Here is the lens through which I view companies.

A company is an organization of people that performs a number of different functions designed to create and satisfy customers in a profitable way.

Let's take that apart.

A company is an organization of people. There are, of course companies composed of a single person - some of them quite successful. But regardless of the number of people, a company is not an amorphous group. It is organized to accomplish something. And by definition all companies are designed to accomplish the same thing.

Create and Satisfy Customers. Creating a customer is the purpose of a business according to Peter Drucker. And once they have created customers most companies find it better to continue to satisfy them rather than just focus on creating new customers. This leads to longevity for the company and improved profitability. Which brings us to the next bit. 

In a profitable way. This is what differentiates a company from a non-profit, a government, a fraternal organization, or any number of other institutions that serve people. A company provides profit to its owner(s). There are many aspects of profit. Financial profit is one that's common to all companies. But particularly with privately held companies, there are other aspects of profit that can drive the direction of the firm depending on what the owners want from the business. Some are objective and others are sub-conscious. They include things like:

• Generational wealth
• Leaving a legacy
• Various missions
• Personal satisfaction, challenges and growth
• Family security
• And a whole host of others.

Performs a number of different functions. This is the key aspect of how companies accomplish their purpose. We often think of people in a company as having a job. But it's more useful to think of them performing various functions. A function is a process which produces an output. The functions in a company are often interconnected. What's really interesting is that most of the functions in most companies produce a very similar output in a very similar way. (The exceptions are the functions that produce the product or service the company sells.)

And as people move within a company - or come into and out of the company - the output of the functions remains the same. And as a company grows the functions can be subdivided to produce more granular outputs allowing for deeper (albeit more narrow) expertise.  This focus on functions and outputs is the key to improvement. 

By considering all aspects of how the company owners define profit, knowing who the customers are, and how the various functions interact we can increase the company's profitability and make the organization more effective.

Andrew Sullivan points to Matthew Yglesias about the benefits of inferior merchandise:

The fundamental story of Lender’s Frozen Bagels is that the winning product isn’t always the best one. Like Ikea for furniture, H&M for clothing, or the Olive Garden for Italian food, Lender’s innovated by finding a way to compromise on quality and reap huge gains in other spheres. To an extent, it’s thankless work. Nobody wants to stand up and proudly proclaim, “I changed the world with my inferior products.” But often this is how the world changes. And if you look at the health care and higher education corners of the American economy where spiraling costs are bankrupting the middle class, you see sectors that are largely untouched by this kind of low-end innovation. The world could probably use a few more Murray Lenders.

I draw a slightly different conclusion. The fact is you (as a business owner) don’t know how to define quality. That’s right. You are not the one to say what’s inferior – or for that matter, superior.  Said a different way, your customers are the ones who decide what’s the right level of quality.  And they show it not in answers to surveys (who would admit to liking a lousy bagel?) but by their buying habits.

If IKEA’s furniture, often made out of press board, is ” inferior”, what about furniture made of cardboard? Worse you say? But customers are buying it from Zach Rotholz in New Haven. That’s his chair in the photo. Be sure to check out his bed, table, sofa and even his bar at  Charigami.com

Obviously cardboard furniture isn’t right for every market, neither is pressboard. But neither is solid maple, cherry wood, or mahogany. Who’s to say that inferior in one context isn’t superior in another? Your customer.

In most industries, there are people who appreciate (and are willing to pay for) different levels of quality. Success comes to those who can supply the quality customers want at a price that’s less than they are willing to pay.

Takeaways:

• Learn how Your Customers Define Quality
• Build Your Business Model Around that Definition

I’ve been saying for years, that there are only three things any company must do to succeed. And as simple as that sounds, I was wrong. The revised three things are:

1. Create Value that people want to pay for.
2. Find those people and sell to them.
3. Build an organization that does the first two, over and over again at a cost below what your customers want to pay.

I used to say the first thing was “Make something people want to buy.” That’s subtly but significantly different from the way I say it now. What made the change? Three reasons.

