As an investor, what we’re not looking for is ‘oh this is a cool app,’ it’s ‘is this something that can become a big business?’ You need to find those that can become real businesses. – Niklas Zennstrom
I came across a document by Elizabeth Yin, the co-founder and General Partner at Hustle Fund, about how to raise a seed round and started reading. And it reminded me about some very basic concepts that we should keep in mind when thinking about business models.
There are five things in particular.
1. The purpose of a business is to create a customer
Peter Drucker said this – your business needs to create and keep customers. An idea is not a business. An idea that serves a market can be. That’s why one of the most important things you can spend time on is getting market-product fit – understanding what someone needs so that you can build a product or service they will buy.
2. Think about the lifetime value of each customer
Lifetime value or LTV is the total amount of money you will make from a customer if they stay and buy from you again and again. It’s too easy to focus on the first sale but it’s the repeat ones where you make your money.
3. How much does it cost you to aquire a customer?
You are always going to have to buy your customers the first time they deal with you. You spend money on sales and marketing, on promotion and advertising, to get them through the door and do that first deal. The commission you pay is part of the price to acquire them.
How much should you spend to acquire a customer? Well, mathematically you should be willing to spend upto a fraction under the net present value of their lifetime value. For example let’s say you get a customer who spents $1,000 with you for five years on average. That $5k over five years is worth perhaps $3k in today’s money with a fairly aggressive inflation factor. So, you could spend $2,999 on getting the customer and walk away with $1 in profit. Not that good – but still a profit.
The important point is that knowing lifetime value will help you avoid making sales mistakes. For example, you might only be willing to spend 20% of your sale in advertising revenue. If you think of the sale as $1,000 that means you might spend $200 in advertising. If you see the total value of a customer as being $3,000, however, you might be willing to spend $600. And that extra spend might be what is needed to get your growth revved up.
Which takes us to the next point.
4. It’s all about speed
The faster you grow your customers the more interesting you are to investors. Growth is what matters. If you have a good product, well, that’s a start. If customers are grabbing it out of your hands – that’s great.
5. Have you got a moat?
A moat is the thing that protects you – it’s the barrier to entry that stops others who see you doing well coming along and copying what you have. Some moats are legal – such as copyrights and patents. Others are less tangible but still real – like brand or trust. Regardless of what it is the best source of competitive advantage is having an effective monopoloy – doing something that no one else can do like you.
Pulling it all together
These ideas make a good checklist to see if you should invest in starting a business. If you’ve identified a set of customers that will buy and buy what you sell again, if you can acquire them, if you can move and grow fast, and if you can protect the business from competitors who want your market – then you have something that investors will also want. And you have just increased your chances of creating something sustainable.