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If you’ve heard the term “business model,” but don’t know exactly what it means, you’re not alone.
It’s used all the time by business analysts, and even they disagree on the exact definition of a business model.
But you know a business model is important.
And it is. Your model sets your business on the path to success or failure, so you need to get it right.
How Does This Article Serve You?
This is a practical guide to:
- What a business model is
- Why it’s important
- How to create one.
It doesn’t require any previous experience or knowledge and will leave you with everything you need to know to pick the right business model for your next venture or reevaluate your current model.
What is a Business Model?
As mentioned, there’s no single definition of a “business model,” so let’s look at the most common interpretations.
Long ago, the concept of a business model was simple – how will your business make money.
It wasn’t until the 1990s or so where people started realizing that your business model can make or break your company.
So it evolved from that basic definition.
While he didn’t specifically mention business models, Peter F. Drucker’s theory of business is often cited as the start of a shift. Instead of just focusing on monetization, he proposed that businesses should also consider customers, goals, and strategy.
Verifying Your Business Model
A modern business model should at the very least answer Drucker’s famous five questions:
- What is your mission?
- Who is your customer?
- What does your customer value?
- What results do you seek?
- What is your plan?
Still, that’s a bit open-ended.
Finally, Alex Osterwalder developed a comprehensive system to define a business model.
His view of a business model was that a business model is a combination of assumptions and guesses.
The Business Model Canvas
He developed the Business Model Canvas, which we’ll be looking at in more detail later.
It divides a model into 9 main sections that provide an organized way to break down all the important assumptions you have about a business.
Video: Alex Osterwalder provides a brief overview of the Business Model Canvas
What’s the Difference Between Business Models and Business Strategy
They both seem similar at first but have different scopes.
A business model covers how a business will operate, but a business strategy defines how that business will carve out a position in its market.
In other words, a business model gives you a set of limitations. It might tell you how much you’ll charge, and what customers you’ll target.
However, your business strategy will focus on how you actually reach those customers and distinguish yourself from competitors.
You’ll see both terms used interchangeably (incorrectly), but it’s good to know the difference.
Why Do Business Models Matter in the Modern Economy?
The right business model can catapult you to glory or collapse, and that’s not an exaggeration.
Business model innovation is arguably the biggest form of competition that exists in modern business.
Clay Christensen, a professor of business administration at Harvard sums it up well:
Most managers think the key to growth is developing new technologies and products. But often this is not so. To unlock the next wave of growth, companies must embed these innovations in disruptive new business models.
IBM’s Institute for Business Value conducted a study in 2009 and found that 70% of companies are actively engaging in business-model innovation.
They also found that 98% of businesses were continually modifying their model to some extent.
Core Values and Competitive Advantage
You’ve seen examples of this, perhaps without realizing it.
Consider taxis and Uber, which both have essentially the same core value to customers of providing flexible, on-call transportation.
Uber has a drastically different business model. When they started up, their business model was their main competitive advantage.
Fast forward to today, and Uber and other similar businesses have overtaken taxis.
3 Traits of a Good Business Model
Before we look at specific models you may want to consider using, let’s briefly go over the attributes of a solid business model.
1. They Match Up With Company Goals and Values
Your business model comes after you define what your company is trying to do.
Certain models will match up with your goals and values, and some won’t. If you start a diamond shop but try to implement a freemium model, there’s essentially no way you’ll succeed.
Pick a model that complements your mission and the way you want to accomplish it.
2. A Business Model Should be Robust
You don’t want to base your entire business off a model that might not be effective after a year or two.
Your business model needs to consider:
- Resources available – If your business model requires an upfront investment, but you have limited access to funding, you’re in trouble.
- Imitators – Can competitors easily copy or improve upon your business model?
- Consumer trends – Will customers still want your solution in the future? Can they substitute it for another?
Taking time to think of these when picking a business model may save you from a big mistake.
3. They Leave Opportunity for Innovation
You’re likely not going to get everything in your business model right the first time.
As Osterwalder noted, business models are based on assumptions. Things rarely go as planned.
If your business model depends heavily on all your assumptions being correct, it’s too rigid. Create a business model that you can re-evaluate and improve upon over time.
The 20 Types of Business Models (with Examples)
Mark W. Johnson has a great book called How to Seize the White Space for Transformation.
In it, he covers 20 types of potential business models that you can choose from and their primary method of monetization.
I’ll summarize them here and provide examples of each, but if you’d like more detail, it’s a good book to pick up.
An affinity club model is based on partnerships with other organizations. By buying or using your products, customers also get special access to other perks, giving them extra incentive.
Of course, you’ll need to provide an incentive to those partners to get them on board.
This is best used in competitive fields where products are all similar.
A great example of this is MBNA, who uses this model with their credit cards. Different cards come with different perks, so they can target a wide audience.
