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A company’s business model tells us how and why it intends to make profits and create value for its owners. Here we look at some common types of company business models and how they affect companies’ business and financial risk as well as their financing needs.
Business Models
A business model offers some detail about how a company proposes to make money. A successful firm must provide a product or service, find customers, deliver the product or service, and make a profit. The business model explains how a firm either does or proposes to do this.
A business model is not the same as a financial plan, which has detailed projections for revenue and expenses, as well as plans for financing the business.
“How we will provide it, sell it, and make a profit” is clearly an oversimplification, but this is the essence of a business model. In practice, the answers to these questions have many facets. Here, we present a framework that incorporates some of the complexities involved.
A business model should :
1- Identify the firm’s potential customers, how they are acquired, the cost of customer acquisition, and how the company will monitor and maintain customer satisfaction. Potential customers can be defined in innumerable ways, ranging from every consumer within a geographic area, to dog owners, to only the company’s home-country military in the case of a weapon.
2- Describe the firm’s product or service, how it meets a need for its potential customers, and what differentiates its products from those of competitors (e.g., low price, premium quality, innovative features).
3- Explain how the firm will sell its product or service (e.g., online, physical location, direct mail, trade shows, sales representatives); whether they will sell direct to the buyers (direct sales) or use intermediaries such as wholesalers, retailers, agents, or franchisees; and how will they deliver their product or service. The answers to these questions comprise a firm’s channel strategy. A strategy that includes both digital and physical channels, such as internet sales with delivery at a physical location, is referred to as an omnichannel strategy.
Firms that sell to other businesses are said to be B2B (business to business) firms, while firms that sell to consumers are said to be B2C (business to consumer) firms.
4- Describe the key assets and suppliers of the firm. Key assets may be, for example, a patent, software, or skilled employees. Key suppliers may be a battery manufacturer for an electric vehicle company, a lithium miner for a battery maker, or a supplier of large excavation machinery for a lithium miner.
5- Explain its pricing strategy and why buyers will pay that price for their product, given the competitive landscape of the market.
Value-based pricing refers to setting prices based on the value received (or perceived) by the buyer.
Cost-based pricing refers to setting prices based on the costs of producing the firm’s good or service (plus a profit).
Price discrimination refers to setting different prices for different customers or identifiable groups of customers. Common examples are tiered pricing (based on volume of purchases).
dynamic pricing (depending on the time of day or day of the week), such as peak and off-peak pricing and low-priced airline tickets for very early or very late flights, and auction pricing (e.g., eBay).
Pricing models for multiple products include:
Bundling
Where multiple products are complementary (e.g., a furnished apartment), bundling the products may be a profitable strategy.
Razors and blades
A company may find it profitable to sell a piece of equipment for a relatively low price (low margins) and make profits by selling a consumable used with the equipment. Printers and ink cartridges and an e-reader and e-books are common examples.
Optional products
Options or add-ons priced with high margins are added to the product after the purchase decision has been made. An example is the many pricey options that may be offered after a customer has decided to purchase an automobile.
Other pricing models include:
Penetration pricing
A company offers a product at low margins or even at a loss for a period of time to grow market share and achieve greater scale of operations. Netflix followed this strategy to grow its subscriber base rapidly.
Freemium pricing
Offer a product with basic functionality at no cost, but sell/unlock other functionality for a fee. Video game makers have used this strategy to encourage wide usage and then profit on sales of greater functionality (e.g., weapons).
Hidden revenue
Online content may be “free” but generate revenue through ads. For example, internet search is free to the user with revenue coming from the sale of user data.
Models that offer alternatives to outright purchase include:
Subscription model
Microsoft’s model for software has changed from selling the software to a subscription (paying monthly for access) to their Office suite of software.
Fractional ownership
Time share companies sell condominium ownership by the week; use of private jets is sold for specific amounts of time.
Licensing
For a biotech company that has developed a new and effective drug, it may be most profitable to license the production of the drug to an established drug maker with a large sales force and established distribution channels, rather than developing those resources itself for the single drug.
Franchising
Similar to licensing, but a franchisee typically is permitted to sell in a specific area and pays a percentage of sales to the franchisor, which provides some level of product and marketing support.
A firm’s value proposition refers to how customers will value the characteristics of the product or service, given the competing products and their prices. How the firm executes its value proposition is referred to as its value chain. A firm’s value chain comprises the assets of the firm and how the organization of the firm will add value and exploit the firm’s competitive advantage. A value chain should not be confused with a firm’s supply chain, which includes every step in producing and delivering its products, even those that other firms perform.
In his 1985 book Competitive Advantage, Michael Porter presents five activities in which firms should strive to execute well:
1- Inbound logistics
2- Operations
4- Outbound logistics
5- Marketing
6- Sales and service
Other business models include:
Private label manufacturers
Companies produce products for others to market under their own brand name, for example, Costco’s Kirkland branded products.
Licensing agreements
A company brand is used by another company on its products for a fee, such as a lunch box branded with a Marvel character.
Value added resellers
Offer such things as installation, service, support, or customization for complex equipment.
E-commerce models for direct sales include:
Affiliate marketing
Another company is paid a commission for measurable marketing results such as page views, leads, or sales.
Marketplace businesses
Provide a platform for buyers and sellers but do not own the goods being sold. Ebay is a prime example of a marketplace business.
