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What are Venture Capitalists? (What are VCs, anyway? Are they right for me?)

What are VCs, anyway? Are they right for me?

Q: I have a business idea on running a cafe. I was thinking of going to a venture capitalist for funding. Problem is, I don`t know how they work. Can you shed some light on some of their practices?

A: VCs are money managers who make high-risk, high-return investments. They raise a fund, usually $10 million to hundreds of millions, from private and institutional investors. They then invest those funds in startup and pre-public companies (their “portfolio companies“), hoping for a substantial return. The VCs are paid a percentage of the fund’s value as a management fee. They also have a “carried interest”—they get a percentage of any profits above a certain point.

VCs get their money back (“harvest” their investment) when a portfolio company sells shares to the public in an initial public offering (IPO) or when it is acquired by another company. Despite all the late-90s publicity around IPOs, there really aren’t very many of them–maybe a couple hundred in a good year, in contrast to several thousand companies invested in by VCs.

VCs want opportunities that have a huge market, tremendous growth potential, a competitive advantage in the marketplace, and experienced management teams. Financially, they often evaluate investment opportunities expecting a minimum return of 40-60% per year on their investment. Since they are required to return money to their investors on a certain timetable, they also want the possibility of harvest in a certain number of years. And depending on the size of the fund, they may only invest in companies raising more than a minimum (e.g. $2-$5 million).

You raise money from VCs by putting together a business plan (see bizplanhints.htm) and arranging for that plan to be given to a VC with a referral from someone they know. Unsolicited plans almost never get funded. Your plan must lay out the market for the business, how the business will operate, who the management team is, etc. See my Entrepreneur.com column “Formatting Your Plan” for a typical plan outline. I also recommend Palo Alto Software’s “Business Plan Pro” (www.paloalto.com) as a good source for guidance in writing a plan.

To return to your situation…a cafe does not meet most venture capital requirements. Most cafes aren’t a new idea, don’t have the growth potential to return 40-60% to their investors, have no obvious harvest strategy [a chain of cafes can go public-a single cafe can’t], and don’t have clear competitive advantages strong enough to outweigh the risks. A cafe furthermore probably takes a few hundred thousand dollars to start, rather than the millions most VCs want to invest.

For smaller businesses, private investors or bank loans are your best bet. Many banks offer small business loans to people starting businesses that aren’t appropriate for high-growth investors. If you’re in the US, check out the Small Business Administration at http://www.sba.gov. They can help you find funding opportunities more appropriate to a cafe.

Best of luck!

Romancing the Dragon: Know What Accepting Investor Money Means

Right around the turn of the millennium, a startup named ArsDigita was born, flourished, and died a horrible death. The entrepreneurs blamed the venture capitalists and circulated their Tale of Woe far and wide.(1) I’m less than sympathetic. If the entrepreneurs had done their homework before eagerly accepting gobs of money, they might have understood the risks of accepting that money.

Having heard a bit from both sides of the ArsDigita story, there seem to be several lessons lurking here for entrepreneurs:

Understand what you’re getting into when you bring in outside money. Read the documents. Choose VCs who know how to run a business. Know how VCs are motivated, and understand that the very nature of VC deals gives the VCs a far better deal than you’re getting.

Read everything you sign. Twice. With lawyers. One ArsDigita founder mentions that the VCs invoked a clause out of the "phonebook" of financing documents. His naivety is touching…Didn’t he notice the quiet guy sitting by VCs? That was their lawyer. It should have tipped him off. They had a lawyer review the thousand-page document. He should have had his own lawyer go over it with a fine-tooth comb.

When you accept money from investors, you’re making a commitment. But you’re not committing to a vision. You’re not committing to a technology. You’re not committing to a dream. You’re committing to providing a certain return on that money to your investors in a certain timeframe. It’s an economic arrangement, and if they disagree with how you’re going about that, they almost certainly structured the deal so they can pull rank.

There’s no reason to believe that any given VC knows anything about running a business, or even choosing managers to run businesses. Some do, but a lot don’t. Many have never held an operational job, and even those who have didn’t necessarily learn from it. And even those who learned didn’t necessarily learn lessons that apply to your business in the current business environment. (Keep in mind that their rule of thumb is 2 home-runs, 2 failures, and a bunch of in-betweens out of a portfolio of 12. That’s called a "normal distribution," ladies and gentlemen, and may mean that most VCs aren’t doing much better than random.)

