The better the business model, the more valuable the business.
The key to building a successful business for the long term–and potentially the opportunity to sell it for top dollar down the road–is to ensure that you have a rock-solid business model as your foundation. But how do you know how your business model rates? It turns out there are nine questions you can use to determine the strength–of lack thereof–of your business model.
Before we dig into those questions, I’d like you to consider some context. Let’s look at three different business models in the IT space and what multiple of their earnings they get valued on. The first is a staffing company, which sells for 2 to 3 times earnings. Next is a consulting company, which might be valued at 5 to 6 times earnings. Finally, we have a managed service company that would sell for 10 to 12 times their earnings. Why is there such a range of values in three companies who all operate in the same space? The answer, as you’re about to learn, comes down to the strength of their business model–which you can assess using the following nine questions.
1. Is the market large?
A lot of people talk about having a market “niche”–a narrow market segment you can easily defend. The catch there is that if your business doesn’t have enough room to grow, you’ll be forced to constantly engage in trench warfare to win every dollar of revenue. Score yourself highly if the market your business operates in is north of $1 billion. If it’s anything less than $100 million, you’ll find yourself chasing scraps.
2. Is it growing?
It’s one thing to operate in a big market–but it’s another thing altogether if that market is shrinking. Ideally your market should be growing at a rapid clip–think 20 percent a year–to help ensure that you’ll have plenty of new opportunities to chase in the future.
3. What’s your market share?
Market share is an interesting metric to track because there really is a Goldilocks zone of having just the right amount–something that usually comes in around 20 to 40 percent. That leaves you plenty of room to grow while still able to dominate your competitors. Paradoxically, if you have too much of the market, you don’t leave yourself enough room to grow–which will force you to enter new markets. Even the late great Jack Welch had to learn this lesson when he was forced to rethink his famous mantra that every business GE was in had to be ranked number one or two in its market or it should get out. They consciously redefined their markets to access larger markets and drop their share and drop out of a number one or two position.
4. Is the basis for competition clear?
Businesses typically compete on one of three measures: cost, innovation, or customer intimacy. What is your business model based on? The key is to pick one that is validated by your customers in the form of orders. If you try to be too many things to too many people, and customers ignore you as a result, you need to rethink your approach.
5. What is the nature and percentage of your recurring revenue?
This is a big factor for me as the more recurring revenue your business has, the more valuable it becomes. And the more committed that revenue is–like locked up in 5- or 10-year contracts–the better. Having sequential revenue, where customers have the incentive to continually upgrade a product, for instance, is nice but a step down. The lowest marks here, though, go to any business that works of a series of one-off contracts that provide little to no recurring revenue. Great companies will have over 90 percent recurring revenue.
6. What is your annual customer retention percentage?
Ideally, every business would retain 100 percent of its customers every year. That way you go into each subsequent year with a customer base you can build on. Retention is the yin to the yang of recurring revenue — you need both. But, if you only work on a repeat revenue model, where you head into every year needing to find new clients, you score low on this measure.
7. What is your gross margin?
Your gross margin is your net income after accounting for cost of goods sold but before you take out your overhead expenses. A good gross margin is something like 80 to 90 percent. That’s when you create cash and cash creates opportunities to grow. If your gross margin is at the other end of the spectrum, like 15 percent or lower, your business will be considerably less valuable.
8. What is your profit rate?
In other words, what does your business drop to the bottom line? Great businesses generate 25 percent profits or more–while less valuable ones have profits of 5 percent or less. Magical things happen to the value of your business when you combine high profits with a high percentage of recurring revenue and a high growth rate.
9. How capital intensive is your business?
The less capital your company needs to operate, the more valuable it comes. An example of a business model to avoid comes from my book, Great CEOs Are Lazy, in which I wrote about a low-margin steel distribution business that was forced to carry $100 million in inventory to support $200 million in revenue. That meant that for every $1 of revenue the business generated, it required 50 cents of capital–which is hugely capital intensive. Highly valuable businesses operate at a fraction of that rate.
Let’s return to our three previously mentioned examples from the IT industry. We can see now that the staffing company is the least valuable of the three because it doesn’t have much recurring revenue or a high percentage of retained customers year over year, and it does have a high gross margin. The consulting business is more valuable because it is more profitable and not capital intensive, but it suffers from the lack of long-term recurring revenue. The managed services business benefits from having long-term contracts with its customers, which ensures that it will have a steady stream of profitable revenue over the long term with room still to grow. It is a bit more capital intensive than the consulting, but the predictable revenue streams more than overcome that negative.
So, when it comes to evaluating your own business model, try to objectively answer these nine questions. After you do that, ask yourself the ultimate follow up question: Do you have a great business model–or not?