Economic Model Part 3: Every Company Has an Optimal Economic Model Waiting to Be Discovered

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This is the third in a series of posts that I am writing aimed at helping entrepreneurs maximize their economic performance.  You can find a summary of the economic model series here .  My last post described why most entrepreneurs don’t think about their economic model enough.  This post explains that every company has an optimal economic model waiting to be discovered and gives you some tips on how to discover yours!

Every Company Has an Optimal Economic Model Waiting to Be Discovered.

Whether you are a consumer Internet company or sell B2B term licenses, perpetual licenses, or services, or even if you are a media company, or a corner dry cleaner or consumer packaged goods company, you have an economic model in existence today.  If you don’t have revenues, then you have only a cost-based economic model (which isn’t sustainable forever), but hopefully you have a hypothesis for how your are going to create revenue and ultimately get to a minimally viable economic model (that’s one where cash coming in is higher than cash going out) and ultimately your optimal economic model (that’s one where the cash coming in net of costs is maximized) in the future.

You have significant opportunities to improve your economic model performance and iterate to find your optimal economic performance.  My view is that every company has the opportunity to increase both its economic model results by at least 25% AND increase its growth rate by at least 25% by focusing more on its economic model (yes, both economic increase AND growth increase!).  That said, you need to do real work if you are going to discover your optimal economic performance.

If you don’t have an economic model management system, then this post is for you!

A Strawman Process for Optimal Economic Model Discovery

This post describes an iterative process that you can use to identify and improve your economic model.  It is straightforward and easy to execute against, but it does take management discipline to keep iterating over long periods of time.  If you use it, you will move toward an optimal model.  Guaranteed.

In this post, I am describing an overview of the system and in further posts I will put some meat on the bone and describe different aspects and issues in more detail.

First, Discover Today’s Economic Model

Find economic model components by following the value delivery chain

The first step is to find the economic model components so that you make sure that you capture all the aspects of your economic model.  The best way that I have found to discover economic model components is to follow the value that is generated through customer interaction.  Most economic models can be discovered this way.  Start with customer value and follow the value back through your company:

  1. You deliver net value to your customers
    • You deliver net value to your customers (value creation to the customers)
    • You take some of the value you create back (The cash that you receive from customers)
    • The net of the two is the net value you are delivering to your customer
  2. You receive net value in the form of economic gross profits from your customers
    • You take some of the value you create back (The cash that you receive from customers)
    • It costs you money to deliver your service (your cost of delivery or cost of good sold that relate to the customer)
    • The net of the two is the net value you are receiving from your customers
  3. You might have some costs associated with delivering ongoing value to your customers that are not customer specific, and therefore are not included in the above.  For example, publishers have costs associated with creating content, communities that are advertising supported have costs associated with building and maintaining the communities.
  4. It costs you money to acquire new customers (your cost of acquisition, which is an investment in acquiring more customer value)
  5. It costs you money for ongoing investments in experiments to improve and new product development to create more competitive advantage in the future, to cross-sell or upsell into current segments and/or to target new customer segments)
  6. It costs you money to keep your company running and satisfy regulatory and investor obligations (General and Administrative expenses)

Now, flip Your thinking to create a causal model – what are your actions, what are the market reactions?

The approach described above helps you to discover your economic model components, but it doesn’t describe how you put resources against activities to stimulate your market and produce results.  You need to flip the thinking in order to create the causal linkage in your economic model.  The key is to think through the aspects of your value delivery and then to consider what resources and actions that you actually do to create ongoing growth and how your market reacts to your actions.

This is a really important point, as most spreadsheet models look more like “this is what we expect our results will be” rather than “this is what we are going to do with our resources and this is what we expect the market reactions of those actions to be.”  If you don’t have that causal linkage in your model, you don’t have a good model.

The way that a causal economic model looks in a spreadsheet for a company that sells direct to their buyers is something like this:

  1. You put sales and marketing resources in place to generate activities that stimulate your market to produce customers.  It costs you money to acquire and ramp up these resources from no productivity to full productivity.  It also costs you money to experiment with new approaches (such as new marketing programs or channels or testing out a new sales channel).
  2. The Sales and Marketing activities plus your market referral traffic (based on cumulative effects of awareness, perception, and customer results) drive new customer sales.
  3. The New Customers are onboarded (delivery, configuration, training, ect.) and you have ongoing servicing costs (customer service, account management) and ongoing revenue streams (hopefully growing over time to great more gross profit).
  4. You have ongoing  costs associated with maintaining the value that you are delivering to your customers that are shared across customers.
  5. You are making some major investments in your company that should have a future effect on all of the relationships above.  The investments are generally in research and development, but they might also be in other areas (such as a major new sales channel).
  6. You also have general and administrative expenses to keep the lights on and manage the business and financial infrastructure of the company that mostly relate to the people you need serving in those roles.