Furthermore, no matter what a VC thinks about their own motivation, as long as they are investing other people’s money, legally, their first priority must be making money. Their funds have a time horizon, and they own a portfolio of companies. That means when push comes to shove, harvesting your company is more important than your company’s mission or sustainability(2). And if another of their portfolio companies looks more promising than yours (say a 10x return in 2 year versus your 5x return in 7 years), that company will get more time, attention, and subsequent reinvestment. It would be bad business from the perspective of the VCs to spend their resources any other way.

And remember: you have to hit certain targets over several years in order to “earn” your equity in your company. They get all their equity simply by engaging in a one-time financial transaction. Unlike you, they are under no onus to do anything once they’ve put that money in. And if another portfolio company suddenly gives them the needed return on their fund, unlike you, there’s no vesting schedule or performance-based incentives to keep them interested or motivated. I’ve coached a CEO dealing with an outside VC that wanted out of the deal simply to simplify their own portfolio management. The VC was pressing to liquidate the company so they could get cash back out of the investment.

Remember: about 85% of a V’s investments aren’t home runs, and it may be their own fault. We rarely hear much about any except the home runs (“I started and grew a mediocre company” doesn’t make the cover of Fast Company).

That said, the right VC can bring a lot to the table when paired with the right management team. A VC can bring legitimacy, the ability to attract top management, and the connections to bring a company to the next stage of growth. But be very careful about what you’re getting into before you sign on the dotted line.

(1) I will not reprint the stories here. There has been a lot of litigation around the case, and I want to keep my distance. It’s juicy, though. Search for “ArsDigita lawsuit” on the web and you may find something on your own. back

(2) I made the mistake once of thinking that the finance community cared about sustainability. Maybe Warren Buffett and a handful of value investors do. But my experience is that this attitude is the exception rather than the rule. Learning that lesson cost me the chance to make $6.5 million … please learn from my experience! back

What is Viral Marketing? (What the buzzwords mean, and why not to use them)

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What the buzzwords mean, and why not to use them

“We will leverage our viral marketing efforts, resulting in widespread adoption of our revolutionary ‘no-revenue’ product, as customers recommend us to their friends.” — Any of a million forgettable business plans

Blech. Let‘s get real. It is mid-2000. Tech stocks are tanking, and VCs have boldly declared startups should have a revenue model. In this brave new world, the old “new rules” don’t apply, and the new “old rules” say business plans need more than New Economy Buzzword Hype.

Nonetheless, every plan I read will blow the world away with “viral marketing.” They almost always use the phrase incorrectly, Let’s explore the correct use of Viral Marketing.

The best plan: don‘t use buzzwords like “viral marketing.” Buzzwords rarely impress your readers. If you can’t say it in plain English (or your native language), then it‘s probably fluff and doesn’t belong in a serious document.

If you must use “viral marketing,” use it correctly. Viral marketing campaigns piggy back on your product, exposing non-customers to your company automatically when your existing customers use the product.

Hotmail spawned the viral marketing revolution. Hotmail is web-based e-mail that appends “Try hotmail!” to every outgoing message. Without any user action, every e-mail advertises the service to the message recipient, who (at that time) probably didn’t know about Hotmail.

Hotmail was weak viral marketing, since the recipient could ignore the ad without trying the service for themselves. Weak viral marketing requires voluntary action. MCI’s successful “Friends and Family” plan gave discounts for calling people in your plan circle if they were also on the plan. This made customers persuade friends to join the plan, and friends could refuse without trying it. The need for both customer and recipient action made this weak..

Strong viral marketing requires the non-customer to try the service. To receive money e-mailed with the “Paypal” payment service, a recipient must register with the service. Since registration means receiving money, Paypal recipients are highly motivated to join. Evite online invitations also require recipients to use the service to confirm an event invitation. Other strong viral applications include Yahoo!’s shared calendar service and their briefcase service.

Pressuring customers isn’t viral marketing. If you’re selling manufacturers a production planning system, and the manufacturers pressure their distributors to switch to the same system for convenience, that’s simple peer pressure. It may be effective, but it isn’t viral marketing, since using the system normally doesn’t automatically expose new prospects to the system.

Word of mouth is neither viral nor marketing. Since it depends on the customer acting voluntarily, it isn’t viral. Since it’s what the customer does, it’s not marketing (marketing is what your company does; not what your customers do).

