On Business Models
I will never forget the (so far) worse pitch I’ve ever witnessed. No deck was sent in advance, I got into the call as a favor to another VC who was super excited about this “metaverse” opportunity. 1 hour in, I still couldn’t understand how the founders planned to make money (and apparently neither did they).
The main problem: they focused so much on the tech that the business model was a mess (if there even was one).
The first question (and maybe the most important one) regarding business models and early-stage startups is, do they actually matter?
The answer depends on the definition of matter.
Do they matter as a predictive tool for the business? Not really.
Do they matter for the investor to make an informed decision? Yes.
How then can a business model improve investment decisions if they don’t actually have any predictive use? Well, first of all, a business plan in a pre-seed, seed, and sometimes even later-stage startup is most likely to change as the people involved in the startup learn about the actual market, study the data, iterate, and the idea evolves.
Adaptability and resilience of the team and the startup have actual risk reduction value, a business plan presented as immutable has the opposite effect.
The real value then is on evaluating the team. If I’m presented with a business plan that makes economic sense, demonstrates that the founders understand the revenue and expense drivers/sources, has a realistic sense of the addressable market and market share, and some sense of the required investment; that says a lot.
Some of the above traits are obvious, if you haven’t figured out how to actually make money or how long will it take to reach breakeven, the model probably makes no economic sense. If the plan is to take a 50% share of the TAM then it probably is unrealistic.
Some others need more work. It is generally a good idea to look at the growth rate on the pro forma financial projections to understand if the founders thought about revenue drivers or not.
If you’re a subscription-based SaaS startup, the revenue drivers are (oversimplification ahead): #subscribers*average revenue per user on a monthly basis (i.e., dividing by 12, 6, 4, etc.).
If the founders thought about both metrics separately, then most likely the revenue growth rate (the product of both drivers) will not have a consistent pattern year over year.
If there is a pattern in the revenue growth rate (5% yearly growth rate, or an increase by 3% each year, etc.), and the numbers are “conspicuous options” (multiples of 5, 2, whole numbers, etc.), then most likely whoever prepared the business model didn’t think about the revenue drivers separately.
Why? because it’s more probable that the human brain will go to conspicuous numbers and use some kind of pattern in growth than that the product of the revenue drivers will actually render those results.
Another good idea is to look at the 5th year. If the revenue is close to a multiple of 50 million, there is a high probability that the starting point was the last year, and numbers were just worked backward from there.
All that tells the investor how much time the founders actually took to think about the business, if they understand it, if they’re trying to deceive the VC, or if they really have no idea of what they’re doing.
In summary
It’s not the business model in itself that matters; that will probably change soon. It’s all about the characteristics of the business model, and what those can tell about the people who prepared such business model.