If you can isolate the economic effects of each of these components, then you should be able to put together a solid economic model for your business.  If you have a business that is doing other things not included in the list above then the key is to figure out why they exist and try to incorporate the cost and the benefit into the economic model (you might also discover some resources that have low or no value/reasons to exist and eliminate them).

Most economic models take some time to really clarify and different business models have clearly different economic models associated with them.  Also, depending on your aspirations and strategies related to your business, you may determine that expressing your economic model a certain way will help you to emphasize those business goals (I will develop this idea in future posts).

Some additional thoughts for creating and tuning your economic model:

  • There are people that you can turn to for help that have the expertise of building economic models for your type of business model.  My suggestion here would be to try to find older experienced CFOs/CEOs, investors in your particular type of business model or industry or financial analysts that might be able to help.  Ultimately, the more experts you have giving you feedback, the more clearly “right” your economic model will be.
  • Project your economic results 3 or 4 years into the future in a spreadsheet using your economic model and some resourcing assumptions.  You aren’t doing it to predict the future, but rather to amplify the effects of your economic model so that you can really see how important small changes are to the future results of your business and will be very helpful in the next step.
  • One key way to test your economic model is to see how well it predicts your past results.  For example, if you start your economic model 1-2 years in the past, can you accurately predict your actual results?  If you can’t, then you have an opportunity to improve your spreadsheet model now or in the future.
  • The simpler you can describe your economic model, the better.  A simple economic model will allow you and your team to better understand the components of the model and what to do about them and it will also help you to make sure that you get the economic model to be accurate.  A simpler economic model will also help you to keep your business as simple as possible, which will in turn create better economic results.

If you lack the understanding of how to turn these ideas into a spreadsheet model or if you have a model that you can’t easily find with this approach, don’t sweat it.  I will describe this in much more detail in future posts.  For now, just assume that you can get there and keep reading.

Second, Hypothesize a Better Future

Once you have your basic economic model together, you are in a good position to start asking questions and gaining Insights.  For example:

  • What will your future look like if you stay on this model?
  • How much faster can we grow by adding more sales and marketing resources?
  • How fast can you grow without taking an investment?
  • How much different would you look in the future if you did take an investment to grow faster?
  • Which of the components of your model are most important to getting to a better future?  This is where you change each component and see what happens to the numbers in the future.  The components that change your results the most are drivers of your results, although sometimes you need to play around a bit with different model constructs before you actually can find the best and most clear drivers.
  • How does your model compare to benchmarks and “rules of thumb” that are available?  This is where the experts discussed earlier can be very helpful.  For example, OpenView Venture Partners does a lot of investing in Software and Internet companies and we have a lot of ratios and “rules of thumb” that we pass onto the companies that we speak to.  While no two companies are alike, comparing your performance to benchmarks and “rules of thumb” can generate a lot of good insights that could turn into useful ideas to explore.
  • What limits do you have that you need to make sure that you are not exceeding?  For example, you have limits to your market size and, more narrowly, limits to the size of the sales and marketing channels that you are using before you are going to need to seek out new channels (that will have different economic results).
  • Putting together a few of the answers from the list above, what might you be able to achieve in the future if you were able to manage to a model that you really like and think is possible?

You should also ask some of your experts for feedback on your hypothesized model, as they should be able to give you some real-world feedback on what looks possible and where you might be stretching your model.  Most companies have models that have projections that are much better than they every achieve, which could set wrong expectations or lead them in the wrong direction, so it is important to be as accurate as possible (yes, you are just guessing do some extent, but educated guesses are better).

Note that this is really hard work and takes a level of skill, time, and modeling sophistication that most people don’t have even if they have the interest.  The more you study, play with, and understand how your economic model works and how you can improve it, the more you will have an intuitive understanding of what you need to do with your business.  Most companies will not get there, but I still strongly recommend that you try and that you get some help from some experienced people.

The companies that do perform this step and have a clear understanding of what they are trying to achieve will get better.  Some much better.

Third, Identify Actionable Opportunities to Improve

At this point, you have a current economic model and a hypothesized economic model that you like a lot better.  You are not going to get better, however, unless you do some things differently.  The key in this step is to try to get a relatively comprehensive list of possible initiatives that you can execute that are intended to help you to improve your economic model.

Find your focal points

Start with trying to create some focal points based on what you have done so far.  For example, you may have found one or more of the following as key focal points:

  • If we can find clever way to create monetize our visitors/users to revenue, we can become a viable company
  • If we can reduce our cost of customer acquisition, we can grow faster without additional capital
  • If we can get our customers to pay us one year in advance, then we can grow faster without additional capital
  • If we can get our gross profit higher, we will be able to…
  • If we can get our G&A costs down to industry benchmarks, we would…

You get the idea.  The key isn’t to describe everything in your economic model, but rather the one or two most important components that you want to improve and start working on now.

