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The
business model objective: maximizing cashflow and value
Key driver analysis
The second tool is a key driver analysis. Each of the elements of the
cashflow model – revenue, direct costs, gross profit, overhead costs,
profit, investment, cashflow and funding - are a result of different
business model decisions. Understanding how these business model decisions
drive cashflow is critical to business model design and optimization.
The key driver analysis, based on an approach developed by McKinsey & Company,
Inc., comprises two steps. The first step is to think first about the
key operating measures that underlie each element of the cashflow
model. In exhibit 2, for example, gross profit in a sample business might
be viewed as a function of two key operating measures – number of customers
and gross profit per customer. Further, gross profit per customer might
be a function of two other operating measures – product volume per customer
and unit margin per product.
Exhibit 2: key driver analysis
Identifying these operating measures in this way tightly links them to the cashflow model. In this example, the managers of the business know that in order to increase gross profit, they need to increase the number of customers, increase the product volume per customer and / or increase the unit margin per product. These operating measures can be built into real-time reports that provide continuous feedback on business performance.
The second step is to identify the key business model elements that drive each of these operating measures. There are typically several of these for each operating measure. For example, number of customers might be a function of the size of the target market (a “markets” decision in our business model framework), to what extent the product offering is superior to competitors (a set of “products” decisions), the effectiveness of the sales and marketing effort (part of the “processes” decisions) and a strategic partnership (a “people” decision).
In this way, you tie the decisions you make in each of the business model components – markets, products, processes and people – directly to operating measures and the cashflow model. This approach thus gives you complete visibility to the integrated economic system at the core of your business model.
Cash and valuation curve
The third tool is the cash and valuation curve. When the cumulative
cashflow of a business is plotted over its lifetime, it ideally takes
on the shape of the well-known S-curve (exhibit 3).
Exhibit 3: cash and valuation curve
In the beginning of the business, the cumulative cash curve trends downward, as cash is steadily invested to build products and launch the business. Once revenue begins to come in, the cash curve turns, and begins to trend upwards. When sufficient revenue has been generated, the cash curve gets to breakeven – i.e. at this point, the business has generated sufficient positive cashflow to pay back the total investment. Thereafter, the cumulative cashflow is all surplus – i.e. pure “profit”8.
The valuation curve more or less follows the cash curve, because valuation is fundamentally a function of cash flow9. In the early stage, the valuation is typically relatively low. As the business moves into positive cashflow, the valuation increases to reflect this.
A primary goal in managing the economics of the business is to move from the
blue dotted lines in exhibit 3 to the red lines. By minimizing upfront investment,
accelerating revenue and increasing profit margins, you get to cashflow breakeven
far more quickly and use far less capital in doing so. Thereafter, the
goal is to increase the surplus above the breakeven line, to increase the total
positive cash generated over the lifetime of the business. Doing so will drive
the valuation up to reflect this increased cashflow.
* * *
In summary, this paper has presented an overview of the “economics” component of a business model, It has emphasized the need to see a business as an integrated economic engine, and to understand the economic impact of every business model design decision. Three useful tools have been presented: an integrated cashflow model, a key driver analysis and the cash and valuation curve. Understanding and applying these tools will contribute significantly to business model design and business success.
References
- For an introduction to how the model was developed and how it compares to others, see What is a business model? A new approach.
- Selecting and understanding markets for technology innovation.
- Developing a winning product offering.
- Optimizing your core processes to execute successfully.
- Evolving your business as a value exchange between stakeholders.
- See for example Mullins, John and Randy Komisar. Getting to Plan B: Breaking Through to a Better Business Model. Boston: Harvard Business Press, 2009.
- We do not include realizing value from capital appreciation in this definition. So we exclude, for example, investing in a property and then selling it, or investing in a business like Skype which delivered huge capital returns to shareholders but never generated revenue.
- For a useful discussion of the cash curve, see Andrew, James P, and Harold L Sirkin. Payback: Reaping the Rewards of Innovation. Boston: Harvard Business School Press, 2006.
- Copeland, Tom et al. Valuation: Measuring and Managing the Value of Companies. New York: Wiley & Sons Inc., 1990.
About the author
Michael Lurie is the CEO and founder of the Agile Strategy Institute, a research, education and consulting organization, and the creator of its original core body of knowledge. He is also the founder of the Agile Strategy Alliance, a non-profit professional association for executives, board members and advisors interested in learning and practicing agile strategy.