In product development, after brainstorming (or ideating if you prefer) the next step is usually prototyping and concept selection. Picking up on my last post, once you have used the business model canvas to generate a few ideas about how you might leverage resources from the current business to launch a new one, how do you pick which design to go with? How do you prototype a business model? I’m pretty sure a 3-D printer won’t work for that.
Business model prototypes are where I think the more quantitatively oriented definitions of business models are useful, like those offered in Seizing the White Space and Getting to Plan B. A business model prototype should be a quantitative description of the various interrelationships of the business model elements – in essence, a financial model. This should be data driven, but given the ambiguity in the business environment, there will be limits to the actual data available. Assumptions will have to be made, which is why the business model prototype serves a dual purpose.
First, the prototype helps you to explore various scenarios and stress test the viability (and profitability) of the venture so designed. As importantly, however, it forces you to begin methodically calling out all your assumptions. This becomes important later on as you move into the business model equivalent of a minimum viable product.
For now, though, for the purposes of selecting a prototype to move forward with into that minimum viable business model phase, you need to understand five major features of the business’s financial model (credit to Mullins and Komisar for identifying these in their book, Getting to Plan B).
Revenues Where is the money coming from? Who is paying? What is the customer’s estimated willingness to pay? What is it going to take and cost you to acquire these customers? Are revenues one time transactional or recurring? What is the pricing strategy? What are the projected volumes at a given price?
Gross Margin After direct costs, what is left over? Are direct costs low enough for an attractive gross margin? How does the gross margin compare to that of your other business units? How much is money is generated to cover other costs and investments? Are gross margins constant or changing over time?
Operating Costs What is your overhead? What other costs does your business incur that don’t vary with sales volume? If sales disappoint, how big a hole might you find yourself in from other obligations? What costs can be reduced or eliminated in accordance with your new business strategy? What new costs should be incurred or increased to capture more value and benefit?
Working Capital and Resource Velocity What do your cash flows look like? When do your customers pay? When do you have to pay your suppliers? How are you impacted by the time value of money and interest rates? Will working capital constrain growth? When if ever do you expect to actually accrue cash?
Investments How much do you need to get things off the ground? How much do you need to reinvest to drive profitable growth? At what point do you break even?
With these questions answered quantitatively in your financial model, you can begin stress testing your business model design, manipulating variables and comparing business models across an array of scenarios. Companies must take care not to focus just on the extreme outcomes but ascertain the most likely outcomes, assuming only average results when there is no compelling reason for a more optimistic prediction.
After comparing prototypes, a subset is selected to move forward with piloting – the business model equivalent of a minimum viable product. For that to happen, assumptions must be turned into the hypotheses to be tested with specific projects, and projects organized into programs that will constitute the minimum viable business. The goal of a minimum viable business – be it a pilot, joint venture, subsidiary, or other limited scale business operation – is to maximize learning while controlling costs. The format isn’t new; the emphasis on hypothesis driven, empirical investigation is.
If you are interested in reading more about the more general innovation process that I actually follow in describing how business model innovation should be done, check out this excellent article coauthored by one of my (favorite) business school professors. There’s also a pretty cool multimedia summary on Vimeo as well.