In short, Viral marketing works in transaction oriented businesses where a customer transacts with a non-customer. The opportunity comes in controlling that interaction so the non-customer must be told about your product (weak viral) or actually made to try the product (strong viral) without action by the current customer.

Returning Money to Investors: How to Calculate their actual return

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You’re giving them money, but how do you calculate their actual return?

Your investors give you money. You give your investors money. In the end, they want a good return on the money they’ve given you. How do you calculate the return you’re providing? The number you’re after is the “internal rate of return” (IRR) of the cash flowing between you and them. Most spreadsheets have an IRR function you can use for this calculation.

Step 1: Identify the cash flows

First, lay out the cash flows as a series of numbers. Use negative numbers for cash you receive from the investors. Use positive numbers for cash the investors receive. Each number should represent the same time period.

For example, if investors give you $1,000 at the start of January, and you give them $50 at the start of February, April, and June, and also return the $1,000 principal in June, the cash flows look like this:

 
A
B
C
D
E
F

1
Jan
Feb
Mar
Apr
May
Jun

2
-1000
50
0
50
0
1050

Step 2: Use the IRR function to calculate the rate of return.

If you’ve typed the above into a spreadsheet, the formula to calculate the rate of return is:

IRR(A2:F2) which equals 3%

Example #1: A bank loan

A bank loans you $10,000. They expect $500/month payments for 6 months. They want principal repaid at the same time as the last payment.

 
A
B
C
D
E
F
G
1
Jan
Feb
Mar
Apr
May
 Jun
Jul
2

-10,000
500
500
500
500
 500
10,500

IRR (A2:G2) = 5%

Example #2: Equity investment

Investors put in $50,000 in preferred stock. They expect a $1,000 dividend each year for four years. On the fifth anniversary of their investment, they expect the company to be acquired, with their stake worth $100,000.

 

A

B

C

D

E

F

1
Now
Y1
Y2
Y3
Y4
Y5

2
-50,000
1,000
1,000
1,000
1,000
100,000

IRR (A2:F2) = 16%

What cash do I need to provide them to produce the return they demand?

Often you know how much you want investors to invest, and they are demanding a certain rate of return. What cash flows do you need to provide to give them that rate of return?

If they provide $100,000 and demand a 40% rate of return per year, that means you’ll have to pay them $40,000 each year. If you agree that they get their money in a lump sum when the company goes public, then the 40% compounds. The calculation is easy—the total due each year is the previous year’s total plus the interest (40%):

Year

What you owe them
Now
 $100,000
1
 $140,000 (100,000 + 40%*100,000)
2
 $196,000 (140,000 + 40%*140,000)
3
 $274,400 (196,000 + 40%*196,000)
4
 $384,160 (274,400 + 40%*274,400)
5
 $537,824 (384,160 + 40%*384,160)

If you estimate the company will be worth $5,000,000 at the end of the fifth year, then the investors will need to own 10.8% of the company ($537,824 / $5,000,000) in order for them to get their 40% return.

EBITDA: The Phantom Measurement. (What's EBITDA all about, anyway?)

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At 04:55 PM 7/3/00 +0200, a visitor asked:
Are you familiar with the term EBITDA and do you know:
a). Why it is used as an indicator for new-economy businesses in general?
b). How Depreciations of <Assets directly related to earnings> are handled?

EBITDA stands for Earnings Before Taxes, Interest, Depreciation, and Amortization. It has become wildly popular with the New Economy set. Is it useful? Well… there are many useful financial measurements that are very similar to EBITDA.

EBIAT, earnings before interest, after taxes, is meaningful: it measures raw earning power, independent of financing sources. It measures earnings available to flow to all financial sources.

EBT is a measure of earning power, given current capital structure, but not taking tax management into account. It measures earnings available to flow to the equity holders. When calculating return on equity, use EBT as the earnings number. The return to equity holders is the earnings after netting out interest.

But what of EBITDA? I side with Warren Buffett in considering EBITDA to be a meaningless financial indicator that seriously distorts and misrepresents a business’s earnings. EBITDA has become popular because people want to value businesses which have essentially unviable business models. It’s often been used in biotech, as well, where companies are valued long before they’re shown to be viable enterprises.

The theory is that depreciation is a non-cash expense, and thus should be backed out of earnings before measuring a company’s earning power. However that ignores the fact that cash actually must be spent on assets in order to run the business. Backing out depreciation without adding in cash expenses is akin to claiming that the business’s capital expenditures aren’t relevant in measuring its earning potential. In fact, the very businesses which use EBITDA are typically the ones in which the expenditures are very relevant in measuring the company’s earning potential!

