Sunday, February 08, 2009

Business Model and Financial Viability

A venture capitalist called Fred Wilson goes back to basic economics - When Talking About Business Models, Remember That Profits Equal Revenues Minus Costs. As Phil Wainewright comments "Has the world become so blind to the basics of commerce that it needs reminding of such a basic tenet? Apparently yes."

Fred is certainly not saying that all companies should try to survive on current revenues alone. Clearly there will be many companies that will continue to attract investment based on future projected revenue - that's exactly where the venture capitalist comes in. However, the viability of a start-up company is entirely dependent on the willingness of people to invest their time, energy and money against some future returns.

What Fred is saying is that these returns are ultimately based on profit rather than revenue. Start-up companies can no longer afford to employ large number of people, if that merely results in a slightly better product and slightly higher revenues. What matters to the venture capitalist are such ratios as operating leverage - how much projected revenue per employee.

Leverage rather than size. Bigger isn't necessarily better. In the recent past, many mergers and acquisitions have been justified in terms of financial engineering rather than genuine creation of value. Fred's point is that even organic growth is suspect if it doesn't make the organization more viable. Why on earth does Facebook (for example) need a thousand employees? What value are they actually going to produce?

A few years ago, we had people asking What is the Right Size of a Service? Now I think the industry is ready to ask the next question: What is the Right Size of a Service-Oriented Business? Many organizations oscillate unstably between uncontrolled growth and painful cost-cutting. It would be better to have a more stable approach to questions of size and viability, and the business model needs to help us with these questions: What is the ideal size of a given business, and how can this size be maintained?

Update: See Seth Godin on The Right Size

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