Reason #1:  COSTCO. Costco doesn’t make anything but they are one of the most successful companies around. They do create value that people are willing to pay for by finding stuff, bringing it to an accessible location and pricing / packaging it in a way that is appealing to their market. So from that perspective it makes sense to think of creating value rather than making something.

Reason #2:  Passion-blinded entrepreneurs. These are folks that get so fixated on the thing they’ve invented that they don’t listen to the market. Either they believe that because they love it everyone else should too; or they refuse to listen to how the market wants to buy it or use it. So I thought changing the emphasis from “making something” to “creating value” would get those people to consider engaging the customer more. Maybe.

Reason #3 – For a business to succeed, you don’t do these thing independently from one another. It’s not like you create value. THEN go out and sell it. THEN build an organization. The best companies create value that is easy to sell and take their organizational strengths and weaknesses into account when doing so. It’s all of a piece. I thought saying “create value” makes it seem slightly less distinct that “make something”.

As I said – a subtle difference, but a significant one.

Takeaways:

1. Create Value that people want to pay for.
2. Find those people and sell to them.
3. Build an organization that does the first two, over and over again at a cost below what your customers want to pay.

And why that’s a good thing!

Just like a bicycle built for one doesn’t usually grow into a bicycle built for two, there is not a linear continuum from small company to big company like there is from little kid to big adult. It doesn’t work that way.

Why? Because the business model has an external component: customers. And if you hadn’t noticed, they have a mind of their own. It’s been said, the things you can’t change include the weather and other people. The things you can change include yourself and the oil in your truck.

But the truth is, if your burrito sales max out at lunch time because there just aren’t enough people in driving distance who want your burritos, then making more of them faster, or adding more chairs or a bigger sign won’t conjure up any more sales. Now if the bottle neck is chairs, or how fast you can roll a burrito, then that’s an internal problem and you can fix it.

But if you’ve maxed out the external aspect of your business model, you just can’t grow it any bigger without changing the model. Opening another store to become a chain or selling online would change your model and allow for more growth. But without changing your model, the company won’t grow in size – but it can grow in profit.

Why is this a good thing?

The silver lining is that most really big business models REQUIRE size. They can’t survive at all when they’re tiny. They need life support (in the form of outside investment). And they need to grow really fast. Because of that, competition can often do a lot more harm to a company with a business model that requires growth.

As Ridgely Evers said “A Silicon Valley start-up is completely focused on getting big, and naturally risks failure to get there. A true small business, on the other hand, is focused on becoming profitable, feeding a family, and staying in business. That’s a fundamental psychographic and cultural difference.”

I’ve often said you need to do three things to have your company succeed.

1. Make something people want to buy.
2. Find those people and sell to them.
3. Build an organization that does the first two, over and over again at a cost below what your customers want to pay.

As I was thinking about Evers’ quote, it occurred to me that people who run small companies focus more on number one and two than they do on number three. While big companies put a lot of focus on number three.

The problem is not that small companies don’t grow into large ones – the problem is that if you ignore point number three, your company is not as successful as it could be regardless of its size.

The better you build your organization the more profitable and less frustrating it will become. Building an organization is the true job of a CEO.

It’s a statistical fact that people with bigger feet are better at spelling than people with smaller feet. Why? … They tend to be older!

Sorry for the bad joke, but ask yourself what’s the difference between big companies and small ones?

Did you answer things like: more customers, greater revenue, larger staff production capacity or sales force? Then you made the same mistake as the joke. Not understanding that size is the consequence not the cause.

What do we mean by “Scale”?

Scale has to be understood in context. If you’re a surgeon, or a personal trainer or a voice coach, then your business is a “practice”; and the maximum size you can get is going to be smaller than the maximum size for a company that makes computer hard drives. (It’s also true that the minimum size you can survive at is likely to be smaller as well.)

The same is true for a restaurant or a knitting shop.  You can only get so big before you’re serving all the customers who want what you sell and are within a reasonable distance from your shop. You’ve saturated the “addressable market” in business jargon.