Which would you rather invest in:

  1. a business which requires $100mm in capital expenditures [which presumably you have to supply!] to produce $100,000 in earnings (but backs out depreciation and presents their EBITDA number of $10,000,000 to you)?
  2. a business which requires $10mm in capital expenditures to produce $100,000 in earnings, but leaves the depreciation in and reports an EBIT of $100,000?

The second business will ultimately give you a far better return on your money.

Only where the depreciation or amortization truly represents a non-cash expense does it makes sense to back it out of the equation. When a company is acquired for more than its asset value, the different between the purchase price and asset value is recorded as “good will.” The good will is then amortized over several years. It does make sense to back out this good will, as it doesn’t represent a use of the business’s cash.

Why is EBITDA used in so many new-economy businesses? Many new-economy businesses spend much of their money on hardware and software infrastructure that’s capitalized as an asset on their balance sheet. Using EBITDA lets entrepreneurs and their bankers produce a positive number with the big up-front expenses backed out of the earnings calculation. It’s certainly not fraud, simply creative misrepresentation aimed at investors who in many cases don’t think particularly deeply about the numbers reported by a business.

The practice is sometimes defended by claiming that a one-time large development expense shouldn’t be used to judge the ongoing attractiveness of a business. But many new-economy businesses have not demonstrated that development is a one-time expense. In fact, technology changes so fast that it is fairly certain that a whole new round of hardware and software purchases will be happening every few years.

All this said, if you‘re raising money or going public, EBITDA subtleties may not matter. If investors are willing to give you an EBITDA-based valuation, that’s their decision. But when using your numbers to actually manage the business, remember that capital expenditures are a genuine cost. Removing them from the equation is wishful thinking, nothing more.

Division of Equity: How equity gets divided initially and at harvest

How equity gets divided initially and at harvest

One of the most common questions I get is about how equity should be distributed. I’ll warn you in advance: there are no hard and fast rules. Equity is negotiated on a case-by-case basis, which makes it hard to give any generalizations. I’ll try to give some thoughts on what to consider when you give out equity.

Dividing equity among founders

Founders receive equity for what they bring to the table. How much of the company they own as a result of their contribution is purely up to the group to decide. There are several factors which need to be considered, however.

Timing, size and duration of contribution. The earlier, bigger, or longer the contribution to the company, the more equity a founder should receive.

Power.Equity conveys voting power and control over the business. Generally, founders who intend to stay with the business long-term should retain the most control. I have heard it recommended that one individual own at least a 51% of the company, to provide consistent decision making when resolution is needed. Equal partners, while great in theory, can destroy a company when the partners don’t agree and have no way to resolve fundamental disagreements.

Money. Early money is a contribution for equity. Money has the side-effect of valuing the company. If you give 10% of the company for someone contributing $50,000, it implies a company value of $500,000. If you try to raise money immediately thereafter, that valuation could hurt your negotiating ability. But if substantial infrastructure has been built in the meantime, if customers have been acquired, or if more of a team has been built, then a higher angel/VC valuation is justified.

Kind of contribution. A founder may contribute in many ways. Some bring patents or product ideas. Some bring business expertise and ongoing work to build the business. Some bring capital. Some bring connections. Some may bring big names or reputations which convey credibility with VCs and/or clients. One big name that provides instant credibility may, in fact, be worth more to the company than a founder who actually puts in the work to build the business. Make sure to understand what each founder’s contribution is, and value it appropriately.

We have 5 founders, what do we do?

Negotiate, big-time. Too many founders can be a big problem. As the company reaches for outside funding, you make many decisions about equity, contribution, and dilution. The more equity-holders, the more negotiation has to enter into each of these decision.

Having several founders makes it hard to keep everyone adequately compensated. By the time of harvest (IPO or acquisition), the founding group can expect to own about 20-30% of the company. With one founder, that can mean riches. With several founders, that may mean splitting the pie into so many pieces that no one is happy with the value of their piece.

In short, fewer major equity holders are better. If you’ve already got several, make sure that you tie each founder’s vesting to the contribution you’re expecting from them.

How much will investors expect to own?

The basic formula is simple: if you need to raise $5 million, and an investor believes the company is worth $15 million, you will have to give them 33% of the company for their money.

Different investors value companies in different ways. Some look at the quality of the idea, assets, market size, and management team. Some rely on financial projections. Some simply look for “big ideas” and determine their percentage ownership purely through negotiation.

