Emails to a Young Entrepreneur: Modelling the Business

Day 121 of Self Quarantine             Covid 19 Deaths in U.S.:  136,000

Modelling the Business

Flip Comic created by David Robinson

“Essentially, all models are wrong, but some are useful.”

George E.P. Box

 

Dundee, Oregon, USA, Archery Summit Vineyards, July 15, 2013

Dear Mikhail,

I really enjoyed your stories of all that you are doing to find the key talent to raise your infant venture. You have a wonderful sense of humor and way with words. I appreciate your sending me the resumes and LinkedIn profiles of the potential co-founders you are interacting with. I am flattered that you think I might offer some insights as to which one might be best for you. One thing my observing and discovering journey has taught me is that I can know what is right for me, but I can’t possibly know what is right for someone else.

When I started my venturing journey forty years ago, as a capable technologist I was focused on the product.  All of my creative energies were spent transforming raw technologies into something that was useful for enterprise customers. I was in the “if I build it, customers will come” state of mind. Fortunately, I was surrounded by enough people in very large companies who spent all their mental energies on attracting and acquiring paying customers.

Prior to founding Attenex, there were no technical and business people to help me think through how to do build a new venture with our conceived visual analytics technology. I had to figure out whether there was a product to be built, whether there were any customers who might care, and could we make money selling it. We spent three months prototyping the technology and were delighted to see that we could get 2-3 times productivity increases. As I explored the technology, I realized we could easily boost the productivity to at least ten times.

We discovered a path forward with the prototype iterations in three months. Then I ran into a brick wall at the intersection of extreme productivity and the existing hourly billing business model of the legal industry. Every time we increased the productivity of the tool, we decreased the revenue and profits for our law firm customers.  Our unique selling proposition would be:  “Buy our product and you will make 1/10 the money you did before using our tool.”  Even I would laugh me out of the room.

I turned my energies to looking for a business model that would allow our customers to make money. I spent five months digging deeper into the many aspects of legal electronic discovery (eDiscovery), reading every business modelling book I could find, and talking to a wide range of attack finance professionals. With all of this research, I couldn’t find a viable business model.

Along the journey I came across Adrian Slywotzky’s many books on business models, profit models and value migration. My frustrating path of understanding profitability felt much like Steve in the following story from the introduction of The Art of Profitability:

“Steve: Where to begin? “I heard your name at a cocktail party. Someone introduced me to a man named Otto Kerner. I told him I had to learn about profitability. And Mr. Kerner told me that if I wanted to learn about profit, I ought to meet you.”

Zhao smiled. Kerner was Zhao’s closest friend. A senior partner at Storm and Fellows, he was the person responsible for connecting Zhao to the firm. At age eighty-five, he still came into the office every day, even if only to spend half the afternoon chatting with Zhao. “I’m old enough to be Zhao’s father,” he liked to say to people at the firm who wondered about Zhao, “But when we talk, Zhao is the teacher and I’m the pupil. That’s why we need him here at Storm and Fellows—he’s my personal continuing education program.”

“An introduction from Otto Kerner is like gold in my book,” Zhao remarked. “But tell me—why?”

Steve was puzzled. “Why what?”

“Why do you have to learn profitability?”

Steve paused. A half dozen reasons were running through his mind. Why, indeed? He was tempted to say a couple of things, but he checked himself, realizing they were platitudes: Because profit is the lifeblood of any organization . . . because the ultimate purpose of business is to create profits for shareholders . . . Somehow, he sensed, the clichés he’d repeated in the workplace and even in business classes he was now taking at night, wouldn’t work so well with David Zhao. He experienced an instant of panic, then consciously relaxed the tension that gripped him.

“It has to do with my job,” he finally responded. “I work in strategic planning at Delmore, Inc.” Steve glanced at Zhao, half-hoping for the raised-eyebrow look of respect he usually got when he mentioned the company name. But Zhao’s expression betrayed nothing. Steve went on, “It’s a big company with a great history, of course. And being in the planning department is a good opportunity for me. I get to look closely at all the various industries we’re in, which is almost like getting a business-school education on the job. But as you probably know,” he continued, “the company hasn’t been doing very well lately. Profits are flat, and the stock price has been stagnant for about eighteen months.”

“For two years, actually,” Zhao remarked.

“I guess you’re right,” Steve said. “You must follow the stock.”

“I find Delmore—interesting is the right word, I suppose,” said Zhao. “And you’re in strategic planning there. Tell me, Steve,” he asked, “what sort of strategy do you plan?”

Was that an amused glint in Zhao’s eye? “What I do is more like research—studying potential mergers, acquisitions, spin-offs—you know the sort of thing,” he responded, immediately feeling that his answer sounded lame. “But I want to contribute more,” he quickly added. “I want to learn how I can help the company get out of the doldrums. Does that make sense?”

