
a great post on how one might create a startup culture in the newsroom.

7. Encourage innovation

Part of having a startup culture includes an environment that encourages innovation, such as
Google’s “20 percent time” rule that allows engineers to work on side projects they are passionate
about, which has resulted in Google products like AdSense, Orkut and more.

8. Charging for quotes is not the answer

The Associated Press signed a deal with iCopyright that will help them track and charge for
unauthorized use of its content. This hasn’t set well with readers and has been criticized by
members of the journalism industry, including the President of Media at Thomson Reuters Chris
Ahearn. He wrote a response in which he outlined his support for the so-called "link economy,"
which the AP's deal with iCopyright goes against.

9. Investing in mobile: E-Readers or smartphones?

Aside from the fact that more people are getting smartphones and using them to stay connected
to the news, there is also some potential for money to be made. Apparently, news organizations
are catching on, becoming the fastest growing iPhone application category.

10. Communicating with readers

It doesn’t make sense for readers to not be able to comment on news stories online, but yet many
newspapers still either doesn’t have the feature on the site, don’t use it, or have various rules to
which stories allow comments and which do not. It makes sense that in many cases it is because
the comments are vulgar or of low quality, but a clear line and definition of what stories have
comments has not yet been drawn.

11. Building community

Newspaper websites are no longer expected to just provide news, but also to create community.
Some newspapers are harnessing social media platforms to achieve this goal. Whether creating
a Facebook Fan Page, a LinkedIn group or a Twitter account, newspapers are using social media
in an attempt to create a community of readers. Developers like Jeff Reifman, founder
of NewsCloud, which creates community-based Facebook applications that aggregate news, are
aware of the changing model of the news industry as well and are trying to take advantage.

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 (Disclosure: I helped launch and managed the content for one of NewsCloud’s Facebook
applications at a previous job).

12. To pay wall or not to pay wall – that is the question

There isn’t a clear-cut answer for whether newspaper websites should charge for online content
and if they should, what the best model is. Whether a subscription based model or a pay-per-
article model, each has some serious implications. However, some think that there has been
enough talking and that newspapers should go ahead and charge for online content. Rupert
Murdoch, CEO and founder of News Corp., is planning to start charging readers for online
content for all of the company’s news websites, starting with The Sunday Times in November.

4. Is it possible to receive payment before incurring expenditure?

Answer:

For instance, when a business hires a contractor to do work for a day, it incurs an expense
because the contractor expects payment for the services that he has performed. If the business
gives the contractor cash for the services performed at the end of the day, the incurred expenses
become a paid expense.

Accumulation of Incurred Expenses

Allowing too many incurred expenses to accumulate without paying them off can be dangerous
because it may make it more difficult to do so. Businesses often take out loans to fund purchases,
but loans do little more than delay payment of incurred expenses. If your company amasses too
much debt and too many outstanding expenses, it might be unable to meet its obligations, which
can lead to default.

Bankruptcy Options to Handle Debts

If you cannot meet the financial obligations of your business, the company may declare
bankruptcy. Bankruptcy is a legal process that allows a business to sell off its assets and close its
doors or restructure to continue operations. Bankruptcy can cancel or reduce certain debts, which
makes it easier for you to pay off incurred expenses that remain. Bankruptcy is typically
considered a method of last resort for dealing with accumulated expenses, as it can have a
severe negative impact on the business's ability to qualify for credit.

5. Why are switching costs useful to consider in the design of a business model?

Answer:
Switching costs play an important role in retaining customers, and motivating repeat purchases in
the future. Technology startups can’t survive without user lock-in and incumbent suppliers with
strong customer lock-in typically earn monopoly profits. Early stage startups thinking about spend
some time understanding the features that create value for the customer while building customer
lock-in for the startup early in product design process. The existence, or lack thereof, of switching
costs amongst the incumbent’s customers will play an important role in determining the
competitive response that is likely to occur once the new-entrant’s intentions become undeniable.

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 In which case speed of market entry is critical for the new-entrant. In a market with low switching
costs, one might expect vicious price wars to ensue. Generally, such price wars will always favor
the presumably better capitalised incumbent. Moreover, price wars are a bad idea for the
incumbent as well as the new entrants. In a market where the incumbent enjoys significant
customer lock-in with ensuing monopoly profits, one generally expects new entrants to find a
foothold from which they can eventually migrate up-market.