I asked a couple VCs, some entrepreneurs who recently received funding, and an angel investor how much of a company is typically given up in the first round. While one VC has seen investments as low as 5%, the majority thought that first round investors will usually take from 25-45% of the equity.

One entrepreneur remarked,

The better thing to ask is: how much should management and founders try to hold onto before the IPO. Answer: as much as possible, but no less than 25%.

The entrepreneur has an important point. If it comes down to the money (as it often seems to, these days), what matters in percentage ownership at harvest multiplied by the valuation at harvest. Owning 1% of a company with a billion dollar valuation is still more interesting than owning 10% of a company with a fifty million dollar valuation.

What equity should part-time contributors expect?

Not very much. The reality of the situation is that startups usually require 150% commitment by everyone involved. Venture capitalists insist equity be given in return for ongoing commitment. Even founders who stay with the company have a multi-year vesting schedule. Many VCs will not allow equity to be given to part-time employees or contractors.

There is a one-time contribution for stock that is routinely made: giving capital itself. A cash investment for stock lets the investor own the stock free and clear, with no further contribution required. Having part-time contributors purchase stock outright may be the best way to include them in the deal.

How can we increase the company’s valuation?

From an interview with Ron Conway in Bankrolled by an Angel, part 3,by Lawrence Aragon, Red Herring 12/22/99.

Angel investor Ron Conway says:

To get a $5 million valuation, you need a great market, a great idea, a crisp business summary, a really good elevator pitch, a compelling product prototype of your software or solution, and two or three members of your management team in place. For a $2 million valuation, none of the software for the solution is written yet. It’s just a CEO without a proven track record and a market to attack.

Q. Given the number of questions, many entrepreneurs seem to focus too much on valuation. Generally, what do you advise?

A. If you’re building a company like Yahoo (NASDAQ: YHOO), Ask Jeeves (NASDAQ: ASKJ), or eBay (NASDAQ: EBAY), you shouldn’t worry about valuation on the front end. If you’re worried, then you probably don’t have the confidence to build a large, significant company. A CEO who’s completely stuck on valuation is a warning sign. That’s a CEO who’s confused about his role. The bottom line: if the idea is great, you’ll end up with a multibillion dollar market cap and everyone will make more money than they can ever spend.

Rather than focusing on valuation, focus on execution.

Q. A guy wrote that he’s worried about not having a Harvard MBA. How would you rate a college dropout with a brilliant idea, an excellent prototype, but no team? Would you fund him?

A. Yes, but that would definitely be in the $2 million pre-money category. If the prototype is excellent, he might get a valuation of $3 million to $4 million.

What does ownership look like after the first round?

According to Ann Bilyew of Advent International, a typical first round is:

  • Founders-20-30%
  • Angel investors-20-30%
  • Option pool-20%
  • Venture capitalists-30-40%

What does ownership look like at IPO?

From an article by Anant Raut published on www.techound.com.I do not have the exact URL.

A May 1999 study by the William M. Mercer, Inc. consulting group [showed] the Internet companies reserved 15.7 percent of their common shares for compensation, compared with traditional industry’s 10.7 percent; after their IPO’s, however, traditional industry had 5.3 percent of their reserved shares still available for option grants in the future, while the Internet 32 had only 3.7 percent to offer.

The same study found the following distribution of median equity stakes among members of the executive team (following an IPO):

  • Founding chairman-20.4%
  • Founder-9.6%
  • Non-founding CEO-4%
  • Other executives-0.79% (0.96% before IPO dilution)

It’s hard to quantify percentages that non-executives should expect. Variables include the age of the company, the degree of financing, and the strike price. Kersey Dastur, an independent consultant based in McLean, Virginia, has assisted a number of high tech companies in establishing stock option plans and explains, "If I am a company with no financial backing yet, I will be likely to set aside 10 percent of my company for non-executive employees because they are taking a risk working for me. I may, however, set a high strike price to ensure that the value of the company is not diluted." It is not uncommon for companies with financial backing to offer no more than 2 percent to non-executive employees, because someone else has already assumed the financial risk. Remember, these allocations are spread out across all employees so, unless you have something truly unique to offer, don’t expect a large piece of the pie.

Fund Raising Destroys Value! Do it wisely and carefully.

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“I just hit a major home run!” exclaimed the entrepreneur.
“Did you ship product? Did you make your first sale? Did you get a large contract?” asked his friend.
“No, no. Something much better: today we closed on a $20 million round of financing.”