“Why not?” Zhao answered. “But Delmore has been in business since 1904. It has revenues of $18 billion a year from forty different businesses. Surely the wise men and women who run the firm must know all about how to make profits? Or do you suppose they need Steve Gardner to teach them that?”

Steve reddened and sat for a moment in silence. He was thinking about some of the disturbing things he’d heard and seen around the offices at Delmore in the past six months. About the company-wide strategy conference, originally scheduled for April, that was first rescheduled twice, then postponed indefinitely, with no explanation as to why, causing rumors to swirl in the corridors . . . about the resignations that summer of three members of the executive committee, all within four weeks of one another. . . about the disparaging tone of recent comments by Wall Street analysts about Delmore, and the defensive tone of the company’s public responses. And just this past week, people were whispering that the long-expected layoffs in three divisions would be a lot bigger than anticipated. Life at Delmore was feeling very different than it had when Steve joined the company.

Steve took a deep breath. “I guess I’m not necessarily convinced that the wise men and women at Delmore do know what profitability is all about,” he finally admitted. He looked Zhao in the eye, wondering how Zhao would react.

Zhao merely turned his head slightly to stare more closely at Steve. A long moment passed. “Honesty,” Zhao commented.

“Excuse me?”

“Honesty. I don’t run into it very often.”

Another pause, as Zhao stared through the glass wall, seemingly focused on a helicopter whirring across the water from New Jersey, nearly at a level with his own forty-sixth-floor perch.

Finally, he turned to Steve.

“If you really want to learn about profitability, I’m willing to teach you,” he said. “But there are several conditions. First, we’ll meet most Saturday mornings between now and next May. Second, every lesson will last exactly one hour. And I’ll expect you to spend time between lessons reading and otherwise preparing. Is that acceptable?”

Steve bowed his head slightly. “Yes, it is.”

“Are you doing anything other than working at Delmore? Moonlighting, or taking classes somewhere?”

“I am taking a night class this fall at NYU—financial management. I thought I’d take one or two courses a semester to help me decide whether to go on for an MBA. That’s okay, right?” It had suddenly occurred to Steve that Zhao might consider him over-booked.

“It’s fine,” Zhao reassured him. “Your preparation time for me will be about four hours per week. I hope that works with your schedule?”

“I think so.”

“Good. There’s just one more thing. Did Otto tell you that I charge a fee?”

“No. How much is it?”

“A thousand dollars per lesson.”

Steve sucked in his breath. Then his shoulders dropped, collapsing in defeat. He looked away, suddenly feeling frustrated and angry. He was tempted to speak his mind—or to simply storm out of the office, slamming the door behind him.

But instead, he simply said, quietly, “I can’t afford that.”

Zhao laughed, cutting the tension in the room. “Of course you can’t,” he replied. “You’re a student. I’m not asking for the money now. You can pay the fee when you’re able to—if you ever are.”

Steve didn’t know whether to feel relieved, embarrassed, or guilty. He thought about the usual four-digit balance in his bank account. “I might not be able to pay you for five or six years. Maybe longer.”

“I know that,” Zhao answered, a playful grin now spreading across his face. “Luckily for you, I’ve decided you’re good for it.”

Steve’s mood turned to puzzlement and mild annoyance. Zhao, he vaguely felt, was being condescending, perhaps toying with him. What makes Zhao think I’ll ever pay him a penny? he thought. Maybe I’ll take all his lessons, absorb all his ideas, then walk away and never see him again. That’s probably what most people would do.

“Do we have a deal?” Zhao asked.

Steve paused. “Yes, it’s a deal,” he found himself saying. Zhao reached across the desk, and the two men shook hands. And suddenly Steve sensed that he would never simply walk away from Zhao . . . that one day he would pay Zhao his total fee . . . and that Zhao had known all this before Steve himself did.

Zhao smiled as if he understood. “Very well then,” he said. “Let’s get started.”

Slywotzky is my Zhao. As I looked at the many profit models, the answer became very clear. So clear that I wondered how we’d missed it for so long. All we had to do was move from a billable hour model to some form of fixed price billing. Fortunately, our lead customer, Preston Gates and Ellis, had fifteen years of billing information to a wide range of customers. As we evaluated the different variables, charging by the number of Gigabytes (GB) of electronic mail and digital documents that a customer gave us became the foundation of our value based pricing structure.

On average, the law firm was charging $30,000 per gigabyte (GB = 1000 megabytes) of digital documents processed to do a full lawyer review. The firm realized a profit of about 20%. The cost of the review with the Attenex Patterns software was on average $10,000 per GB. So the law firm could drop the price to $20,000 per GB giving the customer a nice incentive to move to the new technology. Even decreasing their prices, the law firm increased their profits from 20% to 50% per GB.