Of course, a restaurant can open other locations and become a chain, and the knitting shop can start selling stuff on line. But think how different your day would be as the owner of a knitting shop compared to the owner of an online knitting shop. In the latter case you’d be analyzing your page views and conversion rates. You’d have a shipping department and your business would be open 24/7. You might even need to conduct business in multiple languages.

The difference is not one of size or quantity but a difference of kind or quality.  You’re not really in the same business at all. You are (to use jargon again) operating in a different business model.

And that brings us to the difference between a big company and a small one. A big company is one that understands it’s business model and exploits it for maximum size; and a small company doesn’t.

What is a Business Model?

• Your goals, passion and financial targets. (Otherwise why on earth would you be running your own company if you didn’t have goals and passion for it?)
• Your customer’s desires. (They have to want what you sell more than they want their money or they won’t buy.)
• Your internal processes. (To make a profit, you have to make something  customers want, find those who want it, sell it to them, then build an organization that can do that repeatedly and less than the cost they’re willing to pay).

Two Kinds of Small Companies

Let me mention that there are two kinds of (small) companies that don’t understand or exploit their business models.

The first is what most companies are like. 50% of American workers work for small companies and most are like this. They actually have a business model, and they operate within that model. They just don’t consciously analyze the model so they don’t know how to incorporate it into their business decisions.

The Devil in the Details

To understand and exploit your business model, you have to know what really drives your customers to buy. Is it price? quality? features – and which ones? convenience? That’s why Ray Kroc (McDonald’s founder) used to say that they weren’t in the hamburger business they were in the real estate business. Their customers bought for convenience and consistency (not quality). So the key to their success was picking the right locations to give their customers the most convenient access to their consistent products.

You have to understand all your internal costs and how to maximize the impact of every dollar you spend. Do you know the cost of lead? The cost to convert each lead to a customer? Whether spending an extra 10K to improve production capacity will improve or hurt your bottom line and by how much?

Scalable companies know these things. And they’re always working to improve their execution of the model in which they operate.

Companies without a business Model
The second group of small companies is exemplified by the newest internet start-up. I’d name one but by the time you read this they’ll be supplanted by another.

But it’s true of any novel invention. Novocaine was invented to be a local anesthetic for military use – but found it’s market in dentistry. Early telephones were wired in pairs. You needed a separate line to the phone of each person you wanted to talk to because the business model was predicated on sending only urgent messages (faster than a telegraph). PayPal started selling cryptography on hand held devices. No one bought it. They tried several other business models before they found that people would pay to transfer cash electronically and that required security which they were good at.
These companies don’t have a business model or rather they haven’t found it yet. So what they should be doing is NOT growing. They should be learning. They should be learning what customers want, how much they’ll pay, how to find and sell to them, and how to do this in a way that makes money. Once they’ve figured that out, then they should grow.

Worst Place #1 – Investors! Why? it’s the most expensive money and it takes more of your time and energy to secure it. Plus they almost never tell you no so you waste a lot of energy pursuing deals that are never going to happen.
Worst Place #2 – Lenders. It’s cheaper than investor money but it’s still hard to get (almost impossible for start-ups). Not only do you have to pay it back with interest but often at the most inconvenient times that don’t account for dips and fits that all businesses (especially young ones) go through.
Worst Place #3 – Friends and Family. Why? It can be easy to get, and if you’re a success you probably won’t mind paying it back. But if you aren’t a success you can mess up some important relationships. Seriously.

THE BEST PLACE? Customers.

Not only are they the best place, customers are actually the only place to get money. Here’s why. Your business is like a car. It has to get a lot of power. Power to go, of course, but also for the power steering, power brakes (did you forget cars didn’t use to power those things?) And you need power for the windows, the AC, the audio system, even the GPS and the DVD player for the kids. All that power has to come from the engine. All of it. There are no solar panels (not yet) no gerbils or even rubber bands under the hood. Every single bit has to come from the engine.