Congratulate yourself for raising money, but don’t think it was time well-spent. You need money to stay in business, but raising it destroys value: money changes hands, with a big chunk siphoning off to lawyers, filing fees, travel expenses, and phone calls. You’re left with less than when you started, and that’s before buying your first paper clip! Money may make the business viable, but it doesn’t make it valuable.

Nor does fund-raising use your time wisely. Your investors are betting on what you uniquely bring to the table. Your competitors have all raised money. Most entrepreneurs out there have raised money. fund-raising ability doesn’t distinguish you one whit. Spend your time bringing your vision to life by building your organization.

Actually, your investors would love it if you never raised money again! Every new share of stock issued dilutes current shareholders. With every dollar you raise, your investors wince. In the late 1990s, many companies raised so much capital that they’ll need to be in the Fortune 10 to give investors a decent return. Some may make it. Most won’t.

And beware! Successful fund-raising can snare a CEO. It let’s them avoid their real challenge—building a stellar business—in favor of the “success” of a $20 million closing. You see, fund-raising is easy: the customers are VCs, angel investors, and banks. Their buying criteria is simple and public; most of them will even outline it on their web site. And the product, your business plan and sales pitch, can be created by one or two people.

Running a company is much more challenging. You don’t necessarily know your customers. In fact, you may find they don’t even exist! If you do have customers, you may not know their buying criteria. In fact, they may not know their buying criteria! And delivering your product and services means coordinating dozens of people, each with different priorities and demands on their time. Yet knowing the customer and delivering the product will make or break you. fund-raising is a stressful—but much safer—place for an entrepreneur to spend their time.

So yeah, you have to do it. You have to raise money. Businesses need money to operate. If you aren’t yet profitable, that means pitching investors, haggling over terms, and repricing your round at the 13th hour. Just remember that getting the money merely opens the starting gate. Then it’s time to add value, and you add far more value as a leader and manager than you do as a fund-raiser.

So raise your money, then run your business. Run it well and profitably and you’ll repay your investors a dozen times over.

Thoughts of a Business Plan Judge: Who Gets $30,000?

A quick digression on who gets $30,000

May 1, 2000

The Harvard Business School and Brown University Undergrad business plan competitions are in the final stages. I read and listened to several plans, presentations, and write-ups. It sobers me to realize that $80,000 in prizes have been influenced by my thinking.

Here is some of that thinking, made public, in case it helps you with a presentation you’re making. When I say “the best” below, I mean the best of the plans I saw. These observations may not be representative of the whole contest.

The best-written plan was from a Brown undergrad team.

The best demo was from a Harvard Business School team.

The best industry research was done by an HBS team.

The best pre-launch, idea-specific research was done by a Brown undergrad team.

The worst plan was from an HBS team.

The team which had their business up and running and was proving it profitable did not win their semifinal round. Maybe because their business was not sexy and high tech?

The judging criteria contained implicit value judgments about “good” businesses. High growth, huge market cap, original ideas were given a premium. In fact, my personal favorite plan in each competition was for a limited-growth opportunity. In the Brown competition, it was a limited opportunity with a me-too product!

(It makes sense that the judging is biased towards huge-market companies. It attracts more involvement in future contests if “our winners go on to found billion-dollar companies.” VCs and entrepreneurs are less likely to participate in a contest whose winner had a $100,000 idea, even if the plan was perfect and the idea was executed flawlessly.)

The judging criteria sometimes judged qualities of the idea, not whether the plan handled those qualities. For example, a criterion was “originality of the idea.” Originality is fun, but it isn’t necessarily a good criterion for a business plan competition. How about: “do the entrepreneurs recognize how original their idea is[n’t] and have they taken steps to get the most out of the opportunity, given their degree of originality?” Sometimes originality is detrimental! Me-too products have produced spectacular market successes (can you say, "Windows?" "Blockbuster?" "General Motors?").

My actual rankings reflected my feelings about the team, as expressed through their writing. The well-thought out, clear, concise plan left me with the thought that even if the idea didn’t work as expected, the entrepreneurs would find a way to make things work. Other plans had good product ideas, but wildly unrealistic marketing-speak plans left me afraid that their business judgment would be more influenced by Business 2.0 buzzwords than by their ability to respond to the real world.

In many cases, my lack of specific industry expertise left me judging based on the research process the team seemed to use, rather than on the results of that research.

