One of the "golden rules" of investing we have at our firm, Cue Ball, is that we value the business model over the financial plan. In fact, we value the business model over any particular sector for investment and like to say that we are "business model driven" (versus sector-driven). There is not necessarily a consistent definition for business model, but the Wiki definition is good enough. It says a business model is "the rationale of how an organization creates, delivers, and captures value." Consistent with this definition, we see the business model as the explanation of how a firm translates an idea into value, or more bluntly, into money. There is no doubt that at the heart of a business model is the monetization model.
Over the years we have learned that having a business does not necessarily mean that you have a business model. Think of the dot-com heyday, when shipping 89-cent pet food in an $18 FedEx package was a business. (Some of that delusional hubris has resurged in some recent online media businesses that believe that you can wait to figure out how you'll make money). Some call us an old school VC, but if you come knocking at our door looking to pitch your idea, you have to have clarity on how you are going to make money from your idea -- cash flow is still the basis for a sound business the last time we checked.
In our previous lives running businesses, my partners and I have seen and experienced one business model that we love the best, based on fundamental cash flow and the ability to grow that cash flow as the business scales.
Here it is: recurring revenue + fixed cost leverage = superior cash flow.
If you can find a business that has highly repeatable revenues (and often paying in advance for that recurring revenue) and if you can keep your CAPEX to, say, less than 10%, then you probably have a winner. Businesses that capture this model are often correlated with some differentiated form of intellectual property (IP). Think about examples such as royalties from content; franchise fees from multi-unit branded chains; subscription revenues from software applications, licensing fees from brands, and licensing fees from technology or patents.
The unifying theme between all of these examples is that there is usually an upfront investment to develop some form of the IP (content, software, brands, retail formats, or technology) and once that is developed and proven there is an ability to charge for that product or service on a recurring fee basis. This is not necessarily a cheap investment but if you get it right, you create a defensible moat based on the IP created. From that point on, so long as on-going research and development and CAPEX can be managed, there is tremendous leverage in this model.
The buzz around SaaS (software as a service) is driven by the attractiveness of this "build once run many times" model whereby the marginal cost of each incremental sale is diminutive. It is no coincidence that the most generous philanthropist and one of the world's richest men, Bill Gates, practices this business model.
During my years of working with my partner Dick Harrington at The Thomson Corporation (now Thomson-Reuters), we focused on finding and building "must-have" information services that held the potential for highly repeatable revenue. Understanding that this was the goal, we focused maniacally on the metric of what percent of our revenue represented recurring revenue. Businesses that offer something that is "must have" often exhibit recurring revenue of greater than 90 percent and that is what we eventually achieved across most of our businesses at Thomson. Or put another way, less than 10 percent of customers churn each year. We rarely consider a business model that is not approaching at least 75 percent recurring revenue, with the potential to get over 90 percent.
Another attractive characteristic of this model is that you often get the cash upfront. Consider subscriptions that get renewed and paid before the delivery of those services. While you need to recognize the revenue as services are delivered you have the benefit of upfront cash. As the digital age rapidly evolves, we are inspired and keep a close eye to those changes. But the most important thing for us is to see if those technologies and new businesses can have a rational business model.
There are of course examples of businesses that have had extraordinary valuations and liquidations events before they have demonstrated the soundness of a business model. But those businesses are more dependent on timing of value capture than the stability of true customer value and real sustainable cash flow generation.
But a business model where you get the vast majority of your customers coming back every year, where the cost to deliver an additional customer approaches zero at scale, and where you get a lot of the cash upfront -- what more can you ask for? This is a business model we love and it may indeed be the best business model in the world.
This article first appeared on Harvard Business Publishing on March 18, 2010.
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