Aggregators
Provide a marketplace but sell products and services under its own brand name. Spotify is an example.
Network effects
refer to the increase in the value of a network as its user base grows. There are many examples of this including WhatsApp, eBay, and Facebook. Network effects support an initial strategy of penetration pricing.
Crowdsourcing
models benefit from user contributions: content in the case of Wikipedia, traffic conditions and events in the case of Waze, and product improvements or new applications in the case of open-source software.
Hybrid business
models incorporate both platform and traditional sales models.
Describe expected relations between a company’s external environment, business model, and financing needs ?
Providers of both debt and equity capital are concerned with firm risk and firm growth. Lenders like to see less uncertainty about earnings, cash flow, operating margins, and the like. Equity holders like earnings growth over time, but are also concerned with earnings volatility.
A firm’s overall risk will depend on its business model and other risk factors, both firm- specific and external to the firm. The firm’s overall risk, in turn, affects the cost and availability of both debt and equity capital. Here we briefly describe some significant external factors that can affect business risk.
1- Changes in economic conditions (e.g., economic growth, inflation and interest rates) typically affect all firms to some extent, increasing firm risk. Some industries and sectors have predictable demand for their products and are less affected by economic cycles. Firms with large investments in fixed assets and which face demand that is sensitive to economic cycles can have large cyclical changes in earnings and cash flow.
2- Changing demographics can affect the demand for some sectors’ and firms’ products, either positively or negatively. Consumer tastes change over time as well.
3- The winds of political, legal, and regulatory change affect us all; businesses are no exception. One firm-specific factor is the stage of firm development. A start-up firm that requires large amounts of capital to grow has different financial needs than a stable, mature firm. Another firm-specific factor is a firm’s vulnerability to competition; more vulnerable firms have more business risk.
A firm’s business model can have significant effects on its financing needs. Some businesses follow an asset-light model renting or leasing major assets, or having them owned by franchisees, to reduce capital requirements. Large companies lease hospitals, hotels, distribution warehouses, and data centers to reduce their capital needs. In the case of lean start-ups a firm “rents” its employees, outsourcing as much work as possible to reduce fixed employment costs. Firms with pay-in-advance models, such as insurance companies and online retailers, reduce their working capital needs and may use the advance payments to reduce their capital needs even more.
types of business and financial risks
Explain and classify types of business and financial risks for a company ?
Macro risk
refers to the risk (to operating profit) arising from economic, political, and legal risk factors, as well as other risks that affect all businesses within a country or region, such as demographic changes over time. The primary macro risk for many companies is the risk of an economic slowdown or recession. The level of economic activity or growth may affect some companies strongly and we refer to such companies or their industries as cyclical. Other companies, such as utilities and health care providers, are not affected strongly by economic cycles and we refer to them as non-cyclical or defensive. Multinational companies may face other macro risks such as political instability, political conflict, and changes in exchange rates.
Business risk
refers to the variability of operating income (EBIT) that arises from both firm specific risk factors and industry risk factors. Care must be taken when defining a firm’s industry. Narrower definitions are, in general, better for identifying factors that affect firm profitability, but the definitions must be wide enough that data on demand and competition are available and trends can be identified.
Industry risk factors include:
1- Revenue and earnings cyclicality.
2- Industry structure: Low concentration (many smaller firms) is associated with high competitive intensity.
3- Competitive intensity: Higher competitive intensity in the industry typically reduces profitability.
4- Competitive dynamics within the value chain: Profits are affected by actions of buyers, suppliers, and actual and potential competitors.
5- Long-term growth and demand expectations: An industry with increasing demand and high long-term growth prospects is more attractive to investors, but may also attract more competition.
6- Other industry risks are regulatory risks and other relevant external risks.
Firm specific risk factors include:
Competitive risks
such as the erosion of an existing competitive advantage over time or the introduction of innovative business models that disrupt the industry. Competitive advantage results from cost advantages (including scale of operations), product differentiation, and positive network effects from greater product usage. High costs incurred by a customer to change to a different supplier (switching costs) increase the competitive advantage of existing firms. Firms always have execution risk, as some managements can find a way to fail with even the best of business plans.
Product market risk
For firms early in their life cycles, expectations of growth in demand may decrease over time, consumer preferences may change, products may become obsolescent, and patents may expire. Firms with many products typically face less product risk.
Capital investment risk
refers to investing firm assets in opportunities that do not produce returns above the firm’s cost of capital. Many acquisitions (e.g., Time Warner) turn out to be quite ill-advised, while some (e.g., YouTube) turn out to be brilliant.
ESG risk
measures often focus on corporate governance risk, but the risk of running afoul of current expectations for environmentally and socially progressive company policies can damage a company’s reputation and bottom line (or not, e.g., Volkswagen).
Business risk
is increased by higher operating leverage that results from higher percentages of fixed costs, relative to variable costs, in a firm’s cost structure. The effect of sales variability on operating income is magnified by higher operating leverage.
Financial risk
refers to the increase in the variability of net income and cash flows that results from using debt in a firm’s capital structure, which increases financial leverage.Financial leverage magnifies the effects of business risk on profits. Fixed costs related to leases and underfunded pension obligations also increase financial risk. Higher levels of debt in a firm’s capital structure increase the risk of financial distress, default, or even insolvency.
