What is a ‘proven business model’?

By Johnny Hewett, CEO Smedvig Capital, originally posted on www.growthbusiness.co.uk

Determining what is a quantifiably sound business model is hard work for both entrepreneurs and investors.

Like many development capital stage investors, in contrast to seed investors, we state the need for evidence of a proven business model before investing. One of the questions we frequently get asked is, ‘what does proven business model actually mean?’

The easy answer is to give a run rate revenue number (with £2 million plus being a good proxy at Smedvig Capital), but in practice it is more nuanced than that and we frequently move away from that number in both directions.

Obviously different firms approach this in very different ways but there are two main questions that are likely to be consistently required to be answered for a business model to be ‘proven’.

First, as Rob Ryan put it in his book on entrepreneurship, ‘Will the dogs eat the dog food?’, which translates: can it be demonstrated that customers like the product (or service) offered, and like it sufficiently at the price offered that a high percentage of them come back for more of it?

Second, can the company produce or provide that ‘dog food’ at high enough gross margin to a big enough potential target universe to make the economics of the business attractive in the medium to long term?

Both questions are clearly vital; if the business is not fulfilling a customer need effectively, there will be no customers but if it can’t be delivered in a financially interesting way and with a large enough potential scale, then satisfying a customer need is not going to be relevant for very long.

The above sounds more straightforward when written than perhaps it is in the real world. Many complexities exist when seeking something like demonstrating customer loyalty. Customer loyalty is critical in distinguishing one-off trial versus long-term value to the customer. However, whilst easier for products purchased frequently, where there are long intervals between purchase it is harder.

In those circumstances, other methodologies have to be used including primary research. Likewise, what is an attractive enough gross margin is non-straightforward. For most products and services it may evolve with scale/time but it is the right starting point from which assumptions can be made about its likely evolution along with other elements of the P&L. The latter, though vital, with long experience in many industries can be reasonably forecast, so the assessment of what constitutes an attractive enough gross margin for a given industry or business model is one with which we are comfortable.

It is perhaps worth mentioning a couple of watch outs. On occasion, the evidence of a proven business model is presented as the demonstration that it has worked successfully for another business in another market. This can often be a very helpful additional piece of evidence but, equally often, there are so many different variables at play that it does not really demonstrate convincingly that it can work in a completely different market.

Similarly, we often see early-stage businesses with low priced (i.e. low gross margin) contracts which are presented as evidence of demand. However, this is only evidence of demand at that price – of course, many early stage companies do go on to raise prices, but one shouldn’t assume that demand is fully elastic with pricing.

Hence, a ‘proven business model’ is not really about a revenue level, £2 million or otherwise. In some situations, a low revenue figure (<£1 million) can often suffice if it includes a large number of customers, who regularly repeat purchase, with a price that yields an attractive gross margin. By comparison, a large revenue number (£5 million plus) which is based on a contract with a single customer at a low gross margin, may show a number of things but would not necessarily constitute, in our mind, a proven business model.