Get your experts to help

Getting your focal points together will help you to determine who to ask for help.  You should involve as many thoughtful and experienced people as you can get to help you and it is also a good opportunity to pull in the experts as well as operating experts that are familiar with best practices around various strategies and operating activities.

You have a clear idea of the focal points you are trying to achieve so you can get a bit more focused with your experts by choosing the ones that relate to the areas that you want to improve the most.  For example, if you are trying to improve the effectiveness of your new customer acquisition, then bringing in experts associated with sales and marketing would be really helpful.  If you are trying to figure out how to create or change your pricing model, then getting some people experienced with these issues would be helpful.  If you are trying to better manage your “costs to serve” and the opportunity is in your professional services area, then bringing in a professional services expert to help you identify opportunities would be a good choice.

The goal of this step in the process is to get a fairly comprehensive set of ideas so that the list hopefully will contain the best ideas.  Sometimes discovering the best ideas requires a serious level of creativity and exploration.  If you stop with the first few ideas because you like them, then you are likely to not have done enough hard thinking to find the best ideas.

Fourth, Experiment with a Small Number of Your “Best” Ideas

Now, prioritize your list of ideas based on whatever is important to you.  From my perspective, the more confidence you have in the idea, the more impact the idea will have on your economic future, and the shorter the timeframe to reach success, the higher the priority you should place on the idea.  That said, you might have other criteria that are important to consider such as resource/skill availability to implement or other company-specific criteria.

The key here is to get some high priority ideas and then implement only the few that are at the top of your list.  The more ideas you try, the harder it will be to be successful with any one idea (you will dilute your efforts if you try too many), so pick a small number and let them rip as experiments.

It is important that you assign someone as responsible for your experiments and it is also important that you think of them as experiments until you figure out the results.  Assigning responsibility will help to make sure that they are executed well and thinking of them as experiments will help the person responsible think that success is related to implementation and figuring out whether it is a good idea rather than linking success to the success of the idea.  In other words, you want a successful experiment rather than a successful idea (you want a successful idea too, but the responsible person is successful if he/she performs a good experiment).

Next, Expand the Best, Kill the Rest

As you get the results of your experiments, you need to be tough.  Ideally, you would place them into one of two buckets:  kill or expand.  Experiments with poor results would be killed and the experiments with good results would be expanded into more complete programs.

That said, you will probably find a few ideas that are in a grey zone.  Too good to kill, but not good enough to expand.  With these, you could adjust the activities and see if you could get better results, but in general killing anything that does not have a great outcome will probably serve you well (it is very infrequent that grey zone ideas become great ideas through adjustments in my experience).

Finally, Rinse and Repeat

That is about it for the process.  The only thing left is going back to step one and iterating again.  Adjust your economic model based upon today’s reality, try  to figure out what you want to do better, try to figure out all the ideas and the best ideas, experiment, and then kill or expand.

If you have read the book, The Lean Start-up, are familiar with the Lean PDCA cycle, or are familiar with Agile Scrum, this management model should sound familiar.  It is simply a closed-loop management system that offers you an approach to optimize something, in this case your economic model.

Parting Thoughts

Incorporate your economic model goals into your management systems

Your approach to improving your economic model will not be a permanent approach unless it is baked into the management systems that you use to run your company.  Here are some ideas to do that:

  • Share your economic model and what you are trying to achieve with your entire team.  Having the entire team thinking about your economic goals, developing insights and ideas, and running small experiments will help you to get better faster!
  • State your longer term goals (perhaps 1 year goal and ultimate goal) for your most important economic model components and compare your actual results and trends against your actual goals on a monthly basis so that you can see the progress that you are making and better understand what is working, what isn’t working, and determine what your best focal points are at that time.  Make sure that the entire team has access to this report (hopefully part of a regular management reporting package!) so that they can participate!
  • Have a clear set of goals around the initiatives that you are going to execute against (your experiments, roll outs of successful experiments), assign people responsible for successfully executing the initiatives, and build review and adjustment steps into your management system to ensure that you are successful.

There are lots of ways to skin the cat

I have described an approach that will work to help you discover your optimal economic model.  The approach will work well if you put the time and effort into it and keep iterating on it.  That said, there are different ways to go about this work and if you have a different approach that you think will work better, give it a shot (and do let me know how it works out for you!)

Summary

Every company has an optimal economic model that is waiting to be discovered.  It is up to you to set up a management approach that will allow you to go down the path of discovery.  Later in the series, I will fill in a lot of the details relating to building economic models, identifying key drivers, and developing hypotheses, but they are not going to be effective if you don’t have a management system in place to actively manage your company down the path to your optimal economic model.

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My next post is on “Optimizing Now vs. Later, a Key Question”

If you want to learn more about economic models, keep reading.  I would also appreciate any comments or suggestions that you have, as I plan on turning this series into an e-book and I want to make sure that it is as clear and complete as possible.