Business Model Design.
CONSIDERATIONS IN
Business Concept vs Business Model
These are two different things and one needs to understand distinction between them to be able to make more judicial decision in entrepreneurial venture design or investing in a venture.
Business Concept
Business concept is about what does a business do?
What are the set of activities is it going to take up?
How is the business going to do something it says? (without bringing in the constraint of money)
Business Model
How does the business make money by selling sales and services?
What are the costs that a business has to incur to be able to continuously produce and sell products and services to the end customers?
How each activity in the day to day operations of the business map to revenues and costs of the business?
How does the venture create value for various stakeholders such as customers, employee workforce, vendors, and capital providers (investors)?
The most basic fundamental question one can ask is , "How is the business venture going to make money in long or short term?
Principal vs Agent
Being a principal vs being an agent in a product or a service model has real long term effects on the pressures on profitability of any entrepreneurial venture. The principal vs agent classification is used a lot in accounting, financial reporting, and valuations related areas but we will discuss principal vs agent concept in terms of real essence of having control on the quality of service that gets delivered to the end consumers.
In simple terms, it is about who does the heavy lifting of delivering the last mile service and who ensures that the quality of service and consistency of delivery remains uniform on going concern basis.
Later in the discussion we will also discuss how the principal vs agency way of working affects the operating leverage in a venture.
Principal
Ownership of assets, product quality, service delivery quality, issue resolution and end ownership of customer satisfaction.
Agent
More oriented towards distribution of product or service and less towards quality or consistency of end state of usage.
A Note On Aggregation Models
Aggregation models are little tricky in nature. We will try to explain in brief below.
Aggregation businesses usually work on aggregation of demands and supply of products and services. There are products and service providers and there are users of those products and services. A lot of times the users and providers are not able to be at the same place and at the same time so that the providers and serve users when the need at users' end arises. This is where the concept of 'platforms' comes into existence where users and providers come together to make things happen.
Technological platforms make the supply and demand match with efficiency and thus are an important part of the economy. What is to understand is whether a platform is just a matchmaker (of demand and supply) or has control over quality of products and services to be able to serve the customers in a consistent manner with expected quality standards. This becomes important to understand to able to assess whether the platform is an agent or a principal.
Why is this so important?
Well, it is so because making transactions happen and providing the expected and acceptable service quality are two different things. When the quality of product or service goes wrong, taking ownership of accountability also matters. With the advancements in technology, an aggregation platform is able to route all the transactions (money) through, collect money from customers, keep its fees, and pass on money to the actual service provider. While the overall transaction value that gets routed through the platform can be very high, the share of value that it gets to keep in its P&L is usually very small - roughly 10%-15%.
While one may chose to report all the transactional value as Revenue in their P&L and calculate valuation as a multiple of that, but it does not change the fundamental value distribution amongst all the participants in the ecosystem.
Thus, in a later section we will argue that even in early stages aggregation businesses must be valued using their contribution margins and what these margins can look at scale rather than by using their gross booking value numbers.
Curious Case Of Asset Light Models
We have heard this term multiple times this seems to be quite a popular model in new age entrepreneurs.
The common thinking is as below:
One can create an asset light business without doing Capital Expenditure but by getting access to an infrastructure that exists. It is usually easy to do this in a scenario where the core infrastructure may not be performing well or may be sitting idle. Thus in this case, usually revenue-sharing or profit-sharing deal is struck with the owner of the asset. Or somebody may be ready to invest in an infrastructure expecting a fixed return on their investments. In such cases, it becomes mostly a rental deal.
Look at this from a technical point of view. Below, things happen.
Assume a company 'A' running an asset-light model and coordinating with multiple infrastructure owners to be able to generate demand on those assets.
The Capital Expenditure (Capex) related to those assets sits in the books of the infrastructure owners.
Company A takes care of the sales, marketing, and other management aspects on top of the infrastructure.
Because revenue share is being promised or a rental has been figured out the overall expense on the P&L moves from depreciation cost to a variable cost that sits above EBITDA.
But the net effect on the PAT remains almost the same.
In the case of deals like revenue-sharing deals or profit-sharing deals, the revenue or profit gets proportioned as per the percentages defined, which means that the overall operating leverage decreases on the P&L.
Is this a good way of doing business? This is subject to discussions.
But the important point here is that, even in this model, the concept of principal versus agent comes into the picture.
From a technical point of view, all the revenue may be collected by Company A and can be shown as a principal on the accounting books.
But if company A doesn't control the overall service delivery level and does not take responsibility for delivering the services consistently, even though it shows itself as a principal, it may actually be acting as an agent.