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August 22, 2011

I got this question on a panel a few weeks ago:

“I heard that company X raised money from several good VC’s.  How is that possible given that the company isn’t making any money and doesn’t have any business model?”

I know that there are investors out there that question this behavior too.  Why would you put money into services like Instagram, Tumblr, or others before any real business model is in place?

Start-up boards face this decision too.  When do you focus on growth, users, or product quality and when do you think about testing revenue models?

The answer is that investors do generally care about business models.  I know that I do.  But, the reality is that there aren’t that many different business models in the internet.  My partner Lee often talks about there being only 3 revenue models on the internet (and he has a more lengthy blog post on the topic here).  I’m modifying his categories a bit into these:

1. Media Models (primarily monetized through advertising)

2. Transaction Models (including e-commerce but also lead-generation)

3. Premium, User-Paid services

When I met with an entrepreneur, I want to get a sense for how she is thinking about the different revenue generation options.  And based on those options, I think about 2 things:

1. Does this entrepreneur understand what it takes to “win” with this sort of revenue model?  Does he understand the business implications of a given path?  Stuff like building a sales force, building a customer support organization, etc.

2. How innovative is this entrepreneur in thinking of ways to optimize a given revenue model.  For example, while “advertising” is a catch-all, we are seeing with Twitter the need and promise of innovative product leaders figuring out new and natural ways to advertise within the context of what Twitter has built. Slapping display ads on the side won’t cut it.

But let’s go back to the original question. Here is the typical reason why VC’s sometimes need to see very little in terms of a business model to get excited about a company.  When presented with a particular company, the VC (explicitly or implicitly) asks himself

“Ok, which of the three revenue models is this type of company likely to pursue”?

“Based on the revenue model, how much is each user likely to be worth?”

For many media models (and even some of the premium services models) the answer is each user is probably worth very little.  Or, a few users are going to be worth a lot, but the vast majority will be worth nothing.

If this is the answer, then it will never be profitable to try to “buy” users with the hope of converting them to paid users profitably.  The only way to make this business work is to get massive scale as organically as possible.

Down the road, the equation may change and the company will need to be more deliberate about refining their business model.  But initially, many of these companies have to get to first base.  And first base is getting lots of users.  Actually, that’s probably first and second base.

I’m not saying that user traction is a sure path to victory!  I am a firm believer that every company should seek to build real, sustainable, and potentially independent businesses.  But, if you are going after a market where you are monetizing users at a modest rate, refining business models is a distant priority relative to getting lots and lots of delighted users heavily engaged with your service (and hopefully doing so pretty capital efficiently).

 

 

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David Biesel




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Lee Hower




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