For example, one card is targeted towards football (soccer) fans. If you sign up for a Manchester United card, you get points that can be exchanged for their merchandise.
There are also monthly draws and other perks.
This model relies on technological advancement and is tough to use unless you have a good deal of specific technical knowledge yourself.
The goal is to automate services that typically use human labor, so your operating costs are reduced.
For example, instead of going to a financial advisor, you can go to Betterment. It’s an automated online financial advisor that gives you a similar quality of advice as most financial advisors would.
Video: An overview of how Betterment uses technology to provide financial advice.
A broker connects buyers to sellers and gets a small fee for each transaction.
There are many examples of this:
Any marketplace that allows others to sell on it, and focuses on bringing in customers for those sellers is using a brokerage model.
A bundling business model packages related products together to make a more convenient and enjoyable experience for customers.
A classic example of this is the fast-food value meal, but that can be replicated fairly easily.
A better example is the combination of iPod and iTunes. You can’t use an iPod without iTunes, so each new iPod customer results in a new iTunes user (and potential customer).
Bundling is very effective when a company is launching a new business and can leverage existing success as Apple has done.
Don’t confuse a crowdsourcing business model with crowdsourcing funding from sites like Kickstarter.
A crowdsourcing business model relies on user-generated content. The business focuses on making contributions easy and providing an incentive for users to contribute (usually money or a charitable goal).
YouTube is one example of a crowdsourcing model, where users upload videos, and most hope to generate revenue from those videos.
Wikipedia is another great example, where all the content on the site has been created for free by willing users who want to spread knowledge.
The idea behind a data-into-assets is to obtain valuable data that can be sold to willing buyers.
This is one of the few that can run into real ethical dilemmas.
For example, this is the business model that Facebook uses. The site is free for users, but in return, Facebook collects massive amounts of data about users and uses that to generate revenue through advertisers.
The Dangers of Data
They are facing large privacy lawsuits that could set a precedent for other businesses.
It’s hard to know where to draw the line, as Google is another data-into-assets business that most have no big issues with. They scrape data from just about all sites and transform that into search results that users desire.
Then they sell ads to advertisers on the search results.
Since the beginning of the Internet, creating a digital platform has been a viable business model for some companies.
For example, OpenTable started in 1998, which is a site that provides an online restaurant-reservation service.
There are still opportunities to be innovative in an industry simply by providing a useful product online.
To use this, you can apply modern technology to outdated industries, or apply new technology to any industries ready for it.
We’re also seeing new digital platforms innovate upon old ones by leveraging new technology like machine learning and blockchain technology. These could almost be considered business models of their own.
This mouthful simply means directly delivering a service or product instead of through a middleman.
Tesla is a great modern example of this. Instead of selling cars through a dealership, you buy online and skip the salesman. Not only is it more convenient, but it reduces costs for consumers.
Fractionalization consists of letting customers buy a portion of a product or service.
A good example of this is a time-sharing condo. People buy part of the condo and can use it during a certain time of the year that they purchased it from.
It’s a great model when your target customers only want your product or service part of the time. They get the full benefits but don’t have to pay full price.
Freemium is a modern business model that is often used by software companies.
Because there’s very little overhead in serving data, businesses can choose to provide a portion of their service or product for free, but requiring payment for full access.
Spotify and Dropbox
Dropbox gives you a small amount of free cloud storage and asks you to upgrade to a paid plan if you need more space.
Spotify offers free music but has ads. If a user buys a paid plan, they get rid of the ads.
Freemium lets you reach a wider audience, and often get more referrals, which can lead to a steady stream of customers.
Leasing is nothing new and has been used by car dealerships for many years. It works best for expensive products.
When a customer often can’t afford to pay cash or only needs a product one time, you offer them use of the product for a rental fee.
A low-touch model takes a high-end offering and reduces the cost (and quality) of that product or service.
Competing on cost is a difficult business model to succeed with, but can work if you get enough customer volume.
Walmart is a great example of this, who sell lower-quality products than most competitors, but at a better price.
Negative Operating Cycle
This is a business model popularized by Amazon.
It’s especially popular with online retail businesses and allows businesses to sell products at a low-profit-margin (or even at cost), and still be highly profitable.
How Does It Work?
By maintaining a low inventory and getting payment upfront. Of course, you need a reliable and fast fulfillment process for this to work effectively.
The profits then come from the volume of sales that are attracted through low prices, or by utilizing the money sitting around before having to pay suppliers.
That money generates interest or can be used to fund long-term investments or research and development.
This business model is exactly what it sounds like, customers pay as they use your service.
This can only be used in certain industries where customers regularly consume varying amounts.
For example, car2go lets you pay for car rentals by the minute, hour, or day.
Razors and Blades
Razors and blades can be interpreted literally or symbolically.
This business model consists of bundling 2 products together that require each other. Then, you sell the main component (razor) at no profit or even a loss but recoup that because the complementary product has high margins (blades).