But the engine can’t start itself. In the olden days it was started by muscle power with a crank. In my younger days I had a car that had to be started with a push down a hill. Modern cars get started with power from the battery. But that battery needs to be recharged, and the charge comes from guess where? The engine.

Your business is like that. The customers are the engine. All the money has to come from the customers. Sure you may need a jump start, and you may look to some of those worst case sources I mentioned for that jump start. But if you haven’t built a business model that shows how your customers will ultimately pay your cost of goods, plus all the costs of selling to them, plus the cost of keeping the lights on PLUS paying back the lenders, investors or friends and family your company will sputter and die. In many cases you won’t even get the jump start.

I say this as an ex-entrepreneur who is currently an angel investor. I love it when my investment can jump-start a successful company. But I don’t get to do it enough. Why? Too many entrepreneurs think getting my money is closer to the end not the beginning.

Too often I see pitches from entrepreneurs who don’t really get that my money is just a jump start – and an expensive one at that. So expensive in fact, that there are a lot of good companies who will never get going fast enough to pay me back enough to make me take the risk. Too often they waste so much time trying to pitch to people like me when they could be selling stuff to customers and actually making money.

Many would be much better off to start with a little push, and grow slower but more profitably, with customer’s money.

photo credit http://www.flickr.com/photos/neubie/2273635564/

[tags] start-up, entrepreneur, financing, investors, VC, angel investor [/tags]

Investors all know that business plans are fiction, or rather fairy tales (fiction sometimes has an unhappy ending business plans never do.) And many successful companies thrive without business plans. Even those who promote business plans as a management tool usually say it’s the planning not the plan that’s of value. So what’s better?

A business Model
As I’ve long said, a model is better than a plan. The key difference is that a plan is based on time – what you’ll do in this month, that quarter, the next year. Hint: the vast majority of business plans have a huge sales jump in year three. Why year three? it’s so far in the future that it doesn’t have to be based on reality, yet it gives you the numbers you need to make your return look good. A model, on the other hand, has all the parts of the business based on each other (and ultimately sales) not based on time. So as reality happens differently than you’d like, you can adjust. Quickly.
How to Assume
This article gives a good example of the kind of assumptions that underly a business model. The two key points are Dollars per … and Levels of demand.
Dollars per …
You only spend money in a business because you want to gain something. Usually it’s to gain capacity. Every single one of your costs should have an assumption tied to it that links dollars to some non-financial thing. And no cheating. You can’t assume rent by saying dollars per square feet. That’s the same thing. You need to say dollars per employee (if you’re renting office space) dollars per SKU (if you’re renting retail space) or dollars per widget produced (if you’re renting manufacturing space).

You must tie each dollar you spend to something else – it makes you think long and hard about why you’re spending it. In some cases you need to break down a single line item on your P&L into multiple assumptions. Take the example of rent I gave above. Suppose you rent a building that you use as an office, a warehouse, and a manufacturing space. Your P&L probably just says RENT. But to build a good model, your assumptions have to state why you need so much of each type of space. That way the parts of your model are tied together. If you double your business, you won’t just double your rent because the ratio of office to warehouse to manufacturing won’t stay the same. Likewise if your business falters and you have to downsize.

So having an assumption of Dollars per for each reason you spend money gives you a model you can use.

Levels of Demand
Hidden in this paragraph of the article I linked to is a gem. (emphasis mine)

Admit that revenues are a mystery. If you don’t have any revenues yet, you can’t say what they’ll be. The point of a model is to prove you can make money if people buy your product, not to insist that they will. By developing different scenarios based on different levels of demand, you can later calibrate hiring and spending according to which scenario fits reality best.

This was written for a start-up but it applies to any business that is growing (or shrinking) or attempting a new initiative. Since you don’t know how the customers will react, or how fast, you need to develop scenarios based on different levels of demand. This is possible to do if you’ve made your assumptions with dollars per. Because what you’re buying with those dollars is capacity – the capacity to support a certain level of sales. (And by support I mean everything in the whole company life cycle – market, sell, produce, deliver, invoice, collect etc. Everything.)