One of the ways you know that you have arrived at a good business model is when there are additional benefits for the customer. One of the challenges with a billable hour model is that the customer and the law firm don’t have any idea how much it is going to cost to review a matter. With the new fixed price model, as soon as the customer knew how much digital material they had, they knew how much it was going to cost them to review it. The customer could now budget for each matter which made their finance team much happier.

While the entrepreneurial pundits argue interminably about which is more important – team, market size, product, or go to market strategy, I learned that the hardest component of a new venture is discovering the business model. It doesn’t make sense to invest too much in building a product or doing a lot of customer discovery until you can come up with the simplest business model that will work.

If I didn’t believe this before I started my post-Attenex startup – Wine Transformations – I certainly believed it in the three years I pursued my passion for fine wine growing. As a wine geek, I was intrigued by biodynamics and the growing of fine wine. After the sale of Attenex, I decided to pursue my wine geek passion by finding a way to create a business in the wine industry.

As I walk the vineyards at Archery Summit Estate this morning after spending the night in the winery’s guest house, I marvel at the interaction of humans and wine grapes. The sun is on the rise and it is going to be a hot day. The grape clusters are looking good. You can tell it was a great spring for these older vines. Brian Doyle in The Grail: A Year Ambling and Shambling through an Oregon Vineyard in pursuit of the best pinot noir in the whole wide world captures this human and grape vine interaction:

“Grapevines are amazing life forms when you think about it, they plunge their fingers a hundred feet down into the rocky soil, they can live for hundreds of years, they fend off all sorts of insect attacks, and they have been working with human beings for so long, thousands and thousands of years, that you wonder sometimes who cultivates who, you know what I mean?  Are people manipulating and taking advantage of grape vines, or are grape vines deftly using human beings to take over the world?”

This trip through the vineyards is a “mourning” journey for me.  After three years of research, brainstorming, interviewing, and experimenting, I am unable to find a single business model that can work in the wine industry. As Jim Fetzer shared after fifty years in the wine industry, the only business model he could find that works is to buy some vineyard land, hold onto it for 50 years and sell it. Everything else he’s found in the industry is a way to lose money.

Since I don’t have 50 years of life left, that doesn’t sound like a good business model. I’ve learned a lot over these three years of trying to find a business model and I’ve tasted hundreds of wonderful wines (one side benefit of the fine wine industry). I found 128 ways not to make money in the wine industry. This morning when I realized that I can make more money in a year or two with even a poor idea for a software product then I can in 50 years in the wine industry, it is time for me to move on from my passion.

The good news is that I only had to invest a portion of my time and didn’t waste any time or energy on building a product.

Business model thinking early in the new venture is key. How can you sustainably make money in your new venture?

Ash Maurya in his video promo for his book Running Lean asserts the mantra of the lean entrepreneuring crowd:

“The true product of a startup is a working business model.”

 

Maurya goes on to share:

“We live in an age of unparalleled opportunity for innovation. We’re building more products than ever before, but most of them fail—not because we can’t complete what we set out to build, but because we waste time, money, and effort building the wrong product.”

My treasured mentor, Russ Ackoff shared a lifetime of wisdom in a short twelve minutes in 1994 in a video “If Russ Ackoff had Given a TED Talk…” Near the end of the talk he shares:

“Continuous improvement isn’t nearly as important as discontinuous improvement. Creativity is a discontinuity. A creative act breaks with the chain that has come before it. It’s not continuous. One never becomes a leader by continuously improving – that’s imitation of the leader.  You never overcome a leader by imitating them and improving slightly. You only become a leader by leapfrogging those ahead of you. That comes about through creativity.

“One final point about that. When we look at the models of quality and we frequently point to the Japanese and what they’ve done to the automobile.  There is no doubt they’ve improved the quality of the automobile. But it’s the wrong kind of quality. Peter Drucker made a very fundamental distinction between doing things right and doing the right thing.

“The Japanese are doing things right, but they are doing the wrong thing. Doing the wrong thing right is not nearly as good as doing the right thing wrong. The automobile is destroying urban life around the world. Just visit Mexico City or Santiago or any of those major cities where you find congestion and pollution so bad that children have to be kept home from school. They are not allowed to walk out of doors because the pollution is so intense.

“And then we talk about the quality of the automobiles they are driving. It’s the wrong concept of quality. Quality ought to contain the notion of value, not merely efficiency. That’s a difference between efficiency and effectiveness. Quality ought to be directed at effectiveness. The difference between efficiency and effectiveness is the difference between knowledge and wisdom. Unfortunately we don’t have enough wisdom to go around.

“Until managers take into account the systemic nature of their organizations, most of their efforts to improve their performance are doomed to failure.”