6. Is it possible to limit the threat of competition within your business model?

Answer:
The state of competition in an industry depends on five basic forces, which are diagrammed in
the Exhibit. The collective strength of these forces determines the ultimate profit potential of an
industry. It ranges from intense in industries like tires, metal cans, and steel, where no company
earns spectacular returns on investment, to mild in industries like oil field services and equipment,
soft drinks, and toiletries, where there is room for quite high returns.

New entrants to an industry bring new capacity, the desire to gain market share, and often
substantial resources. Companies diversifying through acquisition into the industry from other
markets often leverage their resources to cause a shake-up, as Philip Morris did with Miller beer.

The seriousness of the threat of entry depends on the barriers present and on the reaction from
existing competitors that entrants can expect. If barriers to entry are high and newcomers can
expect sharp retaliation from the entrenched competitors, obviously the newcomers will not pose
a serious threat of entering.

There are six major sources of barriers to entry:

1. Economies of scale

These economies deter entry by forcing the aspirant either to come in on a large scale or to
accept a cost disadvantage. Scale economies in production, research, marketing, and service are
probably the key barriers to entry in the mainframe computer industry, as Xerox and GE sadly
discovered. Economies of scale can also act as hurdles in distribution, utilization of the sales
force, financing, and nearly any other part of a business.

2. Product differentiation

Brand identification creates a barrier by forcing entrants to spend heavily to overcome customer
loyalty. Advertising, customer service, being first in the industry, and product differences are
among the factors fostering brand identification. It is perhaps the most important entry barrier in
soft drinks, over-the-counter drugs, cosmetics, investment banking, and public accounting. To
create high fences around their businesses, brewers couple brand identification with economies
of scale in production, distribution, and marketing.

3. Capital requirements

The need to invest large financial resources in order to compete creates a barrier to entry,
particularly if the capital is required for unrecoverable expenditures in up-front advertising or R&D.
Capital is necessary not only for fixed facilities but also for customer credit, inventories, and

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absorbing start-up losses. While major corporations have the financial resources to invade almost
any industry, the huge capital requirements in certain fields, such as computer manufacturing and
mineral extraction, limit the pool of likely entrants.

4. Cost disadvantages independent of size

Entrenched companies may have cost advantages not available to potential rivals, no matter
what their size and attainable economies of scale. These advantages can stem from the effects of
the learning curve (and of its first cousin, the experience curve), proprietary technology, access to
the best raw materials sources, assets purchased at preinflation prices, government subsidies, or
favorable locations. Sometimes cost advantages are legally enforceable, as they are through
patents. (For an analysis of the much-discussed experience curve as a barrier to entry, see the
insert.)

5. Access to distribution channels

The newcomer on the block must, of course, secure distribution of its product or service. A new
food product, for example, must displace others from the supermarket shelf via price breaks,
promotions, intense selling efforts, or some other means. The more limited the wholesale or retail
channels are and the more that existing competitors have these tied up, obviously the tougher
that entry into the industry will be. Sometimes this barrier is so high that, to surmount it, a new
contestant must create its own distribution channels, as Timex did in the watch industry in the
1950s.

6. Government policy

The government can limit or even foreclose entry to industries with such controls as license
requirements and limits on access to raw materials. Regulated industries like trucking, liquor
retailing, and freight forwarding are noticeable examples; more subtle government restrictions
operate in fields like ski-area development and coal mining. The government also can play a
major indirect role by affecting entry barriers through controls such as air and water pollution
standards and safety regulations.

5. Access to distribution channels

The newcomer on the block must, of course, secure distribution of its product or service. A new
food product, for example, must displace others from the supermarket shelf via price breaks,
promotions, intense selling efforts, or some other means. The more limited the wholesale or retail
channels are and the more that existing competitors have these tied up, obviously the tougher
that entry into the industry will be. Sometimes this barrier is so high that, to surmount it, a new
contestant must create its own distribution channels, as Timex did in the watch industry in the
1950s.

6. Government policy

The government can limit or even foreclose entry to industries with such controls as license
requirements and limits on access to raw materials. Regulated industries like trucking, liquor
retailing, and freight forwarding are noticeable examples; more subtle government restrictions

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operate in fields like ski-area development and coal mining. The government also can play a
major indirect role by affecting entry barriers through controls such as air and water pollution
standards and safety regulations.

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