What is a Business Model? The anatomy of how a business makes money

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Note: This article was written several years ago, when PayPal.com was a humble startup, Eudora Pro was still a leading desktop e-mail client, and cameras still used film.

Q: Many people say that they want to see your business model. What exactly do they mean by that? Do they want to know your target market and strategy, or do they need financial information as well?

A: A business model is quite simple: it is a brief statement of how an idea actually becomes a business that makes money. It tells who pays, how much, and how often. The same product or service may be brought to market with several business models.

Here are several sample real-world scenes, showing how similar products can have very different business models.

Consumer Reports vs. TIME Magazine

Consumer Reports makes money solely from grants and subscribers . It has a subscription-based business model.

TIME makes money both from subscribers and from advertisers. It has more of an advertising-based business model.

The difference in business models tells you a lot about the two businesses. Consumer Reports is going to concentrate on selecting content which will be of high enough value that people are willing to pay a subscription fee. Since it doesn’t depend on ads for income, no one but the editorial staff influences the articles.

TIME Magazine, on the other hand, also must take advertisers into account. TIME needs content for its readers, but it is largely concerned with growing a demographic for the advertising it sells. Since TIME makes most of its money from ads, an advertiser’s threat to pull advertising may put pressure on the magazine to pull or rewrite a story that the advertiser finds objectionable.

Movie Theaters

During the first several weeks of a movie’s run, almost everything in a theater’s box office goes to the film’s distributors and producers. The theater makes its money from the concession stand! The business model: sell tickets at cost, and make profit on refreshments.

This model implies that staffing the refreshment stand should be high priority. When the theater is crowded, bring in extra staff to keep refreshments flowing. Since that’s where the money is made, losing sales from too-long lines is losing the only profitable sales the theater makes.

A theater near my house rents second-run movies that have been out long enough for the theater to be able to keep most of the ticket revenue. They make much more of their money on ticket sales, and put far less emphasis on the refreshment stand.

Razors vs. Shavers

Gillette is happy to sell you their Mach III razor handle at cost, or even below cost. Because they then sell you the profitable razor cartridge refills. Again and again and again… Their business model is virtually giving away the handle and making their money from a stream of razor blade sales.

Electric shavers have a different model. They cost a lot more than the Gillette handle. They cost enough that the manufacturer makes all their money up front, rather than from the stream of blade refill sales (electric shaver blades do wear out, but it takes a much longer time).

Digital vs. Film Cameras

Traditional film cameras cost a bunch of money. And then, you buy roll after roll of film to take pictures. Then you spend even more getting the pictures developed. If you’re using a Kodak camera, Kodak film, and Kodak developing, then Kodak will be very happy. Their business model makes them money from camera sales, film sales, and processing fees.

Digital cameras eliminate film sales and processing fees. Kodak needs to find a new business model before the cameras catch on more widely. And they are working on it. They are establishing digital printing centers, where you can have your digital camera pictures printed on genuine Kodak paper. The business model that was based on film sales and processing is becoming a model based primarily on photograph printing.

paypal.com … who knows?

Sometimes a business’s business model is not obvious. The web site www.paypal.com allows you to send money to a friend via e-mail. The money is either charged to your credit card or taken in cash from your cash account at paypal.com The intriguing twist is that paypal takes no commission on the transfer.

How do they make money? What’s their business model?

I don’t know, yet. From interest, perhaps? If enough users deposit money with paypal before paying it out, they collect interest on that money until the recipient finishes the transfer. If this is their business model, then they should concentrate on increasing float: getting more interest on their money, encouraging people to fund their paypal accounts long before they will send money to friends, and encouraging people to leave the money sent to them in their account just a bit longer.

Other models they could use:

Charge a fixed transaction fee on each transaction. Resulting business goals: encourage lots of small transactions.
Charge a transaction fee that is a percentage of the transfer. Resulting business goals: encourage large transfers, since they make as much as many smaller transactions, but without the overhead of doing many transactions.
Or, since electronic funds transfers are cheaper for banks than processing check, paypal might have banks give them a percentage of the savings from doing transfers by EFT rather than by check.

Brick-and-Mortar Brokers vs. E*Trade

Traditional brokers make money by charging a commission on purchases and sales. The commission is a percentage of the transfer amount, so brokers may be happy with clients who trade infrequently, as long as they buy and sell enough at a time to generate a nice commission.

