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Business Model Innovation 💸

A lot of startup founders believe that the best product wins. This is simply not true. Great product is a pre-requisite. But the greatest successes of the internet age have one think in common. Business Model Innovation.

Think about Amazon, Google, Ebay. The reasons for their explosive success was not purely product. Amazon didn't invent a new product. There was no 'product-market-fit' to validate. They simply tapped into the supply and demand of an existing retail market. Amazon's true innovation was it's business model.

Amazon was successful because they mastered a new distribution method, the internet. While mastering the supply side to drive down costs.

In his book 'Blitzscaling', Reid Hoffman (Co-founder of LinkedIn) writes that business model innovation is one of the core tenants of startup success.

If you want to grow a big business you need to optimize for the four growth levers, and mitigate the two growth limiters. Business model innovation usually takes place in one of the following areas:

Growth levers:

1. Market size

2. Distribution

3. Gross Margins

4. Network effects

Growth limiters:

1. Lack of product-market-fit

2. Lack of operational scalability

The Four Growth levers 📈

Market Size

The size of your market has a significant influence on success. If a startup does not have the potential to reach a $1bn valuation, venture capitalists tend to avoid investing.

That's not to say that small market sizes don't produce incredible businesses. They do. But they're not big enough to attract VC money. Bootstrapped business are amongst my favorite and create incredible wealth for founders, employees, and customers. Just take a read of the book 'Small Giants' for a host of inspiring companies that chose to stay small.

Startups that fail to show a path to a billion dollar valuation are unlikely to get funded. Take Mention for example. Their CEO, Matthieu Vaxelaire, wrote an incredibly transparent blog post outlining why they had to sell at $6M ARR because investors didn't believe there was a $bn dollar market.

The “listening market” (social media and web monitoring) wasn’t big enough for most of these VCs. Salesforce acquired Radian6 for $350m, and this was seen as the ceiling for companies in our market....This wasn’t a big enough opportunity for investors and our inbound model was seen unscalable...And while our growth rate was good (30% year over year at $6m ARR) — good enough to get me in the door with the top VCs in the world — it was hard to show how we could get to 100% year over year growth. If you can’t scale to that extent, it’s very hard to get the investment we had hoped for.

Companies that innovate on market size are either increasing the size of an existing market by making it accessible to a larger audience, like Uber, or creating a brand new market altogether, like virtual reality headsets.

If your market size is too small, how can you pivot your product to cater to a wider market?

Distribution

Innovating on distribution is often overlooked. This is why most of the content I write on Rocket GTM 🚀 is about distribution and how to acquire customers more effectively.

How often do you come across genuinely innovative ways to acquire customers?

Birchbox is a great example of distribution innovation. Instead of paying to acquire customers, they figured out a way to get customers to pay to be acquired. Sounds backwards right?

Back in 2010 only 2% of the beauty industry's sales came from the internet. The rise of e-Commerce meant this 2% was likely to increase tenfold. There was an incredible opportunity to own that space.

But instead of just trying to sell beauty products online, Birchbox decided that the bigger opportunity was in how beauty brands acquire customers.

Listen to the podcast interview with Reid Hoffman and Katia, Co-founder of Birchbox

Birchbox built a business where customers paid to receive samples of beauty products. The same samples beauty brands gave out for free in shopping malls.

Birchbox was proposing customers buy a subscription to receive these monthly samples direct to their house. Industry experts were convinced it would never work because 'customers don't pay for samples, that's just not how it works'.

The industry experts were wrong.

Customers did pay a monthly subscription to receive samples. Customers not only wanted to pay to receive these samples, but they also went on to buy the full product after.

Birchbox's business model was so innovative that instead of brands paying to acquire customers, customers were now paying brands to to acquire them.

What does The Dollar Shave Club and Nespresso have in common?

Just like Amazon, neither of them needed to validate product-market fit. Everyone buys razors, and everyone buys coffee. Nothing new there.

However, they both sell a product, a shaver handle and a coffee machine, that needs to be supplemented with additional product to work. This model is incredibly smart because of strong user retention.

The core product, like the coffee maker, can be sold at a discount to market, or even free, to encourage widespread adoption. Customers become locked in. Churn is low. Retention is high. And recurred revenue is almost guaranteed.

What other industries could be disrupted by changing the way customers are acquired?

Gross Margins

Amazon didn't re-invent retail. They came up with a new way to distribute product in a cheaper and far more scalable way than competitors. Walmart and Amazon sell the same stuff. But Walmart was never capable of replicating Amazon's online success.