So pick three levels of demand and work your model of what your costs need to be to fully support each level. That way as your initiative goes forward, you know what you should be spending.

If you’re a start-up one of those levels needs to be break-even: the level sales need to be so pay for all the support in a self-sustaining manner.

Takeaways:

• A model is better than a plan.
• You spend money to gain capacity – your assumptions should reflect this.
• Develop scenarios for different levels of demand.
• Building a business model is a CEO skill

[tags] business model, small business, entrepreneur, start-up business plan[/tags]

The idea is “believers” aka investors invest $10 in a share of a new band. When the band has raised $50,000 (5,000 investors) SellABand helps them produce and promote a CD – the investors get one copy of the CD for “free”. Money is split between the band, the investors and the company. Any time before the band raises 50K an investor can get their money back or switch it to another band.

Seems to me that $10 is a really cheap way to “own” part of a band for people who like to be early adopters of new music and a way for a band to raise money but more importantly get 5,000 folks promoting their music from the get go. For the investors, it’s like paying $10 to be a promoter of an idea virus. And you get a CD for the price.

UPDATE: Slice The Pie has a similar concept.

Takeaway:

• The real power of any technology is not to do the same old stuff quicker, better, or more accurately, but to allow you to do things that could not be done before. The web is no different in that it’s real power lies in the uncharted.

[tags] entrepreneur,record label, Music Business, business model [/tags]

A business model is a tool to help you figure out when to spend how much, what results you should be getting when, and to know in advance when you’ll have to raise more money from investors.

How, you ask, can you predict all those things with enough accuracy to bother? Well, you can’t. Certainly not at first. But the fact that you can’t predict the future doesn’t mean you shouldn’t develop a tool that helps you understand it – especially as the future becomes the present. That tool is the business model. Probably the most important thing you’ll do as CEO is develop, refine and then USE the business model when decisions are being made in the company.

What is a Business Model? It’s an understanding of how these three things intersect:

1. What the customers want to buy (and why).

2. How the company will make and sell those things.

3. How the company will make money from doing so.

As you can imagine, there is a bit of guesswork involved. We call them assumptions. And it’s important to write them down and test them against reality, then revise them as you learn more. Pretty soon they’ll actually be dependable.

The other thing you’ll need assumptions about (at least at first) is the capacity of parts of your business. Production capacity is pretty easy to come by – how many widgets can a machine make in a day. But Sales capacity (how much can you sell before you need to hire an additional sales person) and administrative support are things you’ll have to guess and refine.

The parts of your model that you can get exactly are your costs.

Many people don’t build a model because so much of it involves guesses (I mean assumptions) so they don’t think it’s valuable. They are wrong.

I build mine based on cash flow. On the dollars page I put all the sources of cash in on top of the reasons to spend cash out. I group the cash in by product line and the cash out by reasons to spend: COGS, Cost of Sales & Marketing, Overhead, Paying back lenders & investors and PROFIT. Profit can be money taken out of the company or money kept in and used for growth.

On the assumptions page, I make all kinds of assumptions about how long it will take for customers to buy, what the average sale size will be, how interest rates will affect my business, how long it will take to raise more money etc. Make sure the numbers on the dollars page accurately reflect these.

I make a third page for capacity. This is a specialized form of assumptions that relates how much it costs to accomplish or produce a certain number of results. Things like how many people can each administrative assistant support, to how big can you grow before you have to rent larger facilities.

When you first start this, the number of details can seem overwhelming. Don’t worry. Start at the highest level and add details as you need them.

Takeaways:

• A complete business model will help you make every business decisions.
• It will help you adapt quickly when things don’t go as planned (and they won’t).
• It’s not a trivial task to build and use a business model. But I know of no better way to grow a company that has a functioning CEO. Without it, you’ll always be just the CCB – chief cook and bottle washer.