E*Trade charges a low, fixed amount per trade. Their business model is to attract high-trade-volume customers. The customers are more likely to trade often when commissions are fixed and low, and E*Trade is pushing to make up in volume what the traditional brokers make by charging a percentage.

Adware: take your choice

First pioneered in the late 1990s by Qualcomm’s e-mail program Eudora Pro, some software lets the customer choose the business model! A customer can install and use the software for free, and ads will be shown as they use the program. Or, they can pay full price and install the program without the ads.

For users who elect ads, the business model is that Qualcomm provides software for free to build an audience, and then gets income from advertising. They must spend their time selling ads and distributing their software widely to create the audience.

For users who pay for the program, the business model is the same as for any shrink-wrapped software: Qualcomm gets paid up front for a product which the customer can use forever. Qualcomm then spends their time coming up with later versions which they hope will entice customers to upgrade, sending more money into Qualcomm’s coffers.

Retainer vs. Hourly Consulting

Some freelancers charge by the hour for services delivered. Others charge a flat fee retainer which entitles a client to a certain amount of the freelancer’s time. Once again, they deliver the same service, but the different business models will result in their negotiating businesses, administering their business, and controlling costs in a very different way.

Lessons from Wentworth by the Sea

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The power of dreams, community, customer service, and customer retention

Click here to download this article in PDF format.

Come join me at a remarkable hotel. The Wentworth by the Sea was a grand New Hampshire fixture through much of the 20th century. Home to the peace talks that ended the Russo-Japanese War, everyone who was anyone stayed there. Movie stars, politicians, the rich and famous—all could be found summering at the Wentworth. Yet the hotel gradually faded and closed its doors in the early 1980s. By the time I first saw it in 1997, all that was left was a rotted, weathered facade. You could see right through it. It was a protected historical landmark, but no one had the time or money to repair it. We sat in our car and dreamed of how wonderful it would be, fully restored.

Last year, while surfing the Web, I found a story that the Wentworth had been purchased. It was being renovated and would be opened under Marriott’s management in May, 2003. I started calling for reservations a year in advance, and arrived on opening day, May 16, 2003, for the hotel’s first weekend in operation.

The weekend was remarkable. Restored, the hotel was beautiful. But even better than the building and the grounds were the people.

The Wentworth’s service was hands-down the best I’d ever had. We were very challenging guests. We forgot clothes in our car. The valet ran out and got them for us. We ran out of gas, and the concierge arranged a refill from a nearby boat marina. We wanted a special dinner on opening night, opposite a hundred person catered function, and the chef treated us to the best meal of our lives. I had stayed in Marriott hotels before and while the service was good, it wasn’t like this. The staff was going far out of their way to provide a superb experience.

What went right

I had to know why, so I spoke to Kris Francis, Marriott’s on-site training manager. In all the hotels she had ever opened, Kris related, the Wentworth was by far the most exceptional.

The Wentworth was more than a hotel to people. It symbolized an era. It was a national landmark, and for years had been a site where locals would drive past and wish for its restoration. People had invested great emotional pride, longing, and energy into the building over the years.

When Marriott announced the restoration, six years before, the hotel’s draw was so great that Marriott employees requested a transfer years in advance to help bring the building back to life. People from as close as nearby Portsmouth and as far away as Key West asked for a spot at the Wentworth. The staff ended up drawing from people for whom the Wentworth is more than just another hotel; it is part of their personal dreams. They are serving far more than just the guests—they are making their own dreams come true.

Of course, Kris assured us, the guests were just as important. People married there decades before came back to enjoy the hotel’s resurrection. Their stories and reverence for the hotel just reinforced the staff’s dedication to making the hotel experience exceptional.

A devoted staff gives great service. Devoted customers make the staff feel great. The staff gives better service, and the customers have a great time. The interaction becomes self-reinforcing. Once the initial delight shifts to business as usual, the Wentworth will have to continue to be run as an excellent business. But with this kind of energy behind the launch, I have few doubts that the Wentworth can be hugely successful again. Heck, I’m looking for an excuse to hold events there!

This week’s action challenge: unite people with a dream

What does your community long for, just beneath the surface? Find out what it would take to offer the community the dream, and engage both the people who will make it happen and the ones who will enjoy it once it’s done. It may be as huge as re-opening a grand hotel, or something as simple as setting up an old fashioned soda fountain for an evening at the local drugstore, or even just restoring a sign by the corner store. Because sometimes it’s just as important to build community as it is to build business.