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Clockwork Perspectives

Diligence Series: Breaking Apart the Business Model

We’re back again with another installment of the Diligence Series. Today we’re here to talk about the Business Model. Let’s have a little fun and look at a car as a metaphor for a moment. If the Value Proposition is the destination, the team is the Driver, and the Market Context is the combination of the weather, traffic, and terrain, the Business Model is most certainly the engine and motive components. The Business Model presents the mechanics of how the drivers (Team) will traverse the landscape (Market) to make it to the desired destination (Value Proposition / Opportunity). We can have the best people, the best weather, and the sweetest dreams of the destination, but without the vehicle we aren’t going anywhere.

Breaking Apart the Business Model

Just as the car takes various inputs (fuel, oil, air, coolant, etc.) to create desired outcomes (motion), so too does the Business Model of a business depend on the inputs of time, materials, relationships, sales, etc. to produce motion (growth, income, success). Now in the realm of due diligence, if we’re going to understand the health of the engine underneath the hood of the car we have to grab our wrenches, open up the hood, and prepare to get a little dirty. The process of inspecting a Business Model involves taking apart the different components of the engine to see how they fit together, find out where there’s friction, and run some tests to explore performance.

Motor

The core contemplation of Business Model due diligence investigates:

  • How sustainable is the proposed business model and would it be expected to perform well as structured?
  • If applicable, do past milestones and performance lend confidence to momentum and future success?

To explore these we’re going to study two primary topics:

  • Business Model Mechanics & Achievements
  • Financial Traction / Performance, Projections and Assumptions

Business Model Mechanics & Achievements

Business Model mechanics encompass all the factors that dictate the “how” for the business. For example, a coffee shop’s business model mechanics might explore the costs of ingredients, goods from other vendors, service staff, facility costs, sale prices, and estimated customer volume and operating hours to begin to clarify how all of the dollars and cents are going to line out in terms of operating and profit margins. Before getting lost in all of these aspects, it’s best to start simply: how is the company going to generate revenue in practice?

Team meeting

Taking it a bit further: what is sold, to whom, and at what price? What are the margins? Discuss these, analyze them. More specifically, what type of business we’re looking at will also dictate some of the fundamental questions asked. Is the company selling a SaaS or subscription product? What is the pricing model and does it make sense for the delivered value? Or is the company selling hardware? What are the material costs and sales margins? Or rather is the company selling space? What is the pricing structure across different spaces? What key OpEx or CapEx is required to build and maintain the space? Is the company making money off of transactions made in a marketplace it sponsors? What are the average transaction sizes expected, and therefore average revenue per transaction metrics expected?

As you can see, these sample questions are formulated to start to explore the formulaic structure of business operations. How is it all going to work in practice? How will income be generated? For how long will the business need to run in the red before it turns a profit? These questions start to help to clarify the justification behind the sizing of the fundraising target proposed by company leadership. Ultimately, answering many of these types of questions will bring us closer to our desired assessment conclusion, which is gauging our comfort level with how the business model is intended to work, determining whether it is appropriate as structured, and identifying if the company is innovating or novel in its approach to a degree that sweetens the prospect of the investment opportunity according to our assessment criteria.

Financial Traction, Performance, Projections and Assumptions

A company may have the sexiest business model on paper, but as the proverbial saying goes: the proof is in the pudding. What does performance look like to date? This may not always be available for assessment, especially if the company is raising earlier rounds of capital where most of what’s proposed is mapped out in theory with little to no practice. In these cases you may only be left with projections, which should always be taken with a healthy dose of criticality and an eye toward the level of conservatism baked into the underlying assumptions upon which the entire model is based.

Telescope

Here are some guiding questions to get you started when looking at financial traction and projections:

  • Has the company generated actual business model / sales traction? How much over how long? What does the momentum look like?
  • How much activity is there? Are there key metrics or figures that catch attention positively or negatively?
  • Has the company created financial projections? Do the projections seem reasonable and are the assumptions based on real traction or assumption only? How reasonable are the underlying assumptions?

Telescoping into the future is a dangerous game, especially if you are easily swayed by big ticket numbers pasted in financial projections. It’s best to place more weight on fundamental model mechanics and build your own conclusions on the reasonableness of the financial opportunity given market conditions, team ability to execute, and general belief in the attractiveness of the value proposition.

Good luck out there. Thanks for joining us and see you next time!

Black and white photo of leaves

Author: PATRICK ZAILCKAS

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