At a recent UX conference a former ID student, Tania Schlatter, author of Visual Usability: Principles and Practices for Designing Digital Applications, shared that twenty years ago she remembered me saying “don’t get stuck in your plans, put a stake in the ground and move forward.” While teaching an entrepreneuring for designers class at ID, I used that principle to move the student teams quickly through Maurya’s Lean Canvas.

Over the years, I’ve seen most student and professional teams stay stuck on the problem/solution and target customer segment. They will sit around a table and discuss (argue) for hours about the “right” answer with no evidence. A framework like the Lean Canvas is an iterative exercise which you need to quickly move through. In a classroom setting, I have students spend no more than five minutes on a single box of the canvas – put a stake in the ground and then move on. Several things happen by going through the whole canvas in an hour:

  1. You realize as you fill in the later boxes, that some of your earlier decisions no longer make any sense.
  2. You realize that you don’t have enough information to fill out many of the boxes.

With the first issue, you need to get all the way through the whole canvas and then spend a few minutes finding the logical disconnects. Then you rapidly iterate another pass at the canvas to resolve the logical disconnects. With the second issue, you design the experiments to go find out the information preferably by going into the field and observing and talking with real customers.

The Lean Canvas is meant as a scratch pad for what you are learning about the customer and how that changes the solution and even the nature of the problem you are trying to solve for. I recommend that entrepreneurs update their Lean Canvas at least once a day until they get to their Minimum Viable Product. Then they should update it at least once a week. It is a quick way to remind yourself to constantly experiment and then record what you’ve learned.

An entrepreneur understands that no “learning” is business model neutral. If you remember in your ID Master’s Thesis classes with Patrick Whitney, he had you express your yearlong thesis project in multiple media.  I wanted to know why he required so many different artifacts for the thesis projects – thesis document, fifteen minute presentation, large poster format, four page brochure and three minute video. Patrick explained that no medium (in the McLuhan sense) is content neutral. Each time you move content from one media form to another, you are gaining insights into the product (artifact) you are trying to represent and communicate. The primary purpose of having so many media forms is to provide another way for you to acquire insights into what you are designing. The regular process of iterating through the Lean Canvas provides the same kind of opportunity for insight generation.

In a similar way, Adrian Slywotzky suggests that looking for ways to make every part of your business digital generates a wealth of insights. In his book How Digital is Your Business, Slywotzky defines digital business as “one in which strategic options have been transformed – and significantly broadened – by the use of digital technologies. . . A digital business uses digital technologies to devise entirely new value propositions for customers and for the company’s own talent; to invent new methods of creating and capturing profits; and, ultimately, to pursue the true goal of strategic differentiation: uniqueness.

Digital Business Design leads to 10X productivity improvements.  Slywotzky states:

“A 10X productivity improvement is more than an incremental growth in efficiency.  It is a fundamental change in the way companies do business.  It liberates resources to serve customers, leverage talent, grow the business, and help toward achieving strategic leadership.

“Productivity is measured as a ratio of value created to resources used.

“Why are 10X productivity improvements possible when Digital Business Design is employed?  There are several reasons:

      1. Most of the time, in most of the economy, atoms are used when bits would bring better results.  Bits are cheaper.  When bits are used instead of atoms, a lot of big costs go away.
      2. Digital options make it possible to collect very valuable types of bits (such as information on what customers really want)before committing atoms.  The result is that atoms (e.g., inventory or unused factory capacity) are not wasted.  Huge costs vanish quickly when bits precede atoms.
      3. Digital innovators have developed an entire array of bit engines to collect, process, and distribute bits with extraordinary efficiency.  The goal is not just to focus on bits, but to have the tools to manipulate and distribute those bits in smart ways.  When a collection of powerful bit engines is exquisitely tuned to the needs of customer, value can be generated at an extraordinary rate.

“That’s why it is extraordinarily important to be constantly asking:  What bit engines have we put to work in our company?  How can they be improved?  What new bit engines will we need to address tomorrow’s business issues?”

Many of the most successful companies use a multi-sided business model. Google gives away their software and applications to the users and uses advertisers to pay for the free users.  Users get a free ride as long as they don’t mind seeing advertisements on every web page. This business model is dependent on having lots of users. As a general rule, early stage investors don’t like this model because you have to spend 2-4 times the marketing dollars than for a simpler model. However, if you can get the users to engage daily with your product, this model is very powerful.

You can find all kinds of spread sheets and applications for doing business modelling.  What I am talking about in this email is the kind of model you can do on a napkin. It is as simple and as hard as understanding the value of the task the customer is currently doing and how they can make more money (more revenue or reduced costs) by using your product or service. It means you have to understand your customer’s business model and how they make money from their customers.

Yours in entrepreneuring,

Skip Walter

This entry was posted in Content with Context, Emails to a Young Entrepreneur, Entrepreneuring, Flipped Perspective, Learning. Bookmark the permalink.

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