Amazon operates in a game of margin. This is elegantly indicated by Bezos' famous quote:

"Your margin is my opportunity"

In short, if you can cut the cost to produce a product, then you can undercut the competition.

How does this apply to a software business?

Well, most successful software business boast huge profit margins. Anywhere between 60-80%. This is because the cost to produce software doesn't increase that much with each new customer, just a few server costs.

Gross margins don't matter to customers. It's not any easier to sell a low-margin product than a high-margin product. The customer just cares about how much it costs them, not how much it cost to produce. Thus, all things being equal it's much more favorable to have higher margins.

High margin business also tend to scale well. A product with 10% margin likely has a lot of labor and manufacturing costs associated. They tend to have high variable costs that don't shrink much with scale. On the other hand, a SaaS tool may have large fixed costs, but their variable costs are next to nothing, making it extremely attractive to scale.

Product-Led-Growth as a distribution model is also very effective in increasing margins. Building self-serve products means you need to hire fewer people to acquire or maintain customers. Onboarding customers doesn't require you to scale up your hiring.

What other ways can you cut costs and increase margin?

Network effects

I spoke at length about network effects in my previous post on virality. Some of the greatest companies of our time, like PayPal and Slack, have been built off of viral growth.

There are four types of network effects:

1. Direct Network Effect: Each user brings added value. Facebook, WhatsApp, Fax machines, LinkedIn

2. Indirect Network Effect: Increased usage increases adoption of complementary products which thus increase the value of the primary product. Often seen in platform based businesses like Apple Appstore, Microsoft, Salesforce, Xero, and Starling Bank

3. Two-sided Network Effect: Increased usage from one user type increases value to the other user-type. E.g marketplaces

4. Local Network Effects: Increased usage by a small subset of users, increased the value to a larger group. E.G power users on a platform like content creators on LinkedIn or Instagram

5. Compatibility and standards: Increase usage leads to a standard in the industry. PDF is hard to replace as a document type from Adobe.

Not all businesses are suited for viral growth, but when they are it can be a huge catalyst to growth.

I discuss in more length how to know which acquisition method is best suited to your business in my post on the Channel-Fit Framework.

The Two Growth Limiters 📉

We now have four growth levers to innovate. But what growth limiters should we be careful of?

A Lack of Product-Market-Fit

As sales and marketing leaders, we are often tasked with selling product, but we rarely ask the question "Is this not selling well because we suck at selling, or because we lack product-market fit?"

Imagine a sailing boat. Your product-market fit is the wind 💨 and your business model is the ship ⛵️.

Without wind, it doesn't matter how many incredibly talented people you have on board or how amazing your ship is... you aren't moving anywhere.

In the same respect, a strong product-market fit means nothing if you don't have the right business model to capitalize on it.

Ideally we all want to work in a company where the wind is blowing aggressively and all we have to do is build a ship that can capitalize on that product-market fit. This is the case for companies like slack, gong, and salesforce.

Aggressive investments in growth, despite the absence of product-market fit are devastating for startups and is often the reason for failure.

Operational Scalability

You can scale up demand, but if you can't scale up operations you'll be in trouble. There are typically two things that cause scaling problems.

People: More people creates more complexity. HR and communication issues, team dynamics, managerial challenges.

If you have 1,000,000 customers but they need 10,000 people to support them, it'll be a challenge. On the other hand, if you have 1,000,000 customers but a strong self-serve product with only 100 staff you can scale up nicely.

Notion only had around 50 employees with an astonishing $40M run rate. Outbound first sales team struggle to scale, simply because increasing lead generation is directly correlated to the number of sales reps you have. In a candidate driven market hiring bottlenecks are a big reason for stunted growth. This is often the reason for building an internal recruitment team early on in scale-ups.

Infrastructure: This can be technology, or physical operations. Amazon has managed to scale despite a heavily manual operation because they invested greatly in R&D to build the most efficient warehouse and logistics supply chain.

Scrappy code can also hinder growth since engineering teams will have to work on re-writing old code infrastructure alongside prioritizing new features, simply to enable scale. Facebook experienced this when they decided to pivot all their energy into adapting facebook for mobile.

Wrapping it up 🌯

Billion dollar companies are rarely created without leveraging some form of business model innovation.

Innovating the way you acquire customers can be a powerful competitive advantage.

The next time you build a product ask yourself:

• How can I sell this to more people?

• How can I acquire customers cheaper than the competition?

• Can this product be sold in a different way?

• How can I create product with fewer costs?

• How can I leverage network effects to foster growth?

• Do I have a strong PMF, or am I burning money trying to sell a crappy product?

If you got this far, thanks for reading.

Have a great week everyone!

💜