Another good example of this is the personal printer. They’re cheap to buy, but the ink is very expensive and high margin.
Reverse Razors and Blades
This is the same as above, but the two products are split.
You offer the “blades” at a very low cost in order to get people to buy the expensive and high margin “razor.”
One example of this is Amazon Kindle books, which are very cheap, and may tempt consumers into purchasing an expensive Kindle to read the books on.
There are many times that people want to use a product, without buying it. A product-to-service model lets people pay a service fee to have access to a product.
It’s similar to leasing and fractionalization.
A good example of this is Zipcar, which is a car-sharing company. Members pay a monthly or annual fee to have access to car reservations as needed.
If you can take something that has a lot of variabilities and create a consistent, standardized product, you stand out from competitors.
Dominos did this with their “30 minutes or it’s free” offer for pizza delivery, which at the time was unheard of.
A subscription club lets customers buy a product on a regular basis.
This is a popular model for software businesses that most SAAS (Software As A Service) platforms fall under.
Netflix and Dollar Shave Club also would be subscription clubs.
Finally, some businesses create paid user communities that generate revenue from fees and possibly advertising.
The most famous example of this is Angie’s List, a home services review community that required payment until a little while ago.
It’s a tough model because most people prefer free forums and other types of communities, but good if people will pay for higher quality information.
How to Design Your Business Model
We can finally get to some practical work on your business model.
As mentioned before, monetization methods are not enough on their own.
There are 2 main approaches that you can take if you would like to create a new business model or refine an existing one.
Business Model Canvas
The Business Model Canvas comes from Alexander Osterwalder.
It’s a chart that includes the 9 important elements of a business model.
9 Sections of The Business Model Canvas
Let’s go through the 9 sections, each one includes questions to prompt you if you get stuck:
- Value Proposition – Here you outline your product(s) or service(s), as well as how they provide value to customers.
- What value do we deliver to the customer?
- Which one of our customer’s problems are we helping to solve?
- What bundles of products and services are we offering to each Customer Segment?
- Which customer needs are we satisfying?
- Customer Segments – Who your customers are, and what problems you solve for each customer.
- For whom are we creating value?
- Who are our most important customers?
- Channels – Where you’ll reach your potential customers.
- Through which channels do our Customer Segments want to be reached?
- How are we reaching them now?
- How are our Channels integrated?
- Which ones work best?
- Which ones are most cost-efficient?
- How are we integrating them with customer routines?
- Customer Relationships – How you’ll build demand for your products.
- What type of relationship does each of our Customer Segments expect us to establish and maintain with them?
- Which ones have we established?
- How are they integrated with the rest of our business model?
- How costly are they?
- Cost Structure – Specify fixed and variable costs of operating your business.
- What are the most important costs inherent in our business model?
- Which Key Resources are most expensive?
- Which Key Activities are most expensive?
- Key Activities – The essential things your business needs to do to succeed.
- What Key Activities do our Value Propositions require?
- Our Distribution Channels?
- Customer Relationships?
- Revenue streams?
- Key Resources – Suppliers, funding, and other resources needed.
- What Key Resources do our Value Propositions require?
- Our Distribution Channels?
- Customer Relationships?
- Revenue streams?
- Key Partners – List any other businesses you would like to partner with.
- Who are our Key Partners?
- Who are our key suppliers?
- Which Key Resources are we acquiring from partners?
- Which Key Activities do partners perform?
- Revenue Streams – State how you will make money.
- For what value are our customers really willing to pay?
- For what do they currently pay?
- How are they currently paying?
- How would they prefer to pay?
- How much does each Revenue Stream contribute to overall revenue?
Lean Business Model Canvas
The Business Model Canvas is a general model that works well in most cases.
Lean Canvas Sections Explained
Again, there are 9 sections, but it’s “easier” to fill out for these types of businesses.
Here’s a brief description of each section:
- Problem (P) – What are the main 3 problems that your business solves?
- Solution (S) – What are the essential features of your product(s)?
- Unique Value Proposition (UVP) – What’s your business’ differentiating factor from competitors that make you better for your customers?
- Unfair Advantage (UA) – What part of your business can’t easily be copied by competitors?
- Customer Segments (CS) – Who are your target customers? Be as specific and niche as possible.
- Key Activity (KA) – What are the key interactions that lead to revenue? For example, creating their first blog post on a blogging platform.
- Channels (CH) – What channels will you be using to acquire customers?
- Cost Structure (C$) – List both your fixed and variable costs, estimate if needed.
- Revenue Streams (R$) – Specify your revenue model (refer to the previous section of this guide).
If you got this far, you understand business models more than most entrepreneurs.
I’d highly recommend spending just another ten minutes or so and quickly work through either the Business Model Canvas or Lean Canvas.
Even if you can’t fill it out completely, you’ll quickly realize which areas of your business models need more attention and strengthening.