[tags]Business Model, Small Business, Entrepreneur, Management, How to be CEO,CEO Skills[/tags]

Bigger is different – not just more
Companies don’t grow in linear fashion. The characteristics change along with the size. My friend Nick at The Black Sheep started out as a professional baker. He told me you can’t just take a recipe for 3 dozen cookies and multiply everything by ten. At that size you have to change the mix for it to work right. You know the same thing if you’ve raised a family. Going from a couple to having a child is not just 1/2 again as much. It’s completely different. And the quality changes again with your second child and your third. When you only have one kid at least there’s some quite when the little one is taking a nap. When the kids start to out number the adults it’s a whole new world.

Plumbing Plateaus
The best example of this in business is to consider a plumber. The one we’re imagining works from home, has a truck and a helper and is doing well. The two of them are busy 40-50 hours a week, making a nice living. The company grosses 200K per year (at $125 an hour you do the math), the helper makes 45K and the take home pay is decent for the owner.

The company is at what I call a plateau of profitability. So she (or he) decides to grow the business. You can’t grow a company like that by 20%. The boss and her helper can’t do 20% more work – there just aren’t enough hours in the week. And 20% isn’t enough to afford another truck, another plumber and a helper. If they expanded and only grossed $240K they’d loose money. So as the company grows it falls off the plateau of profitability and enters the canyon of negative cash flow.

So what to do? As the saying goes “You can’t leap a canyon in two jumps” The solution, as you’ve probably intuited, is to figure out how much growth is required to make it profitable to run a company of two crews, trucks, helpers and all. Let’s say with increased marketing, a bit of inefficiency due to communication between 4 people, and such it would take 75% growth to be profitable at grossing $350K. That defines the next plateau of profitability.

So now the choice is this: Keep the company small (one crew) or commit to grow it by 75%, and realize it will go through a time of bleeding till it gets to the next plateau. Don’t start on that journey till you have the resources to make it all the way to the next plateau.

Tired of working at Home
Let’s say our plumber makes that leap successfully. After all it’s not rocket surgery. Lot’s of people dumber than you have done it. One day she gets tired of working at home. Doesn’t want to do paperwork at night. Hates taking calls on her cell phone when she’s on a job. She want’s to grow large enough to afford an office with a receptionist/bookkeeper. Can she afford it with just two trucks on the road? Will it take three? Five? Undoubtedly she’ll enter another canyon before she reaches that plateau. How deep is that canyon?

Build a Model not a Business Plan
To answer those questions you need a business model. By now you’ve realized that I’ve been pulling these numbers out of my butt – for illustrative purposes of course. But if you used real numbers – actual cost of vans, labor, advertising, rent, salaries plus realistic sales figures you’d have a model of how money flows through our plumbing company. The most critical feature to put in your model is capacity – the amount of work each person can reasonably be expected to do. The model shows the interrelationship between sales and the various costs required to sell and service that much business. Your model will show you how deep the canyons of negative cash flow are, what level sales have to be to reach the next plateau of profitability and by including capacity your model will show you how many crews it will take to reach that level.

A model is different from a business plan in two ways: 1. It explicitly includes capacity. 2. It’s not time based. Everyone knows that the monthly numbers for most business plans are fiction. What a model allows you to do is state your assumptions (It will take 6 months to increase sales by 50%) and then adjust as reality hits the fan.

What a model does is take the experience, wisdom and gut feel that most entrepreneurs live by and quantify them in a way that you can monitor the progress of your team. That way the changes and tweaks needed to make any vision a reality don’t depend on your immediate involvement. This gives you the space to be the CEO and do the strategic directing of the company.

Takeaways:

• If you expect to build a team that can handle the day to day without you, and allow you to be the CEO – a detailed model is a must.
• This is harder than it looks because it requires you to make guesses and assumptions before hand rather than just make decisions when stuff comes up.
• A well-built model has a place to note your guesses and adjust them as they get tempered by actual accomplishments.
• The model is always a work in progress – but it allows you to see on a daily basis if you need to, how changes will affect your most critical resources: Cash, and staff capacity.

[tags]Business Model, Small Business, Entrepreneur, Management, How to be CEO,CEO Skills, Profitability[/tags]